1. INTERNATIONAL ECONOMICSINTERNATIONAL ECONOMICS Lecture 3 | Carlos Cuerpo | Why do countries trade? Some later answersLecture 3 | Carlos Cuerpo | Why do countries trade? Some later answers

2. CLASSICAL THEORY: ADAM SMITHCLASSICAL THEORY: ADAM SMITH How to measure Absolute Advantage? – Real costs of production. How to measure real costs of production? – Labor Theory of Value i) Labor is the only factor of production. ii) It determines goods' relative price. iii) No reference to money or gold. iv) It moves freely from one industry to another. Within a single country, competition ensures exchange in proportion to L costs. v) Internationally immobile If L requirements differ, prices will differ as well Table 1. Absolute Advantage Source: International Economics (2009). Eicher et al. Days of LItalyScotland Wine Cloth 20 100 120 30

3. CLASSICAL THEORY: ADAM SMITHCLASSICAL THEORY: ADAM SMITH Table 1. Absolute Advantage Source: International Economics (2009). Eicher et al. Different national prices ensure gains from trade at an intermediate ratio Table 2. Efficiency Gains Source: International Economics (2009). Eicher et al. Empirical Evidence: it accounts for important segments of trade Days of L requiredItalyScotland Wine (barrels) Cloth (bolts) 20 100 120 30 ItalyScotlandTotal Wine (barrels)30-525 Cloth (bolts)-62014

4. CLASSICAL THEORY: DAVID RICARDOCLASSICAL THEORY: DAVID RICARDO David Ricardo Principles of Political Economy and Taxation (1817) Trade Pattern: Comparative Advantage (CA) – Definition: Low relative cost of a good compared to other countries in autarky. Every country will have a CA in some good. – Intuition: – Terms of Trade. – Differences in Technology (output per unit of labor) as the source of CA.

5. CLASSICAL THEORY: DAVID RICARDOCLASSICAL THEORY: DAVID RICARDO Trade Benefits: – Broader markets, greater supply, higher welfare. – Overcomes Smith’s limitations: There is scope for mutually beneficial trade between the two countries, if both specialize according to their pattern of CA, even when one of them has an AA in every commodity. Table 3. Comparative Advantage Source: International Economics (2009). Eicher et al. Days of LaborPortugalEngland Wine (1 barrel)32 Cloth (1 bolt)104

6. CLASSICAL THEORY: DAVID RICARDOCLASSICAL THEORY: DAVID RICARDO Table 1. Comparative Advantage Source: International Economics (2009). Eicher et al. Table 2. Efficiency Gains Source: International Economics (2009). Eicher et al. Portugal must shift more days than England because of less efficiency in absolute terms Price ratios will converge (unless there are additional costs) Intermediate Equilibrium ToT Days of L requiredPortugalEngland Wine (barrels) Cloth (bolts) 3 10 2424 PortugalEnglandTotal Wine (barrels)20-182 Cloth (bolts)-693

7. CLASSICAL THEORY: DAVID RICARDOCLASSICAL THEORY: DAVID RICARDO Trade Benefits: – Broader markets, greater supply, higher welfare. – Real Income increases because of specialization – Overcomes Smith’s limitations: There is scope for mutually beneficial trade between the two countries, if both specialize according to their pattern of CA, even when one of them has an AA in every commodity. Economic Policy: Laissez-faire. Any intermediate ToT is mutually beneficial (No zero-sum game) Limitations: – What if relative costs are equal? – ToT indetermination (Barone)

8. CLASSICAL THEORY: J.STUART MILLCLASSICAL THEORY: J.STUART MILL Reciprocal Demand Theory:Cloth Market – Definition: Equilibrium barter ToT (ratio of exchange) will equate Exports Supply with Imports Demand internationally. – Demand elasticity is crucial due to the shape of the Supply curve (L Theory of Value+constant productivity of Labour). – World curves as differences. Walras’ law. England World Trade Germany SeSx,e Sg 2 1.7 DeDm.g Dg 1.5 C* C* C*

9. CLASSICAL THEORY: LIMITATIONSCLASSICAL THEORY: LIMITATIONS – Only two goods: What happens in a more realistic set-up? Consider a rank ordering: relative marginal costs will predict the trade pattern Compare Cloth with other goods and export the one with the lower ratio. MC will depend on wages and the inverse of productivity As long as there is a single wage rate in each country, relative labour productivities will determine the ranking. Countries should tend to export those goods in which their productivity is relatively high. Relative productivity must be high compared with other sector's relative productivity. Chinese surge as an export powerhouse

10. CLASSICAL THEORY: LIMITATIONSCLASSICAL THEORY: LIMITATIONS Strong assumptions (despite Friedman's irrelevance) – No trade barriers: transportation costs, information costs,… If they fall relative to the value of the good being transported, more goods are likely to become available. – Just one Input: L. Labor Theory of Value. – Labor is internationally immobile. – Constant costs of production, Leontieff production function. – Fixed amount of inputs: Vertical Aggregate Supply.

