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“Changing Policy Environment and International Business” Some theory of international trade Prepared by Vassily K. Dermanov International Trade • Buying and selling goods and services from other countries • The purchase of goods and services from abroad that leads to an outflow of currency from the UK – Imports (M) • The sale of goods and services to buyers from other countries leading to an inflow of currency to the UK – Exports (X) 2 Labour productivity and comparative advantage: the Ricardian model 3 Why countries are engaged in international trade? First, countries trade because they are different from each other. Second, countries trade to achieve economies of scale in production. 4 The concept of comparative advantage 5 The concept of comparative advantage Is it possible to grow roses in Saint Petersburg? It is a lot easier to grow roses in the South America. A given amount of resources used in generator production yields fewer generators in South America than in Russia. 6 Opportunity cost and trade-off: the opportunity cost of roses in terms of electric generators is the number of generators that could have been produced with the resources used to produce a given number of roses. The trade-off in South America might be something like 10 million roses for 100 generators, and 10 million roses for 500 generators in Russia. 7 National Production Roses, millions Russia 10 Electric Generators, units - South America 10 - Maximum 20 8 National Production Roses, millions Russia - Electric Generators, units 500 South America - 100 Maximum - 600 9 National Production Roses, millions Russia (50:50) 5 Electric Generators, units 250 South America (50:50) 5 50 Total (50:50) 10 300 10 • Let Russia stop growing roses and devote the resources to produce generators. • Let South America grow those roses instead. • Look what has happened: Russia concentrating on generators and South America concentrating on roses, increases the size of the world's economic pie. 11 Hypothetical Changes in Production Roses, millions Russia - Electric Generators, units 500 South America 10 - World total 10 500 12 • International trade increases world output because it allows each country to specialise in producing the good in which it has a comparative advantage. • A country has a comparative advantage in producing a good if the opportunity cost of producing that good in terms of other goods is lower in that country than it is in other countries. 13 Specialisation and Trade • Different factor endowments mean some countries can produce goods and services more efficiently than others – specialisation is therefore possible: • Absolute Advantage: – Where one country can produce goods with fewer resources than another • Comparative Advantage: – Where one country can produce goods at a lower opportunity cost – it sacrifices less resources in production 14 • South America has a comparative advantage in roses and Russia has a comparative advantage in generators. • The standard of living can be increased in both places if South America produces roses for Russia, while the Russia produces generators for the South America. So, trade between two countries can benefit both countries if each country exports the goods in which it has a comparative advantage. 15 The Terms of Trade • The Terms of Trade looks at the relationship between the price received for exports and the amount of imports we are able to buy with that money. Average Price of Exports Terms of Trade = --------------------------------Average Price of Imports 16 This approach, in which international trade is solely based on international differences in the productivity of labour, is known as the Ricardian model. 17 A One-Factor Economy 18 A One-Factor Economy An economy (Home) has only one factor of production - labour. Only two goods - wine and cheese - are produced. The technology of Home's economy can be summarised by labour productivity in each industry, expressed in terms of the unit labour requirement. 19 A One-Factor Economy It might require: - 1 hour of labour to produce a kg of cheese, - 2 hours to produce a litre of wine. For future reference, we define: alw as the unit labour requirements in wine production, alc as the unit labour requirements in cheese production, respectively. The economy's total resources are defined as L, the total labour supply. 20 Home wine production, Qw, in litres Absolute value of slope equals opportunity cost of cheese in terms of wine L/alw PPF L/alc Home cheese production, Qw, in kg 21 Because Foreign's relative unit labour requirement in cheese is higher than Home's (it needs to give up many more units of wine to produce one more unit of cheese), its production possibility frontier is steeper. Foreign wine production, Qw, in litres L*/a*lw PPF L*/a*lc Foreign cheese production, Qw, in kg 22 RELATIVE PRICES AND SUPPLY 23 RELATIVE PRICES AND SUPPLY Let PС and PW be the prices of cheese and wine, respectively. Costs: It takes aLC person-hours to produce a kg of cheese. It takes aLW person-hours to produce a litre of wine. 24 RELATIVE PRICES AND SUPPLY The economy will specialise in the cheese production if PC /PW > aLC / aLW ; it will specialise in the production of wine if PC /PW < aLC / aLW . Only when PC /PW is equal aLC / aLW , will both goods be produced. 25 The economy will specialise in the production of cheese if the relative price of cheese exceeds its opportunity cost. It will specialise in the production of wine if the relative price of cheese is less than its opportunity cost. 26 • In the absence of international trade, Home would have to produce both goods for itself. But it will produce both goods only if the relative price of cheese is just equal to its opportunity cost. • In the absence of international trade, the relative prices of goods are equal to their relative unit labor requirements. 