China Center for Economic Research
Peking University
International Economics:
Trade Theory and Policy
Professor Wen Hai
Spring 2003
I.
INTRODUCTION
1. Importance of International Economics
Why should we study international
economics?
• Contribution of International Trade to
the Nation’s Standard of Living
• Integration of the World Economy
• Problems in the World Economy
2.Structure of International Economics
• International Trade: Theory and Policy
(Microeconomics of Open Economy)
• International Finance
•
(Macroeconomics of Open Economy)
3.
Brief History of International Trade
• Brief History of the World Trade
– International Trade in Ancient Times
– World Trade after the 15th Century
– The Emergence of Capitalism and Industrial
Revolution
– International Trade after WWII
Brief History of Foreign Trade in China
• A Glorious Period in Ancient China
Isolations after the 16th Century
Open-door Policy under Foreign Warship
Foreign Trade since 1949
5.
Basic Analytical Tools
• General Equilibrium Analysis
• Partial Equilibrium Analysis
General Equilibrium Analysis
•
Supply-side: Production Possibility
Frontier (PPF)
•
•
PPF with Constant Costs
PPF with Increasing Costs
•
PPF with Constant Costs
Qc
Qw
•
PPF with Increasing Costs
Qc
Qw
Demand-side: Community
Indifference Curves (CIC)
– Indifference Curves (review)
– Community Indifference Curves
Qc
Higher social welfare level
CIC3
CIC2
CIC1
Qw
General Equilibrium in Isolation
(PPF with constant costs)
•
•
Qc
Qc0
Autarky Equilibrium
A D=S
CIC0
PPF
Qw0
Qw
General Equilibrium in Isolation
(PPF with increasing costs)
•
•
Qc
Qc0
Autarky Equilibrium
A S=D
CIC0
Qw0
PPF
Qw
Partial Equilibrium Analysis
Commodity markets in an Open
Economy
•
Pw/P
c
Pw/P
US
c
Pw/Pc
China
International Market
1.5
S
Sx
.8
Dm
D
Qw
Qw
Q
w
Equilibrium with Free Trade
Pw/Pc
Pw/P
US
Pw/Pc
China
c
S
D
Qw
Qw
Q
w
Basis for Trade and Gain from Trade
• Basis: lower relative price
•
Higher relative price
export
import
• Gain from Trade:
•
In General Equilibrium Analysis: measured
by increase in social utility level
•
In Partial Equilibrium Analysis: measured
by consumer surplus , producer surplus, and
net welfare change
II. TRADE THEORIES
Main Issues in Trade Theory
•
•
•
•
•
Why do People Trade？－ Gain from
Trade
Basis for Trade?
－Pattern of Trade
Effects of Trade?
Growth and Trade
Trade in Goods and Factor Movement
Framework of Trade Theory
Major Models
Main
Key Assumptions
Basis for Trade
Contributors
Classical Models
Absolute
Adam Smith
Advantages
Labor is the only input
Differences in Absolute
Constant Marginal Cost
Productivity due to
Perfect Competition in both
Different Technology
Product and Factor Markets
Differences in Relative
Neoclassical Models
Comparative
David
Constant Returns to Scale
Productivity due to
Advantages
Ricardo
Demand is given
Different Technology
Factor
E. Heckscher
At least two inputs
Endowment
B. Ohlin
Increasing Marginal Cost
Differences in Factor-
Perfect Competition in both
Endowment of Each Country
Specific
Paul
Factors
Samuelson
Product and Factor Markets
Constant Returns to Scale
and Factor-Intensity of
Each Product
Modern Trade Models
Economy of Scale (Increasing
Economy of
Paul Krugman
Returns to Scale)
Imperfect Competition in
Scale
Differences in
Production Scales
Product Market
Different Stage of
Product
Raymond
Technology Development
Cycle
Vernon
and Factor Intensity
The Classical Trade Theories
1. Economic Thought in International Trade
before Adam Smith
• Mercantilism: Older than Smith but still Alive
Today
2. Adam Smith: Absolute Advantage
a. Basic Assumptions
·One input:
Labor (L)
·Two outputs:
e.g. Wheat (QW) and Cloth (QC)
·Two Countries: e.g. US and China
· Different technologies: different productivity of labor
· Labor supply is fixed. No international labor
movement, but free to move within the country
· Full employment, perfect competition,
and constant return to scale
· No transportation cost
· Balanced trade
b. Basis for Trade
Absolute advantage in Commodity
Production
c. Determination of the Absolute Advantage
Differences in technologies
d. Measurements of Absolute Advantage:
Productivity or Cost of Production
Unit of labor requirement (L)
in each unit of output j: aLj= L/Qj
-- Comparing aLc to a*Lc and aLw to a*Lw
A Numerical Example
Table 2-1 Possible Output (L=L*=100)
Rice
(Qr)
Wheet
(Qw)
China
100
50
US
80
100
Table 2-2 Productivity (Qj/L)
Rice
Wheet
China
1.0
0.5
US
0.8
1.0
Table 2-3 Production Cost (aij)
Rice
Wheet
China
1.0
2.0
US
1.25
1.0
Limitation of the Smith Model
Table 2-4 Production Possibility
Rice
(Qr)
Wheet
(Qw)
China
100
50
US
150
100
e.
