Production and Consumption with and without Trade

International Economics

Chapter 1

Classical Theories of

International Trade

Chapter 1 Classical Theories of International Trade

• 1.1 Mercantilism

• 1.2 Trade Based on Absolute Advantage: Adam Smith

• 1.3 Trade Based on Comparative Advantage: David

Ricardo

• 1.4 Comparative Advantage and Opportunity Cost

• 1.5 Comparative Advantage with More Than Two

Commodities and Countries

• 1.6 Theory of Reciprocal Demand

• 1.7 Offer Curve and Terms of Trade

1.1 Mercantilism

• The mercantilists advocated government regulation of trade to promote a favorable trade balance.

• If a country could achieve a favorable trade balance, it would receive payments from the rest of the world in the form of gold and silver.

Such revenues would contribute to an increase in spending and thus a rise in domestic output and employment.

• Critics

• Possible only for short term

• Assuming static world economy





Ricardo






1.2 Trade Based on Absolute Advantage: Adam Smith

• With free trade, countries could concentrate their production on the goods they could produce most cheaply and enjoy all the consequent benefits from the labor division.

• Cost differences govern the international movement of goods.

The concept of cost is founded upon the labor theory of value.


• Two assumptions, within each country:

• Labor is the only factor of production and is homogeneous (i.e. of one quality).

• The cost or price of a good depends exclusively upon the amount of labor required to produce it.




An arithmetic example

Country

U.K.

U.S.

A Case of Absolute Advantage

Output per Labor Hour iPad Cloth

5 sets

15 sets

20 yards

10 yards

 The U.S. has an absolute advantage in iPad production; its iPad workers' productivity (output per worker hour) is higher than that of the U.K, which leads to lower costs (less labor required to produce a set of iPad).

 In like manner, the U.K has an absolute advantage in cloth production.





Ricardo






1.3 Trade Based on Comparative Advantage: David Ricardo

• Mutually beneficial trade can occur even when one country is absolutely more efficient in the production of all goods.

• The more efficient country should specialize in and export that good in which it is relatively more efficient (where its absolute advantage is bigger).

• The less efficient country should specialize in and export the good in which it is relatively less inefficient (where its absolute disadvantage is smaller).


• Assumptions of a simplified model

• There are only two countries with a fixed level of technology in the world;

• Each country owns only one input – labor, which is fixed endowed and homogenous and can move across industries but cannot flow across countries;

• Each country produces two commodities;

• Perfect competition and free trade prevail in markets.


• An Example of Comparative Advantage

A Case of Comparative Advantage

Country

U.S.

China iPads

5 sets

1 set

Output per labor hour

Cloth Relative cost

15 yards 1 iPad=3 yards of cloth

5 yards 1 iPad=5 yards of cloth

 The U.S. labor has a 5-to-1 absolute advantage in the production of iPads. The U.S. labor also has a 3-to-1 absolute advantage in the production of cloth. The U.S. has a greater absolute advantage in producing iPads than in producing cloth.

 China has an absolute disadvantage in the production of iPads and cloth. However, China’s absolute disadvantage is smaller in producing cloth than in producing iPads.


• Gains from Specialization and Trade with Comparative

Advantage

The Change in the World Output Resulting from Specialization

Change in the production of

Country iPads Cloth

U.S.

China

+5 sets

-3 sets

-15 yards

+15 yards

Change in the World Output +2 sets 0

 As the U.S. transfers 1 worker from cloth production to iPad production, its output of iPads increases by 5 and cloth production falls by 15 yards.

 As China transfers 3 workers from iPad production to cloth production, its cloth production increases by 15 yards and iPad production falls by 3.

 The gain from production and trade is the increase in the world output that results from each country specializing in its production according to its comparative advantage.


• Comparative Advantage in Money Terms

Comparative Advantage in Money Prices

Country Labor Input

Hourly Wage

Rate iPad (sets) Cloth (yards)

Quantity Price Quantity Price

U.S.

1 $20 5 $4 15 $1.33

China 1 $5 1 $5 5

 At this wage rate, China’s average cost in dollars of producing cloth is less than the U.S. average cost. With perfectly competitive markets,

China’s selling price of cloth is lower than its U.S. selling price, and

China exports cloth to the U.S..

 Even though China is not as efficient as the U.S. in the production of cloth, its lower wage rate in terms of dollars more than compensates for its inefficiency.