27 Trade in a One-Factor World 28 Suppose that there are two countries: Home and Foreign. We denote Home's labor force by L and Home's unit labor requirements in wine and cheese production by aLW and aLC, respectively. We denote Foreign's labor force L*; Foreign's unit labor requirements in wine and cheese will be denoted by a*LW and a*LC , respectively. • Let as assume that: aLC /aLW < a*LC / a*LW • or, equivalently, that aLC / a*LC < aLW / a*LW . 29 Home Wine production, Qw, in litres Wine production, QW*, in litres Foreign L*/a*lw L/alw PF L/alc Cheese production, Qc, in kg PF* L*/a*lc Cheese production, Qc, in kg 30 • Home's relative productivity in cheese is higher than it is in wine. Home has a comparative advantage in cheese. • Foreign's relative productivity in wine is higher than it is in cheese. • Foreign has a comparative advantage in wine. 31 When one country can produce a unit of a good with less labor than another country, we say that the first country has an absolute advantage. One of the most important sources of error in discussing international trade is to confuse comparative advantage with absolute advantage. 32 In the absence of foreign trade the relative prices in each country would be determined by the relative unit labor requirements. In case of international trade prices will no longer be determined purely by domestic considerations. 33 The World Relative Supply and Demand 34 World Relative Supply and Demand Pc/Рw Relative prices of cheese RS a*LC / a*LW aLC / aLW RD Relative quantity of cheese L / аLC L* / а*LW Qc + Qc* 35 Qw + Qw* There will be no world cheese production and no world supply of cheese if the world price drops below Relative prices of cheese аLC /аLW. World Relative Supply and Demand Pc/Рw a*LC / a*LW Home and Foreign will produce wine only whenever Pc/Pw < аLC /аLW . RS aLC / aLW RD Relative quantity of cheese L / аLC L* / а*LW Qc + Qc* 36 Qw + Qw* World Relative Supply andprice Demand When the relative of cheese, Pc/Рw a*LC / a*LW aLC / aLW Pc/Pw, is exactly аLC /аLW, workers Relative prices in Home can earn exactly the same of cheese amount making either cheese or wine. So Home will be willing to supply any relative RS amount of the two goods, producing a flat section to the supply curve. Foreign will produce wine whenever Pc/Pw < а*LC /а*LW . RD Relative quantity of cheese L / аLC L* / а*LW Qc + Qc* 37 Qw + Qw* If Pc/Pw is and above Demand аLC /аLW World Relative Supply Pc/Рw a*LC / a*LW Home will specialize in the Relative prices production of cheese. As long as of cheese Pc/Pw < а*LC /а*LW , however. Foreign will continue to RS specialize in producing wine. aLC / aLW RD Relative quantity of cheese L / аLC L* / а*LW Qc + Qc* 38 Qw + Qw* World Relative Supply and Demand Pc/Рw a*LC / a*LW aLC / aLW Relative prices of cheese RS At Pc Pw = а*LC /а*LW, Foreign workers are indifferent between RD producing cheese and wine. Relative quantity of cheese Thus here we again have a L / аLC flat section of the supply Qc + Qc* L* / а*LWcurve. 39 Qw + Qw* World Relative Supply Demand Finally, and for Pc/Pw > а*LC Pc/Рw Relative prices/а*LW, both of cheese Foreign will Home and specialize in cheese production. There will be no RS wine production, so that the relative supply of cheese will become infinite. a*LC / a*LW aLC / aLW RD Relative quantity of cheese L / аLC L* / а*LW Qc + Qc* 40 Qw + Qw* Russia and Germany: mutual trade Oil case Map courtesy of http://www.theodora.com 41 Russia and Germany: Relative Supply and Demand in oil and cars Pc/Рoil Relative prices of cars aruLC / aruLoil RS agerLC / agerLoil RD Relative quantity of cars Lru / аruLC Lger / аgerLoil Qruc + Qcger 42 Q oil + Qoilger ru The Gains From Trade 43 THE GAINS FROM TRADE Trade as an indirect method of production Home could produce wine directly, but trade with Foreign allows it to "produce" wine by producing cheese and then trading the cheese for wine. This indirect method of "producing" wine is a more efficient method than direct production. 44 Trade affects each country's possibilities for consumption. In the absence of trade, consumption possibilities are the same as production possibilities. Once trade is allowed, however, each economy can consume a different mix of cheese and wine from the mix it produces. Trade makes residents of each country better off. 45 Resources and Trade: The Heckscher-Ohlin Model Introduction • Comparative advantage could arise because of international: – differences in labor productivity; – differences in countries' resources. • Canada exports forest products to the United States because Canada has more forested land per capita than the United States. 47 • Labor is important, but what about of other factors of production (such as land, capital, and mineral resources)? • We will examine a model in which resource What does it differences are the only source of mean trade. efficiency? • This model shows that comparative advantage is influenced by the interaction between nations' resources and the technology of production. 48 • Developed by two Swedish economists, Eli Heckscher and Bertil Ohlin (Nobel Prize in economics in 1977), the theory is often referred to as the Heckscher-Ohlin theory (H-O theory). • H-O theory emphasises the interplay between the proportions in which different factors of production are available in different countries and the proportions in which they are used in producing different goods. Due to it is also referred to as the factor-proportions theory. 49 A Model of a Two-factor Economy • The model is in many ways very similar to the specific factors model. • It is assumed that each economy is able to produce two goods and that production of each good requires the use of two factors of production. • The same two factors are used in both sectors. (It is a more difficult model, but with some new insights. 