Why Countries Trade Chapter 1

Chapter Organization:  Introduction  International Trade Versus Interregional Trade  Trade in an Individual Product  Trade Based on Absolute Advantage  Trade Based on Comparative Advantage  Trade Based on Opportunity Costs  The Production Possibilities Frontier and Constant Costs  The Terms of Trade  Trade Under Increasing Opportunity Costs  Dynamic Gains from Trade

Introduction  In this chapter, we first discuss international trade for a single product; we then discuss international trade based on Adam Smith’s theory of absolute advantage. Next, we explain the pattern of trade and the gains from trade based on David Ricardo's theory of comparative advantage. We also explain the theory of comparative advantage in terms of opportunity cost. Finally, we describe the gains from trade that are difficult to quantify and occur over time.

International Trade Versus Interregional Trade  Interregional trade is buying and selling between different regions within a certain country (e.g. Beijing buys vegetables from Shandong province), while international trade is buying from another country and selling to another country (e.g. U.S. buys coffee from Brazil).  Benefits of Trade: -specialization and trade makes total world output of goods and services larger than it would be without trade.

Trade in an Individual Product  Conclusion: for an individual product, international trade equalizes the international price P*. As the figure illustrates, the U.S. imports and India exports cloth at the international price.  effects of trade in two countries

Trade Based on Absolute Advantage  Concept of absolute advantage  Countries should specialize in and export those commodities in which they had an absolute advantage and should import those commodities in which the trading partner had an absolute advantage. One person per day of labor Products countrymachinescloth U.S.5 machines10 yards of cloth India2 machines15 yards of cloth the U.S. has an absolute advantage in machine production, while India has an absolute advantage in cloth production.

Trade Based on Absolute Advantage  The gains from specialization and trade with absolute advantage: The gains from trade are the increase in world output that results from each country specializing its production according to its absolute advantage.

Trade Based on Absolute Advantage  Some Common Myths We hear that trade makes us poorer. We hear that exporters are good because they support a country’s industry, but imports are bad because they steal business from domestic producers. The underlying basis for these words is comparative advantage.

Trade Based on Absolute Advantage  The essence of Ricardo’s argument is that international trade does not require different absolute advantage and that it is possible and desirable to trade when comparative advantage exist.

Trade Based on Comparative Advantage  Comparative Advantage A country has a comparative advantage in producing a goods if the opportunity cost of producing that goods in terms of other goods is lower in that country than it is in other countries. An example: the U.S. has an absolute advantage in the production of cloth and machines, but U.S has a comparative advantage in production machines. One person per day of labor Products countrymachinescloth U.S.5 machines15 yards of cloth India1 machines5 yards of cloth

Trade Based on Comparative Advantage  The principle of comparative advantage: If each country exports the goods in which it has comparative advantage (lower opportunity costs), then all countries can in principle gain from trade.  The gains from specialization and trade with comparative advantage: T he gain from specialization and trade is the increase in world output that results from each country specializing its production according to its comparative advantage.

Trade Based on Opportunity Costs  Opportunity Cost The opportunity cost of cloth in terms of machines is the number of machines that could be produced with the same resources as a given number of cloths. Because the opportunity costs of the same goods differ with each country, both countries could benefit from trade. The gains from specialization and trade with opportunity costs.

The Production Possibilities Frontier and Constant Costs  The production possibilities frontier (PPF) shows the different combinations of two goods that can be produced at a given point of time when all of a country’s factors of production are fully employed in their most efficient manner.

The Production Possibilities Frontier and Constant Costs Production and Consumption without specialization and trade Production Possibilities Frontiers Under Constant Costs for the U.S. and India

The Production Possibilities Frontier and Constant Costs  Production and Consumption without specialization and trade specialization and trade under constant costs : as a result of international specialization and trade, the U.S. and India can both have levels of consumption that are superior to those attainable on their production possibilities frontiers.

The Production Possibilities Frontier and Constant Costs  In the Classical model, production generally takes place at an end point of the PPF of each country.  There is no reason to stop for producers at any point on the PPF until the maximum amount of production is reached.

The Terms of Trade  Changes in the gains from specification and trade as the terms of trade change, the trading possibilities frontier rotates for both countries. India’s consumption point moves from E’ to F’ and the U.S. consumption point moves from E to F.

The Terms of Trade  Demand condition and the terms of trade The theory of reciprocal demand suggests that the actual international exchange ratio at which trade takes place depends on each trading partner’s interacting demands. The reciprocal demand theory indicates that the final international exchange ratio depends on the relative strength of each country’s demand for the other country’s product. The exchange ratio will be set such that more of the gains will be distributed to the country whose goods are in greater demand.

The Terms of Trade  Distribution of the gains from trade The difference between the opportunity cost of purchasing the product from another country determines the gains a country receives from trade. An improvement in a country’s terms of trade does not necessarily reflect an improvement in a country’s overall welfare.

Trade Under Increasing Opportunity Costs  Concept of Complete specialization  Supply Curves of a Good and the Production Possibilities Frontier Under Constant Cost Conditions.  Constant opportunity costs lead to straight-line production possibilities frontiers and supply curves for goods that are horizontal.

Trade Under Increasing Opportunity Costs  Supply Curves of a Good and the Production Possibilities Frontier Under Increasing Cost Conditions Increasing opportunity costs lead to production possibilities frontiers that are concave to the origin and supply curves for goods that are upward sloping.

Trade Under Increasing Opportunity Costs  Production and consumption without specialization and trade production Possibilities Curve with Increasing Costs and the Marginal Rate of Transformation

Trade Under Increasing Opportunity Costs Production and consumption with specialization and trade -Production Possibilities Curve with Increasing Costs As a result of international specialization and trade, the U.S. and India can both have levels of consumption that are superior to those attainable on their production possibilities frontiers. The U.S. can move from point A on its trading possibilities frontier to point K on its trading possibilities line. India can also move from point A’ to point K’

Trade Under Increasing Opportunity Costs  Summary: Under constant costs, a country does not lose its comparative advantage as it produces more of the product. Under increasing costs, as production expands, production costs rise. Production under increasing cost conditions forces the price of goods to converge, and complete specialization in production is improbable.

Dynamic Gains from Trade  Gains in world output that result from specialization and trade are the static gains from trade; while dynamic gains from trade are the gains from trade that occur over time because trade induces greater efficiency in the country’s use of existing resources.  Dynamic gains: a country engaging in international trade uses its resources more efficiently; there may be even greater benefits from trade for small countries; international trade not only increase the quantity of the goods we consume but also may increase the quality and variety of the goods. international trade can be a very effective way to enhance competition in a country’s domestic market.

Comparative advantage-some concluding observations  Up to this point, nothing has been said about the basis for the comparative advantages that a country might have in trade.  The Classical economists thought that participation in foreign trade could be a strong positive force for development.  Specialization in the production of goods that have few links to the rest of the economy can lead to a lopsided pattern of growth.  The Classical writers have made us aware that trade not only produces static gains but also can be a positive vehicle for economic growth and development and that it should be encouraged.