International Trade Theory

1
International Trade Theory

• The Classical Model

2
Two key questions

• Why do countries trade?
• How does it affect them?
• Specialisation
• Economies of scale

3
Early trade theory

• Mercantilism
• Adam Smith and the concept of absolute advantage
  - an example
• What if a country had an absolute advantage in
  both goods?
• David Ricardo and the concept of comparative
  advantage

4
The Ricardian Model

• Labour productivity differences
• Technology is given by
• Utopia Flatland
• Cheese (lb) 1 6
• Wine (gallons) 2 3
• Labour hours per unit of output
• Note that Utopia is more productive than
  Flatland in both goods

5
Utopia

• Utopia has a total of 10 hours of labour in one
  day
• gt Maximum cheese 10 lbs
• or maximum wine 5 gallons
• Construct Production Possibility Frontier (PPF)
• Pc/Pw 1/2
• gt Utopias Opportunity Cost of cheese in terms
  of wine 1/2 unit
• v.v. Utopias OC of wine in terms of cheese 2
  units
• PPF is a straight line

6
Flatland

• Flatland has a total of 12 hours of labour
  available in one day
• gt maximum cheese 2lbs
• gt maximum wine 4 gallons
• Opportunity Costs

7
Pre-trade Prices

• Utopia Pc/Pw 1/2
• Flatland Pc/Pw 2
• pre-trade solutions
• Trade begins
• Utopia has a lower pre-trade price of cheese
  relative to Flatland gt Utopia sees demand for
  cheese increase (ie from B) Utopia sees demand
  for wine(produced at home) fall - its cheaper in
  FlatlandPerfect information gt Utopias
  consumers buy it from Flatland.

8
Trade Begins

• What about Flatland?
• International Trade Equilibrium The terms of
  trade
• ToT ½ lt TOT lt2

9
Terms of Trade

• Say 1
• Now Utopias producers receive 1gallon of wine
  instead of ½ gallongt incentive to expand
  production of cheese
• Flatlands?
• Specialisation in comparative advantage industry
• Extreme degree of specialisation as each country
  completely specialises in CA industry.

10
Trade equilibruim

• Production points consumption points
• Diagrams
• A B

11
Gains from Trade

• Consumption Gains
• Production Gains
• How substantial are the gains?

12
Relative Wages

• Workers in Utopia earn 1 lb of cheese per hour
• Flatlands earn 1/3 gallon of wine per hour
• Relative prices 1/1
• Put say 12 ie a lb of cheese sells for 12
  and gallon of wine sells for 12
• gt Utopias workers earn 12 Flatlands earn 4
  per hour
• Relative wage is 3
• Workers in Utopia must earn more than workers in
  Flatland for trade to occur along the lines of
  CA 3, the relative wage lies between 6 and 1 1/2
• Gives Flatland a cost advantage in wine even
  though it is less productive in producing either
  cheese or wine

13
The Ricardian Model The Real World

• The model has stood the test of time has many
  positive aspects
• Does it fit the real world?
• Yes, but
• 1. Extreme degree of specialisation?
• 2. Distributive implications of trade?
• 3. Resources in trade?
• 4. Economies of Scale?

14
Empirical Evidence

• Mc Dougall 1951/52
• Belassa 1963 US/UK export ratios US/UK
  productivity ratios in 26 manufacturing
  industries using 1951 data
• Bears out the Ricardian Model
• Recent Evidence? Is less clear-cut 1990s it is
  difficult to see what it is that countries do
  badly
• Evidence suggests a role for differences in
  labour productivity in international trade
• There continue to be large differences in labour
  productivities between countries and significant
  variation in those productivity differences
  across industries
• US-Japan Autos- Clothing -

15
Trade Income Distribution

• Ricardian model showed us the gains for countries
  involved in international trade - Why then in the
  real world are countries opposed to free trade?
• Why do governments pursue protectionist policies?
• Overall effects vs sectoral effects
• Model - labour mobility ensured no one was hurt
  by trade
• Reality - uneven distribution of benefits of
  trade
• In the real world , labour is not perfectly
  mobile between industries industries differ in
  terms of the factors they require
• Therefore, trade may not be as unambiguously
  beneficial as Ricardian model led us to believe

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Resources and trade

• Why the opposition to free trade in the real
  world? Why pursue protectionist policy?
• Sectoral effects of international trade - the
  distribution of the overall effects of trade
• Real World - labour may not be perfectly mobile
  between industries
• Factor requirements may differ between industries
• Free trade gt mutual gains for the countries
  involved (Ricardo)

17
Resources

• International trade may not be as unambiguously
  beneficial as Ricardian model led us to believe
  (KO)
• Japans Rice Policy
• Obviously we need to go beyond the Ricardian
  model to consider the role of other resources in
  trade
• Model
• Heckscher - Ohlin

18
H-O

• Shows that comparative advantage is influenced by
  the interaction between a nations resources
  the technology of production
• 3 Factors of Production land ,labour and
  capital
• Q f(L,K,T)
• Labour productivity Q/Lg(K/L, T/L)

19
H-O - 2x2x2 model

• 2 countries - Home and Foreign
• 2 goods - cloth and food
• 2 factors - labour and land
• Home and foreign have identical tastes
• Home and foreign have identical technologies
• Each country has a given factor endowment home
  is labour abundant foreign is land abundant

20
Factor intensity in production

• Cloth is a labour intensive industry
• Food is a land intensive industry
• Comparative AdvantagesHome -
• Foreign -
• HO Theorem Any country will export goods that
  have a high intensity of the countrys abundant
  factor and import goods that have a high content
  of its scarce factor