The Gains from Trade: A General Equilibrium View Between a good and a bad economist this constitutes the whole difference–the one takes account of the visible effect; the other takes account of both of the effects which are seen, and also of those which it is necessary to foresee. (Frédéric Bastiat)

The Goals of this Chapter for ECN 665 Introduce the general equilibrium model of international trade, first in its “small country” version and then in its “two-country” version. Use the small country model to understand opportunity costs and the gains from trade Use the two-country model to understand the determinants of comparative advantage and the terms of trade. Show how increasing returns to scale provide a second source of potential gains from trade.

The Example of the Nebraska Auto Industry International trade reduces the opportunity costs of indirectly producing importable products. The general equilibrium model of this chapter will show that protecting import-competing industries reduces production in export industries. The model makes it clear that trade restrictions are not an issue of favoring domestic interests over foreign interests, but an issue of favoring some domestic interests over other domestic interests.

The “Small-Country” General Equilibrium Model The small-country model assumes that the actions of its citizens have no noticeable effects on foreign prices or the quantities produced by foreign industries. The model’s general equilibrium nature means that it traces the effects of an economic change to all sectors of the domestic economy. To enable us to use two-dimensional diagrams, the model assumes that there are just two industries in the economy. The model uses a production possibilities frontier to represent the supply side of the economy. It uses indifference curves to represent consumer preferences and the demand side of the economy.

The Small-Country General Equilibrium Model The model uses a production possibilities frontier (PPF) to represent the supply side of the economy The PPF is “bowed out” to reflect increasing costs The PPF tells us how much of one good we must sacrifice in order to make available the resources to produce one more of the other good

What determines the location and shape of the PPF? The PPF can be drawn with information on resources and technology (endowments and production functions). It is about what is possible, not what occurs. The PPF is bowed out if opportunity costs are increasing (contrast a one-factor and a two-factor model).

Will the economy operate on the PPF? That is a question about market outcomes. Opportunity cost is another name for relative marginal costs. Firms respond to product prices – do prices reflect marginal costs? If firms are competitive, and there are no distortions in the economy, the economy will operate on the PPF.

The Small-Country General Equilibrium Model If efficient, a closed economy produces and consumes at points located on the PPF. The points B, C, and D are all attainable. Note that the point D implies that not all available resources and technology are being exploited. The point A outside the PPF is not feasible.

The Small-Country General Equilibrium Model The welfare-maximizing production/consumption combination is at the point where the PPF and the indifference curves have the same slope. The tangency between the PPF and the indifference curve at A is the point where the opportunity costs of producing food and clothing are equal to the relative marginal benefits from consuming food and clothing.

Conditions for autarky equilibrium Producers must be happy producing what they are producing: P x/ P Y =MRTS – relative price of X equals opportunity cost in production. Consumers must be happy consuming what they are consuming: P x/ P Y =MRS – relative price of X equals the marginal rate of substitution. Market clearance: supply equals demand.

The Gains from Trade If the world price ratio is different from the domestic price ratio p, an open economy can use foreign trade to reach consumption points outside its PPF. The diagram shows the consumption possibilities line (CPL) whose slope reflects the world price ratio. A small open economy that continues to produce at A can consume anywhere along the CPL.

The Gains from Trade – exchange only Given the bundle of food and clothing produced at A, welfare maximization will take consumers to point B, the tangency between the indifference curve and the CPL. At B, the relative marginal gains from consuming food and clothing are equal to the world price ratio. The trade triangle connects points A and B.

The Gains from Trade – adding specialization An open economy can achieve further gains from trade by specializing. By shifting production from A to P, a higher CPL can be reached. Given production and income generated at P, consumers choose to consume at point C.

The Gains from Trade The combination of exchange and specialization takes the country to a higher welfare level. Compare the smaller exchange-only trade triangle connecting points A and B with the trade and specialization trade triangle connecting points P and C. With exchange and specialization, a higher indifference curve comes within reach.

What do economists mean by gains? These indifference curves are fictions. There is no easy way to compare the “goodness” of different aggregate bundles. Clearly distribution matters, but it is ignored in this analysis. When we say gains we mean consumption possibilities. Market responses to trade imply overall gains but individual winners and losers. Economics helps you figure out who these are!

Summarizing the Results of the Simple Two-Good Model When relative prices (opportunity costs) of goods are not the same at home and abroad, countries can increase national welfare by engaging in international trade. The gains from exchange are the result of domestic consumers substituting the relatively cheaper foreign products for the relatively more expensive domestic products. The gains from specialization are the gains from shifting domestic resources away from producing products that are relatively cheaper overseas to those products that are relatively more expensive overseas.