$1





Ricardo






1.4 Comparative Advantage and Opportunity Cost

• Opportunity Cost

• Opportunity cost is the quantity of one good that must be given up to release enough resources to produce one more unit of another good.

• The marginal rate of transformation (MRT) is the quantity of one good that it must abandon to produce each additional unit of another good.


• Gains from Specialization and Trade with Opportunity Costs

Production and Consumption with and without Trade

Based on an exchange ratio of 1 iPad=4 yards of cloth

Item

Production at Full

Employment

Consumption with Trade

Domestic Production and

Consumption without Trade

Gains from Specialization and

Trade

U.S.

100 iPads

0 yard of cloth

50 iPads

200 yards of cloth

50 iPads

150 yards of cloth

Country

China

0 iPad

300 yards of cloth

50 iPads

100 yards of cloth

40 iPads

100 yards of cloth

50 yards of cloth 10 iPads

 Both countries are better off when they specialize and trade .


• Production Possibilities Frontier and Constant

Opportunity Costs

• A production possibilities frontier (PPF) shows the different combinations of two goods that can be produced when all of a country’s factors of production are fully employed in their most efficient way.

• The slope of PPF is referred to as the marginal rate of transformation (MRT), which shows the amount of one product a country must sacrifice to get one additional unit of the other product.

• Without specialization and trade, the U.S. and China can produce and consume at any point along their respective production possibilities frontiers.


PPF for the U.S. and China at Full Employment

U.S.

China

Numbers of iPads Yards of Cloth Numbers of iPads Yards of Cloth

100

90

80

0

30

60

60

50

40

0

50

100

70

60

50

40

30

90

120

150

180

210

30

20

10

0

150

200

250

300

20

10

0

240

270

300


Cloth

300

U.S.

Cloth

300

China

C

C'

150

B

A

B'

MRT= −3

A'

MRT= −5

100

0 50 100 iPad 0 40 60 iPad

 Points below the PPF, say, Point B or B', represent possible production combinations that can be produced but are inefficient because there would be some unemployed resources.

 Points above the PPF, say, Point C or C', represent production combinations that are not possible for a country to produce with available resources and technology.


Cloth

300

U.S.

Cloth

300

D'

China

200

150 import

E

A

Trading possibilities line export

(terms of trade:

1 ipad = 4 cloth)

100

F' A' import

Trading possibilities line

E'

(terms of trade:

1 ipad = 4 cloth)

0 50

F D export

100 iPad 0 40 50 60 iPad

 With each country specializing in the production of the good in which it has a comparative advantage, 10 more iPads and 50 more yards of cloth are produced in the world.

 With trade, the set of consumption points that a country can achieve is determined by the terms of trade – the relative price of trading iPads for cloth, and vice versa.

 Both countries are better off by specializing and trade than they would be without trade.


• Changes in the Gains from Specialization and Trade

Production and Consumption with and without Trade

Based on an exchange ratio of 1 iPad=3.5 yards of cloth

Item

Production at Full Employment

Consumption with Trade

Domestic Production and

Consumption without Trade

Gains from Specialization and Trade

Country

U.S.

100 iPads

0 yard of cloth

50 iPads

175 yards of cloth

50 iPads

150 yards of cloth

0 iPad

25 yards of cloth

China

0 iPad

300 yards of cloth

50 iPad

125 yards of cloth

40 iPads

100 yards of cloth

10 iPads

25 yards of cloth


• As the international exchange ratio (terms of trade) changes from 1 iPad for 4 yards of cloth to 1 iPad for 3.5 yards of cloth, the trading possibilities curve moves for each country.

Cloth

300

U.S.

Cloth

300

D'

China

200

175

150

G

A

E

125

100

G'

A'

E'

0

D

50 100 iPad 0 40 50 60

Changes in the Terms of Trade for the U.S. and China iPad


• Distribution of the Gains from Trade

• Changes in a country’s terms of trade over time indicate whether a country can obtain more or less quantity of imports per unit of exports.

• A change in a country’s terms of trade may reflect a change in either international or domestic economic conditions.

• When the terms of trade change as a result of a change in domestic economic conditions, the effect on the country’s welfare is uncertain.


 Complete Specialization

 Each country specializes completely in the production of the good in which it has a comparative advantage and imports the other good.

 Complete specialization occurs because as production expands in the industry with a comparative advantage, the domestic cost of producing the product does not rise. Constant costs are assumed to prevail over the entire range of production.


• The firm’s cost curves and the product’s supply curves are horizontal.

