The Benefits of Trade by Elmer G. Wiens

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The Benefits of TradebyElmer G. Wiens
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Benefits of Increasing World Trade?

• Many people are skeptical about the benefits of
  trade.
• The Vancouver Suns Stephen Hume predicts that a
  billion people will fall back into extreme
  poverty because of soaring food prices under the
  existing arrangements for trade among countries.
• Countries like Japan, who import a large
  proportion of food stuffs, are trying to
  increase food production to become more
  self-reliant.
• Why has the world moved deliberately to freer
  trade through international arrangements like
  NAFTA and the W.T.O., despite doubts about more
  free trade?

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Canadian Goods Services exports, imports,
balance of trade GDPBillions of Dollars
2003 2004 2005 2006 2007
Exports 462.5 495.3 520.4 524.7 534.7
Imports 416.9 440.7 468.2 487.7 503.4
Balance 45.6 54.6 52.2 37 31.3
GDP 1,213.2 1,290.8 1,375.1 1,446.3 1,531.4

• The production of goods and services for exports
  accounts for 1 / 3 of domestic production of
  goods and services
• Canadas balance of trade equals exports less
  imports.

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Determinants of Canadas Pattern of Trade

• What are the benefits of free trade?
• What are the arguments against free trade?
• Why does Canada export specific goods and
  services?
• Why does Canada import specific goods and
  services?
• Why are our favourite trading partners the USA,
  Japan, the U.K., the E.E.C. countries, and China?

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Economic Benefits of Specialization and Exchange
A. Comparative Advantage David RicardoB.
Economies of Scale Adam Smith

• A. Comparative Advantage countries have
  differing opportunity costs of producing specific
  goods.
• Example
• Canada and the USA
• Crude Petroleum and Automotive Products
• Canada can produce a barrel of oil at a lower
  cost relative to manufacturing a car, compared to
  the USA.
• Canada has a comparative advantage in crude oil
  production.
• USA has a comparative advantage in manufacturing
  cars.

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A. Comparative Advantage David Ricardo

• The next slide depicts the analysis of
  comparative advantage of the 19th century
  economist, David Ricardo.
• Suppose Canada can produce 200 extra barrels of
  oil if it produces one less car and moves the
  freed-up resources into oil production.
• Canadas opportunity cost of producing a car is
  200 barrels of oil. Its opportunity cost of
  producing one barrel of oil is 1 / 200 of a car
• Similarly, suppose the USAs opportunity cost of
  producing a car is 150 barrels of oil. Its
  opportunity cost of producing one barrel of oil
  is 1 / 150 of a car.
• Canada has a comparative advantage in oil over
  the USA
• -- 1 / 200 versus 1 / 150
• Canada has a comparative disadvantage in cars
• -- 200 versus 150

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A. Comparative Advantage David RicardoCanada
Crude PetroleumUSA Automotive Products
One Car One Barrel of Oil
Canada 200 Oil Barrels 1 / 200 of a Car
USA 150 Oil Barrels 1 /150 of a Car
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Crude Petroleum Production
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Canadian Crude Petroleum exports, imports,
balance of trade Billions of Dollars
2003 2004 2005 2006 2007
Exports 20.6 25.5 30.4 38.6 41.0
Imports 13.3 16.4 21.6 22.5 23.7
Balance 7.3 9.1 8.8 16.1 17.3

• Canadas increasing exports and balance of trade
  in crude petroleum indicate its continuing
  comparative advantage in crude oil production.
• Canada exports 2.3 million barrels of petroleum
  to the USA each day, the USAs top source.

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Car Manufacturing
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Canadian Automotive Productsexports, imports,
balance of trade Billions of Dollars
2003 2004 2005 2006 2007
Exports 87.4 90.4 88.1 82.5 77.7
Imports 76.5 77.4 78.4 79.8 80.0
Balance 10.9 13 9.7 2.7 -2.3

• Canadian exports of automotive products have
  fallen, while its imports have increased.
• Its balance of trade in automotive products has
  decreased to the point where we now have a
  deficit.

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Comparative Advantage David Ricardo ???
Canada Crude PetroleumUSA Automotive Products
One Car One Barrel of Oil
Canada 200 Oil Barrels 1 / 200 of a Car
USA 150 Oil Barrels 1 /150 of a Car

• It would appear that Ricardos theory of
  comparative advantage, based on opportunity
  costs, has some legs.
• Canadian production of crude petroleum has
  increased relative to the production of
  automotive products.
• How long will this trend continue?

