Trade-Theories-1-3 by xiuliliaofz

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									Trade Theories:

#1 - Mercantilism
      Defining mercantilism …

Mercantilism

  •The theory that a country should 
  accumulate financial wealth by amassing 
  as many inflows of “currency” as 
  possible
 Mercantilism: 16th – late 18th century

• A nation’s wealth depends on accumulated 
  treasure
  • Gold and silver are the currency  of trade

• Two means of increasing a country’s wealth are 
  colonialism and international trade.
                  Mercantilism

• A system of government institutions and 
  policies designed to restrict international trade

  – Maximize exports through subsidies.
  – Minimize imports through tariffs and quotas

• The theory therefore says that a country should 
  always have a trade surplus. 
    Mercantilism: Policies


•   Forbidding colonies to trade with other nations
•   Monopolizing markets with staple ports;
•   Forbidding trade to be carried in foreign ships;
•   Maximizing the use of domestic resources;
•   Also restricting domestic consumption with non-tariff 
    barriers to trade.
         Mercantilism – 9-point plan
•   That every inch of a country's soil be utilized for agriculture, mining or 
    manufacturing.
•   That all raw materials found in a country be used in domestic 
    manufacture, since finished goods have a higher value than raw materials.
•   That a large, working population be encouraged.
•   That all export of gold and silver be prohibited and all domestic money be 
    kept in circulation.
•   That all imports of foreign goods be discouraged as much as possible.
•   That where certain imports are indispensable they be obtained at first 
    hand, in exchange for other domestic goods instead of gold and silver.
•   That as much as possible, imports be confined to raw materials that can 
    be finished [in the home country].
•   That opportunities be constantly sought for selling a country's surplus 
    manufactures to foreigners, so far as necessary, for gold and silver.
•   That no importation be allowed if such goods are sufficiently and suitably 
    supplied at home.
           Mercantilism: Flaws

• impaired economic growth
• Ignores living standards 
• Ignores human development
   Trade Theories:

#2 - Absolute Advantage
                 Adam Smith and the 
         Attack on Mercantilism and Economic 
                     Nationalism

• In 1776, Adam Smith published the first modern statement of
  economic theory, An Inquiry into the Nature and Causes of the
  Wealth of Nations
   – The Wealth of Nations attacked mercantilism—the system
     of which dominated economic thought in the 1700s
   – Smith proved wrong the belief that trade was a zero sum
     game—that the gain of one nation from trade was the loss
     of another
   – On the other hand… Voluntary exchange (trade) is a
     positive sum game —both nations can gain
     Theory of absolute advantage

• Adam Smith ideas based on…

  – The capability of one country to produce more 
    of a product with the same amount of input
    than another country 
  – (same thing) The ability of a country to produce
    a good using fewer resources than another 
    country (lower opportunity cost)
      Theory of absolute advantage

• Adam Smith argued:

   – A country should produce only goods where it 
     is most efficient …. and trade for those goods 
     where it is not efficient

• Trade between countries is, therefore, beneficial 
   Theory of absolute advantage
• … destroys the mercantilist idea since there 
  are gains to be had by both countries party to 
  an exchange
• … questions the objective of national 
  governments to acquire “wealth”: through 
  restrictive trade policies
• … also measures a nation’s wealth by the 
  living standards of its people
                 TRADE BASED ON 
               ABSOLUTE ADVANTAGE

• Consider this “simple” example involving the EU 
  and India
• Only two products are produced, machines and 
  cloth
• Labor is fixed, homogeneous within a country, 
  the only factor of production, and is fully utilized
• Technology and production costs are constant
• Transportation costs are zero and the countries 
  barter (trade) for goods
            TRADE BASED ON 
          ABSOLUTE ADVANTAGE



             One Person Per Day of Labor
                      Produces
Country    Machines       Cloth
                          10 yards of
EU         5 machines
                          cloth
                          15 yards of
India      2 machines
                          cloth
        THE PRODUCTION POSSIBILITIES FRONTIER 
                AND CONSTANT COSTS

• The Production Possibilities Frontier (PPF) is a 
  curve showing the various combinations of two 
  goods that a country can produce when all of a 
  country’s resources are fully employed and used 
  in their most efficient manner

