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Fundametals of International Economics for Developing Countries: A Focus on Africa Volume 1: Trade Theory, Policy and Practice Alemayehu Geda Chapter 2:

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Presentation on theme: "Fundametals of International Economics for Developing Countries: A Focus on Africa Volume 1: Trade Theory, Policy and Practice Alemayehu Geda Chapter 2:"— Presentation transcript:

1 Fundametals of International Economics for Developing Countries: A Focus on Africa Volume 1: Trade Theory, Policy and Practice Alemayehu Geda Chapter 2: The Classical Model: The Comparative and Absolute Advantage Theories

2 2.1 Introduction The question of trade has a long history international economics literature. Examining trade theories could give us an insight in the understanding of the North – South trade pattern. The increasing interest of 17th and 18th century mercantilists in foreign trade gave rise to the classical absolute and comparative advantage theories. At the turn of the century, the neoclassical trade theories were developed as a critic to the classical school. Around mid 20th century, the role of technology in explaining world trade patters led to the emergence of trade theories based on technology gaps and imperfect competition. The outcome was the development of the new trade theories. Parallel to the new trade theories was developed a non – orthodox critical school with an alternative analysis, with a primary focus on North – South trade. Fundametals of International Economics for Developing Countries: A Focus on Africa Volume 1: Trade Theory, Policy and Practice – Chapter 2 Alemayehu Geda

3 2.1 Absolute Advantage A quote from Smith (1776) can clearly state the absolute advantage trade theory: If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy of them with some part of the produce of our own industry, employed in a way in which we have some advantage. The motive behind absolute advantage is that each country produces more of something per unit of resources than the rest of the world. In such case, each country should specialize in producing what it produces with least cost – what it has an absolute advantage. Example : Assume two countries, Ethiopia and South Africa, which produce only two goods, wheat and cloth. Also assume that the PPF for Ethiopia is equal to the proportion 50 Quintals of wheat: 25 Meters of cloth while it is 40 Quintals of wheat: 100 Meters of cloth for South Africa. That is, the relative price is 2Q/M (0.5M/Q) in Ethiopia while it 0.4Q/M (2.5 M/Q) in South Africa. This indicates that Ethiopia and South Africa have an absolute advantage in wheat and cloth respectively Fundametals of International Economics for Developing Countries: A Focus on Africa Volume 1: Trade Theory, Policy and Practice – Chapter 2 Alemayehu Geda

4 2.1 Absolute Advantage (Contd.) More specifically, if an Ethiopian wheat producer takes his wheat to South Africa he can get 1.5 M of more cloth for each quintal of wheat than he would have if he sold in Ethiopia (assuming transport costs are negligible). Similarly, if a South African cloth producer takes his cloth to Ethiopia, she could get 1.6 Q more wheat for each meter of cloth than she would have if she sold it in South Africa. Therefore, even though the implications on production and consumption activities as well as the equilibrium relative price after trade are not evident, trade is profitable for both nations. If we assume demand pattern dictate a relative price between the two autarky ratios, trade would enhance Ethiopia and South Africa to specialize in wheat and cloth production respectively. The core problem in Smiths absolute advantage is the assumption that a country has some thing that it can produce with lower cost than the rest of the world. What if not? Would it still benefit from trade? Ricardos answer is yes – because it may have a comparative advantage. Fundametals of International Economics for Developing Countries: A Focus on Africa Volume 1: Trade Theory, Policy and Practice – Chapter 2 Alemayehu Geda

5 2.2 Comparative Advantage Ricardo stressed that trade can improve the welfare of two countries even if they do not have an absolute advantage if they specialize in items that they have a comparative advantage. Ricardos famous Portugal - England example illustrates comparative advantage: Assume Portugal has an absolute advantage on the production of cloth and wine over England. Further assume the cost of production in each country is as indicated in the following table: Fundametals of International Economics for Developing Countries: A Focus on Africa Volume 1: Trade Theory, Policy and Practice – Chapter 2 Alemayehu Geda

