Lecture 24: International Trade
Outline:
1. International trade and the gains from trade
2. Sources of the gains from trade
3. Gains from specialization with given costs
i. Absolute advantage
ii. Comparative advantage
iii. Opportunity cost
4. Gains from trade with variable costs
i. Returns to scale and imperfect competition
ii. Learning by doing
5. Sources of comparative advantage
i. Different factor endowments
ii. Different climates
iii. Acquired comparative advantage
6. The terms of trade
7. Dollars and Sense Article 40
8. New Field Guide 10.2, 10.5, 10.8, 10.9, 10.11, 10.12, 10.13
1. International trade and the gains from trade:
* International trade refers to exchanges of goods and services that take place across international boundaries.
* The source of gains from trade lies in different cost conditions existing in different countries.
* Global income is maximized when countries specialize in the product in which they have the lowest opportunity cost of production
* Costs are determined partly by natural endowments, geography and climate, public policy, technology, and historical accident.
2. Sources of the gains from trade:
* Extension of the explanation for why people trade domestically.
* The alternative to trade is complete self-sufficiency.
*Trade allows for specialization and the efficiency gains that result from specialization.
3. Example: Gains from trade with given costs
Two countries: US and England
Two goods: Wheat and cloth
There are no economies of scale and no learning-by-doing.
Differences in the conditions of production in the two countries are represented by the amounts of the two goods that can be produced with one unit of resources in each of the countries.
Absolute advantage:
Table 34-1
The gains from specialization make the gains from trade possible
Comparative advantage:
Table 34-2
Comparative advantage is determined by what good a country is relatively better at producing than another.
The gains from specialization and trade depend on the pattern of comparative advantage not absolute advantage.
No comparative advantage:
Table 34-3
Without any comparative advantage there are no gains from specialization and trade.
Opportunity cost:
Rather than talking about how much one unit of resources can produce in a given country we can use the concept of opportunity cost to illustrate comparative advantage.
From Table 34-1:
The US can produce 10 bushels of wheat or 6 yards of cloth with one unit of resources
Therefore in the US:
* The opportunity cost of producing a bushel of wheat is 0.6 yards of cloth
* The opportunity cost of producing a yard of cloth is 1.67 bushels of wheat
England can produce 5 bushels of wheat or 10 yards of cloth
Therefore in England:
*The opportunity cost of producing a bushel of wheat is 2 yards of cloth
* The opportunity cost of producing a yard of cloth is 0.5 bushels of wheat
Question: Which country has the lower opportunity cost of producing wheat?
Question: Which country has the lower opportunity cost of producing cloth?
Summary:
1. Gains from trade come from gains from specialization
2. Gains from specialization come from comparative advantage.
3. Comparative advantage is determined by differences in the opportunity cost of producing the goods in different countries.
4. If one country has a lower opportunity cost of producing a good then that country will have a comparative advantage in the production of that good and the other country will have a comparative advantage in the production of the other good.
4. Gains from trade with variable costs:
Opportunity cost in a country can change with the level of production and with time spent in production of specific goods and services:
1. Economies of scale and imperfect competition:
Trade often allows countries to specialize in the production of a few goods and gain the benefits of producing the goods at a large scale. e.g. Japan and cars.
2. Learning-by-doing:
As countries gain experience in producing certain goods and services they often become more efficient at producing them. e.g. U.S. and international finance
5. Sources of comparative advantage:
1. Different factor endowments:
International cost differences reflect differences in resource endowments - land, labor and capital.
According to this explanation - countries have comparative advantages in the goods and services that use most intensively the factors of production that they are abundantly endowed with.
2. Different climates:
International cost differences reflect differences in the natural environment. For example, production may be different in Nicaragua and Iceland.
According to this explanation combing resources in some climates will be more effective than in others leading to cost differences.
3. Acquired comparative advantage:
International cost differences can reflect different levels of human capital in different countries, and other differences that may be the result of differences in public policy.
According to this explanation (put forward by Paul Krugman) some countries can gain a strategic advantage over other countries in cultivating comparative advantages in certain goods and services.
6. The terms of trade:
Question: How will the gains from trade be shared between countries? What determines how these gains will be distributed?
* The division of gains depends on the terms of trade: this relates to the quantity of imported goods that can be imported per unit of goods exported.
* The terms of trade are measured by the price ratio of exports to imports.
Terms of trade = (index of export prices / index of import prices) * 100
Changes in the terms of trade:
A rise in the price of imported goods relative to the price of exports indicates a fall in the terms of trade - it will now take more exports to buy the same quantity of imports.
* A fall in a country's terms of trade is considered UNFAVORABLE
A rise in the price of exported goods relative to the price of imports indicates a rise in the terms of trade - it will now take fewer exports to buy the same quantity of imports.
* A rise in a country's terms of trade is considered FAVORABLE.