                     One Person Per Day of Labor Produces

Country           Machines             Cloth

EU                5 machines           10 yards of cloth

India             2 machines           15 yards of cloth
                                  One Person Per Day of Labor Produces

   Country                   Machines                   Cloth

   EU                        5 machines                 10 yards of cloth

   India                     2 machines                 15 yards of cloth


  Production Possibilities Curves for the United States and India

Machines

        5




        2


                                                                         Cloth
                                            10                      15
                                                  EU
      India
                                        Cloth           Mach
Cloth    Mach
                                          10             0
15        0
                                           8             1
7.5       1
                                           6             2
 0        2
                                           4             3
                                           2             4
                                           0             5
           “Opportunity Cost” also known as “Relative Price”

India - Opportunity Costs              EU - Opportunity Costs

Machine = 7.5 cloth                    Machine   = 2 cloth
Cloth   = 0.133 machine                Cloth     = 0.5 machine
                                                Same graph, drawn more to scale!


             What Determines the Slope of the PPC?
      Slope = ∆Machines/∆Cloth = Opportunity Cost of Machines

          This slope is also known as the … Marginal Rate of Transformation




Machines


                   EU: Slope = Opportunity Cost = -0.5



                                         India: Slope = Opportunity Cost = -0.133
      5



      2
                                                                     Cloth
                                           10                   15
Absolute Advantage: Production Conditions 
       When Each Country Is More Efficient in the 
       Production of One Commodity


 • EU workers are more productive in producing 
   machines
 • The EU has an absolute advantage in 
   machine production

 • Indian workers are more productive in 
   producing cloth
 • India has an absolute advantage in cloth 
   production
                  TRADE BASED ON 
               ABSOLUTE ADVANTAGE … 
        Yes, maybe that was obvious to you from the
                        beginning…



                  One Person Per Day of Labor Produces
Country         Machines            Cloth
EU              5 machines          10 yards of cloth
India           2 machines          15 yards of cloth




                                            What does this mean?
               What ???
     Theory of absolute advantage


• Adam Smith: Wealth of Nations (again)
  argued:

  – A country should produce only goods 
    where it is most efficient,  and trade for 
    those goods where it is not efficient
Assume TWO Persons per day, so that each product can be fully produced

                        Two Persons Per Day of Labor Produces
   Country              Machines              Cloth
   EU                   5 machines   (and)    10 yards of cloth
   India                2 machines    (and)   15 yards of cloth
   World Output         7 machines   (and)    25 yards of cloth




        This is a condition under Autarky: (The
        complete absence of trade)

             •Under Autarky all nations can only
             consume the goods they produce at
             home
Assume TWO Persons per day, so that each product can be fully produced

                           Two Persons Per Day of Labor Produces
   Country                Machines                  Cloth
   EU                     5 machines      (and)     10 yards of cloth
   India                  2 machines       (and)    15 yards of cloth
   World Output           7 machines      (and)     25 yards of cloth

     However, if each country produces to their absolute advantage …below…


                            Two Persons Per Day of Labor Produces
    Country                Machines                 Cloth
    EU                     10 machines               0 yards of cloth

    India                  0 machines               30 yards of cloth            .
    World Output           10 machines      (and)   30 yards of cloth
                                                                             .
                       TRADE BASED ON 
                     ABSOLUTE ADVANTAGE

          So there has obviously been an increase in World Output!!




                                     Change in the Production of

Country                      Machines                Cloth

EU                           +5 machines             –10 yards of cloth

India                        –2 machines             +15 yards of cloth

Change in World Output +3 machines                     +5 yards of cloth



                                                                           .
             TRADE BASED ON 
           ABSOLUTE ADVANTAGE

• Both countries can benefit if trade
  occurs

  – EU produces machines and exports them
    to India
  – India produces cloth and exports it to the
    EU
                           Two Persons Per Day of Labor Produces
  Country                 Machines                  Cloth
  EU                      5 machines      (and)     10 yards of cloth
  India                   2 machines      (and)     15 yards of cloth
  World Output            7 machines      (and)     25 yards of cloth


                            Two Persons Per Day of Labor Produces
   Country                 Machines                 Cloth
   EU                      10 machines               0 yards of cloth

   India                   0 machines               30 yards of cloth
   World Output            10 machines      (and)   30 yards of cloth


                                                                                 .

