2. Foundations of Modern Trade Theory: Comparative Advantage2

3. Chapter Outline (1 of 2) Historical Development of Modern Trade Theory
Production Possibilities Schedules
Trading Under Constant Cost Conditions
Dynamic Gains from Trade
Changing Comparative Advantage
The Impact of Trade on Jobs
Wooster, Ohio, Bears the Brunt of Globalization

4. Chapter Outline (2 of 2)
Comparative Advantage Extended to Many Products & Countries
Exit Barriers
Empirical Evidence on Comparative Advantage
Comparative Advantage & Global Supply Chains

5. Historical Development of Modern Trade Theory (1 of 7)
The Mercantilists,
Promoted a favorable trade balance by encouraging exports and discouraging imports
Sought rise in domestic output and employment
Advocated government regulation of trade (tariffs, quotas, other commercial policies)
Held static view of world economy

6. Historical Development of Modern Trade Theory (2 of 7)
Criticisms of Mercantilism
David Hume’s price-specie-flow doctrine
A favorable trade balance is possible only in short run
Adam Smith, The Wealth of Nations (1776)
World’s wealth is not a fixed quantity
International trade increases general level of productivity within a country as well as increases world output

7. Historical Development of Modern Trade Theory (3 of 7)
Why Nations Trade? Absolute Advantage
Assumption:
Production costs differ among nations due to different productivities of factor inputs
Absolute Cost Advantage
Countries that use less labor to produce one unit of output
Labor theory of value – assumes that within a nation, labor is the only factor of production

8. Historical Development of Modern Trade Theory (4 of 7)
Principle of Absolute Advantage
Consider two-nation, two-product world
Each nation produces a good absolutely more efficiently than its trading partner
With trade and specialization
Countries export goods – if have absolute cost advantage
Countries import goods – if have absolute cost disadvantage

9. 2.1 A Case of Absolute Advantage…

10. Historical Development of Modern Trade Theory (5 of 7)
Principle of Comparative Advantage
Emphasizes relative cost differences based on opportunity costs; the basis for trade
Trade is possible even if a nation has an absolute cost disadvantage in production of both goods
The more efficient nation
Specializes and exports goods in which it is relatively more efficient or where its absolute advantage is greatest
The less efficient nation
Specializes and exports the good in which it is relatively less inefficient or where its absolute disadvantage is least

11. 2.2 Examples of Comparative Advantage…

12. Historical Development of Modern Trade Theory (6 of 7)
Principle of Comparative Advantage Simplified model; assumptions:
1. World consists of 2 nations and 2 goods.
2. Labor, fully employed & homogenous, is sole input.
3. Labor can move freely only within nation.
4. Technology fixed for both nations; all firms within nation utilize common production methods.
5. Costs proportional to amount of labor used and do not vary with level of production.
6. Perfect competition prevails in all markets; firms are price takers; products are identical.

13. Historical Development of Modern Trade Theory (7 of 7)
Principle of Comparative Advantage Simplified model; assumptions:
7. Free trade occurs between nations; no barriers.
8. Transportation costs zero, so consumers don’t care whether domestically produced or imported.
9. Firms make production decisions attempting to maximize profits; consumers maximize satisfaction.
10. No money illusion; consumers and firms take account of all prices in their decisions.
11. Trade is balanced (exports pay for imports), implying no money flows between nations.

14. 2.3 Comparative Advantage when U.S. has Absolute Advantage…

15. Production Possibilities Schedules (1 of 2)
Various alternative combinations of goods a nation can produce when all factors of production are employed to maximum efficiency
Maximum output possibilities of a nation, given resource constraints, level of technology

16. Production Possibilities Schedules (2 of 2)
Marginal rate of transformation (MRT)
The amount of a good a nation must sacrifice to obtain an additional unit of another good
Rate of sacrifice = opportunity cost of a product
MRT equals the absolute value of slope of production possibilities schedule

17. Trading Under Constant-Cost Conditions (1 of 10)
Constant opportunity costs
Straight line production possibilities schedules
Factors of production perfect substitutes, and all units of a factor are of same quality
Autarky
Absence of trade
Specialization and trade result in production gains

18. 2.4 Gains from Specialization & Trade…

19. Trading Under Constant-Cost Conditions (2 of 10)
Consumption Gains from Trade
Consumption gains for both countries
Consumption points:
Beyond domestic production possibilities schedules, so countries consume more of both goods
Terms of Trade
Rate at which country’s export product is traded for other country’s export product
Defines relative prices of the two products

20. Trading Under Constant-Cost Conditions (3 of 10)
Domestic rate of transformation
Domestic terms of trade
Slope of production possibilities schedule
Relative prices at which the two commodities can be exchanged at home
Terms of Trade for exports
For country to consume beyond production possibilities schedule, international terms of trade must be more favorable than domestic terms of trade

21. Trading Under Constant-Cost Conditions (4 of 10)
Trading possibilities line
International terms of trade for both countries
Trade triangle for a country
Exports – along horizontal axis
Imports – along vertical axis
Terms of trade equal to slope
Complete specialization
Produces only one product