50 Assumptions of the Model • The economy we are analyzing can produce two goods: cloth and food. • Production of these goods requires two inputs that are in limited supply: labor and land. Let us define the following expressions: • aTC = acres of land used to produce one m2 of cloth • aLC = hours of labor used to produce one m2 of cloth • aTF = acres of land used to produce one calorie of food • aLF = hours of labor used to produce one calorie of food • L = economy's supply of labor • Т = economy's supply of land 51 • Notice that we speak in these definitions of the quantity of land or labor used to produce a given amount of food or cloth, rather than the amount required to produce that amount. • The reason is that in a two-factor economy there may be some room for choice in the use of inputs. 52 Input Possibilities in Food Production Unit land input a , TF in acres per calorie Input combinations that produce one calorie of food II Unit labor input, aLF , in hours per calorie 53 • What input choice will producers actually make? It depends on the relative cost of land and labor. • If land rents are high and wages low, farmers will choose to produce using relatively little land and a lot of labor. • If rents are low and wages high, they will save on labor and use a lot of land. 54 InAt eachany sector, the ratio of land to labor usedfood in given wage-rental ratio, production depends on the cost of labor relative to uses higher land-labor theproduction cost of land, w/r. Theacurve FF shows the landratio; food production is landlabor ratio so, choices in food production, the curve CC w - is the wage rate the corresponding choices in clothproduction production. intensive and that cloth is Factor Prices and Input Choice Wage-rental ratio, w/r per hour of labor; labor-intensive. r - the cost of one СС acre of land, FF w/r Land-labor ratio, T/L 55 Factor Prices and Goods Prices • Suppose that the economy produces both cloth and food. • Then competition among producers in each sector will ensure that the price of each good equals its cost of production. • The cost of producing a good depends on factor prices: If the rental rate on land is higher, then other things equal the price of any good whose production involves land input will also have to be higher. 56 Factor Prices Relative price of cloth, PC/PF Because cloth production and Goods Prices is labor-intensive there is a one-to-one relationship between the factor price ratio w/r and the relative SS price of cloth PC/PF . The higher the relative cost of labor, the higher must be the relative price of the labor-intensive good. Wage-rental ratio, w/r 57 Let us put previous figures together. In combined figure the SS curve will be turned on its side, while the right panel reproduces figure with “Factor prices and Input Choice”. Wage-rental Relative price of cloth, PC/PF ratio, w/r СС SS FF w/r Wage-rental ratio, w/r Land-labor 58 ratio, T/L By putting these diagrams together, we see a surprising linkage of the prices of goods to the ratio of land to labor used in the production of Wage-rental each good. From Goods Prices to Input Choices ratio, w/r SS СС FF w/r2 w/r1 Relative price of cloth, PC/PF PC/P 2F PC/P1F Increasing TC/L1C TC/L2C TF/L1F Increasing TF/L2F Land-labor ratio, T/L 59 From Goods Prices to Input Choices Wage-rental ratio, w/r SS СС FF w/r2 w/r1 Relative price of cloth, PC/PF PC/P 2F PC/P1F Increasing TC/L1C TC/L2C TF/L1F Increasing TF/L2F Land-labor ratio, T/L 60 Resources and Output • Let us describe the relationship between goods prices, factor supplies, and output. • Suppose that we take the relative price of cloth as given. • Relative price of cloth determines the wage-rental ratio w/r, and thus the ratio of land to labor used in the production of both cloth and food. 61 The Allocation of Resources Increasing Land used in cloth production Labor used in cloth production Increasing Increasing Land used in food production Increasing Labor used in food production 62 The Allocation of Resources Increasing Land used in cloth production Labor used in cloth production Increasing Increasing The height of the box represent s total supply of land. Land used in food production Increasing Labor used in food production 63 The Allocation of Resources The width of the box represents the economy's supply Labortotal used in food production of labor. Land used in cloth production Labor used in cloth production Increasing Increasing Land used in food production Increasing Increasing 64 The Allocation of Resources Increasing OF Labor used in food production Land used in cloth production TC 1 TF Increasing C Land used in food production Increasing LF F LC OC Labor used in cloth production Increasing 65 We measure the use of labor The Allocation of Resources and land in the cloth sector as the horizontal and verticalIncreasing distances of such a point Labor used in food production from OC . OF Land used in cloth production TC 1 TF Increasing Thus at point 1 OCLC is the labor used in cloth production and OCTC is the land used C in cloth production. Land used in food production Increasing LF F LC OC Labor used in cloth production Increasing 66 The Allocation of Resources Increasing OF Labor used in food production Land used in cloth production TC 1 We measure inputs into the food sector starting from the opposite comer: F OFLF is the labor, OFTF LC theOland used in food Labor used in cloth production C production. Increasing TF Increasing C Land used in food production Increasing LF 67 The question is what happens when the economy's supply of land is increased, holding both goods prices and the labor supply fixed. 