6 2.2 Comparative Advantage (Contd.) It can be seen from the table that, although Portugal absolute advantage in both items, it has a comparative advantage in producing wine than cloth. Similarly, although England has an absolute disadvantage in both items, it has a comparative advantage in producing cloth. Therefore, both countries could gain from free trade if they specialize in the items they have comparative advantage. Specifically, if Portugal decides to produce one more unit of wine than cloth and exchange it with one unit of cloth from England, it would save 10 units of labor while England would save 20 units of labor to serve for the exchange. Both gain from trade. The major problem of this theory is that it presumes comparative advantage as given. For example, according to this theory, African countries should specialize in the production of primary commodities and remain that way. This would be against the aspiration of many countries to use trade as a tool to attain industrial development. Fundametals of International Economics for Developing Countries: A Focus on Africa Volume 1: Trade Theory, Policy and Practice – Chapter 2 Alemayehu Geda

7 2.3 Some Basic concepts: The Geometry of Production, Consumption and Trade 2.3.1 Production Possibility Curve The production of goods in a country depends on the technological capacity and endowment of resources the country possesses. A common tool to understand the production choice in a simple two – goods economy is the production possibility curve, which is defined as the locus of all possible combination of the two goods. It is concave because of the assumption of increasing opportunity costs. A country producing inside its PPC is using it s resources inefficiently, while producing outside the curve is unattainable at the current level of technology. Fundametals of International Economics for Developing Countries: A Focus on Africa Volume 1: Trade Theory, Policy and Practice – Chapter 2 Alemayehu Geda

8 2.3 Some Basic concepts: The Geometry of Production, Consumption and Trade (Contd.) The increasing cost - production possibility curve, which is commonly used in trade literature, is based on the assumption of single production factor. That is, the increase in opportunity costs arises from the fact the resources are being moved from the sector they are more efficient to the sector they are less efficient. In Fig 2.3, if a country is specialized in the production of wheat, the marginal product of increases as more and more of resources are shifted to the production of cloth. That is, the opportunity cost of producing a unit of cloth increases as cloth production increases. Fundametals of International Economics for Developing Countries: A Focus on Africa Volume 1: Trade Theory, Policy and Practice – Chapter 2 Alemayehu Geda O A Cloth W C Wheat Fig 2.3 t A

9 2.3 Some Basic concepts: The Geometry of Production, Consumption and Trade (Contd.) The shape of the PPC can differ between the short run and the long run. This is because some factors are difficult to move in the short run. The PPC assumes perfect competition. This assumption implies: – Perfect factor market : The slope of the PPC is the ratio of marginal costs. – Perfect product market : Firms produce at point where price equal marginal cost. Production takes place at a point where the slope equals the price ratio for the two goods. 2.3.2 The Community Indifference Curve Assume the economy has two consumers and two goods, wheat and cloth. Both consumers will be engaged in exchange to a point where neither can gain from exchange (e.g. P1 ).If the composition of goods changes in the economy keeping the total wealth constant, the consumers go to exchange again until they reach another efficient equilibrium point which puts them back to their original well being (e.g. P2). Such points of same well being with changing quantity of goods make the Community Indifference Curve (CIC). Fundametals of International Economics for Developing Countries: A Focus on Africa Volume 1: Trade Theory, Policy and Practice – Chapter 2 Alemayehu Geda

10 2.3 Some Basic concepts: The Geometry of Production, Consumption and Trade (Contd.) It can be seen from the Fig 2.4 that, –Any point on the diagram could be related to different levels of well being. –The Community indifference curves for different income distributions may intersect each other. To rule out the crossing of indifference curves we should assume there exists a social welfare functions such that a given reduction in the utility of one individual is compensated by an exact increase in the utility of the other. That is, Redistribution is costless. Fundametals of International Economics for Developing Countries: A Focus on Africa Volume 1: Trade Theory, Policy and Practice – Chapter 2 Alemayehu Geda WheatWheat Cloth O I0I0 P1P1 P2P2 P3P3 I0oI0o I1I1 I1I1 Fig 2.4

11 2.3 Some Basic concepts: The Geometry of Production, Consumption and Trade (Contd.) Given that CICs do not cross each other, maximizing the welfare function implies moving further from the origin. The Gain from Trade The above framework can be used to outline the classical theory of gains from trade. The PPC tells the supply side of the story while the CIC handles the demand side. Assuming perfect competition, the economy under autarky reaches equilibrium at a point where the PPC is tangent to the CIC. Trade changes the equilibrium price ratio in autarky. That is, one of the goods becomes more/less expensive and factors move from the production of the cheaper to the more expensive one. Eventually, a trade - equilibrium is reached where the new terms of trade equals to the slope of the PPC. That is, the MRTP equals the international terms of trade. Fundametals of International Economics for Developing Countries: A Focus on Africa Volume 1: Trade Theory, Policy and Practice – Chapter 2 Alemayehu Geda