22. Trading Under Constant-Cost Conditions (5 of 10)
Domestic cost ratio
Negatively sloped production possibilities schedule
Transforms into a positively sloped cost-ratio line
Sets outer limits for equilibrium terms of trade
Constitutes the no-trade boundary
Region of mutually beneficial trade bounded by cost ratios of the two countries

23. 2.2 Equilibrium Terms-of-Trade Limits

24. Trading Under Constant-Cost Conditions (6 of 10)
Equilibrium Terms of Trade
Theory of Reciprocal Demand
Within outer limits of the terms of trade, actual terms of trade determined by relative strength of each country’s demand for other country’s product
Production costs determine outer limits of terms of trade
Reciprocal demand determines what actual terms of trade will be within those limits

25. Trading Under Constant-Cost Conditions (7 of 10)
Theory of Reciprocal Demand
Best applies when both nations are of equal economic size, so that their demand has noticeable effect on market price
If two nations are of unequal economic size
Relative demand strength of smaller nation is dwarfed by that of larger nation
Domestic exchange ratio of larger nation will prevail
Small nation can export as much of the commodity as it desires

26. Trading Under Constant-Cost Conditions (8 of 10)
Importance of Being Unimportant
For two nations of approximately same size engaged in international trade, gains from trade will be shared equally between them
If one nation is significantly larger
Larger nation – fewer gains from trade
Smaller nation – most of the gains from trade
Larger nation may continue to produce comparative-disadvantage good because smaller nation cannot meet all demand

27. Trading Under Constant-Cost Conditions (9 of 10)
Terms-of-Trade estimates
Commodity terms of trade (a.k.a. barter terms of trade)
Measure of the international exchange ratio
Measures the relation between the prices a nation gets for its exports and the prices it pays for its imports

28. Trading Under Constant-Cost Conditions (10 of 10)
Improvement in a nation’s terms of trade
Rise in export prices relative to import prices
A smaller quantity of export goods sold abroad to obtain a given quantity of imports
Deterioration in a nation’s terms of trade
Rise in import relative to export prices
Given quantity of imports requires sacrifice of greater quantity of exports

29. 2.5 Commodity Terms of Trade, 2013…

30. Dynamic Gains from Trade (1 of 2)
Dynamic gains from international trade
Effect of trade on country’s growth rate and volume of additional resources made available to, or utilized by, trading country
Dwarf static gains from trade

31. Dynamic Gains from Trade (2 of 2)
Dynamic gains from international trade include:
More efficient use of an economy’s resources
Higher output and income
More saving, more investment
Higher rate of economic growth
Higher productivity
Economies of large-scale production
Increased competition

32. Changing Comparative Advantage
Patterns of comparative advantage change over time
Productivity increases
Production possibilities schedule changes
More output can be produced with same amount of resources
Producers must hone skills to compete in more profitable areas

33. 2.3 Changing Comparative Advantage

34. Trading Under Increasing-Cost Conditions (1 of 5)
Increasing opportunity costs
Concave production possibilities schedule
Bowed outward from the diagram’s origin
Inputs are imperfect substitutes for one another
MRT rises along slope of production possibilities schedule

35. 2.4 Production Possibilities Schedule…

36. Trading Under Increasing-Cost Conditions (2 of 5)
Increasing-Cost Trading Case
One country specializes, producing one good; other country specializes in producing the other good
Process of specialization continues in both nations until
Relative cost of one good is identical in both nations
One country’s exports of one good equal other country’s imports of the good
Domestic rates of transformation are same

37. 2.5

38. Trading Under Increasing-Cost Conditions (3 of 5)
Production Gains
More of each good is being produced
Consumption gains
Both countries consume more of at least one good
Trade Triangle
Denotes country’s exports, imports, and terms of trade
Same for both countries
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39. 2.6 Increasing…

40. Trading Under Increasing-Cost Conditions (4 of 5)
Partial Specialization
Each country specializes only partially in production of good in which it has comparative advantage
Arises from increasing costs: mechanism that forces costs in two trading nations to converge, at which point basis for further specialization ceases to exist
Counties then likely to produce some of each good

41. Trading Under Increasing-Cost Conditions (5 of 5)
Reasons for Partial Specialization
Not all goods and services are traded internationally
Differing tastes for products
Most products are differentiated

42. The Impact of Trade on Jobs
The extent to which an economy is open
Influences mix of jobs within an economy
Can cause dislocation in certain areas or industries
Has little effect on the overall level of employment

43. 2.6

44. Wooster, Ohio Bears the Brunt of Globalization
Rubbermaid, based in Wooster, Ohio, was an industry leader and solid corporate citizen.
In 1995, resin prices skyrocketed; when the firm tried to raise its prices to compensate, Walmart ceased carrying its products, broke relations, & turned to foreign producers with lower labor costs.
Profits plunged 30%; closed 9 manufacturing plants; laid off 10% of workforce.
In 1999, firm purchased by Newell Corp, known for cost-cutting; 1,000 jobs left Wooster.