68 An Increase in the Supply of Land Increasing Labor used in food production O2 F Land used in cloth production T1C 1 T2C 2 F2 OC F1 L2C L1C Labor used in cloth production Increasing Increasing C Land used in food production Increasing O1 F 69 An Increase in the Supply of Land Increasing Labor used in food production O2 F Land used in cloth production T1 C T2C F2 OC Increasing C Land used in food production Increasing O1 F Thus an increase in the 1 economy's supply of land 2 will, holding prices constant, 1 Flead to a fall in the output of 2 1 LC LC the labor-intensive good. 70 Labor used in cloth production Increasing Resources and Production Possibilities Output of food, QF 2 Q2 Q1 F Slope = - PM / PF 1 F Slope = - PC / PF TT1 Q2 C Q 1C An increase in the supply of land shifts the economy's production possibility frontier outward from TT1 to TT2, but does so disproportionately in the direction of food production. The result is that at an unchanged relative price of cloth (indicated by the slope -PС/PF), cloth production actually declines from Q1C to Q2C. TT2 Output of cloth, Q71C Output of energy, QE Russia: resources and Production Possibilities An increase in the supply 2 Q2 E Slope = - PM / PE of energy shifts the economy's production possibility frontier outward case Q1 1 E Slope = - PM / PE from TT1 to TT2. The result is that at an unchanged relative price of machinery (indicated by the slope -PM /PE), machinery production actually declines from Q1M to Q2M. TT1 Q2 M Q 1M TT2 Output of machinery, 72 QM • The biased effect of increases in resources on production possibilities is the key to understanding how differences in resources give rise to international trade. • An increase in the supply of land expands production possibilities disproportionately in the direction of food production, while an increase in the supply of labor expands them disproportionately in the direction of cloth production. 73 Abundance and Intensity The resource of which a country has a relatively large supply is the abundant factor in that country, and the resource of which it has a relatively small supply (land in Home, labor in Foreign) is the scarce factor. 74 Abundance and Intensity • Since Home has a higher ratio of labor to land than Foreign, Home is laborabundant and Foreign is land-abundant. Example: If America has 80 million workers and 200 million acres (a labor-to-land ratio of 1: 2.5), while Britain has 20 million workers and 20 million acres (a labor-to-land ratio of 1:1) we consider Britain to be labor-abundant even though it has less total labor than America. 75 Abundance and Intensity • So, "abundance" is always defined in relative terms, by comparing the ratio of labor to land in the two countries. • Thus, no country is abundant in everything. • Since cloth is the labor-intensive good, Home's production possibility frontier relative to Foreign's is shifted out more in the direction of cloth than in the direction of food. 76 Thus an economy with a high ratio of land to labor will be relatively better at producing food than an economy with a low ratio of land to labor. Generally, an economy will tend to be relatively effective at producing goods that are intensive in the factors with which the country is relatively wellendowed. 77 Effects Of International Trade Between Two-Factor Economies • What happens when two such economies, Home and Foreign, trade. • Home and Foreign are similar along many dimensions: – the same tastes, – identical relative demands for food and cloth, – the same technology: a given amount of land and labor yields the same output of either cloth or food in the two countries. 78 Effects Of International Trade Between Two-Factor Economies The only difference between the countries is in their resources: Home has a higher ratio of labor to land than Foreign does. 79 • That means that Home will have a larger relative supply of cloth. • Home's relative supply curve, then, lies to the right of Foreign's. • The relative supply schedules of Home (RS) and Foreign (RS*) are illustrated in the next figure. 80 In the absence of trade, Home's In the absence of trade,toForeign's Trade Leads a Convergence of Relative equilibrium would be at point 1, equilibrium would be at point 3., Prices where domestic relative supply where Foreign relative supply Relative price RS intersects the relative demand RS* intersects * of cloth, PC/PFthe relative demand RS curve RD. curve RD. RSWORLD 3 (PC/PF)* 2 RS (PC/PF)W (PC/PF) Trade leads to a world relative price that lies between the pretrade prices, e.g., at point 2. 1 RDWORLD Relative quantity of cloth, Qc + Qc* QF + QF* 81 The standard trade model In spite of the differences in their details, our models share a number of features. 1. The productive capacity of an economy can be summarized by its production possibility frontier. 2. Production possibilities determine a country's relative supply schedule. 3. World equilibrium is determined by world relative demand and a world relative supply. 83 • The models may be viewed as special cases of a more general model of a trading world economy. • So, let’s develop a standard model of a trading world economy to understand how a variety of changes in basic parameters affect the world economy. 84 A STANDARD MODEL OF A TRADING ECONOMY The standard trade model is built on four key relationships: • the relationship between the production possibility frontier and the relative supply curve; • the relationship between relative prices and relative demand; • the determination of world equilibrium by world relative supply and world relative demand, • and the effect of the terms of trade on a nation's welfare. 85 PRODUCTION POSSIBILITIES AND RELATIVE SUPPLY • Let’s assume that each country produces – two goods, food (F) and cloth (C), – country's production possibility frontier is a smooth curve. 