2 Mercantilists popular from 1500-1800 in Europe assumption that a trade surplus (exports > imports) would lead to a nation obtaining more gold which would lead to increased domestic production and employmentpolicy implication was for domestic government to limit trade through tariffs, import quotas, and other methods
3 Price-Specie-Flow Doctrine David Humecounter argument to mercantilismtrade surplus possible only in short runinflow of gold or other form of wealth will lead to an increase in the price of domestic goodshigher prices for domestic goods will eventually lead to increased imports and decreased exports
4 Absolute Advantage Adam Smith – Wealth of Nations cost differences determine the patterns of international tradebased on natural and acquired resourceslabor theory of value – amount of labor required determines the cost of any goodprinciple of absolute advantage – trade is beneficial when each country is a least cost producer of one of the goods being traded
5 Absolute Advantage - Example Since the U.S. can produce more cloth, we should produce cloth and trade it to the U.K. for wine, for which the U.K. has greater capacity.
6 Comparative Advantage David Ricardotrade as mutually beneficial even if one country is more efficient than anotherprinciple of comparative advantage – each nation should specialize in production of those goods for which it is relatively more efficient with a lower opportunity costnot possible for one country to have a comparative advantage in everything
7 Comparative Advantage - Example The U.S. can produce twice as much wine as the U.K. but four times as much cloth. Therefore the U.S. should specialize in producing cloth while the U.K. specializes in producing wine.
8 Production Possibilities Schedule (PPS) PPS - various combinations of two goods that a nation can produce using all available factor inputs
9 Marginal Rate of Substitution (MRT) amount of one good a country must sacrifice to get one more unit of another goodsynonymous with opportunity costequal to the absolute value of the slope of the production possibilities schedule∆ good Y∆ good XMRT =
10 MRT (cont.)In this graph the MRT equals 0.5 because wheat output falls by 20 when auto rises by 40
11 Basis for TradeThe MRT or opportunity cost for each nation will indicate the direction of trade.The MRT or opportunity cost can also indicate the potential gains from trade.We begin with an assumption of constant opportunity costs.Benefits will be measured in terms of both improved production and consumption.
12 Gains from Specialization 1 additional auto in the U.S. => loss of 0.5 bushel of wheat1 additional auto in Canada => loss of 2 bushels of wheat
13 Gains from Specialization (cont.) Since the U.S. has a lower opportunity cost of auto production, it will be mutually beneficial for the U.S. to produce autos and trade them to Canada for wheat.
14 Production GainsWithout trade or specialization, world production is 80 autos and 120 bushels of wheat.If both nations specialized based on their comparative advantages, world production would increase to 120 autos and 160 bushels of wheat.
15 Consumption GainsIf the U.S. trades 60 autos for 60 bushels of wheat, then consumption will increase in each country.
16 Consumption Gains (cont.) Graphically consumption could increase from A to C for the U.S. and A to C for Canada or elsewhere along the Trading Possibilities Lines.
17 Distributing Gains from Trade comparative advantage => only outer limits for the terms of tradebased on domestic cost ratiosform no-trade boundaries and region of mutually beneficial trade
18 Equilibrium Terms of Trade John Stuart Mill – Theory of Reciprocal Demandterms of trade determined by the relative strength of each nation’s demand for the other nation’s productnations of roughly equal size => gains from trade distributed roughly equallyone nation larger => smaller nation attains most of the gains from trade because trade occurs closer to the larger nation’s existing price ratio – “importance of being unimportant”
19 Terms of Trade Estimates export price indeximport price indexterms of trade = × 100prices of exports rise in relation to imports shows improvement2006 terms of trade data using 2000 as the base year
20 Dynamic Gains from Trade increased income leads to increased savings which leads to increased investmentgreater options in supply chainincreased output level can lead to benefits from economies of scaleimproved competition can lead to lower prices for consumers and a greater variety of products offered to consumers
21 Changes in Comparative Advantage Thus far our analysis has assumed comparative advantage did not change.However, if productivity changed at different rates, comparative advantage could shift from one nation to another.
22 Increasing Opportunity Costs result of diminishing marginal productivitycost of producing one good increases as more of that good is producedproduction possibilities schedule has concave shapeMRT will increase as we move around the curve towards the intercepts
23 Trade with Increasing Opportunity Costs specialize until relative costs are equalline tt becomes terms of trade for both the U.S. and Canada
24 Gains – Increasing Cost Case If the U.S. specializes and trades 7 autos for 7 bushels of wheat, consumption would increase in each country.
25 Impact of Trade on U.S. Jobs little to no impact on overall employmentwill impact mix of jobs and specific industries
26 Many ProductsVarious products have different comparative costs resulting in different degrees of comparative advantage.Each nation will produce and export the goods for which it has the greatest comparative advantage subject to supply and demand constraints.
27 Many Countries multilateral trade implies bilateral trade balance is unlikely result
28 Outsourcing – Pros & Cons reduced costs and increased competitiveness for domestic companiesincreased exports to countries in which new jobs are createdhigher level of repatriated earnings reinvested into domestic economyConsreduced employment in specific industrieslower wages, particularly for unskilled workers