ECON5335 - International Economics

1
ECON5335 - International Economics

• Chapter 4
• Trade Flows in Theory

2
Introduction

• Trade models
• - usually question being asked why do we
  trade what we trade?
• - 3 very simple theoretical models
• - autarky initial position
• - permit trade to occur
• - other question asked is who do we trade
  with?
• - empirical model based on econometrics

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1. Simplest version of the Ricardian Model

• Only two goods
• Meat
• Potatoes
• Only two people
• Rancher
• Farmer

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1. Simplest version of the Ricardian Model

• If rancher (R) produces only meat
• and farmer (F) produces only potatoes
• then both have potential to gain from trade
• If both R and F produce both meat and potatoes
• Both can potentially gain from specialization and
  trade
• Production possibilities frontier (PPF)
• Various mixes of output that economy can produce
  if all resources used to capacity

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Figure 1
The Production Possibilities Frontier (a)
Panel (a) shows the production opportunities
available to the farmer and the rancher.
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Figure 1
(b) The farmers production possibilities
frontier
(c) The ranchers production possibilities
frontier
Panel (b) shows the combinations of meat and
potatoes that the farmer can produce. Panel (c)
shows the combinations of meat and potatoes that
the rancher can produce. Both production
possibilities frontiers are derived assuming that
the farmer and rancher each work 8 hours per day.
If there is no trade, each persons production
possibilities frontier is also his or her
consumption possibilities frontier.
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1. Simplest version of the Ricardian model

• Specialization and trade
• Farmer specialize in growing potatoes
• More time growing potatoes
• Less time raising cattle
• Rancher specialize in raising cattle
• More time raising cattle
• Less time growing potatoes
• Trade 5 oz of meat for 15 oz of potatoes
• Both gain from specialization and trade

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Figure 2
(a) The farmers production and consumption
(b) The ranchers production and consumption
The proposed trade between the farmer and the
rancher offers each of them a combination of meat
and potatoes that would be impossible in the
absence of trade. In panel (a), the farmer gets
to consume at point A rather than point A. In
panel (b), the rancher gets to consume at point
B rather than point B. Trade allows each to
consume more meat and more potatoes.
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Figure 2
The proposed trade between the farmer and the
rancher offers each of them a combination of meat
and potatoes that would be impossible in the
absence of trade. In panel (a), the farmer gets
to consume at point A rather than point A. In
panel (b), the rancher gets to consume at point
B rather than point B. Trade allows each to
consume more meat and more potatoes.
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Absolute advantage

• Absolute advantage
• Produce a good using fewer inputs than another
  producer

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Table 1
The Opportunity Cost of Meat and Potatoes

• Opportunity cost
• Whatever must be given up to obtain some item
• What you give up to get something else
• Measures the trade-off between the two goods that
  each producer faces

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Comparative Advantage

• Comparative advantage
• Produce a good at a lower opportunity cost than
  another producer
• Reflects the relative opportunity cost
• Principle of comparative advantage
• Each good - produced by the individual that has
  the smaller opportunity cost of producing that
  good
• Developed by David Ricardo

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Comparative Advantage

• One person
• Can have absolute advantage in both goods
• By definition, cannot have comparative advantage
  in both goods
• For different opportunity costs
• One person - comparative advantage in one good
• The other person - comparative advantage in the
  other good

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Comparative Advantage

• Gains from specialization and trade
• Based on comparative advantage
• Total production in economy rises
• Increase in the size of the economic pie
• Everyone better off
• Can apply to individuals, firms, and countries

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Comparative Advantage

• Trade can benefit everyone in society
• Allows people to specialize
• The price of trade
• Must lie between the two opportunity costs
• Principle of comparative advantage explains
• Interdependence reliance on other individuals,
  firms or countries
• Gains from trade applies to individuals, firms
  and countries

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Applications of Comparative Advantage

• Should the U.S. trade with other countries?
• U.S and Japan
• Each produces food and cars
• One American worker, one month
• One car, or
• Two tons of food
• One Japanese worker, one month
• One car
• One ton of food

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Applications of Comparative Advantage

• Principle of comparative advantage
• Each good produced by the country with the
  smaller opportunity cost of producing that good
• Specialization and trade
• All countries have more food and more cars

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What drives comparative advantage in the
Ricardian model?

• In theory
• Clear that there are gains from specialization
  and trade that arise from differences in
  productivity of labor and capital in each sector
• So in Ricardian model if we assume labor is the
  only factor of production then labor productivity
  would drive comparative advantage and determine
  who trades what

aLFQF aLMQM L
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Ricardian model analytics

• If the domestic country wants to consume both
  meat and food (in autarky), relative prices must
  adjust so that wages are equal in the wine and
  cheese industries.
• If PF /aLF PM /aLM workers will have no
  incentive to flock to either the food or the meat
  industry, thereby maintaining a positive amount
  of production of both goods.
• PF /PM aLF /aLM
• Production (and consumption) of both goods occurs
  when relative price of a good equals the
  opportunity cost of producing that good.