86 Relative Prices Determine the Economy's Output Food production, QF The point on PPF at which an economy actually produces depends on the price of cloth relative to food, PC/PF. Cloth production, QС 87 Relative Prices Determine the Economy's Output Food production, QF It is a basic proposition of microeconomics that a market economy maximizes the value of output at given market prices, PCQC + PFQF . Cloth production, QС 88 We can indicate the market value of output by drawing a number of isovalue lines — that is, lines along which the value of output is constant. 89 Relative Prices Determine the Economy's Output Food production, QF Isovalue lines Q TT An economy whose production possibility frontier is TT will produce at Q, which is on the highest possible isovalue line. Cloth production, QС 90 Relative Prices Determine the Economy's Output Food production, QF Each of these lines is defined by an equation of the form PCQC +lines PFQF = V. Isovalue Q TT Cloth production, QС 91 Relative Prices Determine the Economy's Output Food production, QF Isovalue lines Q The higher V is, the farther TT out an isovalue line lies; thus isovalue lines farther from the Cloth production, QС origin correspond to higher values of 92 output. Relative Prices Determine the Economy's Output Food production, QF Isovalue lines Q TT The economy will produce the highest value of output it can, which can be achieved by producing Cloth production, QС at point Q. 93 How an Increase in the Relative Price of Cloth Affects Relative Supply Food production, QF Q1 VV1 (PC/PF)1 Q2 VV2 (PC/PF)2 TT The isovalue lines become steeper when the relative price of cloth rises from (PC/PF)1 to (PC/PF)2 (shown by the rotation from VV1 to VV2). As a result, the economy produces more cloth and less food and the equilibrium output shifts from Q1 to Q2. Cloth production, QС 94 RELATIVE PRICES AND DEMAND • The value of an economy's consumption equals the value of its production: PCQC + PFQF = PCDC + PFDF = V • Production and consumption must lie on the same isovalue line. 95 Production, Consumption, and Trade in the Standard Model Food production, QF Indifference curves D Food imports The economy consumes at point D. The economy produces at point Q,. Q Isovalue line TT Cloth exports Cloth production,96QС Production, Consumption, and Trade in the Standard Model Food production, QF D Food imports Cloth exports The economy produces Indifference curves more cloth than it consumes and therefore exports cloth; correspondingly, Q it consumes more food Isovalue than line it produces and therefore imports food. TT Cloth production, Q97 С Effects of a Rise in the Relative Price of Cloth Food production, QF TT D2 When that relative price rises all isovalue lines become steeper. D1 The maximum-value line rotates from VV1 to VV2. Q1 Q2 VV1 (PC/PF)1 VV2 (PC/PF)2 Cloth production, QС 98 Effects of a Rise in the Relative Price of Cloth Food production, QF TT The economy's consumption choice shifts from D1 to D2 D2 D1 Q1 Q2 The Theeconomy economyproduces produces more more C and C and lessless F, F, shifting production from shifts from Q1 to Q1Qto2 Q2 VV1 (PC/PF)1 VV2 (PC/PF)2 Cloth production, QС 99 The move from D1 to D2 reflects two effects of the rise in PC/PF Food production, QF TT D2 D1 1) the economy has moved to a higher indifference curve: It is better off. The reason is that this economy is an exporter of cloth. Q1 Q2 VV1 (PC/PF)1 VV2 (PC/PF)2 Cloth production, QС 100 The move from D1 to D2 reflects two effects of the rise in PC/PF Food production, QF TT D2 D1 2) the change in relative prices leads to a shift towards consumption of more food food. Q1 Q2 VV1 (PC/PF)1 VV2 (PC/PF)2 Cloth production, QС 101 Effects of a Rise in the Relative Price of Oil Consumer goods production, QC TT D2 D1 case Q1 Q2 VV1 (PO/PC)1 VV2 (PO/PC)2 Oil production, Q102 О THE WELFARE EFFECT OF CHANGES IN THE TERMS OF TRADE • When PC/PF increases, a country that initially exports cloth is made better off, as illustrated by the movement from D1 to D2. • Conversely, if PC/PF were to decline, the country would be made worse off; for example, consumption might move back from D2 to D1. 103 THE WELFARE EFFECT OF CHANGES IN THE TERMS OF TRADE The general statement, then, is that a rise in the terms of trade increases a country's welfare, while a decline in the terms of trade reduces its welfare. 104 World Relative Supply and Demand Relative price of cloth, PC/PF RS 1 (PC/PF)1 1) An increase in PC/PF leads both countries to produce more cloth and less food. 2) An increase in PC/PF leads both countries to shift their consumption RD mix away from cloth toward food. Relative quantity of cloth, Qc + Qc* QF + QF* 105 Now we can use RS, RD and the ToT to understand a number of important issues in international economics. 106 ECONOMIC GROWTH: A SHIFT OF THE RS CURVE • The effects of economic growth in a trading world economy are a source of concern around two questions: – is economic growth in other countries good or bad for our nation? – is growth in a country more or less valuable when that nation is part of a closely integrated 107 world economy? The effects of growth “+” “-” at home on other economies in other countries on home economy 108 The effects of growth at home • On one hand, growth • On the other hand, the benefits of in an economy's growth may be production capacity passed on to should be more foreigners in the valuable when that country can sell some form of lower prices for the country's of its increased exports rather than production to the retained at home. world market. 