Pattern of Production and Trade
A country should specialized in and export the
product that it has absolute advantage, and
import the product that it does not have
absolute advantage in production.
In this case, US should export wheat and China
should export rice.
3. Davis Ricardo: Comparative Advantage
a. Basic Assumptions
(the same as the Smith Model)
b. Basis for Trade
Comparative Advantage in Commodity
Production
c. Determination of the Comparative
Advantage
Differences in relative technologies
d. Measurements of Comparative Advantage:
-- Relative productivity
-- Relative production cost:
aLw /aLr vs. a*Lw /a*Lr
-- Opportunity cost:
Qr /Qw vs. Q*r /Q*w
-- Relative Price (exchange rate adjusted)
Pw /Pr vs. P*w /P*r
A Numerical Example
Table 2-5
Relative Productivity
Rice
(Qr/L)/(Qw/L)
Wheet
(Qw/L)/(Qr/Qw)
China
2.0
0.5
US
0.8
1.25
Table 2-6 Relative Cost
Rice
aLR/aLW
Wheet
aLW/aLR
China
0.5
2.0
US
1.25
0.8
Table 2-7 Relative Productivity
(based on Table 2-4)
Rice
Wheet
China
2.0
0.5
US
1. 5
0.67
Limitation of the Smith Model
Table 2-4 Production Possibility
Rice
(Qr)
Wheet
(Qw)
China
100
50
US
150
100
e.
Pattern of Production and Trade
A country should specialized in and export the
product that it has comparative advantage, and
import the product that it does not have
comparative advantage in production.
In this case, US should export wheat and China
should export rice.
f. Gain from Trade: General Equilibrium Analysis
Equilibrium Relative Prices and Comparative Advantage
（PPF with constant costs)
China
Qw
Q*w P*r/P*w
US
Pr/Pw
Qr
Pr/Pw < P*r/P*w
Q*r
General Equilibrium with Free Trade
（PPF with constant costs)
Q*w
Pr/Pw
Qw
P*r/P*w
Qr
Q*r
The Gains from Trade
China
Qw
Q*w P*r/P*w
US
Pr/Pw
CIC1
S0,D0
CIC0
Qr
Q*r
1.2
Comparative Advantage in the HechscherOhlin Model
a. Basic Assumptionsa.
• Two inputs (factors):
• Two outputs:
• Production Functions:
Labor (L) and Land (T)
Cloth (Qc) and Food (QF)
Qc = Qc (Tc, Lc), labor-intensive
QF = QF (TF, LF), land intensive
At any given factor price ratio w/r, TF /L F > Tc /Lc
• Two Countries,
e.g. US and China
Different proportion of factor endowment:
(T/L)US > (T/L)China;
US is a T-abundant country, China is a L-abundant country
• Full Employment, Perfect Competition, and Constant return to
Scale
b: Basis for Trade
• Comparative advantage
Different relative factor endowments (different proportion)
different relative factor prices
different relative production costs
different relative prices of products
Comparative advantage in producing and exporting the
product that uses its abundant recourse intensively (lower
relative cost)
c. Pattern of Production and Trade
A country should produce more and export the product that
uses its abundant recourse intensively, and import the
product that uses its scarce recourse intensively. In this case,
US should export wheat and China should export cloth.
2. Economies-of-Scale and Imperfect Competition
Model
2.1. Modern Trade Facts
a. Rise of Intra-industrial Trade
Intra-industrial Trade Index:
T = 1- (|X - M|/X + M)
b. Development of Trade among Developed
Countries.