Now, suppose that the EU trades … 3 machines to India … for 12 yards of cloth?
                                                                             .
India - Opportunity Costs                 EU - Opportunity Costs

Machine = 7.5 cloth                       Machine   = 2 cloth
Cloth   = 0.133 machine                   Cloth     = 0.5 machine


                       World Price
    Back to our opportunity costs (above) Trade will 
      occur at a trading price … World Price …which 
      will occur between these respective “Relative
      Prices”…                   Also called the “Terms of Trade”




                                                            Look…
                        Remember this graph?

     Slope = ∆Machines/∆Cloth = Opportunity Cost of Machines

      This slope is also known as the … Marginal Rate of Transformation




Machines


                 EU: Slope = Opportunity Cost = -0.5



                                       India: Slope = Opportunity Cost = -0.133
      5

                                                                  Pw
      2
                                                                   Cloth
                                         10                  15
    Introduction: The Gains from Trade



• The improvement in national welfare (for
  both countries) is known as the gains
  from trade
  One more quick example, just to be sure….
         Output per Hour  Worked

                          Output/hour worked
                       EU            Canada
     Bread             2 loaves      3 loaves
     Steel             3 tons        1 ton


What are the EU’s relative prices (opp. cost) … Bread? Steel?
What are Canada’s relative prices (opp. cost) … Bread? Steel?

Who has absolute advantage in Bread?
Who has absolute advantage in Steel?

Given 2 working hours per country… what is the maximum world output?
    Implications of Adam Smith’s Theory

• Access to foreign markets helps create wealth
  – If no nation imports, every company will be limited by
    the size of its home country market

  – Imports enable a country to obtain goods that it cannot
    make itself or can make only at very high costs

  – Trade barriers decrease the size of the potential
    market, hampering the prospects of specialization,
    technological progress, mutually beneficial exchange,
    and, ultimately, wealth creation
        Adam Smith and Trade Barriers

• Smith was highly critical of trade barriers (Tariffs,
  Quotas, Subsidies…)

• Trade barriers decrease
     - Specialization
     - Technological progress
     - Wealth creation

• The modern view of trade shares Smith’s dislike
  for trade barriers
             TRADE BASED ON 
           ABSOLUTE ADVANTAGE



• Labor Theory of Value
  – Assumes that labor is the only relevant
    factor of production
  – This implies that the pre-trade price of a 
    good is determined by the amount of labor 
    it took to produce it.
               2-Country Scenario

                   One Person Per Day of Labor
                           Produces
Country          Machines       Cloth
U.S.             5 machines       15 yards of cloth
India            1 machine         5 yards of cloth



 U.S. has an Absolute Advantage in both goods.
                                 One Person Per Day of Labor Produces

   Country                   Machines                  Cloth

   U.S.                      5 machines                15 yards of cloth

   India                     1 machine                  5 yards of cloth


  Production Possibilities Curves for the United States and India

Machines
                       Graphically obvious …
                       U.S. has an Absolute Advantage in both goods.



      5




      1
                                                                       Cloth
                            5                                   15
One country has Absolute Advantage
          in BOTH goods
                   One Person Per Day of Labor Produces

Country         Machines             Cloth

U.S.            5 machines           15 yards of cloth

India           1 machine             5 yards of cloth



• In this scenario, there is obviously no 
  opportunity to trade… especially not for U.S.
• NO… No … No!!!  This is not correct.  We need 
  to introduce the concept of:
          Comparative Advantage
     Trade Theories:

#3 - Comparative Advantage
   Theory of Comparative Advantage

• David Ricardo: Principles of Political Economy (1817)

   – Extended free trade argument

   – Should import even if the country is more efficient in
     the product’s production than country from which it
     is buying.

   – Look to see how much more efficient.  If only 
     comparatively efficient, then import.
               TRADE BASED ON 
            COMPARATIVE ADVANTAGE


• Why would trade occur if one country had an 
  absolute advantage in both goods?