12 2.3 Some Basic concepts: The Geometry of Production, Consumption and Trade (Contd.) Figures 2.5 (a) and (b) designate the equilibrium without trade and with trade, respectively. Under autarky, E is the equilibrium where the domestic price ratio line PP is tangent to the PPC. Fundametals of International Economics for Developing Countries: A Focus on Africa Volume 1: Trade Theory, Policy and Practice – Chapter 2 Alemayehu Geda Q E Cloth O I o IoIo I 2 I1I1 I2I2 I3I3 I3I3 P P I1I1 Q Fig 2.5 (a) Cloth O I2I2 I1I1 I2I2 I3I3 I3I3 T T E Q Q I1I1 P C C wheat Fig 2.5 (b)

13 2.3 Some Basic concepts: The Geometry of Production, Consumption and Trade (Contd.) Once the country is involved in trade, cloth gets more expensive than. This increases the opportunity cost of producing a unit of wheat hence resources move to the production of cloth until the new equilibrium P, where the international price ratio line is tangent to the PPC. The Weakness of the Ricardian Model (Income Distribution): An important implication of the above analysis is that, as a nation gets involved in trade, factors employed in the export sector gain a relatively higher reward. That is, trade favors the distribution of income towards owners of these factors. Therefore, even though the country as a whole gains from trade, the welfare of its population may be negatively affected via biased income distribution. Failure of the classical school to account for the role of income distribution in the analysis of gains from trade is a major weakness. Fundametals of International Economics for Developing Countries: A Focus on Africa Volume 1: Trade Theory, Policy and Practice – Chapter 2 Alemayehu Geda

14 2.3 Some Basic concepts: The Geometry of Production, Consumption and Trade (Contd.) 2.3.3 The Offer Curve The offer curve shows how a countrys exports and imports change as the price of these commodities change. For every international price ratio line resulting from change in either prices, there is a tangent equilibrium which dictates how much the nation imports and exports of each commodity. The offer curve is simply the locus of these points in an import – export graph. In other words, the offer curve presents the amount of the export commodity (cloth in Fig 2.6 ) the country is willing to offer in exchange of the import commodity (wheat) at every level of international price ratio. Fundametals of International Economics for Developing Countries: A Focus on Africa Volume 1: Trade Theory, Policy and Practice – Chapter 2 Alemayehu Geda Fig 2.6 The Offer Curve

15 2.3 Some Basic concepts: The Geometry of Production, Consumption and Trade (Contd.) The shape of the offer curve depends on the nature countrys PPC and CIC. –In the early stage of trade, the country is ready to offer more of the export good in exchange of the import good. That is, the offer curve is elastic. –As the volume of trade increases, the country wills to offer less and less of the export commodity at the margin and reach a point where it is not willing to import. In such case, the offer curve becomes inelastic. Its worth noting that the offer curve is a general equilibrium concept and hence it can be derived for both trading countries based on the production and consumption information in each country. If we map the two offer curves in one panel, the intersection point defines the free trade equilibrium for the two countries. Changes in the PPC (as a result of technological change, for example) result in a shift of the offer curve. If the country is small in terms of its partners market, or if it can not affect the terms of trade, it faces a perfectly elastic offer curve – a straight line which passes through the origin. Fundametals of International Economics for Developing Countries: A Focus on Africa Volume 1: Trade Theory, Policy and Practice – Chapter 2 Alemayehu Geda

16 2.3 Some Basic concepts: The Geometry of Production, Consumption and Trade (Contd.) 2.3.4 Derivation of the PPC in the Classical Model Assumptions: 1. Labor is the only factor; which is in fixed supply, fully employed and perfectly mobile. 2. The MP and AP of labor are constant in each industry, while their productivity differs in each country. 3. Perfect competition prevails 4. No obstacles to trade Given these assumptions the classical PPC can be driven using a four quadrant diagram as in Fig 2.8 Fundametals of International Economics for Developing Countries: A Focus on Africa Volume 1: Trade Theory, Policy and Practice – Chapter 2 Alemayehu Geda

