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  International trade
                Nex topic: International Trade
• Ch 16 in the text begins by reviewing some statistics
  about one of the most dramatic developments in the
  world economy in the second half of the 20th century: the
  expansion of exports from Asia to the rest of the world
• In the early stages, the most remarkable performers
  were Hong Kong, Singapore, Taiwan, and South Korea
   – of course, the export success of those economies was preceded
     by the earlier success of Japan; other countries that had
     considerable (though not as dramatic) success were Malaysia
     and Thailand; they may be followed by Vietnam
• In the last 25 years, the even more dramatic example of
  successful economic growth through a focus on exports
  of course have been China and (to a somewhat lesser
  extent) India
              Basic theory of international trade
• Section 16.2 describes the basic principle of comparative
  advantage for the case of constant costs and differing
   – study the example in Table 16.5 in the text, involving computers
     and rice (next slide)
   – make absolutely sure that you know the difference between
     comparative advantage and absolute advantage
• Section 16.3 talks about sources of comparative
  advantage: 1) Technology differences; 2) Factor
  endowments; 3) Preferences; 4) Economies of Scale
   – technology differences can obviously cause different
     comparative advantage, as in the computer-rice example
   – note that if we want to talk about China’s economic success, we
     should talk not just of comparative advantage but also of the
     improvements in technology associated with expanding trade
              Comparative advantage example
• The following table summarizes information about
  production technology in two countries (N and S) that
  produce two goods (computers, rice)

         Technology/     Labor per   Labor per
         Country        computer     sack rice
          N              10           15
          S              40           20

• Also assume that each country has 600 units of labor each
• Note in this example that labor is more productive in N
  whether it produces computers or rice
   – fewer units of labor is needed in N than in S to produce one
     computer (10 vs 40) or one sack of rice (15 vs 20)
• The principle of comparative advantage still says that S
  will be able to compete in the production of rice
          Comparative advantage, PPCs and trade
• On the board, we draw the PPCs for the two countries
• We can illustrate the potential gains from trade in several
  ways in this example
   – in the text it shows that if N imports rice from S, it is possible for
     citizens in N to consume a combination of C and R that would
     not be attainable if N did not trade with S
• Another way of illustrating the gains from trade would be
  if we assumed that citizens in both countries always
  consumed C and R in fixed proportions (that is,
  consumed the same number of units of C and R)
• With no trade, how much would consumption be in each
  country? Answer: in N citizens would consume 24R,
  24C; in S they would consume 10R, 10C
               Comparative advantage, cont’d
• So in the whole world, consumption of C and R would be
  34 each
• But now suppose S specializes completely in the
  production of R (why would it do that?)
• You can then show that in the whole world, it would then
  be possible for all citizens to consume 42 units of C and
   – how would the gains from trade be distributed in this case? You
     can show that citizens in S could consume {R=18,C=18},
     meaning citizens in N would consume {24,24}. So all of the gains
     would go to citizens in S in this case.
• What about the role of currencies and exchange rates in
  this discussion?
   – suppose S and N had different currencies
         International trade and different currencies
• The problem of different currencies can be overcome
  this way: producers of rice in S could just bring their rice
  to N, sell it for N-currency, then buy computers in N
• These computers could then be brought back to S and
  sold for S currency; so indirectly, rice producers in S
  would be paid for their sales in N, in S-currency
• In reality, currencies are sold in separate markets, by
  separate traders
   – however, the underlying demand by foreigners for a country’s
     currency reflects foreigners’ demands for goods that they want to
     import from that country; the supply of a country’s currency in
     foreign markets reflects amounts that exporters to that country
     have earned by sales there
• Exchange rates adjust until supply and demand for a
  country’s currency is in equilibrium
               Basic theory of international trade
• In the previous example comparative advantage arose
  because countries’ technologies were different
• However, comparative advantage can be caused by
  differences in factor endowments even if countries have
  access to the same technology in each line of production
   – the analysis of this source of comparative advantage is on pp.
     631 to 635 in the text
• On the board, I will go through the interpretation of the
  “box diagrams” in the example with cars and textiles,
  with cars being the capital-intensive and textiles being
  labor-intensive commodities
   – the box diagrams lead to production possibilities curves. With
     similar tastes in the different countries, this leads the country that
     is rich in capital to specialize (incompletely) in the production of
     the capital-intensive good, and vice versa