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B. Economies of Scale Adam Smith

• The 18th century economist, Adam Smith, explained
  the notion of economies of scale in the Wealth of
  Nations.
• A firm can obtain cost advantages of expanding
  output if by increasing its fixed costs it shifts
  its short-run average total cost curve down and
  to the right along its long-run average cost
  curve.
• To achieve these economies of scale, automotive
  manufactures close inefficient plants in Canada
  and upgrade to more efficient plants in the USA.
• In the diagram of the next slide, I approximate
  the LRAC by a quadratic function.
• A firm can chose its SRAC by choosing its fixed
  costs plant and equipment.

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Economic Benefits of Specialization and Exchange
B. Economies of Scale Adam Smith

• B. Economies of Scale cost advantage of
  expansion of output by a firm that shifts its
  short-run average total cost curve (SRAC) down
  and to the right along its long-run average cost
  curve (LRAC).

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B. Economies of Scale Sources

• Specialized machinery and production lines with
  greater investment in capital equipment and
  automation.
• Skilled, specialized, and trained labour force
  working with machinery.
• Research and development making the technological
  improvements possible.
• Managerial innovations
• Lower per unit marketing costs as advertising is
  spread over greater output
• Access to lower cost financing, e.g. borrowing at
  lower interest rates.
• Lets look at the effects of economies of scale
  on opportunity costs!

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B Comparative Advantage Economies of Scale
ExploitedCanada Crude PetroleumUSA Automotive
Products
One Car One Barrel of Oil
Canada 220 Oil Barrels 1 / 220 of a Car
USA 140 Oil Barrels 1 /140 of a Car

• In this scenario, on the one hand when the USAs
  automotive industry exploits economies of scale,
  American comparative advantage in cars increases.
  
• On the other hand, Canadas comparative
  advantage in oil increases as Canadas
  automotive industry becomes less efficient.

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USA Automotive Industry Limits to
Specialization

• The diagram on the next slide depicts the
  following situation
• Assume three major firms behave competitively in
  the USAs automotive industry.
• Short-run equilibrium obtains for each firm where
  Price Marginal Cost, with Marginal Cost
  increasing.
• The demand function is mildly quadratic. So, at
  the equilibrium price output level, industry
  marginal revenue is positive and the elasticity
  of demand is greater than one in absolute value.
• Long-run equilibrium obtains when further
  expansion of plant and equipment moves the SRAC
  curves upward and to the right, as the
  opportunity cost of producing cars increases.
• Long-run and short-run diseconomies limit the
  extent of specialization.

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Limits to Specialization Short RunDiminishing
marginal returns to variable inputsFirms produce
where marginal cost price with mc increasing
U.S.A. Automobile Industry
Competitive Version
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Unexploited Economies of Scale Opportunity Costs
One Car One Barrel of Oil
Canada 200 Oil Barrels 1 / 200 of a Car
USA 150 Oil Barrels 1 /150 of a Car
Unexploited Economies of Scale Monetary Costs
One Car One Barrel of Oil
Canada 10,000 50
USA 9,000 60
Average 9,500 55

• As a review, lets convert the opportunity cost
  tables to monetary costs.
• If the cost of producing a Canadian car is
  10,000, then the cost of producing one barrel of
  oil is 10,000 / 200 50. If the cost of
  producing an American car is 9,000, then the
  cost of one barrel of oil is 9,000 / 150 60.
• Buying oil in Canada and selling it in the US
  could obtain a profit. Buying cars in the US and
  selling them in Canada could obtain a profit.

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Question Part A. Complete the bottom
table.Exploited Economies of ScaleOpportunity
Costs
One Car One Barrel of Oil
Canada 220 Oil Barrels 1 / 220 of a Car
USA 140 Oil Barrels 1 /140 of a Car
Monetary costs
One Car One Barrel of Oil
Canada 11,000 ?
USA ? 60
Average ? ?
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Question Part B.

• What are the assumptions underlying Ricardos
  theory of the benefits of trade due to
  comparative advantage?
• Describe Ricardos model as set out in your
  textbook.
• - Write a two page essay to hand in
  at your next
• class.

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Works consulted

• Krugman, Paul. Pop Internationalism. Cambridge
  MIT Press.
• Wonnacott, P., R. Wonnacott, and A. Blomqvist,
  Economics. Toronto McGraw-Hill.
• Wikipedia The Free Encyclopedia Various Web
  Pages
• Statistics Canada Various Publications.
• Next topic
• 1. Efficiency gains to producers from exports.
• 2. Efficiency gains to consumers from imports.