45. Comparative Advantage Extended to Many Products & Countries (1 of 2)
More than two products
Comparative advantage ranks goods by degree of comparative cost
Each country exports product(s) in which it has greatest comparative advantage
Each country imports product(s) in which it has greatest comparative disadvantage
Cutoff point between exports & imports depends on relative strength of international demand

46. Comparative Advantage Extended to Many Products & Countries (2 of 2)
More than two countries
Multilateral trading relations
Bilateral balance should not pertain to any two trading partners
Trade surplus with trading partners that buy many products it supplies at low cost
Trade deficit with trading partners that are low-cost suppliers of goods it imports intensively

47. 2.8

48. Exit Barriers (1 of 2) In an open trading system
Resources channeled from low productivity to high productivity uses
Competition forces high cost plants to exit, leaving low cost plants to operate in long run
Exit barriers hinder market adjustments that would occur through comparative advantage

49. Exit Barriers (2 of 2) Exit barriers in U.S. steel industry caused by:
Relatively fixed cost of union-negotiated wages & benefits
Antiquated plants with no other use; contract termination fines; environmental problems
Exit barriers associated with:
Overcapacity (caused by imports, reduced demand, productivity-improving technology)

50. Empirical Evidence on Comparative Advantage (1 of 2)
Ricardian model
Implies nations export goods in which their labor productivity is relatively high
Testing Ricardian model
MacDougall, 1951
Export patterns of 25 industries in the United States and United Kingdom (1937) examined
20 industries fit predicted pattern
Balassa and Stern
Also supports Ricardo’s conclusions

51. Empirical Evidence on Comparative Advantage (2 of 2)
Testing Ricardian model (cont.)
Stephen Golub
Found that relative unit labor costs help explain trade patterns of U.S. vis-à-vis United Kingdom, Japan, Germany, Canada, and Australia
Limits of Ricardian model
Labor not the only factor input; production and distribution costs also impact trade
Differences in product quality impact trade as well

52. 2.9

53. The Case for Free Trade (1 of 2)
Main arguments
For world as whole, free trade results in higher level of output and income than would occur in absence of free trade
Allows each individual nation to achieve higher level of production and consumption than would be achieved in isolation

54. The Case for Free Trade (2 of 2)
Additional benefits of free trade:
Deters monopoly
Fosters innovation
Yields wider range of product choice
Reduces international political animosities
However, trade sometimes harms particular domestic industries and workers, prompting calls for protections from imports

55. Comparative Advantage & Global Supply Chains (1 of 7)
Ricardian theory assumes production cannot move to other nations
Today, labor, technology, capital, ideas all shift around globe
Today, many goods supplied by global supply chains, international production networks that allow firms to move goods and services efficiently across national borders

56. Comparative Advantage & Global Supply Chains (2 of 7)
Global supply chains use outsourcing
Subcontracting work to another firm, or
Purchasing components rather than manufacturing them
Advantages of outsourcing
Reduced costs & increased competitiveness
New exports, repatriated earnings
Creation of new industries and products

57. Comparative Advantage & Global Supply Chains (3 of 7)
Outsourcing & U.S. Auto Industry
Early 1900s, Ford Motor Model T: utilized just 700 parts
Achieved gains of large-scale mass production
Achieved gains of a high degree of specialization within plant
More sophisticated cars and competition compelled Ford to outsource production
Strategically important tasks & production kept in-house; noncore tasks purchased from external suppliers

58. Comparative Advantage & Global Supply Chains (4 of 7)
Outsourcing & U.S. Auto Industry
Increasing numbers of parts and services now considered noncore
Today, about 70% of typical Ford vehicle comes from parts, components, and services purchased from external suppliers

59. Comparative Advantage & Global Supply Chains (5 of 7)
iPhone Economy & Global Supply Chain
In early years, Apple outsourced little of its production to foreign manufacturers
Around 2000, Apple switched to foreign manufacturing
Drawn by Asia’s less expensive, semiskilled workers and ease of maintaining supply chains for parts and components
Software & marketing remain in U.S.

60. Comparative Advantage & Global Supply Chains (6 of 7)
Outsourcing Backfires for Boeing 787 Dreamliner
Japan, Italy, China & Australia all supplied sections of Boeing 787, assembled in U.S.
Boeing required foreign suppliers to share in cost of developing plane; foreign suppliers invested billions
Strategy backfired when suppliers fell behind; production delayed four+ years
By giving up control of supply chain, Boeing lost ability to oversee production

61. Comparative Advantage & Global Supply Chains (7 of 7)
Reshoring Production to U.S.
Emphasis had been on cheaper labor cost but wage gap narrowing
Cost of shipping goods by ocean freight increasing sharply; goods in transit for weeks
Distance made it difficult to customize goods to local markets; natural disasters, geopolitical shocks disrupt supply chains
Many firms now returning some production to U.S.