Chapter 8 International trade

Chapter 8 International trade
Economics Chapter 8 International trade

International trade Trade: Exchange of goods and services
Exchange of goods and services between countries or regions. Example 1. USA and China USA sells computer to China China sells garment to USA 2. HK and other regions exports electronics goods Imports rice and cars

International trade

International trade Term of trade (in terms of goods exchange)
Measure of amount of import can be exchanged by one unit of export (to exporting country) E.g. Export of clothes = 10 units Import of food = 50 units Then terms of trade = 50 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑓𝑜𝑜𝑑 10 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑐𝑙𝑜𝑡ℎ𝑒𝑠 Usually expressed as: 1 unit of clothes = 5 units of food

Mutual benefits Why trading?  Mutual benefits
Free trade benefits both buyers and sellers. Exporting country will gain from Px > Production cost, PX > PL Importing country will gain from PM < Production cost, PM < PL HK USA Trade? If exports / imports Loss  Gain 

Absolute advantage Definition Adam Smith 2 definitions
If a country can produce more Good X than other countries by using the same amount of resources, then this country has an absolute advantage in producing Good X. If a country can produce the same amount of a good with fewer resources than another country, then this country has an absolute advantage in producing Good X.

Absolute advantage Definition Given the same input of resources:
 China has an absolute advantage in producing Good X Conversely, USA has an absolute disadvantage. China USA Production of Good X 1,000 units 300 units

Absolute advantage Comparison of same goods among countries.
Determined by productivity. Technologically advanced  higher productivity in all good  absolute advantage Conversely, low level technology  low productivity  absolute disadvantage

Absolute advantage Each unit of resources can produce: Good X (units)
Good Y (units) Country A 85 or 25 Country B 120 40 Yes No a. Country B must have more resources.  b. Country B is more technologically advanced. c. Country B must have a higher total output than Country A. d. Country B has an absolute advantage in the production of both goods. e. Country B has an absolute advantage in producing Good X since each unit of resources can produce more X than Y. ∵ Compare the same goods among countries

Case study: Absolute advantage
Suppose Japan and USA both have 2,000 units of resources. They use half of their resource (1,000 units) to produce food and clothes on their own. Total resources (units) Total production of food (units) Total production of clothes (units) USA 2,000 5,000 and 6,000 Japan 4,000 8,000 Total output - 9,000 14,000

Each unit of resources can produce: For each unit of resources USA produce more food than Japan  USA has absolute advantage on food  Japan has absolute disadvantage on food Japan produce more clothes than USA  Japan has absolute advantage on clothes  USA has absolute disadvantage on clothes Food (units) Clothes (units) USA 5 or 6 Japan 4 8

Suppose Japan and USA specialize on producing goods with absolute advantages, i.e. USA uses all the resources to produce food. Japan uses all the resources to produce clothes. Total output of food and clothes  Total resources (units) Total production of food (units) Total production of clothes (units) USA 2,000 10,000 and Japan 16,000 Total output -

Suppose USA exchanges 4,500 units of food for 7,000 units of clothes with Japan. After international trade: Compare with the output before trade: Total resources (units) Total production of food (units) Total production of clothes (units) USA 2,000 5,500 and 7,000 Japan 4,500 9,000 Total output - 10,000 16,000 Total resources (units) Total production of food (units) Total production of clothes (units) USA 2,000 5,000 and 6,000 Japan 4,000 8,000 Total output - 9,000 14,000

Assume that Free trade No transaction cost Through international trade USA gains Japan gains 500 units of food  units of food 1,000 units of clothes  1,000 units of clothes Total output  1,000 units of food  2,000 units of clothes Conclusion Specialize in production of goods with absolute advantage Mutual benefits

Comparative advantage
Definition David Ricardo A country can produce Good X at a lower opportunity cost than other countries. Limitation of the principle of absolute advantage A technologically advanced country  Absolute advantage in all goods  Why import??? E.g. Japan has high level of technology Absolute advantage in all goods, but still imports from other countries

Each unit of resources can produce: Country A has absolute advantage in both Good X and Y. Good X (units) Good Y (units) Country A 50 or 25 Country B 10 2

With same units of resources Calculating the opportunity cost in Country A To product 50 units of Good X  give up producing 25 units of Good Y  Opportunity cost of producing 1X = Y = 0.5Y To product 25 units of Good Y  give up producing 50 units of Good X  Opportunity cost of producing 1Y = X = 2X

Convert the table to show the opportunity cost: Good X (units) Good Y (units) Country A 50 or 25 Country B 10 2 Good X Good Y Country A or Country B Table 8.2: Unit costs of producing Good X and Y in Country A and B.