Yards of

Cloth per iPad

Cloth

300

U.S.

S

U.S.

A

MRT= −3

3

150

0 100 iPad 0 50

Supply Curves of a Good and the PPF

100 iPad


• Trade under Increasing Opportunity Costs

• Increasing Costs and the PPF

Cloth

300

A

D

B

Yards of Cloth per iPad

E

F C

0

C

B

H

100

G iPad 0 100

The PPF and Supply Curve under Increasing Cost Conditions iPad


• The slope of the PPF at any point is represented graphically by the slope of a tangent to that point.

• A country has increasing opportunity costs.

• the tangent FG is steeper than DE.

• Two reasons:

• the factors of production used to produce the products are specialized in the production of a particular product.

• the premise that all resources are identical in the sense that all workers and capital have the same productivity in the production of both commodities is unrealistic.


• Production and Consumption without Specialization and Trade

• Without specialization and trade, the U.S. and China can produce and consume at any point on their PPF.

• Production and Consumption with Specialization and Trade

Cloth

0

Cloth

F

F'

C

K

A

Trade Triangle

H'

C'

J

H

D

Trade Triangle

A'

G

J'

K'

D' G' iPad 0

Specialization and Trade under Increasing Cost Conditions iPad


 Specializing in and exporting the good in which the country has a comparative advantage and trading for the other good enables both countries to become better off by consuming beyond their respective PPFs.

 Production under increasing cost conditions constitutes a mechanism that forces prices to converge and results in neither country specializing completely in the production of the good in which it has a comparative advantage.

 In the case of increasing costs, both countries continue to produce both goods after trade and it is called as

partial specialization.





Ricardo






1.5 Comparative Advantage with More Than Two


• Comparative Advantage with More Than 2 Commodities

• Each country will then have a comparative advantage in the commodities that it exports at the particular equilibrium exchange rate established .

Commodity Prices in the U.S. and U.K.

Commodity Price in the U.S. ($) Price in the U.K. ( ￡ )

A

B

C

D

E

6

8

2

4

10

3

2

6

4

1



 If the exchange rate is ￡ 1=$2, the dollar prices of the commodities in the U.K. would be:

Commodity A

Dollar price in the U.K

12

B

8

C

6

D

4

E

2

 The U.S. will export Commodities A and B to the U.K. and import Commodities D and E from the U.K., leaving Commodity

C not traded.



 If the exchange rate becomes ￡ 1=$3. The dollar prices of the commodities in the U.K. would be:

Commodity A


18

B

12

C

9

D

6

E

3

 The U.S. will export Commodities A, B and C to the U.K. and import Commodities D and E from the U.K.



 If the exchange rate turns to be ￡ 1=$1, the dollar prices of the commodities in the U.K. would be:

Commodity A


6

B

4

C

3

D

2

E

1

 The U.S. would export only Commodity A to the U.K. and import all other commodities, with the exception of

Commodity B.



• Comparative Advantage with More Than 2 Countries

Ranking of Countries in Terms of International P

W

/P

C

Country A B C D E

P

W

/P

C

1 2 3 4 5

 Given the equilibrium P

W

/P

C

=3 with trade, Countries A and B will export wheat to Countries D and E in exchange for cloth. Country C will not engage in international trade in this case because its pre-trade PW/PC equals the equilibrium PW/PC with trade.

 Given a trade equilibrium P

W

/P

C

=4, Countries A, B and C will export wheat to Country E in exchange for cloth, and Country D will not engage in the international trade.

 If the equilibrium turns to be P

W

/P

C

=2 with trade, Country A will export wheat to all the other countries except Country B, in exchange for cloth.





Ricardo

• 1.4 Comparative Advantage and Opportunity Costs





1.6 Theory of Reciprocal Demand

• Theory of reciprocal demand suggests that the actual price at which trade takes place depends on the trading partners’ interacting demands.

• According to the theory of reciprocal demand, final terms of trade will be closer to the domestic price ratio of the country with stronger demand for the imported good.

• The reciprocal demand theory contends that the equilibrium terms of trade depend on the relative strength of each country’s demand for the other country’s product.


• The stronger Canadian demand for autos relative to U.S. demand for wheat, vice versa.

2 C

Improving U.S.

Terms of Trade

Terms of Trade

(1:1)

Improving Canadian

Terms of Trade

1

D

E

U.S. Price Ratio (0.5:1)

0.5

A

B

0 0.5

1 2 Autos

Equilibrium Terms-of-Trade Limits


• The reciprocal demand theory best applies when both countries are of equal economic size, so that the demand of each country has a noticeable effect on the market price.