C1                   D



A                   L1                 Labor
                   A typical box diagram
• The preceding is a diagram in which an economy’s fixed
  amounts of capital and labor can be allocated to either
  the production of good A (measured from the lower left)
  or good B (measured from the upper right)
• The dimensions of the box reflect the total amount of
  capital and labor in this economy
• You can think of this as a competitive economy in which
  the two goods are produced by many similar small firms
• Now consider a fixed amount of good A (say, the
  quantity corresponding to isoquant A1). It can be
  produced by any combination of capital and labor in
  industry A along isoquant A1
• But for given amounts of capital and labor allocated to A,
  the rest goes to the production of B!
                   Box diagram, cont’d
• Similarly, isoquant B1 shows various combinations of
  capital and labor allocated to the production of good B
  (measured from point B, on the upper right) that can
  produce a fixed quantity B1
• Now suppose we are given a fixed quantity of good A,
  say A2. We can tell what combinations of capital and
  labor are sufficient to produce A2 (along the isoquant
• But now ask the question: for this amount of good A,
  what is the maximum amount of good B that we can
• The answer is given by point D, which shows that we
  can produce B2 units of B if we produce A2 units of A.
  B2 is the maximum amount of B we can produce then
                 Box diagrams and PPCs
• But if we know the quantities of A and B corresponding
  to each isoquant in the box diagram, we can use these
  tangency points to derive a PPC for this economy (next
• Given this PPC, and supposing also that all consumers
  in this economy have identical incomes and indifference
  maps, we can find the point on the PPC that gives the
  highest welfare for the representative consumer in this
• This is the point where the slope of this consumer’s
  indifference curve is the same as the slope of the PPC
• The following slide then shows PPCs for two countries
  with different factor endowments
     C        In this economy consumers are best off when
A             A0, B0 are produced, as this enables consumers
              to reach indifference curve C. (It represents a
              higher level of utility than at any other point on
              the PPC)



         B0                                            B
         C       If one country has PPC1 and another country
A                has PPC2, if they don’t trade consumers can
                 only reach indifference curve C. If they do trade
                 consumers can reach any point along the
    D’           dotted line (such as F*), where they will be
                 better off than without trade