109 The effects of growth in other countries • On one side, • On the other economic growth in side, growth in the rest of the other countries world may be good may mean for our economy increased because it means competition for larger markets for our exporters. our exports. 110 The standard model of trade provides a framework that can clarify the effects of economic growth in a trading world. 111 GROWTH AND THE PRODUCTION POSSIBILITY FRONTIER • This growth can result either from increases in a country's resources or from improvements in the efficiency with which these resources are used. • The international trade effects of growth result from the fact that such growth typically has a bias. 112 Biased Growth Food production, QF Food production, QF Growth is biased when it shifts production possibilities out more toward one good than toward another. In both cases the production possibility frontier shifts out from 1 to TT2 . TT 1 2 TT TT Cloth production, QC a) growth biased toward cloth TT1 TT2 Cloth production, QC 113 b) growth biased toward food Biased Growth Food production, QF In case (a) this shift is biased toward cloth. TT1 TT2 Cloth production, QC a) growth biased toward cloth In case (b) this shift is biased toward food. Food production, QF TT1 TT2 Cloth production, QC 114 b) growth biased toward food Biased Growth FoodIn case (a) at an unchanged production, QF price of cloth the relative In case (b) at an unchanged Food production,relative QF price of cloth the output of food actually falls. TT1 TT2 Cloth production, QC a) growth biased toward cloth output of cloth actually falls. TT1 TT2 Cloth production, QC 115 b) growth biased toward food Growth may be biased for two main reasons: 1. The Ricardian model shows that technological progress in one sector of the economy will expand the economy's production possibilities more in the direction of that sector's output than in the direction of the other sector's output. 116 Growth may be biased for two main reasons: 2. The H-O Model showed that an increase in a country's supply of a factor of production — say, an increase in the capital stock resulting from saving and investment — will produce biased expansion of production possibilities. 117 Growth and Relative Supply Relative price of cloth, PC/PF RS1 RS2 1 (PC/PF)1 2 (PC/PF )2 RD Suppose that Home experiences growth strongly biased toward cloth, so that its output of cloth rises at any given relative price of cloth, while its output of food declines. Relative quantity Qc + Qc* of cloth, QF + QF* a) Cloth-biased growth 118 Growth and Relative Supply Relative price of cloth, PC/PF RS1 RS2 1 (PC/PF)1 2 (PC/PF )2 RD Relative quantity Qc + Qc* of cloth, QF + QF* a) Cloth-biased growth Then for the world as a whole the output of cloth relative to food will rise at any given price and the world relative supply curve will shift to the right from RS1 to RS2. 119 Growth and Relative Supply Relative price of cloth, PC/PF RS1 RS2 1 (PC/PF)1 2 (PC/PF )2 RD Relative quantity Qc + Qc* of cloth, QF + QF* a) Cloth-biased growth This shift results in a decrease in the relative price of cloth from (PС/PF)1 to (PС/PF)2 , a worsening of Home's terms of trade and an improvement in Foreign's terms of trade. 120 Growth and Relative Supply Relative price of cloth, PC/PF Relative price of cloth, PC/PF RS1 RS2 RS2 RS1 1 2 (PC/PF)1 (PC/PF)2 2 (PC/PF )2 (PC/PF )1 1 RD RD Relative quantity Qc + Qc* of cloth, Relative quantity Qc + Qc* of cloth, QF + QF* a) Cloth-biased growth QF + QF* b) Food-biased growth 121 Growth and Relative Supply Relative price of cloth, PC/PF Relative price of cloth, PC/PF RS that the RS Notice important RSconsideration RS here is not which economy Grows but the bias RD RD of the growth. 1 2 2 1 1 2 (PC/PF)1 (PC/PF)2 2 (PC/PF )2 (PC/PF Relative quantity Qc + Qc* of cloth, QF + QF* a) Cloth-biased growth )1 1 Relative quantity Qc + Qc* of cloth, QF + QF* b) Food-biased growth 122 Growth and Relative Supply Either Home or Foreign growth biased toward food leads to a leftward shift of the RS curve (RS1 to RS2) and thus to a rise in the relative price of cloth from (PС/PF)1 to (PС/PF)2. This increase is an improvement in Home's terms of trade, a worsening of Foreign's. Relative price of cloth, PC/PF RS2 RS1 2 (PC/PF)2 (PC/PF )1 1 RD Relative quantity Qc + Qc* of cloth, QF + QF* b) Food-biased growth 123 • Growth that disproportionately expands a country's production possibilities in the direction of the good it exports (cloth in Home, food in Foreign) is export-biased growth. • Similarly, growth biased toward the good a country imports is import-biased growth. 124 Our analysis leads to the following general principle: • Export-biased growth tends to worsen a growing country's terms of trade, to the benefit of the rest of the world; • Import-biased growth tends to improve a growing country's terms of trade at the rest of the world's expense. 125 INTERNATIONAL EFFECTS OF GROWTH • We are now able to resolve our questions about the international effects of growth. • Is growth in the rest of the world good or bad for our country? • Does the fact that our country is part of a trading world economy increase or decrease the benefits of growth? 126 • export-biased growth in the rest of the world is good for us, improving our terms of trade, • while import-biased growth abroad worsens our terms of trade. 127 • Export-biased growth in our own country worsens our terms of trade, reducing the direct benefits of growth, • while import-biased growth leads to an improvement of our terms of trade, a secondary benefit. 128 Economies of scale and international trade 129 There are two reasons why countries specialize and trade: 1. countries differ either in their resources or in technology and specialize in the things they do relatively well; 2. economies of scale (or increasing returns) make it advantageous for each country to specialize in the production of only a limited range of goods and services. 