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Ricardian model analytics

• Suppose that the domestic country has a
  comparative advantage in food production its
  opportunity cost of producing cheese is lower
  than it is in the foreign country.
• aLF /aLM lt aLF /aLM
• where notates foreign country variables
• Note here that this is the relative productivity
  which therefore determines comparative advantage

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Other models

• Heckscher Ohlin Model (1919)
• Problem with Ricardian model was that it only had
  one factor of production
• So here a 2 good, 2 FoP model
• Different rule emerges for comparative advantage
• Krugman economies of scale model
• Differentiated products
• Economies of scale
• Different results for comparative advantage

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Factor endowment theory/H-O model

• Look at abundance of FoP or resources
• Country with relatively abundant amount of FoP
  will export good or service which is intensive in
  that factor
• Therefore comparative advantage is in the
  relative abundance of the FoP
• K/L ratio indicates factor abundance
• If US has K/L 0.5 and China has K/L 0.02 then
  US has relatively more K and China relatively
  more L

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H-O model

• So China should export good which uses L
  intensively, and US should export good which uses
  K intensively
• So price of K rises in US and price of L falls
• Opposite happens in China price of L rises and
  price of K falls
• But before in autarky L was paid much less in
  China than in the US as so much L in China.
• Implication is that there is convergence in
  factor prices across countries known as factor
  price equalization

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H-O Model

• In Ricardian model no distributional consequences
  here they are possible
• If US exports more K intensive goods, then income
  earned by K goes up (conversely income earned by
  L goes down)
• Vice versa for China
• Therefore owners of K in US better off compared
  with L and v-v for China
• Known as the Stolper Samuelson Theory

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Leontief Paradox

• Need to test H-O theory to see if it is true
• Wassily Leontief collected data for US and if H-O
  correct US exports should have higher K/L ratio
  than imports
• (1947) Results US X 14K/L
• US M 18K/L
• Was H-O wrong? Leontief called it a paradox.
• Resolution came from widening defn of K

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Leontief Paradox
By looking at average years of education (human
capital) Baldwin found that greater factor
intensity in exports.
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Krugman model

• Paul Krugman developed a model of trade with
  differentiated products. Why?
• Here by trading we can expand our market and
  lower our costs
• But depends on the size and type of economies of
  scale
• Economies of scale internal?
• Economies of scale external?
• Linders theory of overlapping demands

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Krugman model

• Paul Krugman developed a model of trade with
  differentiated products. Why?
• Here by trading we can expand our market and
  lower our costs
• But depends on the size and type of economies of
  scale
• Economies of scale internal?
• Economies of scale external?
• Linders theory of overlapping demands

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Krugman model

• Given trade begins between 2 countries with
  similar industries
• We would expect
• Total of firms to fall
• Price to fall as costs fall
• Variety in each country to increase
• Average size of firms to increase
• Ricardian and H-O models explain inter-industry
  trade
• Krugman explains intra-industry trade

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The Gravity Model

• 3 of the top 10 trading partners with the US in
  2011 were also the 3 largest European economies
  Germany, UK and France.
• These countries have the largest gross domestic
  product (GDP) in Europe.
• Why does the US trade most with these European
  countries and not other European countries?

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Size Matters The Gravity Model (cont.)

• In fact, the size of an economy is directly
  related to the volume of imports and exports.
• Larger economies produce more goods and services,
  so they have more to sell in the export market.
• Larger economies generate more income from the
  goods and services sold, so people are able to
  buy more imports.

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Size Matters The Gravity Model (cont.)
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The Gravity Model

• Other things besides size matter for trade
• Distance between markets influences
  transportation costs and therefore the cost of
  imports and exports.
• Distance may also influence personal contact and
  communication, which may influence trade.
• Cultural affinity if two countries have cultural
  ties, it is likely that they also have strong
  economic ties.
• Geography ocean harbors and a lack of mountain
  barriers make transportation and trade easier.

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The Gravity Model (cont.)

• Multinational corporations corporations spread
  across different nations import and export many
  goods between their divisions.
• Borders crossing borders involves formalities
  that take time and perhaps monetary costs like
  tariffs.
• These implicit and explicit costs reduce trade.
• The existence of borders may also indicate the
  existence of different languages (see 2) or
  different currencies, either of which may impede
  trade more.

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The Gravity Model (cont.)

• In its basic form, the gravity model assumes that
  only size and distance are important for trade in
  the following way
• Tij A (Yi Yj)/Dij
• where
• Tij is the value of trade between country i and
  country j
• A is a constant
• Yi the GDP of country i
• Yj is the GDP of country j
• Dij is the distance between country i and country
  j

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The Gravity Model (cont.)

• In a slightly more general form, the gravity
  model that is commonly estimated is
• Tij A x Yia x Yjb /Dijc
• where a, b, and c are allowed to differ from 1.
• Perhaps surprisingly, the gravity model works
  fairly well in predicting actual trade flows, as
  the figure above representing USEU trade flows
  suggested.

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Distance and Borders

• Estimates of the effect of distance from the
  gravity model predict that a 1 increase in the
  distance between countries is associated with a
  decrease in the volume of trade of 0.7 to 1.
• Besides distance, borders increase the cost and
  time needed to trade.

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Distance and Borders (cont.)

• Trade agreements between countries are intended
  to reduce the formalities and tariffs needed to
  cross borders, and therefore to increase trade.
• The gravity model can assess the effect of trade
  agreements on trade does a trade agreement lead
  to significantly more trade among its partners
  than one would otherwise predict given their GDPs
  and distances from one another?

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Distance and Borders (cont.)

• The US has signed a free trade agreement with
  Mexico and Canada in 1994, the North American
  Free Trade Agreement (NAFTA).
• Because of NAFTA and because Mexico and Canada
  are close to the US, the amount of trade between
  the US and its northern and southern neighbors as
  a fraction of GDP is larger than between the US
  and European countries.

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Distance and Borders (cont.)
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Distance and Borders (cont.)

• Yet even with a free trade agreement between the
  US and Canada, which use a common language, the
  border between these countries still seems to be
  associated with a reduction in trade.
• So Canadian provinces trade more with each other,
  than with US states, ceteris paribus

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Distance and Borders (cont.)
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Distance and Borders (cont.)
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Gravity model

• Shows that still more likely to trade if no
  borders
• But also shows that size and geography also
  matter
• Gravity model tested extensively in economics
  literature
• Shows that USs natural trade partner is Canada
  and to a lesser extent Mexico