Good X Good Y Country A 0.5Y or 2X Country B 0.2Y 5X Table 8.2: Unit costs of producing Good X and Y in Country A and B. Country A has a lower opportunity cost in producing Good Y. Country A has comparative advantage in Good Y. Country B has lower opportunity cost in producing Good X. Country B has comparative advantage in Good X. No country can have a comparative advantage in all goods. Low opportunity cost in Good X  High opportunity cost in Good Y

Textbook p.36 Each unit of resources can produce: Good X (units) Good Y (units) Country A 6,000 or 7,200 Country B 4,000 Good X Good Y Country A or Country B Table 8.2: Unit costs of producing Good X and Y in Country A and B.

Each unit of resources can produce: Good X (units) Good Y (units) Country A 6,000 or 7,200 Country B 4,000 Yes No a. Country A has more resources.  b. Country A has an absolute advantage in producing Good X. c. Country A has a comparative advantage in producing Good X. d. Country A has a comparative disadvantage in producing Good X. e. Country A has a comparative advantage in producing Good X since the opportunity cost of producing Good X is lower than that of Good Y. ∵ Compare the same goods among countries

Absolute advantage & Comparative advantage
A country with high productivity (usu.  technology) Can be all types of goods Comparative advantage A country with lower costs in producing a certain kind of goods Comparatively a certain kinds of goods only

Principle of comparative advantage
If a country specializes in and exports goods in which it has a comparative advantage, and imports goods in which it has comparative disadvantage, the world’s total output will increase and both countries will benefit.

Assumptions Only 2 countries, Country A and Country B Only 2 types of goods, Goods X and Goods Y Amount of goods produced by each unit of resources is fixed Barter system (exchange of goods) No transaction cost

Good X Good Y Country A 0.5Y or 2X Country B 0.2Y 5X Table 8.2: Unit costs of producing Good X and Y in Country A and B. Country A vs. Country B Produce 1X 0.5Y 0.2Y Produce 1Y 2X 5X Table 8.3: Unit costs of Country A and B. Lower cost B should produce Good X Lower cost A should produce Good Y

Therefore, after specialization: Country A Country B Specialize production in Good Y Good X Exports Imports

After specialization (Good X) Good X Good Y Country A 0.5Y or 2X Country B 0.2Y 5X Table 8.2: Unit costs of producing Good X and Y in Country A and B. Effect on Good X Effect on Good Y Country A produces 1 less unit of X - 1X +0.5Y Country B produces 1 more unit of X +1X -0.2Y Total output Unchanged +0.3Y

After specialization (Good Y) Country A vs. Country B Produce 1X 0.5Y 0.2Y Produce 1Y 2X 5X Table 8.3: Unit costs of Country A and B. Effect on Good X Effect on Good Y Country A produces 1 more unit of Y - 2X +1Y Country B produces 1 less unit of Y +5X -1Y Total output +3X Unchanged

Potential gain from trade
Potential gain (highest possible gain) Gain before deducting the cost (transaction cost) of trade, such as transportation costs If transaction cost is involved, Actual gain < Potential gain

After specialization (Good X) Cost saved by Country A = 0.5Y Cost paid by Country B = 0.2Y World Total cost saving = 0.3Y Total increase in output = World total cost saving = 0.3Y Effect on Good X Effect on Good Y Country A produces 1 less unit of X - 1X +0.5Y Country B produces 1 more unit of X +1X -0.2Y Total output Unchanged +0.3Y

From the example: Countries specialize in producing goods with lower opportunity cost International trade is mutually beneficial to 2 countries Potential gain form trade = Cost difference between 2 countries = 0.3Y Next questions: Which country gains more? Is the gain evenly distributed among 2 countries?

Terms of trade determine the distribution of gains
Before trade: Suppose the terms of trade: 1X = 0.4Y Trade. Total gain is shared by Country A (0.1Y) & B (0.2Y) Country A vs. Country B Produce 1X 0.5Y 0.2Y Produce 1Y 2X 5X Table 8.3: Unit costs of Country A and B. Country A’s gain from importing 1X Domestic cost of 1X 0.5Y Import price 0.4Y Cost saved 0.1Y Country B’s gain from exporting 1X Domestic cost of 1X 0.2Y Export price 0.4Y Gain

Before trade: Suppose the terms of trade: 1X = 0.3Y Trade. Total gain is shared by Country A (0.2Y) & B (0.1Y) Country A vs. Country B Produce 1X 0.5Y 0.2Y Produce 1Y 2X 5X Table 8.3: Unit costs of Country A and B. Country A’s gain from importing 1X Domestic cost of 1X 0.5Y Import price 0.3Y Cost saved 0.2Y Country B’s gain from exporting 1X Domestic cost of 1X 0.2Y Export price 0.3Y Gain 0.1Y