130 International trade plays a crucial role: It makes it possible for each country to produce a restricted range of goods and to take advantage of economies of scale without sacrificing variety in consumption. 132 • Mutually beneficial trade can arise as a result of economies of scale. • Each country specializes in producing a limited range of products, which enables it to produce these goods more efficiently than if it tried to produce everything for itself. • Specialized economies then trade with each other to be able to consume the full range of goods. 133 • External economies of scale occur when the cost per unit depends on the size of the industry but not necessarily on the size of any one firm. • Internal economies of scale occur when the cost per unit depends on the size of an individual firm but not necessarily on that of the industry. 134 • External and internal economies of scale have different implications for the structure of industries. – An industry where economies of scale are purely external will typically be perfectly competitive. – Internal economies of scale lead to an imperfectly competitive market structure. • Both external and internal economies of scale are important causes of international trade. 135 THE EFFECTS OF INCREASED MARKET SIZE • In our contemporary world – both the variety of goods that a country can produce – and the scale of its production are constrained by the size of the market. • By trading with each other, and therefore forming an integrated world market, nations are able to loosen these constraints. 136 Effects of a Larger Market Cost, C and Price, P An increase in the size CC1 of the market allows each firm, other things equal, to produce CC2 more and thus have lower average cost. 1 P1 2 P2 n1 n2 The more firms there are in monopolistically industry the lower the output of PP each firm, and thus the higher its average cost per unit of 137of Number output. firms, n Equilibrium in the Automobile Price per auto Market in thousands USD 38 Figure shows the PP and CC curves for the Home auto industry. In the absence of trade when the market is for 900 000 auto Home would have 6 automobile firms, selling at a price of $10,000 each. CC 36 34 32 30 24 22 20 18 16 14 12 10 8 PP 6 4 1 2 3 4 5 6 7 8 9 10 11 (a) The Home market 12 Number of firms, n 138 Equilibrium in the Automobile Price per auto Market in thousands USD 38 Figure shows the PP and CC curves for the Foreign auto industry. In the absence of trade when the market is for 1.6 million auto Foreign would have 8 automobile firms, selling at a price of $ 8750 each. 36 34 32 30 24 22 20 18 16 14 CC 12 10 8 PP 6 4 1 2 3 4 5 6 7 8 9 10 11 12 (b) The Foreign market Number of firms, n 139 Equilibrium in the Automobile Price per auto Market in thousands USD 38 Figure shows the PP and CC curves for combined market. Integrating the two markets creates a market for 2.5 million autos. This market supports 10 firms, and the price of an auto is only $8000. 36 34 32 30 24 22 20 18 16 14 CC 12 10 8 PP 6 4 1 2 3 4 5 6 7 8 9 10 11 (c) Integrated 12 Number of firms, n 140 ECONOMIES OF SCALE AND COMPARATIVE ADVANTAGE • How economies of scale interact with comparative advantage to determine the pattern of international trade. • Let us imagine a world economy consisting, as usual, of our two countries Home and Foreign. • Each of these countries has two factors of production, capital and labor. 141 Trade in a world without increasing return Home (capitalabundant) Manufactures Food Foreign labor-abundant) The length of the arrows indicates the value of trade in each direction; so Home would export 142 manufactures equal in value to the food it imports. Trade with increasing return and monopolistic competition Home (capitalabundant) Home will be a net Foreign exporter of labor-abundant) manufactures and an importer of food. Manufactures Food Interindustry trade Intraindustry trade Because of economies of scale, neither country is able to produce the full range of manufactured products by itself; 143 thus they will be producing different things. Trade with increasing return and monopolistic competition Home (capitalabundant) Foreign labor-abundant) Manufactures Food Interindustry trade Intraindustry trade Home, although running a trade surplus in Because of economies of scale, neither country is able to manufactures, will import as well as export produce the full range of manufactured products by itself; 144 within the manufacturing industry. thus they will be producing different things. Trade firms withinincreasing return and Foreign the manufacturing sector will competition monopolistic produce products different Manufactures Food Home (capitalfrom those that Home abundant) firms produce. Interindustry trade Foreign labor-abundant) Intraindustry trade Because of economies of scale, neither country is able to produce the full range of manufactured products by itself; 145 thus they will be producing different things. • World trade in a monopolistic competition model consists of two parts. • There will be two-way trade within the manufacturing sector. This exchange of manufactures for manufactures is called intraindustry trade. • The remainder of trade is an exchange of manufactures for food called interindustry trade. 146 Four points about this pattern of trade: • Interindustry (manufactures for food) trade reflects comparative advantage. The pattern of interindustry trade is that Home, the capital-abundant country, is a net exporter of capital-intensive manufactures and a net importer of labor-intensive food. So comparative advantage continues to be a major part of the trade story. 