ECON5335 - International Economics
Chapter 4
Trade Flows in Theory
Trade models
- usually question being asked: “why do we
trade what we trade?”
- 3 very simple theoretical models
- autarky initial position
- permit trade to occur
- other question asked is “who do we trade
with?”
- empirical model based on econometrics
3/19/2016
2
Only two goods
Meat
Potatoes
Only two people
Rancher
Farmer
3
If rancher (R) produces only meat
and farmer (F) produces only potatoes
then both have potential to gain from trade
If both R and F produce both meat and potatoes
Both can potentially gain from specialization and
trade
Production possibilities frontier (PPF)
Various mixes of output that economy can produce if
all resources used to capacity
4
The Production Possibilities Frontier (a)
Panel (a) shows the production opportunities available to the farmer and the rancher.
5
(b) The farmer’s production
possibilities frontier
Meat (oz)
If there is no trade, the farmer
chooses this production and
consumption.
(c) The rancher’s production
possibilities frontier
Meat (oz)
24
8
12
4
0
If there is no trade, the
rancher chooses this
production and consumption.
B
A
16
32
Potatoes (oz)
0
24
48
Potatoes (oz)
Panel (b) shows the combinations of meat and potatoes that the farmer can produce. Panel (c)
shows the combinations of meat and potatoes that the rancher can produce. Both production
possibilities frontiers are derived assuming that the farmer and rancher each work 8 hours per
day. If there is no trade, each person’s production possibilities frontier is also his or her
consumption possibilities frontier.
6
Specialization and trade
Farmer – specialize in growing potatoes
More time growing potatoes
Less time raising cattle
Rancher – specialize in raising cattle
More time raising cattle
Less time growing potatoes
Trade: 5 oz of meat for 15 oz of potatoes
Both gain from specialization and trade
7
(a) The farmer’s production
and consumption
Meat (oz)
Meat (oz)
Farmer's production
and consumption
without trade
8
A*
5
4
0
(b) The rancher’s production
and consumption
A
16 17
24
Farmer's
consumption
with trade
Rancher’s production
with trade
18
B*
13
12
B
Farmer's
production
with trade
32
Potatoes (oz)
0
12
24 27
Rancher’s
production and
consumption
without trade
Rancher’s
consumption
with trade
48
Potatoes (oz)
The proposed trade between the farmer and the rancher offers each of them a combination of
meat and potatoes that would be impossible in the absence of trade. In panel (a), the farmer gets
to consume at point A* rather than point A. In panel (b), the rancher gets to consume at point B*
rather than point B. Trade allows each to consume more meat and more potatoes.
8
The proposed trade between the farmer and the rancher offers each of them a
combination of meat and potatoes that would be impossible in the absence of trade. In
panel (a), the farmer gets to consume at point A* rather than point A. In panel (b), the
rancher gets to consume at point B* rather than point B. Trade allows each to
consume more meat and more potatoes.
9
Absolute advantage
Produce a good using fewer inputs than another
producer
10
The Opportunity Cost of Meat and Potatoes
Opportunity cost
• Whatever must be given up to obtain some item
• What you give up to get something else
• Measures the trade-off between the two goods that each
producer faces
11
Comparative advantage
Produce a good at a lower opportunity cost than
another producer
Reflects the relative opportunity cost
Principle of comparative advantage
Each good - produced by the individual that has the
smaller opportunity cost of producing that good
Developed by David Ricardo
12
One person
Can have absolute advantage in both goods
By definition, cannot have comparative advantage
in both goods
For different opportunity costs
One person - comparative advantage in one good
The other person - comparative advantage in the
other good
13
Gains from specialization and trade
Based on comparative advantage
Total production in economy rises
Increase in the size of the economic pie
Everyone – better off
Can apply to individuals, firms, and countries
14
Trade can benefit everyone in society
Allows people to specialize
The price of trade
Must lie between the two opportunity costs
Principle of comparative advantage explains:
Interdependence – reliance on other individuals,
firms or countries
Gains from trade – applies to individuals, firms and
countries
15
Should the U.S. trade with other countries?
U.S and Japan
Each produces food and cars
One American worker, one month
One car, or
Two tons of food
One Japanese worker, one month
One car
One ton of food
16
Principle of comparative advantage
Each good – produced by the country with the
smaller opportunity cost of producing that good
Specialization and trade
All countries have more food and more cars
17
In theory
Clear that there are gains from specialization and
trade that arise from differences in productivity of
labor and capital in each sector
So in Ricardian model if we assume labor is the only
factor of production then labor productivity would
drive comparative advantage and determine who
trades what
aLFQF + aLMQM = L
Labor required for
each unit of food
production =
productivity
Total units
of food
production
Labor required for
each unit of meat
production
Total amount of
labor resources
Total units
of meat
production
18
If the domestic country wants to consume both meat
and food (in autarky), relative prices must adjust so
that wages are equal in the wine and cheese
industries.
If PF /aLF = PM /aLM workers will have no incentive to flock to
either the food or the meat industry, thereby maintaining a
positive amount of production of both goods.
PF /PM = aLF /aLM
Production (and consumption) of both goods occurs when
relative price of a good equals the opportunity cost of
producing that good.