• Comparative Advantage is the ability of a country 
  to produce a good at a lower opportunity cost 
  than another country

• We compare the degree of absolute advantage or 
  disadvantage in the production of goods
            Comparative Advantage: U.S. More
             Efficient in the Production of Both
                         Commodities

                            One Person Per Day of Labor
                                    Produces
Country                   Machines       Cloth
U.S.                      5 machines          15 yards of cloth
India                     1 machine            5 yards of cloth


U.S. has bigger Absolute Advantage in production of Machines


 US - Opportunity Costs                India - Opportunity Costs

 1 Machine = 3 cloth                   1 Machine = 5 cloth
 1 Cloth  = 0.33 machine               1 Cloth = 0.2 machine
             TRADE BASED ON 
          COMPARATIVE ADVANTAGE

• The U.S. has a greater absolute advantage 
  in producing machines than is does in 
  producing cloth (5x more efficient in
  machines … only 3x more efficient in cloth)
• India’s absolute disadvantage is smaller in 
  producing cloth than in producing machines
• Thus the U.S. has a comparative advantage 
  in machines and India has a comparative
  advantage in cloth
             TRADE BASED ON 
            OPPORTUNITY COSTS

• Even though U.S. has an absolute 
  advantage in both goods, India has a 
  comparative advantage in cloth 
  production
• Even if U.S. has an absolute advantage in 
  both goods, beneficial trade is possible
• If both countries specialize according to 
  their comparative advantage, they both 
  can gain from this specialization and 
  trade
              Since we are dealing with Opp. Costs, we
              will compare across 15 yards of cloth

                          One person Per Day of Labor Produces

Country                 Machines                  Cloth

U.S.                    5 machines                15 yards of cloth

India                   1 machine                  5 yards of cloth


 Let us allow India to produce cloth up to the level that the U.S. can…


                           One Person Per Day of Labor Produces
 Country                 Machines                  Cloth
 U.S.                    5 machines                -15 yards of cloth
 India (3 days)          -3 machines      (per)    15 yards of cloth
 World Output            +2 machines               0 cloth
                                                                          .
                       TRADE BASED ON 
                    COMPARATIVE ADVANTAGE

Change in World Output Resulting from Specialization According to
           Comparative Advantage

                                        Change in the Production of

Country                         Machines                 Cloth

U.S.                            +5 machines              –15 yards of cloth

India                           –3 machines              +15 yards of cloth

Change in World Output          +2 machines                 0 yards of cloth
     Trade in the Ricardian Model 
                (cont.)
• A country can be more efficient in 
  producing both goods, but it will have a 
  comparative advantage in only one good.
• Even if a country is the most (or least) 
  efficient producer of all goods, it still can 
  benefit from trade.
                            TRADE BASED ON 
                           OPPORTUNITY COSTS
                Unit Labor Costs in 24 Developing Economies for Selected Sectors,
                2000 (Ratios relative to the U.S.)
                        Food                                 Electrical Transport
Country                 Products      Textiles   Clothing    Machinery Equipment
Argentina                  1.95         1.28       0.64         2.11       1.78
Bolivia                    0.61         0.76       0.65         1.00       1.34
Brazil                     0.74         0.65       0.47         0.81       0.53
Chile                      0.80         0.89       0.51         0.90       0.74
Columbia                   0.62         0.66       0.47         1.01       0.97
Cote d’Ivoire              1.50         1.06       1.02         1.34       1.69
Ecuador                    0.88         0.30       0.34         1.20       0.55
Egypt                      1.45         1.21       0.38         1.10       0.71
Ghana                      0.82         0.96       0.60         0.39       1.63
India                      1.29         1.57       0.47         0.98       1.43
Indonesia                  1.71         0.42       0.45         0.62       0.26
Kenya                      1.31         2.20       0.96         0.74       3.34
                            TRADE BASED ON 
                           OPPORTUNITY COSTS
              Unit Labor Costs in 24 Developing Economies for Selected Sectors,
              2000 (Ratios relative to the U.S.)
                      Food                                 Electrical Transport
Country               Products      Textiles   Clothing    Machinery Equipment
Malaysia                 1.08         0.59       0.84         1.01       0.69
Mexico                   0.90         0.88       0.64         1.06       0.43
Morocco                  1.61         1.38       1.05         1.49       0.92
Nigeria                  0.29         0.80       0.11         0.56       0.04
Peru                     1.02         0.62       0.46         0.95       0.50
Philippines              0.65         0.67       0.59         0.80       0..40
Korea                    0.73         0.63       0.62         0.56       0.71
Taiwan                   1.93         1.45       0.80         1.81       1.17
Thailand                 0.92         0.87       1.07         0.65       0.41
Turkey                   1.09         0.96       0.43         0.97       0.65
Uruguay                  1.64         0.74       0.69         1.52       1.22
Venezuela                0.93         0.72       0.49         0.68       0.17
   DYNAMIC GAINS FROM TRADE