• If one country is significantly larger than the other, the larger country attains fewer gains from trade while the smaller country attains most of the gains from trade. This situation is characterized as the

importance of being unimportant.





Ricardo






1.7 Offer Curve and Terms of Trade

• Offer Curve

• The offer curve (or reciprocal demand curve) of a country indicates the quantity of imports and exports the country is willing to buy and sell on the world market at all possible relative prices.

• In short, the curve shows the country’s willingness to trade at various possible terms of trade.

• The offer curve really is a combination of a demand curve and a supply curve.


• Deriving an offer curve: trade triangle approach

Y Y

Y

3

Y

1

C

C'

S

1

Y

2

R P







P

P

X

Y







1

Y

4

R'

O X

1

X

2

(a)

V

X

O

S

2

X

3

(b)

X

4

P'







P

P

X

Y







2

V'

X

Trade Triangles at Two Possible Terms of Trade


• The construction of the offer curve is completed by connecting all possible

Imports of

I points at which a country is willing to trade.

(P

X

/P

Y

)

4

(P

X

/P

Y

)

3

T"'

(P

X

/P

Y

)

2

(P

X

/P

Y

)

1 T"

Y

6

T'

Y

5

T

O X

5

X

6

Exports of

Good X

Alternative Terms of Trade and Export-Import Combinations on the Offer Curve


• Equilibrium Terms of Trade

• Point E is the trading equilibrium. TOT

E

II's Exports of Good Y is the market-clearing price ratio.

OC

I (P

X

/P

Y

)

E or TOT

E

(P

X

/P

Y

)

1 or TOT

1

Y

2

Y

E E

B

OC

II

A

Y

1

O

X

1

X

E

Trading Equilibrium

X

2

I's Eports of Good X

II's Imports of Good X


Shifts of Offer Curves

I's Imports of Good Y

Decreased

Willingness to Trade

OC

I

"

F

G

OC

I

H

F'

OC

I

'

H'

TOT

2

TOT

E

G'

Reasons for Shifts:

 A change in tastes for the imported good;

TOT

1

 A rise in income that leads to an increased demand for imports;

Increased

Willingness to Trade

 An improvement in productivity in Country I’s export industries.

O

I's Exports of Good X

Shifts in Country I’s Offer Curve


 When offer curves shift, the equilibrium terms of trade and volume of trade

OC

I

' change.

I's Imports of Good Y

II's Exports of Good Y

OC

I

Y

TOT

E

2 E''

TOT

1

E'

Y

1

Y

E

OC

II

E

O

X

E

X

1

X

2

I's Exports of Good X

II's Imports of Good X

Increased Demand for Imports by Country I


• Terms of Trade Estimates

• The relative price ratio P

X

/P

Y in the offer curve diagram is called as the commodity terms of trade, or net barter terms of trade .

• The economic interpretation of the terms of trade:

•

As the price of exports rises relative to the price of imports, each unit of a country’s exports is able to purchase a larger quantity of imports. Thus, more imports, which like any other goods bring utility to consumers, can be obtained with a given volume of exports, and the country’s welfare on the basis of those price relations alone has improved.


• In calculating the terms of trade for any given country, a price index must therefore be calculated for exports and imports.

• The price index is a weighted average of the prices of many goods, calculated for comparison with a base year.

• The base-year price indices are then set at values of

100, and other years can be compared with them.

• Over a long period, terms of trade illustrates how a country’s share of the world gains from trade changes and gives a rough measure of the fortunes of a country in the world market.


• Other Concepts of the Terms of Trade

• Income Terms of Trade

• TOT

Y

= (P

X

/P

M

) × Q

X or (P

X

× Q

X

)/P

M

• where Q

X is the quantity index of exports.

• Single Factoral Terms of Trade

• TOT

SF

= (P

• where O

X

X

/P

M

) × O

X is the productivity index.

• Double Factoral Terms of Trade

• TOT

DF

= (P

• where O imports.

X

M

/P

M

) × (O

X

/O

M

) represents the foreign productivity index for the home country’s

Production and Consumption with and without Trade

International Economics

Chapter 1

Classical Theories of

International Trade

An arithmetic example

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Production and Consumption with and without Trade

International Economics

Chapter 1

Classical Theories of

International Trade

An arithmetic example

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