                   PPC1                               PPC2

         Endowment-based trade and factor prices
• If countries have access to the same technology and
  trade with one another, there is a tendency for the
  returns to different factors of production to be the same
  everywhere in the world (discuss why)
   – this tendency will be less strong if costs of transportation
     between countries is high
• Be careful to distinguish between “technology” and
  “production technique”
   – “technology” can be interpreted as referring to the production
     function; “technique” refers to the particular factor combination a
     firm uses
• In reality, international trade reflects both differences in
  factor endowments, and differences in the nature of the
  technology used in different countries
 Substitution between trade in goods and trade in factors
• When we explain patterns of international trade by
  differences in factor endowments, we are implicitly
  suggesting that trade in goods and services can
  substitute for international flows of factors of production
• For example, if a country has a very large endowment of
  unskilled labor but little capital and land, labor income
  can be raised if workers migrate to countries where there
  is more abundant capital and land
• Similarly if a country has a large amount of capital, the
  capital can be exported to countries where there are
  large amounts of labor and land
   – what does “exporting capital” mean? It can mean shipping
     capital goods (machines, trucks) to other countries; or it can
     mean financing the consumption that is foregone when domestic
     production factors are used for investment
 Substitution between trade in goods and trade in factors
• However, an alternative to sending abundant factor to
  foreign countries is to specialize instead in the
  production of goods and services that use factors that
  are abundant in the domestic economy
• The clearest examples of this pattern is either when
  countries with large amounts of unskilled labor specialize
  in the production of labor-intensive goods, or when
  countries with an abundance of certain kinds of natural
  resources export these resources
   – energy and minerals are perhaps the most important examples
• An early paradox relevant to this idea was that data on
  US exports in the first half of the 1900s did not seem
  consistent with the idea that they were capital-intensive
   – however, further analysis showed that while US exports were not
     capital-intensive in the traditional sense, they were intensive in
     the use of human capital
       Endowments, technology; economies of scale
• Another aspect that probably has been of great
  importance for Asian countries is the idea that
  international trade may help in technology transfer
   – they need not be linked in principle, but in reality they probably
• Text also observes that international trade may also
  reflect differences in the structure of demand
   – for example, many low-income countries may have comparative
     advantage in production of food
   – however, they may not be major food exporters because at low
     levels of income, a large share of total income is spent on food
   – note that the supply of particular kinds of exports can be
     interpreted as the excess of domestic supply over domestic
• Finally international trade may also reflect strong
  economies of scale
         International trade and economies of scale
• Especially in industries with differentiated products,
  economies of scale may be very substantial for each
  product variety
   – a good example is the car industry, where there is differentiation
     among vehicle types (subcompact, compact, large passenger
     cars; SUVs, mini-vans; light/heavy trucks), as well as among
• Economies of scale can be very substantial for each type
  and brand of car
   – hence it is common for a particular large car factory to produce
     only one or two models of a particular brand, for many countries
• In aircraft manufacturing some firm specialize in large
  wide-bodied jets (Boeing, Airbus), while others produce
  smaller short-haul jets (Canada, Brazil, Sweden)
         International trade and economies of scale
• Each type of plane is produced in at most one or two
  places, and sold everywhere in the world
• In industries where there is product variety, there can
  therefore be a large amount of “cross-hauling”
   – meaning that a given country may both import and export large
     amounts of goods and services produced by the same industry
• Another component of international trade arises because
  of economies of scale in production of intermediate
   – intermediate products: production of components that go into
     assembling final goods
• Intermediate products are important in industries like
  cars, electronics, construction … Some are shipped to
  factories all over the world
      Trade, economies of scale, and transport costs
• A very important explanation for the high growth of
  international trade has been reductions in transport cost
• There have been large reductions in the cost of ocean
  shipping (larger boats), and air freight
   – “containerization” has been a very important factor, which has
     reduced transshipment costs tremendously
• Another crucial factor has been improvements in
  telecommunication and IT in general
   – important not just for outsourcing of services (the case of India)
     but also for the globalization of manufacturing
• An issue on the horizon: to what extent will attempts at
  protecting the environment put a brake on the expansion
  of international trade?
   – air and truck transport are major contributors to GHG emissions
         International trade policy and development
• Although most Asian countries have benefited from
  expanded international trade, historically there were
  many who thought that international trade might not
  benefit developing countries
• In early international trade developing countries mostly
  exported primary products
   – tropical foodstuffs, minerals, wood products, …
• It was often thought that this put them at a long-term
  disadvantage because the “terms of trade” would tend to
  move against primary producers
   – changes in the terms of trade: how a price index of a country’s
     exports changes relative to a price index for its imports
• The hypothesis was that the relative prices of primary
  products would fall over time
      Declining terms of trade for primary exporters?