1.4 Equilibrium Relative Prices and Comparative
Advantage （PPF with increasing costs)
P*w/P*c
Q*c
Pw/Pc
Qc
Qa
Pw/Pc < P*w/P*c
Q*a
1.5 General Equilibrium with Free Trade
（PPF with increasing costs)
P*w/P*c
Q*c
Pw/Pc
Qc
Qw
Q*w
1.6 The Gains from Trade
（PPF with increasing costs)
P*w/P*c
Q*c
Pw/Pc
Qc
Qw
Q*w
• Changes in an export market
Pw/Pc
Effects of Free Trade
S
Price:
Production:
Consumption:
Welfare Changes:
P.S. +(a +b)
C.S. - a
net: + b
P1
a
b
P0
D
Qw
• Changes in an import market
Pw/Pc
Effects of Free Trade
S
Price:
Production:
Consumption:
Welfare Changes:
P.S. - c
C.S. + (c + d)
net: + d
P0
c
P1
d
D
Qw
Gain from Exchange and from Specialization
C
CIC
B
1
CIC0’
CIC0
A
A: autarky
B: consumption through
Exchange of existing products
C: consumption after
specialization and free trade
S: production after
specialization and free trade
Gain from exchange:
CIC0
CIC0’
Gain from specialization:
CIC0’
CIC1
S
Production: A
Consumption A
S;
C
1.7 Trade based on Differences in Tastes
Qc
Qw
2.4 The Terms of Trade
TOT = Px / Pm
Qm
TOT= Px/Pm
Px/Pm
S
D
Qx
Qx
2.2. Economies-of-Scale Model
a. Economies of Scale: external and internal
External Economies of Scale
External economies of scale occur when the average cost (AC) of
output depends on the size of the industry, but not necessarily on the
size of any one firm. An industry where economies of scale are
purely external will typically consist of many small firms and be
perfectly competitive.
Internal Economies of Scale
Internal economies of scale occur when the average cost of output
depends on the size of an individual firm, but not necessarily on that
of the industry. Internal economies of scale give a cost advantage
over small and lead to an imperfectly competitive market structure.
b. Monopolistic-Competitive Firm with
Internal Economies-of-Scale
• Equilibrium of a Monopolistic Competitive Firm in a
Closed Economy
P, C
($)
P0
AC
MC
Dhome
Q0
MR0
Q
• Equilibrium of a Monopolistic Competitive Firm in an
Open Economy (with Trade in Short Run, Case 1: P )
P, C
($)
P1
P0
AC1
AC
Dtotal
MC
Dhome
Q0
Q1 MR0
MR1
Q
• Equilibrium of a Monopolistic Competitive Firm in an
Open Economy (with Trade in Short Run, Case 2: P )
P, C
($)
P1 P0
AC1
AC
Dtotal
MC
Dhome
Q0 Q MR0
1
MR1
Q
• Equilibrium of a Monopolistic Competitive Firm in an
Open Economy (with Trade in Long Run)
P, C
($)
P0 = AC0
P2 = AC2
AC
MC Dtotal
Dhome
Q0 Q2MR
0
Q
MR2
3.2 Economy-of-Scale & Intra-Industrial Trade
US
US
30
AC
Japan
15
Q car
AC
Q car
AC
Q truck
Japan
AC
Q truck
3. Dynamic Comparative Advantage: the
Product-Cycle Model
3.1 Change in Pattern of Trade (Dynamic
Pattern)
Export
Color TV
China
Japan
US
Import
3.2 The Product Cycle Theory: Change in Factor
Intensity
Technological cycle of a new product:
• Stage 1: Innovation
(High technology; cost of research: R&D intensive
product)
• Stage 2: Tech. Diffuses
(Technology becomes less important - standardized, cost
of capital and skilled labor: capital and skilled-labor
intensive product)
• Stage 3: Tech. Stagnates
(Technology embodied in purchasable equipment, cost of
less skilled labor: labor intensive product)
3.3 Dynamic Changes in Comparative
Advantage
• Stage 1: R&D intensive product
R&D and scientists abundant country such as the US has
comparative advantage
• Stage 2: Capital and skilled-labor intensive product
Capital and Skilled labor abundant countries such as Japan
and Germany have comparative advantage
• Stage 3: Labor intensive product
Labor abundant countries such as China have comparative
advantage
C. EFFECTS OF TRADE ON INCOME
Effect of Trade on Income in the H-O Model
1. Effects of Trade on Factor Prices in Each Country
1.1 Short-Run (no factors are mobile among sectors)
Return to factors: W = P x MPL,
R = P x MPT
In the short run, returns to factor are determined by
changes in Product Price. No changes in marginal
productivity of factor
Price of export product increases, both factors in the export
sector gain
Price of import-competing product decreases, both factors in
the import-competing loss
1.2 Long-Run
(all factors are able to move among sectors)
The Stolper-Samuelson (S-S) Theorem
Free trade raises the return to the factor used intensively in
the rising-price sector (export sector) and lowers the return
to factor used intensively in the falling-price (import
competing sector)
Magnification Effect
Changes in returns to factors are greater than the changes
in product prices
2. Effects of Trade on Factor Prices in Both Countries
The Factor Price Equalization Theorem
Under the assumptions of H-O model, free trade will
equalize not only commodity prices but also factor prices.