147 Four points about this pattern of trade: • Intraindustry trade does not reflect comparative advantage. Even if the countries had the same overall capitallabor ratio, their firms would continue to produce differentiated products. • Thus economies of scale can be an independent source of international trade. 148 Four points about this pattern of trade: • The pattern of intraindustry trade itself is unpredictable. All we know is that the countries will produce different products. Since history and accident determine the details of the trade pattern, an unpredictable component of the trade pattern is an inevitable feature of a world where economies of scale are important. 149 Four points about this pattern of trade: • The relative importance of intraindustry and interindustry trade depends on how similar countries are. If , for instance, Home and Foreign are similar in their capital-labor ratios, then there will be little interindustry trade, and intraindustry trade, based ultimately on economies of scale, will be dominant. 150 THE SIGNIFICANCE OF INTRAINDUSTRY TRADE • About 1/4 of world trade consists of intraindustry trade. • The industrial countries have become increasingly similar in their levels of technology and in the availability of capital and skilled labor. • There is often no clear comparative advantage within an industry, and much of international trade therefore takes the form of two-way exchanges within an industry. 151 Indexes of Intraindustry Trade for U.S. Industries Inorganic chemicals 0.99 Power-generating machinery Electrical machinery Organicintraindustry chemicals trade/total trade Medical and pharmaceutical 0.97 0.96 0.91 0.86 Office machinery Telecommunications equipment Road vehicles 0.81 0.69 0.65 Iron and steel Clothing and apparel Footwear 0.43 0.27 0.20 152 The Theory of External Economies What does it • Economies of scale that occur at the level of the industry instead of the firm are called external economies. • There are three main reasons why a cluster of firms may be more efficient than an individual firm in isolation: mean cluster? – Specialized suppliers – Labor market pooling – Knowledge spillovers 153 Clusters: Definitions from the Cluster Literature • Porter (1998) “A cluster is a geographically proximate group of interconnected companies and associated institutions in a particular field, linked by commonalities and complementarities”. • Crouch and Farrell, (2001) “The more general concept of ‘cluster’ suggests something looser: a tendency for firms in similar types of business to locate close together, though without having a particularly important presence in an area.” • Rosenfeld (1997) “A cluster is very simply used to represent concentrations of firms that are able to produce synergy because of their geographical proximity and interdependence, even though their scale of employment 154 may not be pronounced or prominent.” Clusters: Definitions from the Cluster Literature • Roelandt and den Hertag (1999) “Clusters can be characterised as networks of producers of strongly interdependent firms (including specialised suppliers) linked each other in a value-adding production chain.” • Swann and Prevezer (1998) “A cluster means a large group of firms in related industries at a particular location”. • Simmie and Sennett (1999) “We define an innovative cluster as a large number of interconnected industrial and/or service companies having a high degree of collaboration, typically through a supply chain, and operating under the same market conditions.” 155 Specialized Suppliers • In many industries, the production of goods and services and the development of new products requires the use of specialized equipment or support services. – An individual company does not provide a large enough market for these services to keep the suppliers in business. • A localized industrial cluster can solve this problem by bringing together many firms that provide a large enough market to support specialized suppliers. – This phenomenon has been extensively documented in the semiconductor industry located in Silicon Valley. 156 Labor Market Pooling • A cluster of firms can create a pooled market for workers with highly specialized skills. – It is an advantage for: • Producers – They are less likely to suffer from labor shortages. • Workers – They are less likely to become unemployed. 157 Knowledge Spillovers • Knowledge is one of the important input factors in highly innovative industries. – The specialized knowledge that is crucial to success in innovative industries comes from: • Research and development efforts • Reverse engineering • Informal exchange of information and ideas 158 External Economies and International Trade • External Economies and the Pattern of Trade – A country that has large production in some industry will tend to have low costs of producing that good. – Countries that start out as large producers in certain industries tend to remain large producers even if some other country could potentially produce the goods more cheaply. 159 External Economies and Specialization Thailand could potentially supply the world market more cheaply than Switzerland. If the Swiss industry gets established first, however, it may be able to sell watches at the price P1, which is below the cost C0 that an individual Thai firm would face if it began production on its own. Price, cost (per watch) C0 1 P1 ACSWISS 2 ACTHAI D Q1 Quantity of watches 160 produced and demanded Trade and Welfare with External Economies • Trade based on external economies has more ambiguous effects on national welfare than either trade based on comparative advantage or trade based on economies of scale at the level of the firm. 161 Russia in a changing world • What is a Russia’s role in current international division of labour? • What may be a Russia’s role in a future international division of labour? 162