Before trade: Suppose the terms of trade: 1X = 0.1Y No trade. Country B will lose if trading. Country A vs. Country B Produce 1X 0.5Y 0.2Y Produce 1Y 2X 5X Table 8.3: Unit costs of Country A and B. Country A’s gain from importing 1X Domestic cost of 1X 0.5Y Import price 0.1Y Cost saved 0.4Y Country B’s gain from exporting 1X Domestic cost of 1X 0.2Y Export price 0.1Y Loss

Case study (textbook p.39)
Given the domestic costs: Country A: 1Y = 2X and Country B: 1Y = 5X Country A exports Good Y, because opportunity cost is lower. Conversely, Country B exports Good X. Opportunity cost Country A Country B Produce 1X 0.5Y 0.2Y Produce 1Y 2X 5X Term of trade Exports Y A’s gain B’gain 1Y = 1X No trade - 1Y = 2X Country A 3X 1Y = 3X 1X 2X 1Y = 4X 1Y = 5X 1Y = 6X Mutual benefits

Case study (textbook p.39)
Conclusion Mutual benefits Cost of importers > Terms of trade > Cost of exporters If term of trade = Cost of importer Importer’s gain = 0 Exporter’s gain = max. (i.e. potential gain) If term of trade = Cost of exporter Importer’s gain = max. (i.e. potential gain) Exporter’s gain = 0 If term of trade > cost of importer or term of trade < cost of exporter No trade Determination of term of trade Depends on the bargaining power of the countries E.g. Bilateral trade negotiations bet. USA and China

Conditions for mutually beneficial trade
Each party has a comparative advantage Different opportunity costs in producing different goods Mutual beneficial terms of trade Terms of trade lies between domestic costs of both parties Cost of importer > Terms of trade > Cost of exporter Reasonable cost of trade Low transaction cost Transportation Negotiation Trade protection policies

Exam question Country A and Country B each have 100 units of resources. Country A allocates 40% of resources to produce A4 paper and the remaining resources to produce tissue paper. Country B uses half of its resources to produce A4 paper and half to produce tissue paper. The table below shows the output of Country A and B: a. Which country has an absolute advantage in producing A4 paper? Explain. (3 marks) b. Which country has a comparative advantage in producing tissue paper? Explain. (3 marks) c. What should the two country exports? Assume there is no other cost of exchange, what is the range of terms of trade between Country A and Country B for every unit of tissue paper in order to achieve mutual benefits? (3 marks). A4 paper (units) Tissue paper (units) Country A 40 AND 480 Country B 120 300

Exam question a. Which country has an absolute advantage in producing A4 paper? Explain. (3 marks) Ans. Suppose all resources are used to produce only one kind of product: (i.e. if Country A uses all her resources to produce one kind of goods only) Given the same resources, Country B can produce more A4 paper than Country A. So, Country B has an absolute advantage in producing A4 paper. A4 paper (units) Tissue paper (units) Country A 100 OR 800 Country B 240 600

Exam question b. Which country has a comparative advantage in producing tissue paper? Explain. (3 marks) Ans. From (a) The opportunity cost of producing each kind of products: The opportunity cost of producing 1 unit of tissue paper in Country A = 100/800 unit of A4 paper = unit of A4 paper The opportunity cost of producing 1 unit of tissue paper in Country B = 240/600 unit of A4 paper = 0.4 unit of A4 paper Since the opportunity cost of producing tissue paper in lower in Country A, Country A has a comparative advantage in producing tissue paper. A4 paper (units) Tissue paper (units) Country A 100 OR 800 Country B 240 600 1 unit of A4 paper 1 unit of Tissue paper Country A 8 units of tissue paper 0.125 unit of A4 paper Country B 2.5 units of tissue paper 0.4 unit of A4 paper

Exam question c. What should the two country export? Assume there is no other cost of exchange, what is the range of terms of trade between Country A and Country B for every unit of tissue paper in order to achieve mutual benefits? (3 marks). Ans. Since Country A has a comparative advantage in producing tissue paper and Country B has an absolute advantage in producing A4 paper, Country A should export tissue paper and Country B should export A4 paper. The term of trade is 0.4 unit of A4 paper > 1 unit of tissue paper > unit of A4 paper or 8 units of tissue paper > 1 unit of A4 paper > 2.5 units of tissue paper Assuming that there is no other (transaction) costs involved.

Advantages of international trade
Social development Exchange of products Native products E.g. teapots, art-crafts Cultural interflow Cultural exchange during communication and negotiation E.g. Western businessmen learn Chinese culture

Advantages of international trade
Economical aspect Comparative advantage Lower cost Specialization More experience and knowledge Better use of technology Economies of scales Specialization allows increasing scale of production Thus, lower average cost Technological interflow Trade enhance technological interflow Higher productivity Enhancement of competition Higher quality of domestic products Lower cost to produce domestic products with advanced technology

The effects of exchange rate on international trade
Think about this: A Japanese car costs ¥1,500,000 Assume the exchange rate is HKD1 = JPY10 How much should a HK citizen pay for this car in terms of HKD? HK$ 1 can be converted into JP¥ 10  The car costs HK$1,500,000 / 10 = HK$150,000 If HKD depreciates against JPY, what do you think about the price of the car in terms of HKD? If the exchange rate is now HKD1=JPY9, The car costs HK$1,500,000 / 9 = HK$166,666.67 The same car, but the price . HK people suffer.

