Global Economics Eco 6367 Dr. Vera Adamchik

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Global EconomicsEco 6367Dr. Vera Adamchik

• Foundations of Modern Trade Theory Comparative
  Advantage

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Key questions about trade

• Why do countries trade? More precisely, what
  determines the pattern of trade (what is exported
  and what is imported)?
• How does trade affect the economic well-being of
  each country?
• How does trade affect the distribution of
  economic well-being or income among various
  groups within the country?

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Why do countries trade?

• Demand and supply conditions differ between
  countries, so prices differ between countries if
  there is no international trade. Trade begins as
  someone conducts arbitrage to earn profits from
  the price difference between previously separated
  markets.

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Why would product prices differ with no trade?

• Production conditions differ (technology, factor
  endowment, differences across products in the use
  of productive factors in producing the products)
  the relative shapes of the PPFs differ between
  countries.
• Demand conditions differ.
• Some combination of these two differences.

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• While trade can be driven by differences in
  demand, most of our attention is on
  production-side differences. Production-side
  differences cause the countries PPFs to skew in
  different ways, reflecting different comparative
  advantages.
• Sources of production-side differences
• differences in technologies or factor
  productivities
• differences in factor endowments and differences
  across products in the use of productive factors
  in producing the products.

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Leading theories of trade

• Chapter 2
• Mercantilism (gold and silver).
• Adam Smiths theory (absolute advantage).
• David Ricardos theory (comparative advantage).
• The standard modern theory of trade (increasing
  marginal costs).
• Chapter 3
• 5. The Heckscher-Ohlin theory (factor endowment
  factor-use).

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Leading theories of trade (cont.)

• 6. Product life-cycle theory (dynamic theory of
  technology and trade).
• 7. Stolper-Samuelson Theorem
• 8. New trade theory (scale economies)
• - monopolistic competition product
  differentiation
• - substantial internal scale economies and
  global oligopoly
• - external scale economies (industries that
  concentrate in a few places).
• 9. Gravity model of trade (a countrys size,
  distance between countries, impediments to trade).

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1. Mercantilism
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Mercantilism Older than Smith and Alive Today

• Mercantilism was the philosophy that guided
  European thinking about international trade in
  the several centuries before Adam Smith published
  his Wealth of Nations in 1776.

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• Mercantilists viewed international trade as a
  source of major benefits to a nation.
• Merchants engaged in trade, especially those
  selling exports, were good hence the name
  mercantilism.
• A central belief of mercantilism was that
  national well-being or wealth was based on
  national holdings of gold and silver.
• Given this view of national wealth, exports were
  viewed as good and imports (except for raw
  materials not produced at home) were seen as bad.

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• If a country exports more than imports, the gain
  in gold and silver increases the countrys
  well-being.
• Also, gold and silver accruing could be
  especially valuable in maintaining a large
  military for the country.
• Imports are undesirable because they reduce the
  countrys ability to accumulate gold and silver.
• In addition, imports were feared because they
  might not be available to the country in time of
  war.

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• Mercantilists maintained that government
  regulation of trade was necessary to provide the
  largest national benefits.
• Based on mercantilist thinking, governments, (1)
  imposed an array of taxes and prohibitions to
  limit imports and (2) subsidized and encouraged
  exports.

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A zero-sum game

• Because of its peculiar emphasis on gold and
  silver, mercantilism viewed trade as a zero-sum
  activity one countrys gains come at the
  expense of some countries, since a surplus in
  international trade for one country must be a
  deficit for some other(s).

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Criticism

• Before Adam Smith, David Hume showed that the
  goal of acquiring gold and silver can be
  self-defeating if this acquisition expands the
  domestic money supply and leads to domestic
  inflation of product prices.
• Adam Smith and economists after him pointed out
  that mercantilist thinking turns social
  priorities upside down (will be discussed later
  see slides 26-28).

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Still alive

• Mercantilist thinking is very much alive today.
  It now has a sharp focus on employment.
  Neo-mercantilists believe that exports are good
  because they create jobs in the country, and
  imports are bad because they take jobs from the
  country. Neo-mercantilists continue to depict
  trade as a zero-sum activity.

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• In the late 18th and early 19th centuries, first
  Adam Smith and then David Ricardo explored the
  basis for international trade as part of their
  efforts to make a case for international trade.
  Their writings were responses to the doctrine of
  mercantilism prevailing at the time.

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2. Adam Smiths theory of absolute advantage
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• In his Wealth of Nations, Adam Smith promoted
  free trade by comparing nations to households
• It is the maxim of every prudent master of a
  family, never to attempt to make at home what it
  will cost more to make than to buy. The tailor
  does not attempt to make his own shoes, but buys
  them from the shoemaker
• Hence, every country should produce a specific
  product if this country is better than the rest
  of the world at producing this product.

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• What do we mean by better at producing?
• We can indicate each countrys ability to produce
  a product as (i) labor productivity, that is, the
  number of units of output per hour or (ii) the
  number of hours it takes a worker to produce one
  unit of output.
• Country with a higher labor productivity is said
  to have an absolute advantage in producing the
  good.

