1. International Trade and Finance for Global Logistics MAGL 570 Fall 2010 Steven Yamarik syamarik@csulb.edu

2. II. Trade Theory We will examine the theoretical underpinnings for the prediction that countries gain from trade. We take a historical approach to show the evolution of ideas that leads to modern-day trade theory.

3. II. Trade Theory A. Mercantilism (1500-1800) 1.Mercantilism is an economic theory that holds that the prosperity of a nation depends upon its supply of capital, represented by bullion (gold, silver, and trade value) held by the state. Therefore, the world’s wealth is relatively fixed.

4. II. Trade Theory A. Mercantilism (1500-1800) 2.The Mercantilists advocate protectionism in order to achieve a positive trade balance. A positive trade balance would bring about a net inflow of payments from the rest of the world in the form of bullion.

5. II. Trade Theory A. Mercantilism (1500-1800) 3.As a result, trade is a zero-sum game in that protectionism benefits your country in greater bullion and harms your trading partner or colony in less bullion.

6. II. Trade Theory A. Mercantilism (1500-1800)

7. II. Trade Theory A. Mercantilism (1500-1800) 4.Although discredited by Adam Smith, a variant of mercantilism is alive today in places like China and Singapore. Neo-mercantilism advocates the promotion of exports, suppression of imports and the imposition of capital controls in order to build up huge levels of foreign reserves.

8. II. Trade Theory B.Adam Smith and Absolute Advantage (1776) Adam Smith (1723-1790)

9. II. Trade Theory B.Adam Smith and Absolute Advantage 1.Smith argued that the prosperity of a nation depends not upon its stock of bullion but rather its consumption of goods and services. Therefore, the world’s wealth is not fixed, but rather it will grow through time.

10. II. Trade Theory B.Adam Smith and Absolute Advantage 2.Smith advocated free trade so that countries could benefit from the international division of labor. As a result, each country will gain greater consumption from voluntary exchange.

11. II. Trade Theory B.Adam Smith and Absolute Advantage 3.Smith argued that countries (and individuals) specialize based on the principle of absolute advantage. An absolute advantage refers to the ability of a nation to produce a good or service at a lower absolute cost in terms of resources.

12. II. Trade Theory B.Adam Smith and Absolute Advantage 4.Specialization would led to an increase in productivity (more goods produced) for all. 5.Specialization and thus trade, however, depends on the extent of the market. 6.There is a virtuous circle of growth: specialization → productivity → larger markets

13. II. Trade Theory C.David Ricardo and Comparative Advantage (1817) David Ricardo (1772-1823)

14. II. Trade Theory C.Ricardo and Comparative Advantage 1.Like Smith, Ricardo argued that the prosperity of a nation depends upon its consumption of goods and services.

15. II. Trade Theory C.Ricardo and Comparative Advantage 2.Like Smith, Ricardo advocated free trade so that countries could benefit from international division of labor. As a result, each country will gain from voluntary exchange with other nations.

16. II. Trade Theory C. Ricardo and Comparative Advantage 3.However, Ricardo argued that countries specialized based on the principle of comparative advantage. A comparative advantage refers to the ability of a nation to produce a good or service at a lower opportunity cost.

17. II. Trade Theory C.Ricardo and Comparative Advantage 4.The Ricardian Model (2 x 2 x 1) 1)two countries: U.S. and Canada 2)two goods: wheat W and autos A 3)one factor of production: labor L

18. II. Trade Theory C.Ricardo and Comparative Advantage 5.Due to differences in opportunity costs, one country will have a comparative advantage in one good (U.S. with autos) while the other country will have a comparative advantage in the other good (Canada with wheat).

19. II. Trade Theory C.Ricardo and Comparative Advantage

20. II. Trade Theory C.Ricardo and Comparative Advantage 6.However, one country can have an absolute advantage in producing both goods, but will still have a comparative advantage in producing only one good.

21. II. Trade Theory C.Ricardo and Comparative Advantage

22. II. Trade Theory C.Ricardo and Comparative Advantage 7.With constant costs, each country will specialize completely in the good in which they have a comparative advantage. The U.S. produces only autos, while Canada produces only wheat.

23. II. Trade Theory C.Ricardo and Comparative Advantage 8.Each country in return will trade for the other good and enjoy higher consumption after trade (gains from trade). The U.S. and Canada consume more autos and wheat as a result of trade.

24. II. Trade Theory C.Ricardo and Comparative Advantage

25. II. Trade Theory C.Ricardo and Comparative Advantage 8.Ricardo showed that as long as the international relative price fell between the two domestic relative prices (opportunity costs) than trade will occur. In fact, the two opportunity costs form the outer limits of the region of mutually beneficial trade.

26. II. Trade Theory C.Ricardo and Comparative Advantage

27. II. Trade Theory D.Edgeworth and Increasing Costs Francis Ysidro Edgeworth (1845-1926)

28. II. Trade Theory D.Edgeworth and Increasing Costs 1.The analysis of Smith and Ricardo was based on the assumption that costs are constant. However, one would expect the opportunity cost to increase as more of a good is produced because resources differ within each country.

29. II. Trade Theory D.Edgeworth and Increasing Costs 1.The best-suited resources will be used first so you will initially give up little of the other good. The not-so-well-suited resources will be used next so you will give up more of the other good.

30. II. Trade Theory D.Edgeworth and Increasing Costs 1.Finally, the poorly-suited resources will be used last so you will give up a lot of the other good at the end.

31. II. Trade Theory D.Edgeworth and Increasing Costs 2.As a result, the production possibilities schedule will be bowed out or concave with increasing opportunity cost. The opportunity cost of one auto increases from 1 wheat at point A to 4 wheat at point B.