11. CLASSICAL THEORY: EMPIRICAL EVIDENCECLASSICAL THEORY: EMPIRICAL EVIDENCE It predicts an extreme degree of specialization. It assumes away effects of International Trade on the distribution of income within countries. Allows no role for differences in resources among countries as a cause of trade. Neglects the possible role of economies of scale as a cause of trade.

12. NEOCLASSICAL THEORYNEOCLASSICAL THEORY Haberler's Contributions: – Laid the conceptual foundation of modern trade theory – Opportunity Cost conception of CA: value of X in terms of foregone units of Y rather than in labour units. More systematic analysis of potential gains from trade. Neclassical Set-up: – Rational agents, perfect competition. – Examine Demand Conditions and Consumer Preferences. – Look at an economy's production capabilities. – Trade Pattern still determined by Comparative Advantage, but expand the reasoning behind relative price differences: Differences in Technology (labor productivity as well as capital productivity). Heterogeneity in preferences.

13. NEOCLASSICAL THEORY:PREFERENCESNEOCLASSICAL THEORY:PREFERENCES Consumer preferences: – Indifference curve: Definition: combination of goods that give an individual the same level of utility or satisfaction. Derived from the Utility function, as well as its properties. Curvature: Diminishing Marginal rate of substitution (ratio of Mg Utilities). Good Y Good X A B C ΔYΔY ΔXΔX MRS x,y = ΔY/ ΔX = MU x /MU y

14. NEOCLASSICAL THEORYNEOCLASSICAL THEORY Consumer preferences: – Edgeworth Box: Definition: represents the preferences of 2 individuals and the allocation of goods between them. Derived from the Utility function, as well as its properties. Curvature: Diminishing Marginal rate of substitution (ratio of Mg Utilities). Good Y Good X B A E Oa Ob A’ B’ Homothetic Preferences Two sources of trade: Preferences Endowments or production capabilities Representative consumer: Individuals have The same preferences and spend their income in the Proportion in the two goods.

15. NEOCLASSICAL THEORYNEOCLASSICAL THEORY Production Capabilities: – Assumptions: Perfect Competition in commodity and factor markets: flexible prices, factors fully employed. Fixed quantitites of inputs. Perfect mobility of L,K within a country bet immobile internationally. Zero transport costs and no barriers to trade: international price is unique. Balanced Trade: M=X. – Opportunity Cost: Definition: In a two-good world (X and Y), the opportunity cost (OC) of X is the amount of Y which is given up for a unit of X. Redefine CA: A country has a CA in commodity X if it can produce an extra unit at a lower OC in terms of foregone Y than any other country.

16. NEOCLASSICAL THEORYNEOCLASSICAL THEORY Production Capabilities: – Production Possibility Frontier: Definition: highest attainable combinations of goods that can be produced with a fixed available supply of inputs (labour). Slope: Ratio at which good X can be transformed into good Y. Marginal rate of Transformation (ratio of Mg Costs): rate at which good X can be transformed into good Y. Good Y Good X A B ΔYΔY ΔXΔX MRT x,y = ΔY/ ΔX = MC x /MC y

17. NEOCLASSICAL THEORYNEOCLASSICAL THEORY Production Capabilities: – Production Possibility Frontier: Increasing Costs: As resources are shifted from good X to good Y, the opportunity cost of each additional unit of X increases. Intuition: Profit maximization leads to an efficient use of resources. Marginal rate of Transformation (ie the slope of tangent RR) will become steeper as the opportunity cost increases [concavity]. Good Y Good X P MRT x,y = ΔY/ ΔX = MC x /MC y R R

18. NEOCLASSICAL THEORYNEOCLASSICAL THEORY Equilibrium in a closed economy: Individual firms, motivated by price signals are taken the necessary actions in order to reach the higher possible welfare. Intuition: The economy is operating at maximum efficiency. The rate at which the production of one good can be transformed into the production of the other commodity equals the rate at wich the consumer is indifferent and determines the barter ratio. Good Y Good X P MRT x,y = MRS x,y = p x /p y R R

19. NEOCLASSICAL THEORYNEOCLASSICAL THEORY International Trade: 2 countries-2 Goods – Pre-Trade Equilibrium: Search of a Comparative Advantage Good Y Good X P R R D D P* U U* Good X Good Y

20. NEOCLASSICAL THEORYNEOCLASSICAL THEORY International Trade: 2 countries-2 Goods – Post-Trade Equilibrium: Shift resources until equilibrium price ratio Good Y Good X P R R D D P* U U* Good X Good Y Q T T T T U’ V S U*’ V* Q* S* Country ACountry B

21. NEOCLASSICAL THEORYNEOCLASSICAL THEORY Trade Results: – Reallocation of resources due to CA. Complete specialization will usually not occur due to increasing costs. – Equalization of relative prices Different prices provided the incentive for trade – Increase in economic welfare in both countries: Division of Gains

22. CLASSICAL THEORY: J.STUART MILLCLASSICAL THEORY: J.STUART MILL Trade Results: – Reallocation of resources due to CA. Complete specialization will usually not occur due to increasing costs. – Equalization of relative prices Different prices provided the incentive for trade – Increase in economic welfare in both countries: Division of Gains Country A World Trade Country B SSx,a S P* DeDm.b D Po C* C* C* Po Mb Xa