Suppose that the domestic country has a
comparative advantage in food production:
its opportunity cost of producing cheese is lower
than it is in the foreign country.
aLF /aLM < a*LF /a*LM
where “*” notates foreign country variables
Note here that this is the relative productivity which
therefore determines comparative advantage
Heckscher Ohlin Model (1919)
Problem with Ricardian model was that it only had
one factor of production
So here a 2 good, 2 FoP model
Different rule emerges for comparative advantage
Krugman economies of scale model
Differentiated products
Economies of scale
Different results for comparative advantage
Look at abundance of FoP or resources
Country with relatively abundant amount of FoP
will export good or service which is intensive in
that factor
Therefore comparative advantage is in the
relative abundance of the FoP
K/L ratio indicates factor abundance
If US has K/L = 0.5 and China has K/L = 0.02 then
US has relatively more K and China relatively
more L
So China should export good which uses L
intensively, and US should export good which
uses K intensively
So price of K rises in US and price of L falls
Opposite happens in China: price of L rises and
price of K falls
But before in autarky L was paid much less in
China than in the US as so much L in China.
Implication is that there is convergence in factor
prices across countries – known as “factor price
equalization”
In Ricardian model no distributional
consequences – here they are possible
If US exports more K intensive goods, then
income earned by K goes up (conversely income
earned by L goes down)
Vice versa for China
Therefore owners of K in US better off
compared with L and v-v for China
Known as the “Stolper Samuelson Theory”
Need to test H-O theory to see if it is true
Wassily Leontief collected data for US and if H-O
correct US exports should have higher K/L ratio
than imports
(1947) Results: US X = $14K/L
US M = $18K/L
Was H-O wrong? Leontief called it a “paradox”.
Resolution came from widening defn of K
By looking at average years of education (“human capital”)
Baldwin found that greater factor intensity in exports.
Paul Krugman developed a model of trade with
differentiated products. Why?
Here by trading we can expand our market and
lower our costs
But depends on the size and type of economies
of scale
Economies of scale – internal?
Economies of scale – external?
Linder’s theory of overlapping demands
Paul Krugman developed a model of trade with
differentiated products. Why?
Here by trading we can expand our market and
lower our costs
But depends on the size and type of economies
of scale
Economies of scale – internal?
Economies of scale – external?
Linder’s theory of overlapping demands
Given trade begins between 2 countries with
similar industries
We would expect
Total # of firms to fall
Price to fall as costs fall
Variety in each country to increase
Average size of firms to increase
Ricardian and H-O models explain “interindustry” trade
Krugman explains “intra-industry” trade
3 of the top 10 trading partners with the US
in 2011 were also the 3 largest European economies:
Germany, UK and France.
These countries have the largest gross domestic
product (GDP) in Europe.
Why does the US trade most with these European
countries and not other European countries?
2-30
In fact, the size of an economy is
directly related to the volume of imports
and exports.
Larger economies produce more goods and
services, so they have more to sell in the
export market.
Larger economies generate more income from the
goods and services sold, so people are able to buy
more imports.
2-31
2-32
Other things besides size matter for trade:
1. Distance between markets influences transportation
costs and therefore the cost of imports and exports.
Distance may also influence personal contact and
communication, which may influence trade.
2. Cultural affinity: if two countries have cultural ties, it
is likely that they also have strong economic ties.
3. Geography: ocean harbors and a lack of mountain
barriers make transportation and trade easier.
2-33
4. Multinational corporations: corporations spread
across different nations import and export many
goods between their divisions.
5. Borders: crossing borders involves formalities that
take time and perhaps monetary costs like tariffs.
These implicit and explicit costs reduce trade.
The existence of borders may also indicate the
existence of different languages (see 2) or different
currencies, either of which may impede trade more.
2-34
In its basic form, the gravity model assumes that
only size and distance are important for trade in the
following way:
Tij = A * (Yi * Yj)/Dij
where
Tij is the value of trade between country i and country j
A is a constant
Yi the GDP of country i
Yj is the GDP of country j
Dij is the distance between country i and country j
2-35
In a slightly more general form, the gravity model that
is commonly estimated is
Tij = A x Yia x Yjb /Dijc
where a, b, and c are allowed to differ from 1.
Perhaps surprisingly, the gravity model works fairly
well in predicting actual trade flows, as the figure
above representing US–EU trade flows suggested.
2-36
Estimates of the effect of distance from the gravity
model predict that a 1% increase in
the distance between countries is associated with a
decrease in the volume of trade of
0.7% to 1%.
Besides distance, borders increase the cost and time
needed to trade.
2-37
Trade agreements between countries are
intended to reduce the formalities and tariffs
needed to cross borders, and therefore to
increase trade.
The gravity model can assess the effect of
trade agreements on trade: does a trade
agreement lead to significantly more trade
among its partners than one would
otherwise predict given their GDPs and
distances from one another?
2-38
The US has signed a free trade agreement
with Mexico and Canada in 1994, the North
American Free Trade Agreement (NAFTA).
Because of NAFTA and because Mexico
and Canada are close to the US, the
amount of trade between the US and its
northern and southern neighbors as a
fraction of GDP is larger than between the
US and European countries.
2-39
2-40
Yet even with a free trade agreement between the
US and Canada, which use a common language, the
border between these countries still seems to be
associated with a reduction in trade.
So Canadian provinces trade more with each other,
than with US states, ceteris paribus
2-41
2-42
2-43
Shows that still more likely to trade if no
borders
But also shows that size and geography also
matter
Gravity model tested extensively in economics
literature
Shows that US’s natural trade partner is Canada
and to a lesser extent Mexico