International Trade Theory Early Concept

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					Spring 2009, Prof. Iwan Azis, NBA524

                    International Trade Theory:
                           Early Concept
                 • Basic notion of the “gain from trade”
                   & Theory of comparative advantage
                 • Terms-of-trade (TOT), tariff, transfer
                 • Protection: Arguments and counter-


                      Theories of International Trade:
                          Historical Perspective
                    • MERCANTILISTS [1500-1800]: Maximize gold,
                      subsidize exports, create surpluses, monopolies
                      intended to benefit colonial powers (e.g.,Great
                      Britain, Spain)
                    • NEO MERCANTILISTS: Run up export
                      surpluses, achieve political or social objectives
                    • ABSOLUTE ADVANTAGE (Adam Smith, 1776)
                    • COMPARATIVE ADVANTAGE: Heckscher-
                      Ohlin-Samuelson: Static & Dynamic        trade
                      between developing and developed countries
                    • INTRA-INDUSTRY TRADE: Monopolistic
                      competition, economies of scale (e.g.,
                      manufacturing trade among developed               2

Spring 2009, Prof. Iwan Azis, NBA524

                                         No Trade Case
                 The Corn Laws (1829-1845): High tariffs on grain
                 import were imposed by British after the Napoleonic
                 wars    trade was prevented, output = x0 and y0
                 Quantity of
                 machinery (y)
                                                            The equilibrium prices will be
                                                            px* and py*


                                                                          − px*
                                                                slope =
                                                                           py     Consumer good (x)
                 More common case: protectionism leads to high
                                      x       0

                 import tariffs. Thus, at the extreme the above                                       3
                 equilibrium reflects “no trade” scenario.

                 Tariff Removal (Freer Trade) Raises Welfare
                 Removal of tariff will change the prices to px’ and py’;
                 Output: x1’ and y1’; Individuals demand x1 and y1
                                                      Imports will be x1 – x1’
                 Quantity of
                 machinery (y)   New prod eq           These imports will be financed by
                                                       the export of manufactured goods
                  exports                              equal to y1’ – y1
                  machine 0                                           New cons eq

                                                                                            − px '
                                                                                  slope =
                                                                                             py '

                                                                                  Consumer good (x)
                                   x1’       x0            x1

                 Cap-abundant            imports of cons

                 country                     goods

Spring 2009, Prof. Iwan Azis, NBA524

                 Effects on Factors (K and L): Edgeworth Box
                 Tariff removal results in a move from p3 to p1: more machinery
                 (y) and less consumer goods (x) are produced: Py/Px declines,
                 relative price of capital to labor (r/w) will fall, harmful to capital
                 owners and helpful to laborers        K/L increases.

                           Total Capital


                                                y4                                  x3

                                                          Total Labor                              5

                       Theory of Comparative
                 • First proposed by Ricardo: “countries
                   should specialize in producing those
                   goods of which they are relatively
                   more efficient producers”
                 • If countries do specialize this way,
                   total world production will be greater

Spring 2009, Prof. Iwan Azis, NBA524

                    2-Countries 2-Goods 2 Factors
                      Comparative Advantage
                    • Countries: Home (H) and Foreign (F)
                    • Goods: Cloth (C) and Food (F)
                    • Factors of production: Land (T) and Labor
                    • The corresponding prices of factors are: “r”
                      for land, and “w” for labor
                    • Assumption: Home is “labor abundant”
                      and Foreign is “land abundant”
                    • Use a lot of “ratios”                      7

                                                            1. Relative Price of
                                                            Product to Factor Price
                                        cloth               If cloth is labor-intensive,
                                                food        and food is land-intensive,
                                                            there is a one-to-one
                                                            relation between factor
                                                            price ratio (w/r) and relative
                                                            price of products (Pc/Pf)

                                                            2. Factor Price Ratio to
                                                            Factor Proportion
                                                            Given w/r, food production
                                                            uses a higher land/labor
                                                            ratio (T/L).

                                                       Combining 1 and 2:
                                                       • given (Pc/Pf)1 the factor price
                                                       ratio is (w/r)1 and the factor
                                                       proportion is (Tc/Lc)1 for cloth and
                                                       (Tf/Lf)1 for food.
                                                       • If (Pc/Pf)1 increases to (Pc/Pf)2,
                                                       (w/r)1 rises to (w/r)2 and the
                                                       factor proportions for cloth and
                                                       food are (Tc/Lc)2 and (Tf/Lf )2 8

Spring 2009, Prof. Iwan Azis, NBA524

                • Total supply of land and labor is measured by vertical and horizontal axis,
                   respectively. Inputs into cloth and food are measured, respectively, from lower-left
                   and upper-right corner. Given Tc/Lc and Tf /Lf (full utilization of factors)
                   the resource allocation is at point 1, where food production is Of1 and cloth
                   production is Oc1.
                • If the supply of land increases (e.g, by Of1Of2), assuming product price ratio is
                  unchanged (hence factor price is also unchanged), production of food increases,
                  production of cloth decreases, because food is more land-intensive than cloth.


                 As the supply of land increases, the
                 “production possibility curve” (PPC) shifts
                 outward disproportionately, such that
                 at an unchanged product price ratio (at
                 point 2) the production of labor-intensive                             PPC
                 cloth declines, and that of land-intensive
                 food increases.

                 Two Countries Trade:
                 Resulting Trade Pattern
                 • If Home is labor-abundant & Foreign                      foreign
                 is land-abundant, then Home (Foreign)
                 is said to have a comparative-advantage in
                 cloth (food). This suggests that Home
                 exports cloth and imports food, and Foreign
                                                                               Post Trade
                 exports food and imports cloth.
                 • Without trade, Home’s equilibrium is at 1
                 and Foreign’s equilibrium is at 3. When they
                 trade the equilibrium is at 2: Home’s
                 relative price of cloth increases, so does
                 its cloth production. As Home exports cloth,
                 its relative consumption of cloth declines.                                    10
                 For Foreign, it is the opposite.