Think about this: Assume you have no special preference towards rice from different countries. If HKD depreciates against AUD, and HKD appreciates against THB (Thai Baht). Which one will you choose? Why?

Depreciation and exports
Suppose garments are exported to Europe. Price of garment made in HK = HK$100 Exchange rate: HK$100 = €11 Export price = €11 HKD depreciation: Exchange rate: HK$100 = €10 Local price = HK$100 Export price = €10 Price   Qd (Law of demand) That is, quantity demanded of HK garment export increases. P (€) HK garments 11 10 Export volume Q1 Q2

Appreciation and exports
Suppose garments are exported to Europe. Price of garment made in HK = HK$100 Exchange rate: HK$100 = €11 Export price = €11 HKD appreciation: Exchange rate: HK$100 = €12 Local price = HK$100 Export price = $100 = €12 Price  Qd (Law of demand) That is, quantity demanded of HK garment export decreases. P (€) HK garments 12 11 Export volume Q2 Q1

Depreciation and imports
Suppose watches are imported from Europe. Price of European watch = €110 Exchange rate: HK$100 = €11 Import price = HK$1000 HKD depreciation: Exchange rate: HK$100 = €10 Import price = $110 x (100/10) = HK$1100 Price   Qd (Law of demand) That is, quantity demanded of European watches import decreases. P ($) European watches 1100 1000 Import volume Q2 Q1

Appreciation and imports
Suppose watches are imported from Europe. Price of European watch = €110 Exchange rate: HK$100 = €11 Import price = HK$1000 HKD appreciation: Exchange rate: HK$100 = €12 Import price = $110 x (100/12) = HK$916.7 Price  Qd (Law of demand) That is, quantity demanded of European watches import increases. P ($) European watches 1000 916.7 Import volume Q1 Q2

Summary Case study in textbook p.46: Change in revenue which is brought be depreciation or appreciation depends on the price elasticity of demand. Try yourself!!! Exports Imports Price Qd Depreciation   Appreciation

Trade in Hong Kong Merchandise trade (Goods) Exports Garments
Electronic products Toys Jewellery (accounted for more than 60% of total domestic exports in 2008)

Trade in Hong Kong Merchandise trade (Goods) Retained imports
Raw materials (e.g. gold, silver) Semi-finished goods (e.g. LCD display, plastic button) Capital goods (e.g. truck, machine) Consumption goods (e.g. clothes, TV) Fuel Food (accounted for more than 99% of total retained imports in 2008)

Trade in Hong Kong Trade in services
Exports of services (Exports have higher value than imports) Financial consultation Commerce Accounting Transportation Entertainment Imports of services (Imports have higher value than exports) Tourism Insurance

Trade in Hong Kong Major trading partners Total trade volume
Import suppliers Export markets Re-exports Sources Destinations The Mainland USA Japan Taiwan Netherlands Korea UK Germany Value of goods High Low

Trade in Hong Kong Trade based on comparative advantage
Low opportunity cost: Exports Goods (e.g. garments, electronic products) Services Low opportunity cost: Re-exports High opportunity cost: Imports Goods (e.g. capital goods)

Importance of trade to Hong Kong’s economy
Acquiring consumption goods and raw materials HK is lack of resources Rely on imports Hugh demand of daily necessities (e.g. food) and raw materials (e.g. coal) Favourable to the development of high value-added industries HK has comparative advantage in specializing in value-added industries E.g. finance and commercial industrials

Importance of trade to Hong Kong’s economy
Trade generates huge income In 2010, GDP = $1,748.1billion International trade is very important to HK economy Exports Value of exports of goods = $3,061.3 billion (175.1% of GDP) Value of exports of services = $835.0 billion (47.8% of GDP) Imports Value of imports of goods = $3,395.1 billion (194.2% of GDP) Value of imports of services = $396.6 billion (22.7% of GDP)

Pros and Cons of free trade
Consumers More choices Cheaper and higher quality imported goods Workers Products can be sold worldwide  More job opportunity More profits  Higher wages Businessmen Open new markets  More profits Owners of Trading firm More business for the company Service providers (e.g. banks, transportation firms) More business More income

Pros and Cons of free trade
Workers Keen international competition  Close down of factories  unemployment or  less profits  Lower wages Local famers Large quantity imported farm products  Less sales  Poor livelihood Local consumers High quality products are for exports  Buy only low quality products locally

Chapter 8 International trade

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