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• Adam Smith showed the benefits from free trade by
  showing that global production efficiency is
  enhanced because trade allows each country to
  exploit its absolute advantage.
• At least one country is better off with trade
  (not at the expense of the other country) in
  many cases both countries will gain from trade.

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In-class exercise

• Exercise 1 (handout).

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Criticism

• Yet Smiths arguments failed to address the
  following fears What if a country has no
  absolute advantage? What if the foreigners are
  better off at producing everything than we are?
  Will they want to trade? If they do, should we
  want to?
• We turn next to the theory that first answered
  these fears and established a fundamental
  principle of international trade.

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3. David Ricardos theory of comparative advantage
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• David Ricardos main contribution to our
  understanding of international trade was to show
  that there is a basis for beneficial trade
  whether or not countries have any absolute
  advantage.
• Ricardo carefully examined the concept of
  opportunity cost and demonstrated the principle
  of comparative (meaning relative and not
  necessarily absolute) advantage.

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In-class exercise

• Exercise 2 (handout)

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Key points that refute mercantilist thinking

• 1. National well-being is based on the ability to
  consume products now and in the future. Imports
  are part of the expanding national consumption
  that a nation seeks, not an evil to be suppressed.

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Key points that refute mercantilist thinking

• 2. The importance of national production and
  exports is only indirect. They provide the income
  to buy products to consume. Exports are not
  desirable on their own rather, exports are
  useful because they pay for imports.

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Key points that refute mercantilist thinking

• 3. Trade freely transacted between countries
  generally leads to gains for all countries
  trade is a positive-sum activity.

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In-class exercise

• Exercise 3 (handout) Comparative Advantage
  Extended to Many Products and Countries

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• Criticism Simple theories of trade rely on
  a set of many unrealistic assumptions (see p.
  32). Among others
• A simple world in which there are only two
  countries and two goods.
• In each nation, labor is the only input, fixed
  and homogeneous.
• Labor can move freely from the production of one
  good to another good within a country, but cannot
  move between nations.
• The level of technology is fixed for both nations.

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• 5. Costs do not vary with the level of production
  and are proportional to the amount of labor used
  (that is, constant returns to scale). In reality,
  both diminishing and increasing returns to
  specialization exist.

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4. The standard modern theory of trade (based on
increasing marginal costs)
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• This extension of the Ricardian model relaxes
  assumption 3 and 5 (on page 32).
• The standard theories of trade (that is, Smith
  and Ricardo) assume constant returns to scale
  (CRS). With CRS, average cost does not change
  when the quantity of output changes, assuming
  both adjustments of all factor inputs and
  constant factor input prices.

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• In reality, however, many industries incur
  rising, rather than constant, marginal
  opportunity costs.
• Reasons
• (1) Resources are specialized, of different
  quality, and do not always move easily from one
  economic activity to another.
• (2) Different goods use resources in different
  proportions.

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• For instance, efforts to expand U.S. wheat
  production would fairly quickly run into rising
  costs caused by limits on
• (1) how much more land could be drawn into
  wheat production and how suitable this additional
  land would be for wheat production
• (2) the availability of additional workers
  willing and suitable to work on the farms
• (3) the availability of seeds, fertilizers,
  and other material inputs.

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• Hence, as one industry expands at the expense of
  others, increasing amounts of the other products
  must be given up to get each extra unit of the
  expanding industrys product.
• Increasing marginal costs are illustrated by a
  bowed-out PPF.

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The PPF with increasing opportunity costs /
diminishing returns

• The PPF tells us how much of one good we must
  sacrifice in order to make available the
  resources to produce one more of the other good.

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In-class exercise

• Exercise 4 (handout) Example with a non-linear
  PPF.

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• The standard modern theory of trade shows that it
  is not feasible for a country to specialize to
  the degree suggested by the simple trade
  theories. The gains from specialization are
  likely to be exhausted before specialization is
  complete. In reality, most countries do not
  specialize but, instead, produce a range of
  goods.
• The basic conclusion that unrestricted free trade
  is beneficial still holds, although the gains may
  not be as great as suggested in the constant
  returns case.

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Criticism

• Comparative-advantage theory of trade focuses on
  technology or resource productivity differences
  as a production-side basis for trade /
  comparative advantage.
• According to comparative-advantage theory,
  nations that are similar in their production-side
  capabilities (and in their general demand
  patterns) should trade little with each other.
• In reality, we observe the opposite.

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• Industrialized countries (which are similar in
  many aspects in their technologies, technological
  capabilities, and factor endowment) trade
  extensively with each other.
• Trade between industrialized countries is nearly
  half of all world trade.
• Over 70 of the exports of industrialized
  countries go to other industrialized countries,
  and about 4/5 of these exports are nonfood
  manufactured products.
• These facts appear to be inconsistent with
  comparative-advantage theory.

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• Furthermore, technology quickly spreads
  internationally because it is difficult for a
  country to keep its technology secret. Hence,
  many countries usually have access to the same
  technologies for production and are capable of
  achieving similar levels of resource
  productivity.
• We turn next to the theory that focuses on
  another important source of production-side
  differences (that is, international differences
  in the shapes of bowed-out PPFs).