The Trade Theory
International Economics
International Trade
International Finance
International Trade
A definition:
• A study of trade (of goods and services)
between nations and its economic
implications
Why nations trade: gains from trade
The Trade theory
Factor movements
Free trade versus protection
International Finance
A definition:
• A study of the financial dimension of
international economic transactions among
nations
Balance of payments
Exchange markets and exchange rates
The international monetary system
International monetary institutions
The Basic Theory of Trade
• Absolute advantage in production
• Comparative advantage and the gains from
trade
• Trade as a means to economic efficiency
• Trade as a way of life
• Trade and economic interdependence
• Trade and economic growth
Early Thinking about Trade
• Mercantilism
• David Hume and the specie-flow
mechanism
• Adam Smith (1776)
Adam Smith’s View on Trade
• "It is the maxim of every prudent master of a
family, never to attempt to make at home what it
will cost him more to make than to buy.”
Adam Smith
• The opportunity to trade what one has (or can
produce) for what he/she does not have (or cannot
produce easily) makes it rational for each person to
specialize in the production of what she can
produce most efficiently (least costly.)
• Specialization and trade among regions and
countries are based upon the same principle as
among individuals.
Trade and “Absolute Advantage”
• A nation (or country) has absolute advantage in the
production of a good if, compared to another
country, it uses less resources to produce it.
Example: If US uses 15 hours of labor to produce
one unit of tomatoes and Mexico uses 10 hours to
produce the same amount of tomatoes, Mexico has
absolute advantage in the production of tomatoes.
Total labor: US: 240 , Mexico: 240
Under autarky:
Labor needed
Mexico U.S.
Tomatoes: 10 hrs
15 hrs
Output Produced
Mexico U.S.
12
8
Corn:
8 hrs
4 hrs
15
30
===================================
World’s output of tomatoes: 20
World’s output of Corn:
45
After specialization and trade:
Mexico
Tomatoes 24
Corn
0
U.S.
0
60
Total World’s Output
24
60
Gains from trade: 24 - 20 = 4 units of tomatoes
60 - 45 = 15 units of corn
• Terms of trade: The number of units of the
imported good received for each unit of the
exported good
• Relative price: Price of one good in terms of
another
Relative Price
Relative price of one unit of corn in US before trade:
4/15 = .266 unit of tomato
(Note:Relative price of one unit of tomato in terms of corn = 15/4 = 3.75 units of corn)
Relative price of one unit of corn in Mexico before trade:
8/10 = .80 unit of tomato
(Note:Relative price of one unit of tomato in terms of corn = 10/8 = 1.25 units of corn)
Terms of Trade: .266 <=====> .80
Terms of Trade: A graphical Analysis
T
T
24
240/10
TT
A
16
A
TT
0
60
C
0
US
US Price under autarky: .26
Production under autarky: A
Terms of trade after trade: TT = .50
30
240/8
C
Mexico
Mex Price under autarky = .8
-Slope = relative price
= MRT
(Marginal Rate of Transformation)
Indifference Curves
• An indifference curve is a curve showing all the
combinations of two goods from which a consumer
derives the same level of utility.
• A consumer is indifferent along any given
indifference curve.
• The farther an indifference curve is from the point
origin the higher level of utility it represents.
• The indifference curves in an indifference map
never cross
• A social indifference curve?
A Social Indifference Map
T U1
U2
U3
U4
U5
U5>U4>U3>U2>U2
ΔUc
MRS = ------ΔUt
Slope = MRS
C
0
Mexico Under Autarky
T
At “a” MRS>relative cost/price
At “c” MRS<relative cost/price
At “b” MRS = relative cost/price
MRT
a
b
c
0
U4
U3
U2
U1
C
Terms of Trade: A graphical Analysis
T
T
24
TT
16
A
A
t
y
12
y
0
30
US
60
TT
C
0
30
Mexico
US imports = Mexico’s exports = t w
US exports = Mexico’s imports = w y
C
Terms of Trade: A graphical Analysis
T
T
24
TT
A
16
A
TT
0
60
C
0
US
US Price under autarky: .26
30
C
Mexico
Mex Price under autarky = .8
-Slope = relative price
Production under autarky: A
Terms of trade after trade: TT = .50
David Ricardo and Comparative Advantage
Again consider US and Mexico.
Labor needed for one unit
Mexico
U.S.
Output produced
Mexico
U.S.
Rugs
10 hrs
8 hrs
12
Computers
40 hrs
10 hrs
3
15
12
•US has absolute advantage in both goods!
•US Relative price computers in terms of rugs = 10/8 = 1.25
•Mexico’s Relative price computers in terms of rugs = 40/10 = 4
•US has comparative advantage in computers but Mexico in rugs.
The Ricardian Trade Model
US
Mexico
Rugs
Rugs
TT
30
24
U2
U1
1.25
c
k
A
U2
U1
f
g Cmp
0
c
f
24
g
A
4
0
h
6
TT
Cmp
Productivity, Wage, and Price
Assume the only input used in production is labor,
Marginal cost of producing good X is:
W
MCx = -------
=
ax.
W;
ax =
1/MPL
MPL
If Px = MC
Px
Wage = W = ----------
ax
Py
or W = ---------
ay
In autarky under competitive conditions where uniform labor
is the only input:
Wx= Wy
Px
Py
---------- = ---------
===>
ax
Px
ay
ax
===> --------- = --------- = MRT
Py
ay
Trade and Wage
Recall:
Pr
Wr = -------
ar
Pc
Wc = -------
ac
After complete specialization and trade,
the price of “export” will go up. ==> W will go up.
The Effects Trade on Prices and Wages
After specialization and trade:
In US:
• The output of computers will go up
• The output of rugs will go down
• Price of computers will go up
• Price of rugs will go down
• The wage will go up
Note: US is now producing only computers and
recall: W = P/a
After specialization and trade:
In Mexico:
• The output of computers will go down
• The output of rugs will go up
• Price of computers will go down
• Price of rugs will go up
• The wage will go up
Note: Mexico is now producing only rugs and
recall: W = P/a
Demand and Supply in Autarky
S
Pr/Pc
Pr/Pc
S
4/5
Export
Import
1/4
D
D
Q
0
0
Rug Market in US
Rug Market in Mexico
Q
International Market for Rugs
Pr/Pc
S
4/5
1/4
D
0
Q