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ECON3315 – International Economic Issues Instructor: Patrick M. Crowley Issue 1: Free trade and comparative advantage Overview Some basics Trade and the gravity model Absolute vs comparative advantage Theory of comparative advantage Ricardian model of trade Heckscher-Ohlin model of trade Increasing returns model of trade Leontief paradox Patterns of trade Some basics Macroeconomics vs microeconomics Ceteris paribus GDP = ? GNP = ? National income accounting identity: Value of Production = Income = Expenditure Using expenditure: GDP = Y = C + I + G + (X – M) Real variable ($) = Nominal variable($)/Prices Real variable (%) = Nominal variable(%) - ∏ Some basics Unemployment rate = #U/(#E+#U) Govt budget balance = T – G if >0 - budget surplus if <0 - budget deficit Trade balance = X – M if >0 - trade surplus if <0 - trade deficit FDI = Foreign direct investment Balance of payments: Current a/c +Financial a/c = 0 Exchange rates Demand and supply US trade US trade relatively small… 2007 …but large $ amounts US trading patterns Q: So why does the US trade with larger European countries? A: Because their GDP is bigger – larger countries produce more g&s and have more to sell in the export market So gravity model suggests that distance and size of economy determine how much trade is done between countries Size of EU economy and trade with the US What determines amount of trade? 1. 2. 3. 4. 5. 6. Size Distance Size of economy Cultural affinity (language, historical association) Multinational corporations – about 1/3rd of world trade is between different divisions of same company. Borders ( - different currencies, languages) Gravity model 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 Gravity model results 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%. Trade agreements between countries are intended to reduce the formalities and tariffs needed to cross borders, and therefore to increase trade. Gravity model shows that they do this. Adding NAFTA countries …but even free trade doesn’t take away border effect Examples of trade flows for BC Transportation speed and technology Gravity model suggests distance is important, but surely speed and technology associated with transportation have led to a “smaller” world? Wheels, sails, compasses, railroads, telegraph, steam power, automobiles, telephones, airplanes, computers, fax machines, internet, fiber optics,… are technologies that have increased trade. But history has shown that political factors, such as wars, can change trade patterns much more than innovations in transportation and communication. 2 waves of globalization How have patterns of trade changed between these 2 periods? Today, most of the volume of trade is in manufactured products such as automobiles, computers, clothing and machinery. • Services such as shipping, insurance, legal fees and spending by tourists account for 20% of the volume of trade. • Mineral products (e.g., petroleum, coal, copper) and agricultural products are a relatively small part of trade. World trade composition World trade composition - 2008 …other differences UK exported mostly manufactured goods and imported raw materials in early 1900s. US mostly imported and exported raw materials and agricultural products. Now, both countries import and export mostly manufactured products… …and same pattern clear for developing countries …but most jobs are non-Tradable ( - they are connected to the Services part of the economy) Source: J. Bradford Jensen and Lori G. Kletzer, “Tradable Services: Understanding the Scope and Impact of Services Outsourcing,” Peterson Institute of Economics Working Paper 5-09, May 2005 Mercantilism & absolute advantage Mercantilism – idea that trade is a zero-sum game – more you export, the better off you are as you have gold coming in to pay for the exports. Hume’s price-specie mechanism showed that this wasn’t the case…the accumulation of gold would lead to inflation which would correct trade imbalance. Adam Smith advocated instead absolute advantage – idea that with free trade country that can supply cheapest g&s would prevail. Objections: i) Fear was that developing countries would suffer, as they usually were at an earlier stage of production; and ii) that loss of welfare to those who lost could offset gains from trade. Absolute vs comparative advantage Absolute advantage (Adam Smith) – advantage based solely on cost considerations Comparative advantage (David Ricardo) – takes into account both scarcity of resources and cost A country has a comparative advantage in producing a good if the opportunity cost of producing that good is lower in the country than it is in other countries Example: • Japan can produce 300m electronic goods, compared to 100m tons of rice that it could otherwise produce. • Indonesia can produce 300m electronic goods, compared to 150m tons of rice that it could otherwise produce. Comparative advantage example Start with both countries not trading ( - called “autarky”), and then assume that they trade. Can both countries be made better off? A: YES!!! Why? Because Japan has a comparative advantage in electronics, so should specialize in electronics, while Indonesia has a comp adv in rice so should specialize in rice production Potential Million Million max gains electronics tons rice Japan +300m -100m Indonesia -300m +150m 0 +50m Total Comparative advantage example The production possibility frontier (PPF) of an economy shows the maximum amount of a goods that can be produced for a fixed amount of resources. If QE represents the quantity of electronics produced and QR represents the quantity of rice produced, then the production possibility frontier of the