An economy can enjoy the gains from exchange without specializing, but it cannot enjoy the gains from specialization without trading. Merely shifting production to P only reduces welfare, as evidenced by the lower indifference curve passing through P. It takes exchange to get to C and the higher indifference curve. There Are No Gains from Specialization Without Exchange

The Two-Country General Equilibrium Model The small-country model can only tell us how one country is affected by international trade. This assumes that there are no effects on the rest of the world. More importantly, it doesn’t tell us why relative prices differ. In general, international trade causes changes in prices and shifts in resources both at home and abroad. We therefore develop a two-country general equilibrium model that explains trade between two countries and describes the many changes that occur in both countries as a result of the opening up of trade.

The 2-Country General Equilibrium Model The two-country model shows that both countries gain from trade; each reaches a higher indifference curve. Each country specializes in producing products for which it has the lower opportunity costs. One country’s exports are the other’s imports. Relative prices are equalized across both countries.

The Principle of Comparative Advantage Comparative advantage reflects the opportunity costs of production of food and clothing in each economy as given by the PPFs at their autarky equilibria. Each country reaches a higher level of welfare by specializing in, and exporting, the good that has the lower opportunity cost. The two-country, two-product general equilibrium model illustrates the law of comparative advantage because it shows that each country exports the product for which it has the lower opportunity costs. Comparative advantage also implies that trade is welfare enhancing for both countries.

Why do opportunity costs differ? Technological differences Differences in factor proportions Differences in tastes Does country size matter? It doesn’t if there are no scale economies and tastes are “homothetic.” When will size matter? Is that important?

Technology Differences Suppose only one factor: labor Tastes are the same in both countries PPF cannot differ due to differences in relative endowments or tastes. Why can it differ? How does that determine comparative advantage? What if one country has higher productivity in all activities? Can both gain from trade?

Differences in Factor Proportions Suppose everyone has the same technology. Suppose tastes are the same everywhere. Suppose there are 2 factors: labor and capital. Suppose two goods: labor-intensive textiles and capital-intensive manufactures. Do their PPFs differ systematically?

Factor Proportions Model (2) Suppose Home has a higher K/L ratio than does Foreign – Home is capital abundant. Which country will have the lower autarky relative price for manufactures? Why? The Heckscher-Ohlin Theorem: a country will have a comparative advantage in the good that uses intensively its abundant factor.

Differences in tastes lead to gainful trade The two-country general equilibrium model shown above assumed PPF’s differed across the two countries, which caused relative prices to differ. Relative prices. (opportunity costs) can also differ when preferences differ. When indifference curves vary, closed economy price ratios differ even for the same PPF: p* > p

A skewed preference for a good leads a country to be an importer of that good If free trade equalizes prices across both countries, each country produces at point P but consumes at different points, C and C*. Each country will consume more of the product it “prefers,” exporting the other product in order to acquire more of the product it prefers.

Constant-returns-to-scale models do not explain all trade The two-country general equilibrium model predicts that countries trade more if their PPF’s and opportunity costs differ a lot. Thus, dissimilar countries should trade more than countries that have similar productive capacities and tastes. We should see only one-way trade. This is not what we observe in the world, however!

Most Trade Is Between Highly-Developed Economies Most trade occurs among similar high-income economies. Only about one-third of the world’s trade occurs between economies with very different productive capacities. Of course, countries with similar income levels are not identical, but their relative opportunity costs are no doubt more similar than for pairs of countries at very different levels of development.

Alternative Models of Trade Economists have developed alternative models to explain trade that does not seem to be driven purely by differences in economic capacity and consumer preferences. One of the most useful is the model that assumes production is subject to increasing returns to scale rather than constant returns to scale. In that case, opportunity costs may be decreasing as we move along the PPF. In this case, the PPF is bowed inward rather than outward; that is, opportunity costs decrease the higher the level of production in an industry. In these models, there is a tendency for specialization.

Figure 3.14 The PPF with Increasing Returns

Increasing Returns to Scale and Trade Increasing returns to scale imply that prices will be lower when industries produce large quantities of similar products. Consumers do like variety, as suggested by the bowed-in indifference curves. Consumers can gain more variety and lower costs if countries trade freely. In the case of increasing returns, trade may raise consumption possibilities in each country even though both countries are identical.

Increasing returns and the gains from trade Increasing returns introduce may new ways for countries to gain. Many researchers believe a key way countries gain is through access to a greater variety of intermediate goods. But middle-income countries may also lose from trade – if they compete in goods at too low a scale of production. That is new!