Spring 2009, Prof. Iwan Azis, NBA524

                 Demand also matters (taste)
                 Given PPC, the production equilibrium
                 is at Q. But the consumer’s preference
                 at Home (reflected by the indifference
                 curves) indicates that they prefer to
                 consume cloth less and want more
                 food. Hence, Home will export
                 cloth and import food (point D).

                 Terms of Trade (TOT)
                 • Suppose Home experiences growth strongly
                 biased toward cloth, so that given Pc/Pf
                 the world’s output of cloth increases,
                 causing the world relative supply curve to
                 shift rightward. This leads to a decrease in
                 Pc/Pf. Hence, Home’s terms of trade (TOT)
                 worsens (does it matter which country
                 • Export-biased growth tends
                 to worsen a growing country’s TOT,
                 to the benefit of the rest of the world;
                 vice-versa with import-biased growth
                 (what is the effect of a country’s protection?)                            11

                  The Terms of Trade of Advanced
                        Countries, 1970-1997

                            pushed export growth
                                                                   other countries pushed
                                                                   their export growth?


Spring 2009, Prof. Iwan Azis, NBA524

                               Tariff              If Home imposes tariff on imported
                                                   food, the relative internal price of food
                                                   rises, causing production shift to
                                                   more food and less cloth (RS shifts
                                                   leftward), and relative demand shifts to
                                                   more cloth (RD shifts rightward). Hence,
                                                   The world’s relative price of cloth rises,
                                                   home’s TOT improves at the rest of
                                                   the world expense      invites retaliation &
                                                   domestic distortion. What about the case
                                                   of export subsidy?
                                                        If Home transfers income to Foreign,
                                                        the relative demand (RD) does not
                               Transfer            necessarily change since resources are
                                                   not transferred, and the consumption
                                                   proportion of food and cloth in Foreign
                                                   and Home may not change. But if Home
                                                   has a higher marginal propensity to
                                                   consume (MPC) on cloth than Foreign,
                                                   RD shits leftward because lower Home’s
                                                   income causes a larger relative drop in
                                                   cloth consumption       Pc/Pf declines
                                                   Home’s TOT worsens (e.g., capital
                                                   outflows worsens TOT). What about if
                                                   Home has a lower MPC?

                            Arguments for Protection
                 • Argument (A): “Must have a functioning, e.g., in case of war.”
                   Counterargument (CA): Many of the industries that use this
                   argument are not really crucial for war.
                 • A: “Our industry could be competitive if given a chance to
                   mature.” CA: The industry may not become competitive
                   because it is protected. Politically difficult to remove protection
                   once it is started.
                 • A: “Foreign producers use really cheap labor. It’s unfair to
                   expect us to compete.”
                   CA: Why not take advantage of cheap foreign labor? Use US
                   labor only on goods in which it has a comparative advantage.
                 • A: “Foreign producers sell their products in America for less
                   than they sell them at home.”
                    CA: That’s good for US consumers. Only a problem if US firms
                   driven out of business and replaced by a foreign monopolist
                 • Conclusions: There is seldom an economic justification for
                   barriers to trade. Industries use these arguments to further their
                   own interests at the expense of consumers. The economy will
                   use its resources most efficiently if it lets comparative
                   advantage determine where they are used. Industries will rise   14
                   or decline over time as comparative advantage changes.

Spring 2009, Prof. Iwan Azis, NBA524

                     Effect of Tariff and Export Subsidy on
                               Income Distribution
                 • Effect on international distribution of income:
                   A higher tariff improves Home’s TOT but creates domestic
                   distortion (unless the tariff increase is small). Hence, while the
                   rest of the world’s welfare worsens, that of Home may or
                   may not worsen. Export subsidy worsens both Home’s
                   TOT and distortion. Although Foreign gains TOT, the subsidy
                   creates an unfair competition (not sending a ‘thank you’ note or
                   even a trade war)
                 • Effect on domestic distribution of income:
                   A higher tariff has the direct effect of raising the internal relative
                   price of imported goods. Hence, along with the resulting
                   distortion it tends to worsen consumers’ welfare. But import-
                   competing sector is benefited. There is a possibility that
                   improved TOT is so large that the internal relative price of
                   import falls (Metzler paradox). An export subsidy raises the
                   internal relative price of exported goods, benefiting exporters
                   but not consumers and non-exporting producers. The resulting
                   distortion could also worsen the welfare further. There is also a
                   possibility that TOT worsens so much that the internal relative  15
                   price of export falls (Metzler paradox).


Spring 2009, Prof. Iwan Azis, NBA524

                           Porter’s National
                         Competitive Advantage
                 • Factor Conditions: Land, labor, capital,
                   educational level of the workforce, quality of the
                   country’s infrastructure
                 • Demand Conditions: Large, sophisticated
                   domestic consumer base (e.g., Japanese
                   consumer’s electronic edge)
                 • Related and supporting industries: Competition
                   among input suppliers leads to lower prices,
                   higher quality products! (intermediate inputs,
                   “missing” in comparative advantage theory)
                 • Firm Strategy, Structure, Rivalry: U.S’ PC
                   industry is aided by intense domestic competition
                      potential economies of scale

                 Porter’s National Competitive Advantage
                                        Firm Strategy,
                                        Structure, and

                            Factor                        Demand
                           Conditions                    Conditions

                                          Related and