All labors will earn the same wage rate and all units of
capital (or land) will earn the same profit (or rental returns)
in both countries regardless of the factor supplies or the
demand patterns in the two countries.
Effect of Trade in the Specific Factor Model
1. Basic Assumption of the Model
Three inputs (factors):
Mobile factor:
Specific Factors:
Two outputs:
Labor (L)
Capital (K) and Land (T)
Manufacture (QM)
Food (QF)
Production Functions:
QM = f (K, LM)
QF = f (T, LF)
Full Employment:
LM+ LF = L
Perfect Competition and Constant return to Scale
2. Production possibility Frontier in the Specific
Factors Model
2.1
Qm
The Production Function
Qm(K, Lm)
Lm
2.2 The Marginal Product of Labor
MPLm
Lm
2.3
Production Possibility Frontier
Qf
PPF
Qm
Lf
Lm
3. The Allocation of Labor and
Determination of Wage
3.1 Allocation of Labor
W
W
W*
PmMPLm
Pf MPLf
Lf
Lm
3.2
Effects of Price Changes
• An Equal Proportional Change in Prices
W
W
W*’
W*
P’mMPLm
P’f MPLf
PmMPLm
Pf MPLf
Lf
Lm
• An Equal Proportional Change in Prices
No changes in labor allocation
no changes in output
Nominal Wage (W)
Profit (RK)
Rent (RT)
In real term, not affected
•
A Change in Relative Price (say Pf 10%)
W
W
W*’
W*
P’f MPLf
PmMPLm
Pf MPLf
Lf
Lm
• A Change in Relative Price (say Pf 10%)
LM
and LF
W (< 10%), RT
QM
and QF
(> 10%), RK
In real term,
T gains
K loses
L is ambiguous (depending on using what price to
measure)
3.3
Effects of International Trade
• Trade and Relative Prices
Before trade: (PF/PM)A < (PF/PM) J
After trade: (PF/PM)A = (PF/PM) world = (PF/PM) J
Relative Price of Export
• Income Distribution (same effect of relative price
change)
Specific factor in export sector gains
Specific factor in import sector loses
Ambiguous effects on mobile factor
3.4
•
Effects of Economic Growth
A Change in Capital Stock
W
W
W*’
W*
Pf MP’Lf
PmMPLm
Pf MPLf
Lf
Lm
• K
the same effects as PM on Labor allocation,
production, and nominal returns to factors.
However, the returns to labor in real terms
increase since there is no price change
•
A Change in Labor Supply
L , labor and output in both sectors ,
L loses, both K and T gain
W
W
W*
W*’
PmMPLm
Pf MPLf
Lf
Lm
D.
GROWTH AND TRADE
Growth and Trade in the H-O Model
1. Definition of Growth and Types of Growth
1.1
Increases in factor endowments and
Factor-saving technological progress
1.2
Biased economic growth:
Export Expanding (EE) Growth
vs. Import Replacing (IR) Growth
2. Effects of Growth in a Small Country
2.1 IR Growth
Qc
TOT
D2
D1
S2
S1
Qw
2.2 EE Growth
Qc
D2
TOT
D1
S1
S2
Qw
The Rybczynski Theorem
The Rybczynski Theorem postulates that at
constant commodity prices, an increase in the
endowment of one factor will increase by a greeter
proportion the output of the commodity intensive
in that factor and will reduce the output of the
other commodity.
3. Effects of Growth in a Large Country
3.1 IR Growth
Qc
D2
TOT
D1
S2
S1
Qw
3.2 EE Growth
Qc
TOT
D2
D1
S2
S1
Qw
3.3 A Special Case in the EE Growth
- Immiserizing Growth
Qc
TOT
D2 D1
S2
S1
Qw