• This prediction in part was based on the idea that the
  income elasticity of world demand for food products was
  less than one (so demand for tropical foods would grow
  slowly), in part on the idea that technology would
  develop substitutes for primary raw materials
   – synthetic rubber is a good example; plastics vs wood products is
• The idea also was that economic growth would ultimately
  be based on the invention or at least adoption of more
  productive technology in the domestic economy, and that
  this would happen at a faster rate in an economy with a
  large industrial sector than in an economy that focused
  on primary production
   – in part this was based on the idea that productivity can increase
     through “learning by doing”
              Terms of trade, learning by doing
• At the same time, it was thought that learning by doing
  was not rapid in primary production, especially not when
  primary exports were based on foreign technology
• So some degree of restriction of international trade was
  supported for developing countries, both in order to
  improve developing countries’ terms of trade, and to
  encourage domestic industrialization
• An additional argument for taxation of international trade
  was that it was an easily accessible source of
  government revenue
• In some countries, primary exports were discouraged
  through export taxes
   – export taxes were used to raise government revenue; they could
     also be justified by arguing that they would improve the terms of
     trade for primary exporters (diagram)
                 Export taxes vs import tariffs
• Indirectly, taxes on primary exports would also
  encourage domestic industrialization
   – by reducing exports, they would reduce the supply of foreign
     currency, hence raise its market price. This would make it easier
     for domestic producers to compete with imported products
• However, export taxes are unpopular among domestic
  producers in the export sector (including foreign-owned
  firms). Tariffs (that is, taxes on imported goods) are
  easier to defend politically
   – they are popular among domestic firms who compete with
     importers (and among workers who work for domestic industrial
     firms), and bring in government revenue
• Sometimes restrictions of imports was also
  accomplished via systems of import licensing and quotas
• On the board illustrate the conventional efficiency effects
  of tariffs and quotas
           Tariffs, quotas, and exchange controls
• Finally in many countries international trade was further
  restricted through systems of foreign exchange controls
   – under systems of exchange controls, residents are not allowed
     to buy and sell foreign currency except with government
   – by restricting the approvals to use foreign currency to buy
     imported goods, governments could further restrict imports
• In some countries, the policy of encouraging domestic
  industrialization by protecting domestic producers
  against foreign competition appears to have had some
   – Japan in the early stages of industrialization may be one
     example; Mexico and Brazil also have had some degree of
   – in these cases, industrial sectors emerged that ultimately were
     able to compete in world markets
           Import substitution vs export promotion
• The strategy of encouraging domestic industrialization
  through restriction of imports is referred to as “import
   – it is intended to be temporary
• In many cases in Latin America, Africa, and in some
  places in Asia, however, this strategy proved ineffective
   – in many cases, domestic industries that were protected against
     competition from imports failed to become more productive and
     were unable to compete without protection
• Another strategy that proved more successful was a
  strategy of “export promotion”
   – in such cases, domestic firms were assisted in various ways as
     they tried to compete in export markets
• Examples of economies that have been successful with
  this strategy include South Korea, Taiwan, Singapore,
  Malaysia, Thailand, Vietnam …
                       Export promotion
• In some cases, export promotion has been more
  successful as an industrialization strategy because it has
  involved more intensive use of foreign technology and
  marketing efforts
• A downside of an export-oriented strategy is that makes
  a country vulnerable to international economic conditions
• An obvious example is what happened to China’s export
  industries as a result of the international recession in
   – to some extent, shocks in the international economy can be
     offset via macro-economic management, but such policies work
     with a time lag
• A country that depends to a substantial extent on exports
  also become vulnerable to trade policies in importing
     Export dependence and international trade policy
• Governments in importing countries often find it difficult
  to resist pressure from domestic industries that want to
  protect themselves against competition from imports
• This issue can be particularly difficult for a country that is
  trying to compete in labor-intensive industries
   – in importing countries, there are still labor-intensive industries
     that employ many workers. Workers in such industries can be
     able to exert considerably pressure on their political
     representatives to advocate various policies to restrict imports.
     This can hurt exporting countries, and workers in these countries
     export industries
• For exporting countries in this situation, international
  agreements (such as the WTO) offer valuable protection
  against arbitrary restrictive policies in importing countries
• Other important policies relate to exchange rate
           The international economy in the future
• One issue that must be watched in the next few years is
  the international monetary system
• As a result of the 2008 crisis, countries everywhere in
  the world have pursued very inflationary monetary
• Either these policies will have to be reversed (causing
  rising interest rates), or countries will accept much higher
  rates of price inflation than has prevailed in recent years
   – both alternatives are risky
• Another issue will be climate change and Green-House
  Gas Emissions
   – industries in countries where governments force firms to reduce
     emissions will try to ask for restrictions on imports from countries
     where emissions are less strictly controlled

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