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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