International Economics

Classical and Neoclassical Trade Theory

Historical development of trade theory Mercantilism

Regulation to ensure a positive trade balance Critics: possible only for short term; assumes static

world economy Absolute advantage (Adam Smith)

Countries benefit from exporting what they make cheaper than anyone else

But: nations without absolute advantage do not gain from trade

Comparative advantage (David Ricardo) Nations can gain from specialization, even if they lack

an absolute advantage

Foundations of trade theory

Absolute & Comparative Advantage

Comparative advantage

Absolute advantage: each nation is more efficient in producing one good

Output per labor hourNation Wine Cloth

United States 5 bottles 20 yardsUnited Kingdom 15 bottles 10 yards

Comparative advantage: the US has an absolute advantage in both goods

Output per labor hourNation Wine Cloth

United States 40 bottles 40 yardsUnited Kingdom 20 bottles 10 yards

Ricardo’s Comparative Advantage in money prices

Comparative advantage

Cloth (yards) Wine (bottles)Nation Labor Wage Quant. Price Quant. Price

US 1 hr $20/hr 40 $0.50 40 $0.50UK 1 hr £5/hr 10 £0.50 20 £0.25UK 1 hr $8 10 $0.80 20 $0.40 (at $1.6 = £1)

Production possibilities schedule Generalizes theory to include all factors,

not just labor Shows combinations of products that can

be made if all factors are used efficiently Slope, or marginal rate of transformation,

shows the opportunity cost of making more of one good (how much of one good must be given up to make more of another)

Comparative advantage

Marginal Rate of Transformation

Comparative advantage

Production possibilities schedules: constant opportunity costs

Comparative advantage

Trading under constant opportunity costs

Comparative advantage

Production gains from specialization: constant opportunity costs

Comparative advantage

Autos Wheat Autos Wheat Autos Wheat

US 40 40 120 0 80 -40Canada 40 80 0 160 -40 80

World 80 120 120 160 40 40

Before After Net GainSpecialization Specialization (Loss)

Consumption gains from trade: constant opportunity costs

Comparative advantage

Autos Wheat Autos Wheat Autos Wheat

US 40 40 60 60 20 20Canada 40 80 60 100 20 20

World 80 120 120 160 40 40

Before After Net GainTrade Trade (Loss)

Production possibilities schedule under increasing costs

Increasing opportunity costs

Indifference curves and int'l. trade

Bringing demand into the model

Trading under increasing costs: US

Increasing opportunity costs

Trading under increasing costs: Canada

Increasing opportunity costs

trade pattern-”Trade triangle”

1. FT cons’n point

2. FT prod’n point3. NB: Home consumes

more food than it produces (i.e. imports food)

4. NB: Home produces more cloth than it consumes (i.e. exports cloth)

Production gains from specialization: increasing opportunity costs

Autos Wheat Autos Wheat Autos Wheat

US 5 18 12 14 7 -4Canada 17 6 13 13 -4 7

World 22 24 25 26 3 3

Before After Net GainSpecialization Specialization (Loss)

Increasing opportunity costs

Consumption gains from trade: increasing opportunity costs

Autos Wheat Autos Wheat Autos Wheat

US 5 18 5 21 0 3Canada 17 6 20 6 3 0

World 22 24 25 27 3 3

Before After Net GainTrade Trade (Loss)

Increasing opportunity costs

Basis for trade, gains from trade

Bringing demand into the model

Factor endowment theory (Heckscher-Ohlin)

Comparative advantage is explained entirely by different national supply conditions, especially resource endowments

Nations export products that use inputs which are relatively abundant (cheap) at home, and import products which need inputs which are relatively scarce (expensive) at home

Why relative price differentials?

Factor endowment theory: assumptions Nations all have the same tastes and

preferences (same indifference curves) They use factor inputs which are of uniform

quality They all use the same technology

Why relative price differentials?

Comparative advantage according to factor endowment theory

Factor endowment model

Autarky equilibrium

Comparative advantage according to factor endowment theory

Factor endowment model

Post-trade equilibrium

Factor endowment theory: implications Factor price equalization

The shift within each nation towards use of cheaper factors, and away from expensive ones, leads to more equal factor prices (if factors are mobile)

Distribution of income Trade changes domestic distribution of income as

demand for different factors changes Tests of factor endowment theory

Emphasize the importance of varieties of different factors (such as human capital) and accounting for changes in resource endowment; other explanations are also important

Factor endowment model

Factor Price Equalisation Theorem

In Hecksher-Ohlin's world, by trade, each countries' factor price (W/r) will be eventually the same. (Remember that in the H-O world, commodities can freely move while factors cannot. However, as a result of free trade of commodities, factor prices will be the same as well as commodity prices).

The relation between factor price (W/r) and factor intensity (K/L) Assumptions we sustain: As wage is relatively higher (W/r ), producers use more K-intensive

technology (k = K/L ) X is more labour intensive (kX = KX /LX < kY = KY /LY) Both countries have the same production technologies.

Relazione tra prezzo relativo dei fattori e prezzo relativo dei beni-paese H

If H country's total endowment ratio is kh, the wage-rental ratio in H will range (W/r)U < (W/r) < (W/r)L

La relazione tra prezzo dei fattori (W/r) e prezzo dei beni (PX / PY)

As (W/r) increases, PX / PY increases, because X is more labour intensive.

Before trade, (PX / PY )F is greater than (PX / PY)H as H is labour abundant.

Therefore, from the corresponding factor prices, (W/r)F > (W/r)H before trade.

Relazione tra prezzo relativo dei fattori e prezzo relativo dei beni-paese F

Teorema del pareggiamento del prezzo dei fattori By trade, the two countries' commodity prices will

converge (1) to the one world price (PX / PY).W

Eventually, (PX / PY).F = (PX / PY).W = (PX / PY).H

after trade. When (PX / PY). = (PX / PY).W, the only

corresponding factor price (1) is (W/r)W

With (W/r)W , both H and F use kX and kY for the two sectors' production.

Teorema del pareggiamento del prezzo dei fattori

Teorema del pareggiamento del prezzo dei fattori

We sustain the assumption that X is (always) more labour intensive. However, sometimes it is possible that two industries change the order of factor intensities. Suppose kY > kX when (W/r) is low, but kY < kX when (W/r) is high.

Then the graph we saw before changes:

Il caso della inversione dell’intensità fattoriale

Il caso della inversione dell’intensità fattoriale The relation between (W/r) and (PX / PY) is not

linear any more. When (W/r) is low, (1) as (W/r) increases, PX / PY increases because X is more labour intensive. Once (W/r) is higher (1) than (W/r)*, Y is more labour intensive. Therefore, as (W/r) increases, Py increases faster than Px, i.e. (PX / PY ) decreases.

In this case, even if there is one commodity price (PX / PY )w in the world by trade, two factor prices (1) (W/r)' and (W/r)" can exist. We cannot guarantee that H and F have the same (W/r).