• Static Gains from trade are gains in 
  word output that result from 
  specialization and trade
• Dynamic gains from trade are gains 
  from trade over time that occur because 
  trade induces greater efficiency in the 
  use of existing resources
    Assumptions and limitations
• Driven only by maximization of production 
  and consumption
• Only 2 countries engaged in production and 
  consumption of just 2 goods?
• What about the transportation costs?
• Only resource – labor (that too, non-
  transferable) 
• No consideration for ‘learning theory’
         Absolute and Comparative 
     Productivity Advantage Contrasted


• Absolute productivity advantage: Held by a
  country that produces more of a certain good per
  hour worked than another
• Comparative productivity advantage (or
  comparative advantage): Held by a country that
  has lower opportunity costs of producing a good
  than its trading partners do
• Comparative advantage allows a country that
  lacks absolute advantage to sell its products
  abroad
               One more time for practice…


                            Output per hour of “team”
Country                      Cars           Steel (tons)
Japan                          2                       2
Malaysia                      0.5                      1


 Do you see any Absolute Advantages?

 Do you see any Comparative Advantages?



Japan - Opportunity Costs           Malaysia - Opportunity Costs

1 car = 1 steel                     1 car = 2 steel
1steel = 1 car                      1steel = 0.5 car
                   Output per Hour Worked

                           One Person Per Day of Labor
                                   Produces
Country                      Cars          Steel (tons)
Japan                             2                       2
Malaysia                        0.5                       1

 Let us allow Malaysia to produce steel up to the level that Japan can…

                            One Person Per Day of Labor
                                    Produces
Country                       Cars          Steel (tons)
Japan                             2                        2
Malaysia                          1                        2
World Output                     +1                        0
           Gains from Trade with 


Summation …

• Japan has an absolute advantage in both cars (2>0.5)
  and steel (2>1), yet it can still gain from trade, as can
  Malaysia
• Once trade opens, the world price of cars will be
  between one and two tons of steel per car

Japan’s Price…                            … Malaysia’s Price
 Terms of Trade and Gains from Trade
• The closer the terms of trade are to one 
  country’s pre-trade price ratio, the greater the 
  gain for the other country.
• Importance of being unimportant—when 
  small countries trade with big countries, the 
  small countries are likely to enjoy most of the 
  mutual gains from trade.
        Evaluation of the Classical Model

• The model does not explain why differences in productivity 
  levels between countries exist.
• It makes extreme and unrealistic predictions such as countries 
  will completely specialize in the production of exportables 
  only.
• It maintains that the gains from trade are greater between 
  countries of dissimilar production technologies (despite the 
  fact that most trade occurs between DCs with similar 
  technology and income levels).
               Evaluation (cont.)

• The classical model is a useful tool because:
  – It provides a motive for trade between developed 
    and developing countries
  – It explains why high-wage countries may still 
    benefit from trade even when faced with low-
    wage competing countries 
 Summary of the Comparative Advantage 
                Model
• It is not necessary for a country to possess absolute 
  advantage in order to participate in trade. What is 
  required is comparative advantage in production.


• A country will specialize in and export that good in 
  which its has comparative advantage, i.e., has a lower 
  pre-trade relative price than in the other country.


• The terms of trade or world price will settle between 
  the autarky prices of the two countries and is 
  determined by reciprocal demand. 

								
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