1. INTERNATIONAL ECONOMICS Lecture 2 | Carlos Cuerpo | Why do countries trade? Some early answers

2. INTERNATIONAL ECONOMICS International Trade: focuses on the real transactions – Physical movement of goods – Tangible commitment of economic resources – Micro side: individual nations treated as single units, relative price issues. A.International Trade Theory: basis and gains from trade B.International Trade Policy: reasons for and effect of trade restrictions International Finance: focuses on the monetary side – Financial transactions – Macro side: deals with aggregate variables, such as output and the general price index. A. Balance of Payments: summary statement of all the international transactions of the residents of a nation with the rest of the world, during a particular period of time. B. Foreign Exchange Markets: Framework for the exchange of one national currency for another.

3. INTERNATIONAL TRADE International Trade Theory: Why do countries trade? A. Classical Theory – Adam Smith – David Ricardo – John Stuart Mill – Gottfried Haberler B. Neoclassical Theory – Factor Endowments Model – Extensions of the Hecksher-Ohlin model – Empirical evidence and fallacies C. New Trade Theory – Inter and intra industry trade. – Imperfect competition, economies of scale, and product diversification. – Geography and Trade.

4. MERCANTILISM Bankers, Merchants, Government officials,… [XVII th and XVIII th ] Key Assumptions: – Trade Balance Surplus is necessary – Wealth associated to precious metals (gold and silver to finance war) – Protectionism: limited imports/defend national production – Zero-sum game, national interests were in conflict. Great Criticism: Money is not wealth Free-Trade as a first best

5. MERCANTILISM Economic Policy: Neo-Mercantilism – Intuition: Provide incentives in order to shape trade – Empirical evidence for Britain:trade networks and profits from early mercantilism fostered Industrialization – Dangers: Rent-Seeking Trade conflicts – Advantages: Feedback between the private sector and Government. National Champions, globally competitive. [Gov't collaborating with large businesses]. Examples: energy, transportations, communications

6. CLASSICAL THEORY: ADAM SMITH Who was Adam Smith? The Wealth of Nations (1776) Trade Pattern: Absolute Advantage (AA) – Definition: When a nation is more efficient than (or has an AA over) another in the production of one commodity but is less efficient than (has an absolute disadvantage with respect to) the other nation in producing a second good, then both nations can gain by each specializing in the production of its AA and engaging in trade. – Intuition: International implications of the theory of division of labour. Trade Benefits: – Broader markets: Room for specialisation and increased productivity. – Greater Output: increased potential supply and capital stock accumulation. – Resources are utilized more efficiently. – Output of both commodities will rise.

7. CLASSICAL THEORY: ADAM SMITH How to measure AA? – Real costs of production. How to measure real costs of production? – Labor Theory of Value i) Labor is the only factor of production. ii) It determines goods' relative price. iii) No reference to money or gold. iv) It moves freely from one industry to another. Within a single country, competition ensures exchange in proportion to L costs. v) Internationally immobile If L requirements differ, prices will differ as well Table 1. Absolute Advantage Source: International Economics (2009). Eicher et al. Days of LItalyScotland Wine Cloth 20 100 120 30

8. CLASSICAL THEORY: ADAM SMITH Table 1. Absolute Advantage Source: International Economics (2009). Eicher et al. Different national relative prices ensure gains from trade at an intermediate ratio Table 2. Efficiency Gains by shifting 600 days of labor Source: International Economics (2009). Eicher et al. Empirical Evidence: it accounts for important segments of trade: Brazil (coffe), Florida (oranges) Days of L requiredItalyScotland Wine (barrels) Cloth (bolts) 20 100 120 30 ItalyScotlandTotal Wine (barrels)30-525 Cloth (bolts)-62014 1Bwine/ 4bcloth 1Bwine/ 0.2bcloth 1Bwine/ 1bcloth

9. CLASSICAL THEORY: DAVID RICARDO David Ricardo Principles of Political Economy and Taxation (1817) Trade Pattern: Comparative Advantage (CA) – Definition: Low relative cost of a good compared to other countries in autarky. Every country will have a CA in some good. – Intuition: – Terms of Trade. – Differences in Technology (output per unit of labor) as the source of CA.