17 2.3 Some Basic concepts: The Geometry of Production, Consumption and Trade (Contd.) The 3rd quadrant shows the fixed level of labor supply. The straight line TPPs are consistent with the assumption of constant MP (and AP). The constant slopes alc and alw show the AP. Choosing full employment in the 3rd quadrant and by projecting each respective point both TPPs to the 1st quadrant, we end up with the straight line PPC. Fundametals of International Economics for Developing Countries: A Focus on Africa Volume 1: Trade Theory, Policy and Practice – Chapter 2 Alemayehu Geda Fig 2.8

18 2.3 Some Basic concepts: The Geometry of Production, Consumption and Trade (Contd.) The slope of the PPC (i.e, the marginal rate of transformation in production) is: Which is also the opportunity cost of W. Given perfect markets and perfect mobility of labor, the MRTP also equals the ration of marginal costs. Fundametals of International Economics for Developing Countries: A Focus on Africa Volume 1: Trade Theory, Policy and Practice – Chapter 2 Alemayehu Geda

19 2.3 Some Basic concepts: The Geometry of Production, Consumption and Trade (Contd.) 2.3.5 Free Trade with Incomplete Specialization in the Large Country If the size of the trading countries is different, the large country may not completely specialize in the production of the export good because the small country may be incapable of sufficiently supplying the import good. In such scenario of incomplete specialization free trade may not have on the commodity price ratio in the large country. The terms of trade will then be equal to the large country price ratios under autarky. Fundametals of International Economics for Developing Countries: A Focus on Africa Volume 1: Trade Theory, Policy and Practice – Chapter 2 Alemayehu Geda

20 2.3 Some Basic concepts: The Geometry of Production, Consumption and Trade (Contd.) 2.3.6 The Specific Factors Model Adding a third factor specific to particular sectors, Jones (1971) developed a three – factor, two – goods, two – country (3X2X2) model as the opposed to the classical model of 2X2X2. This is called The Specific Factors Model. Example: Two countries (South Africa and Ethiopia) Three factors; capital (specific to the industrial/cloth sector), land (specific to the agricultural/wheat sector) and labor (mobile in the two sectors). Assume: –Homogenous factors are in fixed supply –Constant Returns to Scale Fundametals of International Economics for Developing Countries: A Focus on Africa Volume 1: Trade Theory, Policy and Practice – Chapter 2 Alemayehu Geda

21 2.3 Some Basic concepts: The Geometry of Production, Consumption and Trade (Contd.) –Diminishing marginal productivity –Perfectly competitive markets –Full employment Fig 2.10 portrays the derivation of the PPC given the above assumptions. Fundametals of International Economics for Developing Countries: A Focus on Africa Volume 1: Trade Theory, Policy and Practice – Chapter 2 Alemayehu Geda Fig 2.10

22 2.3 Some Basic concepts: The Geometry of Production, Consumption and Trade (Contd.) Production Possibilities in The Specific Factors Model The decreasing slope of the TPPs is because of the assumption of diminishing marginal physical products. This also results in a concave PPC. Note that for a shift of L for the X sector to the Y sector, Y will increase by Y=MPL Y L and X will decrease by X = -MPL X L (given the assumption of full employment). This means, Given the assumption of perfect markets which induces firms to employ labor to the point were its price (wage) equals the value of its marginal product: W=P X.MPL X =P Y.MPL Y, which implies that P X /P Y =MPL Y /MPL X. Fundametals of International Economics for Developing Countries: A Focus on Africa Volume 1: Trade Theory, Policy and Practice – Chapter 2 Alemayehu Geda

23 2.3 Some Basic concepts: The Geometry of Production, Consumption and Trade (Contd.) Note that there would not be trade if the two countries are identical in every thing as their autarky price ratios would be identical too. The room for trade opens if there are differences in factor endowment, technology, test, etc... Difference in the Endowment of Capital Assume that South Africas wealth increased in the form of capital. That means its TPP for cloth (Y) will shift upward which will also shift its PPC in the same direction as can be seen in Fig 2.11. The maximum output of X is the same in both countries (point C) while the maximum output of Y is greater in country S (Point A for South Africa and Point B for Ethiopia). Fundametals of International Economics for Developing Countries: A Focus on Africa Volume 1: Trade Theory, Policy and Practice – Chapter 2 Alemayehu Geda Fig 2.11

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25 End of Chapter 2 © Alemayehu Geda, 2007


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