32. II. Trade Theory D.Edgeworth and Increasing Costs

33. II. Trade Theory D.Edgeworth and Increasing Costs 3.Under autarky, production (and consumption) occurs where the domestic price line t is tangent to the production possibilities schedule. Production (and consumption) occurs at point A for the U.S. and point A’ for Canada under autarky.

34. II. Trade Theory D.Edgeworth and Increasing Costs

35. II. Trade Theory D.Edgeworth and Increasing Costs 4.Under trade, production occurs where the trading possibilities line tt is tangent to the production possibilities schedule. Production occurs at point B for the U.S. and point B’ for Canada under trade.

36. II. Trade Theory D.Edgeworth and Increasing Costs

37. II. Trade Theory D.Edgeworth and Increasing Costs 5.With increasing costs, each country will specialize partially in the good in which they have a comparative advantage. The U.S. produces more autos and less wheat with a higher relative price of autos. Canada produces less autos and more wheat with a lower relative price of autos.

38. II. Trade Theory D.Edgeworth and Increasing Costs

39. II. Trade Theory D.Edgeworth and Increasing Costs 6.Under trade, consumption occurs outside the production possibilities curve so that each country gains extra consumption. The U.S. consumes at point C where they enjoy 3 extra wheat and Canada consumes at point C’ where they enjoy 3 extra autos.

40. II. Trade Theory D.Edgeworth and Increasing Costs

41. II. Trade Theory E.Heckscher-Ohlin and Factor Endowment Theory Eli Heckscher (1879-1952) Bertil Ohlin (1899-1979)

42. II. Trade Theory E.Heckscher-Ohlin and Factor Endowment Theory 1.Factor-Endowment Theory Differences in relative factor endowments → Differences in relative factor prices → Differences in relative product prices → Pattern of comparative advantage →

43. II. Trade Theory D.Heckscher-Ohlin and Factor Endowment Theory 2.Heckscher-Ohlin Model a. Assumptions (2 x 2 x 2)

44. II. Trade Theory 1)two countries: U.S. and China 2)two goods: textiles T and aircraft A 3)two factors of production: labor L and capital K 4)T are labor-intensive, but A is capital-intensive 5)U.S. is relatively capital-abundant, but China is relatively labor-abundant.

45. II. Trade Theory 2.Heckscher-Ohlin Model b. Production Possibilities Schedules 1)With a relative abundance in K, U.S. is better able to produce the capital-intensive aircraft. 2)With a relative abundance in L, China is better able to produce the labor-intensive textiles.

46. II. Trade Theory 2.Heckscher-Ohlin Model c. Autarky Equilibrium 1)Under autarky, production (and consumption) occurs where the domestic price line (MRT) is tangent to the production possibilities schedule.

47. II. Trade Theory 2.Heckscher-Ohlin Model c. Autarky Equilibrium

48. II. Trade Theory 2.Heckscher-Ohlin Model d. Trade Equilibrium 1)Under trade, production occurs where the international price line is tangent to the each production possibilities schedule.

49. II. Trade Theory 2.Heckscher-Ohlin Model d. Trade Equilibrium

50. II. Trade Theory 2.Heckscher-Ohlin Model d. Trade Equilibrium 2)Under trade, consumption occurs outside the production possibilities curve so that each country gains extra consumption from trade.

51. II. Trade Theory 2.Heckscher-Ohlin Model d. Trade Equilibrium

52. II. Trade Theory 2.Heckscher-Ohlin Model e. Predictions #1Heckscher-Ohlin theorem: Under trade, each country will export the good that uses their abundant factor intensively.

53. II. Trade Theory 2.Heckscher-Ohlin Model e. Predictions #2Factor-Price Equalization theorem: Trade will bring about an equalization of factor prices (wages and rents) across countries.

54. II. Trade Theory 2.Heckscher-Ohlin Model e. Predictions #3 Stolper-Samuelson theorem: For each country, trade benefits the factor that is abundant, but hurts the factor that is scarce.

55. II. Trade Theory F.New Trade Theory and Increasing Returns Paul Krugman (1954- ) Avinash Dixit (1952- )

56. II. Trade Theory F.New Trade Theory and Increasing Returns 1.Fixed Costs and Increasing Returns a. High fixed costs imply decreasing average costs. b.Decreasing average costs imply increasing returns to scale.

57. II. Trade Theory F.New Trade Theory and Increasing Returns

58. II. Trade Theory F.New Trade Theory and Increasing Returns 2.Increasing Returns and Trade By increasing the size of the market, international trade has the ability to simultaneously increase both the variety of goods available for consumption and the scale of production of each firm.

59. II. Trade Theory F.New Trade Theory and Increasing Returns 3.Interindustry vs. Intraindustry Trade The H-O model predicts that countries will specialize in different industries (i.e. manufacturing, food, textiles) and thus trade will occur across industries: interindustry trade.

60. II. Trade Theory F.New Trade Theory and Increasing Returns 3.Interindustry vs. Intraindustry Trade The increasing returns model predicts that countries will produce differentiated products for a specific industry and thus trade will occur within an industry: intraindustry trade.

61. II. Trade Theory G.Trade Frictions and Costs 1.Government regulations (i.e. environment, workplace safety, product safety, health care mandates) raises the cost of domestic production and decreases the competitiveness of the domestic industry

62. II. Trade Theory G.Trade Frictions and Costs

63. II. Trade Theory G.Trade Frictions and Costs 2.An increase in trade costs will reduce the degree of specialization in production and thus decrease the gains from trade.

64. II. Trade Theory G.Trade Frictions and Costs