10. CLASSICAL THEORY: DAVID RICARDO Trade Benefits: – Broader markets, greater supply, higher welfare. – Overcomes Smith’s limitations: There is scope for mutually beneficial trade between the two countries, if both specialize according to their pattern of CA, even when one of them has an AA in every commodity. Table 3. Comparative Advantage Source: International Economics (2009). Eicher et al. Days of LaborPortugalEngland Wine (1 barrel)32 Cloth (1 bolt)104 1Bwine/ 0.3bcloth 1Bwine/ 0.5bcloth

11. CLASSICAL THEORY: DAVID RICARDO Table 3. Comparative Advantage Source: International Economics (2009). Eicher et al. England is more efficient at the production of both goods Table 4. Efficiency Gains shifting 60days in Portugal and 36 in England Source: International Economics (2009). Eicher et al. Portugal must shift more days than England because of less efficiency in absolute terms Price ratios will converge (unless there are additional costs) Intermediate Equilibrium ToT Days of L requiredPortugalEngland Wine (barrels) Cloth (bolts) 3 10 2424 PortugalEnglandTotal Wine (barrels)20-182 Cloth (bolts)-693 Arbitrage

12. CLASSICAL THEORY: DAVID RICARDO If we look at it horizontally: Table 3. Comparative Advantage Source: International Economics (2009). Eicher et al. England is more efficient at the production of both goods However Portugal has a CA in Wine: 1.5<2.5 Days of L requiredPortugalEngland Wine (barrels) Cloth (bolts) 3 10 2424

13. CLASSICAL THEORY: DAVID RICARDO Trade Benefits: – Broader markets, greater supply, higher welfare. – Real Income increases because of specialization – Overcomes Smith’s limitations: There is scope for mutually beneficial trade between the two countries, if both specialize according to their pattern of CA, even when one of them has an AA in every commodity. Economic Policy: Laissez-faire. Any intermediate ToT is mutually beneficial (No zero-sum game) Limitations: – What if relative costs are equal? – ToT indetermination (Barone)

14. CLASSICAL THEORY: J.STUART MILL J.S. Mill Reciprocal Demand Theory – Definition: Equilibrium barter ToT (ratio of exchange) will equate Exports Supply with Imports Demand internationally. – Intuition: Demand elasticity is crucial due to the shape of the Supply curve [due to the L-theory of value and constant productivity]. Let’s see the cloth market: England World Trade Germany SeSx,e Sg 2 1.7 DeDm.g Dg 1.5 C* C* C* Everything is imported X

15. CLASSICAL THEORY: J.STUART MILL Trade Benefits: – The closer the equilibrium ToT to your original relative price, the smaller the benefits from international trade. – Small country vs. Large country (its supply will exceed the small country’s Demand and therefore trigger the prices down).

16. CLASSICAL THEORY: LIMITATIONS Strong assumptions (despite Friedman's irrelevance) – No trade barriers: transportation costs, information costs,… If they fall relative to the value of the good being transported, more goods are likely to become available. – Just one Input: L. Labor Theory of Value. – Labor is internationally immobile. – Only two goods: What happens in a more realistic set-up? Consider a rank ordering: relative marginal costs – We could introduce more countries: influence of transport costs. – Constant costs of production. – Fixed amount of inputs: Vertical Aggregate Supply.

17. CLASSICAL THEORY: EMPIRICAL EVIDENCE It predicts an extreme degree of specialization. It assumes away effects of International Trade on the distribution of income within countries. Allows no role for differences in resources among countries as a cause of trade. Neglects the possible role of economies of scale as a cause of trade. Countries should tend to export those goods in which their productivity is relatively high. – Relative productivity must be high compared with other sector's relative productivity. – Chinese surge as an export powerhouse

18. CLASSICAL THEORY: LIMITATIONS Competitiveness via ULC: -There are 3 ways to affect it: I.Wages II.Productivity III.Exchange rate