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Introduction Smith's argument for free trade Analysis of absolute cost advantage Application: Japan and the USA Problems with absolute cost advantage and.

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Presentation on theme: "Introduction Smith's argument for free trade Analysis of absolute cost advantage Application: Japan and the USA Problems with absolute cost advantage and."— Presentation transcript:

1 Introduction Smith's argument for free trade Analysis of absolute cost advantage Application: Japan and the USA Problems with absolute cost advantage and the example Measuring trade advantages: the Balassa index I Conclusions CHAPTER 2; OPPORTUNITY COSTS International Trade & the World Economy;  Charles van Marrewijk

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3 Introduction Smith's argument for free trade Analysis of absolute cost advantage Application: Japan and the USA Problems with absolute cost advantage and the example Measuring trade advantages: the Balassa index I Conclusions CHAPTER 2; OPPORTUNITY COSTS International Trade & the World Economy;  Charles van Marrewijk

4 Introduction International Trade & the World Economy;  Charles van Marrewijk Adam Smith (1723-1790)

5 Introduction Smith's argument for free trade Analysis of absolute cost advantage Application: Japan and the USA Problems with absolute cost advantage and the example Measuring trade advantages: the Balassa index I Conclusions CHAPTER 2; OPPORTUNITY COSTS International Trade & the World Economy;  Charles van Marrewijk

6 Smith's argument for free trade International Trade & the World Economy;  Charles van Marrewijk You do not make your own clothes or shoes but buy them from your tailor or shoemaker to enjoy the benefits of increased specialization. You concentrate on producing what you do best. International trade, similarly, allows countries to concentrate on producing what they do best.

7 Introduction Smith's argument for free trade Analysis of absolute cost advantage Application: Japan and the USA Problems with absolute cost advantage and the example Measuring trade advantages: the Balassa index I Conclusions CHAPTER 2; OPPORTUNITY COSTS International Trade & the World Economy;  Charles van Marrewijk

8 2 countries; USA and Japan International trade based on differences in technologyassumptions No transport costs 2 goods; Food and Cars 1 factor of production; labor L Constant returns to scale; CRS Labor mobility between sectors, not between countries Perfect competition unit labor requirement= units of labor required to produce one unit of a final good By assumption this is independent of the number of laborers active in a sector (CRS), but may differ between the two countries. Let be the for good F in USA, etcunit labor requirement Analysis of absolute cost advantage International Trade & the World Economy;  Charles van Marrewijk

9 Ch. 2 tool: productivity table to summarize the state of technology Note that the USA is more efficient than Japan for the production of Food (requires 2 < 3 laborers), while Japan is more efficient than the USA in the production of cars (requires 6 < 8 laborers). In autarky (without international trade) both countries will produce both goods if consumers demand both Food and Cars. Analysis of absolute cost advantage International Trade & the World Economy;  Charles van Marrewijk

10 According to Adam Smith, both countries can gain from international trade through specialization (USA producing more food and Japan producing more cars): Suppose the USA produces 1 car less, this frees up 8 laborers. These 8 laborers can now produce 8/2 = 4 units of food To keep the production level of cars constant, Japan should make 1 car more. This requires 6 laborers. These 6 laborers could have made 6/3 = 2 units of food. Conclusion: USAJapanchange world prod. production of cars:-1+10 production of food:+4-2+2 The extra production represents gains from trade Analysis of absolute cost advantage International Trade & the World Economy;  Charles van Marrewijk

11 Introduction Smith's argument for free trade Analysis of absolute cost advantage Application: Japan and the USA Problems with absolute cost advantage and the example Measuring trade advantages: the Balassa index I Conclusions CHAPTER 2; OPPORTUNITY COSTS International Trade & the World Economy;  Charles van Marrewijk

12 This single observation on productivity and international trade is in accordance with Adam Smith’s prediction. Application: Japan and the USA International Trade & the World Economy;  Charles van Marrewijk

13 Introduction Smith's argument for free trade Analysis of absolute cost advantage Application: Japan and the USA Problems with absolute cost advantage and the example Measuring trade advantages: the Balassa index I Conclusions CHAPTER 2; OPPORTUNITY COSTS International Trade & the World Economy;  Charles van Marrewijk

14 Problems with absolute cost advantage and the example International Trade & the World Economy;  Charles van Marrewijk Not all exports behave in accordance with absolute advantage

15 Introduction Smith's argument for free trade Analysis of absolute cost advantage Application: Japan and the USA Problems with absolute cost advantage and the example Measuring trade advantages: the Balassa index I Conclusions CHAPTER 2; OPPORTUNITY COSTS International Trade & the World Economy;  Charles van Marrewijk

16 Measuring trade advantages: the Balassa index I International Trade & the World Economy;  Charles van Marrewijk Two approaches: Develop theory  empirically check if trade flows are consistent Empirically find strong export sectors  develop consistent theory How do you determine a country’s strong export sectors? Most often used: Balassa index or Revealed Comparative Advantage (RCA) Ottens (2000): 28 manufacturing sectors, OECD reference countries 2 sectors with highest Balassa index for Finland and Italy next slide

17 Measuring trade advantages: the Balassa index I International Trade & the World Economy;  Charles van Marrewijk

18 Introduction Smith's argument for free trade Analysis of absolute cost advantage Application: Japan and the USA Problems with absolute cost advantage and the example Measuring trade advantages: the Balassa index I Conclusions CHAPTER 2; OPPORTUNITY COSTS International Trade & the World Economy;  Charles van Marrewijk

19 Conclusions International Trade & the World Economy;  Charles van Marrewijk Countries specialize according to absolute costs advantage This increases world output Some empirical support Balassa Index (RCA) is empirically used to measure strong sectors


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