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International Economics Classical and Neoclassical Trade Theory.

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Presentation on theme: "International Economics Classical and Neoclassical Trade Theory."— Presentation transcript:

1 International Economics Classical and Neoclassical Trade Theory

2 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

3 Absolute & Comparative Advantage Comparative advantage Absolute advantage: each nation is more efficient in producing one good Output per labor hour NationWineCloth United States5 bottles20 yards United Kingdom15 bottles10 yards Comparative advantage: the US has an absolute advantage in both goods Output per labor hour NationWineCloth United States40 bottles40 yards United Kingdom20 bottles10 yards

4 Ricardos Comparative Advantage in money prices Comparative advantage Cloth(yards)Wine(bottles) NationLaborWageQuant. PriceQuant.Price US1 hr$20/hr40$0.5040$0.50 UK1 hr£5/hr10£0.5020£0.25 UK1 hr$810$0.8020$0.40 (at $1.6 = £1)

5 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

6 Marginal Rate of Transformation Comparative advantage

7 Production possibilities schedules: constant opportunity costs Comparative advantage

8 Trading under constant opportunity costs Comparative advantage

9 Production gains from specialization: constant opportunity costs Comparative advantage AutosWheatAutos WheatAutosWheat US Canada World BeforeAfterNet Gain SpecializationSpecialization(Loss)

10 Consumption gains from trade: constant opportunity costs Comparative advantage AutosWheatAutos WheatAutosWheat US Canada World BeforeAfterNet Gain TradeTrade(Loss)

11 Production possibilities schedule under increasing costs Increasing opportunity costs

12 Indifference curves and int'l. trade Bringing demand into the model

13 Trading under increasing costs: US Increasing opportunity costs

14 Trading under increasing costs: Canada Increasing opportunity costs

15 trade pattern- Trade triangle 1. FT consn point 2. FT prodn point 3. 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)

16 Production gains from specialization: increasing opportunity costs AutosWheatAutos WheatAutosWheat US Canada World BeforeAfterNet Gain SpecializationSpecialization(Loss) Increasing opportunity costs

17 Consumption gains from trade: increasing opportunity costs AutosWheatAutos WheatAutosWheat US Canada World BeforeAfterNet Gain TradeTrade(Loss) Increasing opportunity costs

18 Basis for trade, gains from trade Bringing demand into the model

19 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?

20 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?

21 Comparative advantage according to factor endowment theory Factor endowment model Autarky equilibrium

22 Comparative advantage according to factor endowment theory Factor endowment model Post-trade equilibrium

23 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

24 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 (k X = K X /L X < k Y = K Y /L Y ) Both countries have the same production technologies.

25 Relazione tra prezzo relativo dei fattori e prezzo relativo dei beni-paese H If H country's total endowment ratio is k h, the wage-rental ratio in H will range (W/r) U < (W/r) < (W/r) L

26 La relazione tra prezzo dei fattori (W/r) e prezzo dei beni (P X / P Y ) As (W/r) increases, P X / P Y increases, because X is more labour intensive. Before trade, (P X / P Y ) F is greater than (P X / P Y )H as H is labour abundant. Therefore, from the corresponding factor prices, (W/r) F > (W/r) H before trade.

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

28 Teorema del pareggiamento del prezzo dei fattori By trade, the two countries' commodity prices will converge (1) to the one world price (P X / P Y ).W Eventually, (P X / P Y ).F = (P X / P Y ).W = (P X / P Y ).H after trade. When (P X / P Y ). = (P X / P Y ).W, the only corresponding factor price (1) is (W/r) W With (W/r) W, both H and F use k X and k Y for the two sectors' production.

29 Teorema del pareggiamento del prezzo dei fattori

30 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 k Y > k X when (W/r) is low, but k Y < k X when (W/r) is high. Then the graph we saw before changes:

31 Il caso della inversione dellintensità fattoriale

32 The relation between (W/r) and (PX / PY) is not linear any more. When (W/r) is low, (1) as (W/r) increases, P X / P Y 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, P y increases faster than P x, i.e. (P X / P Y ) decreases. In this case, even if there is one commodity price (P X / P Y ) 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).


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