domestic economy has the equation: aLEQE + aLRQR = L - where aLE and aLR measure the productivity of labor. So in this example: Opportunity cost = slope = -(aLE/aLR) [assuming R is on the vertical axis of the PPF] Let’s now put example numbers in plot the PPF: Comparative advantage example For Japan, opp cost = 1/3 and for Indonesia, opp cost = ½ Unit labor requirements As long as the opp cost is different trade can benefit both parties Electronics Rice Japan aLE = 2 aLR = 6 Indonesia a*LE = 4 a*LR = 8 Graphing this with rice on the vertical axis and electronics on the horizonatal axis, lhs is Indonesia and rhs is Japan. Comparative advantage example Presumably before trade the price in each country should equal the opp cost (aa) Why? Otherwise wages would be different in each sector So when trade occurs, the price changes in both countries ( to cc which is the same in both graphs) Consumption point moves beyond the PPC 1 = autarky production & consumption 2 = free trade production point (i.e. with specialization) 3 = free trade consumption point Comparative advantage example Note that free trade production and consumption points are at different places. – and that trade allows the country to move outside its PPC Given the numbers, how much labor is there in each country? Idea here is that wages reflect productivity, so that comparative advantage happens because of productivity differences, not because of wage differences But is this the case in reality? Productivity and wages compared with the US Ricardo’s comparative advantage theory criticisms Does this result hold in a world with many goods? What happens to the losers from trade? What about labour standards? Surely this could lead to worker exploitation? Wouldn’t this constitute a “race to the bottom” in terms of things like environmental standards? Human rights? What about capital? Doesn’t this play a role? What about technology? Don’t different goods use different processes that require different amounts of labor and capital? – this criticism led to the HeckscherOhlin model which was drawn up by 2 Swedish economists Other trade theories – H-O model 2 factors of production –L & K Trade depends on factor intensity In autarky, if there’s a lot of L compared to K in one country, then w will be low compared to other country Assume 2 products – each requiring a a different degree of labor intensity compared to capital (Rice would be L intensive , whereas electronics will be K intensive). Continuing our example…assume K = 400 in both J and I, but that labor endowments differ so that LJ = 600 and LI = 1200. We measure production processes by their K/L ratio. The necessary amounts of K and L to produce each good are given by: Other trade models: H-O Looking at the K/L ratio, electronics is clearly K intensive, and rice is clearly labour intensive. But I has more labor, then without trade if we look at the w/r ratio, then: (w/r)I < (w/r)J So that rice must be expensive in J and electronics are expensive in I Factor requirements Electronics Rice K 12 10 L 4 20 K/L 3 0.5 Other trade models: H-O Now let them trade! What happens?? Obviously I specializes in rice and J specializes in electronics. So price of electronics comes down in I and price of rice comes down in J. But increased demand for rice raises wI and lowers wJ, and likewise will raise rJ and lower rI. This is known as the “Stolper-Samuelson theory”. When will this process stop? When they have the same product prices…so that: (pE/pR)J = (pE/pR)I But this also means that: (w/r)J = (w/r)I This is known as “factor price equalization” Other trade models: H-O - results Countries have a “comparative advantage”, not because of productivity differences, but because of differences in endowments of factors A country should produce the good which is intensive in the factor that the country is relatively abundant in. Idea can also be extended to natural resources leads to the insight that if you have lots of natural resources you should produce those, and those factors that are intensively used in their exploitation will benefit. Also countries that are not endowed with natural resources have to develop labor skills or technological know-how to have something to trade Leontief paradox H-O leads to thought that as US is most K-abundant in the world, we should be exporting K-intensive goods and importing L-intensive goods. The paradox is that all the data shows that this isn’t the case Leontief paradox But US is complicated, as has lots of labour too, but even when tested on other developed countries, H-O doesn’t seem to work. But H-O does seem to work on trade flows between low and high income countries. See below for China Other theories: Krugman Motivation here is to explain fact that most trade that occurs, occurs between developed countries, and they tend to trade the same goods Uses notion of economies of scale 2 factors, 2 heterogeneous goods, internal economies of scale Example: red wine and white wine – schedule for either is on right Litres Hrs of L Units of L/Litre 10 80 8 20 120 6 30 150 5 40 160 4 50 200 4 Other theories: Krugman 1 – autarky production and consumption 2 – after trade occurs, one country specializes in production of white, other country in red 3 – after trade, consumers in both countries have increase in consumption of both red and white wine Other theories: Krugman In fact price for both red and white wine will fall as output increases in both countries Both countries produce same product, but differentiated versions Leads to notion of inter-industry and intraindustry trade Patterns of trade About 25% of world trade is intra-industry Level of intra-industry trade is industry dependent Intra-industry trade Intra-industry trade