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INTERNATIONAL TRADE LECTURE 6: Gains from Trade in Neoclassical Theory Contents To illustrate the equilibrium point under autarky To introduce the international trade and to see its influence to autarky economy To research the minimum conditions for trade To explain some important assumptions in the analysis Introduction The effects of restrictions on international trade Example: U.S. to non-NAFTA countries in 1999 Conclusion: sizable welfare losses in general can occur because of interferences with free trade This chapter focus on participating the trade to avoid welfare cost An updating of the Ricardian analysis Loose some assumptions Increasing opportunity cost Factors more than labor Explicit demand considerations Autarky Equilibrium Autarky: total absence of participation in international trade Basic assumptions Consumers seek to maximize satisfaction Suppliers of factor services and firms seek to maximize their return from productive activity There is mobility of factors within the country but not internationally (same factor return) There are no transportation costs or policy barriers to trade (simple) Perfect competition exists (simple) Autarky Equilibrium In autarky, production takes place on the PPF, and the equilibrium is at point E Px/Py=MRT=MCx/MCy Px/MCx = Py/MCy Point A situation and B Autarky Equilibrium Bring consumers into the picture and autarky equilibrium is at point E Px/Py=MRS=MUx/MUy Px/MUx = Py/MUy Autarky Equilibrium Conclusion In autarky equilibrium, the following condition should be satisfied MRT = MCx/MCy = Px/Py = MUx/MUy = MRS In autarky equilibrium, production of each good in a country must equal the consumption of that good (OX1 Vs OY1) What happened when export or import exist? Contents To illustrate the equilibrium point under autarky MCx/MCy = Px/Py = MUx/MUy production equal consumption To introduce the international trade and to see its influence to autarky economy To research the minimum conditions for trade To explain some important assumptions in the analysis Introduction of International Trade The trade triangle The opening of a country to international trade means exposing the country to a new set of relative prices Result: the producers and consumers will adjust to them by reallocating their production and consumption patterns and thus lead to gains from trade The ultimate source of gain from international trade is the difference in relative prices in autarky between countries Introduction of International Trade Prices in autarky is (Px/Py)1 International prices is (Px/Py)2 What does the difference mean? The change of equilibrium point for producer The change of equilibrium point for consumer Note: C’ is beyond the PPF Introduction of International Trade Trade triangle FC’E’ The base of this right triangle FE’ represents the exports of the country The height or vertical side of the triangle FC’ represents the imports of the country The hypotenuse C’E’ represents the trading line, and its slope indicates the world price ratio or terms of trade Introduction of International Trade The consumption and Production Gains from trade The total gains from trade will be divided into two parts: the consumption gain and the production gain, or we say, the gains from exchange and the gains from specialization Introduction of International Trade Initial equilibrium point E Consumption gain: When faced with trade price ratio, even without changes in production, E C Production gain: with the new relative prices, there is an incentive to producers CC’ The total gains from trade is composed by CI1CI1’ and CI1’CI2 Introduction of International Trade Trade in the partner country Assume a two-country world Analysis for the partner is analogous to that employed for the home country while trade pattern is reversed Introduction of International Trade For partner, the international relative prices is less than autarky prices Export? Import? Trade triangle? Introduction of International Trade Note: The partner country also gains from trade The two trade triangle must be the same Again, the ultimate source of gain from international trade is the difference in relative prices in autarky between countries Concept Check P95 Contents To illustrate the equilibrium point under autarky To introduce the international trade and to see its influence to autarky economy Both country gain and the source of gain from international trade is the difference in relative prices in autarky between countries To research the minimum conditions for trade To explain some important assumptions in the analysis Minimum Conditions for Trade Introduction Relative price differences will present potential gains from trade Two principal sources of relative price variation between two countries Differences in supply conditions Differences in demand conditions Minimum Conditions for Trade Trade between countries with identical PPFs In the Classical Ricardian analysis, there is no incentive for trade because the pretrade price ratios in the two countries would be the same In Neoclassical theory, two countries with identical production conditions can benefit from trade because of different demand conditions in the two countries and the presence of increasing opportunity costs Minimum Conditions for Trade Two countries have different autarky ratio Country I good at produce X and Country II good at produce Y The equilibrium point will stand between E and e Both countries will attain higher indifference curves Note: with constant opportunity cost PPF, relative prices in the two countries would not differ Minimum Conditions for Trade Trade between countries with identical demand conditions Production conditions may differ because different technologies are employed with the same relative amounts of the two factors Assume: country I is more efficient in producing good X and country II is more efficient in producing good Y Minimum Conditions for Trade Identical community indifference map and different PPF exist and thus different domestic price ratio The equilibrium point will stand between E and e Both countries will attain higher indifference curves Minimum Conditions for Trade Conclusion Relative prices in autarky reflect underlying supply and demand conditions which include the relative amounts and quality of available resources, the characteristics of the production technologies employed, and the nature of demand in a country The underlying basis for trade can change as technology changes, as factors grow within countries, as factors move between countries, and as individual country demand patterns change in response to economic development and the increased exposure to different products and cultures. Some Important Assumptions Costless factor mobility Factors of production can shift readily and without cost along the PPF as relative prices change and trade opportunities present themselves This is impossible in the ‘real world’ and the factors will not slide easily along the PPF but moves inside it—equipment, labor, etc. Thus, some type of government assistance is required Some Important Assumptions Full employment of factors of production All of a country’s factors of production are fully employed It means that the country is operating on the PPF The real world does not always reach full employment This assumption is to separate conceptually the problem of efficiency and welfare from that of idle capacity Some Important Assumptions The indifference curve map can show welfare changes We know that when income distribution changed, the community indifference curves may intersect Assumptions used here is to construct nonintersecting community indifference curves Individuals within the economy have reasonably similar tastes The opening of the economy to trade does not radically alter the distribution of income Much moreCompensation principle: potential gains from trade exist in the sense that, within the country, the people who gain from trade can compensate the losers and still be better off Thus, trade would still be preferred to autarky Concept check on P101 Summary To illustrate the equilibrium point under autarky To introduce the international trade and to see its influence to autarky economy To research the minimum conditions for trade To explain some important assumptions in the analysis