Global Trade:2

Global Trade: Lessons Lessons Topics Lesson 1 The World Economy and Global Trade: An Overview and Stylized Facts on Global Trade Lesson 2 Theories of International Trade-I: The Ricardian Model: Labor Productivity and Comparative Advantage: Lesson 3 Theories of International Trade-II: The Heckscher-Ohlin Model: Factor Endowments and Comparative Advantage Lesson 4 Theories of International Trade-III: The Standard Trade Model and Gains from Trade Combination of Labor Productivity and Factor Endowments Lesson 5 Policy Instruments of International Trade: Tariffs, Export Subsidies, Import Quotas, Export Restraints Lesson 6 Policy Issues of International Trade: Free Trade vs. Protectionism Liberalization in Developing Countries The Role of the World Trade Organization

Texts Recommended: Main Text: Required: International Economics: Theory & Policy, Krugman, P.R., and Obstfeld, M., 8th Edition, Pearson-Addison-Wesley. Recommended: International Economics, Husted, S., and Melvin, M., 8th Edition, Addison- Wesley. International Economics, Gerber, J., 5th Edition, Addison-Wesley. World Trade and Payments: An Introduction, Caves, R.E., Frankel, J.A., and Jones, R.W., 10th Edition, Pearson-Addison-Wesley. The World Economy: International Trade, Yarbrough, B.V., and Yarbrough, R.M., 7th Edition, Thomson-South-Western. Principles of Microeconomics, Only Chapter 3: Interdependence and the Gains from Trade, Mankiw, N.G., 5th Ed., South-Western Cengage Learning.

Lesson 2 Lesson 2: Global trade theory-I: The Ricadian Theory of Comparative Advantage Procedure: The PowerPoint Presentation Duration: 60 minutes Overview This lesson provides us with the understanding of the classical Ricardian trade model of comparative advantage based on labor productivity, and the relevant concepts and tools: the production possibility frontier, opportunity costs, specialization, and direction of trade.

Lesson 2 (cont.) Outline List of Class needs: the text, a computer, and a notebook. Pre-class reading and preparation: Chapter 3 of the recommended text by Mankiw. Chapter 3 of the text will be beneficial. Activities and timing: Go over the entire presentation in 60 minutes and think about the main findings of the lesson. Do the exercises at the end of the lesson. Identification of Learning Objectives: Objective #2 from Section I Identification of the Global Workforce Skills for the lesson: Skill point #3 in Section II

Lesson 2 (cont.) Outline Lesson notes and suggestions for Instructors: Read the relevant chapters in the recommended texts and look for online data for the latest figures of global trade. Acknowledgment: The Course Developer took help of different sources as referred while preparing the study materials. When a considerable number of diagrams have been developed to enhance interest in the subject, many diagrams come from the required text for the convenience of the students. Studying Ch 3 of Mankiw is strongly recommended.

Theories of International Trade Differences in Labor Productivity and Comparative Advantage The Ricardian Model

Understanding Interdependence and the Gains from Trade The concepts we need to cover here are: The production possibilities frontier (PPF) Opportunity cost (OC) Gains from trade: Absolute advantage (Smith 1776) Comparative advantage (Ricardo 1817)

Production Possibility Frontier (PPF) Sam works 4 hours a day. He takes 40 minutes to make a book and 20 minutes to make a pen. Draw Sam’s PPF. Total number of books can be made = (4X60)/40 = 6 Total number of pens can be made = (4X60)/20 = 12 Let us put “Books” in the X-axis and “Pens” in the Y-axis, and locate the maximum possible production points.

PPF for Sam: OC Sam can make either 6 books or 12 pens, or any combination of both. However, there is a tradeoff for any combination: Sam has to lose one to get another. Opportunity cost of book = how many pens he has to give up to get one unit of book = simply the slope of the PPF = 12/6 = 2. Opportunity cost of pen in terms of book is just the inverse of the previous result (why?). Pens 12 PPFSam 6 Books

Questions Why do we choose to be interdependent? What are the driving forces behind trade?

Answers Trade can make everyone better off. Both absolute advantage (AA) and comparative advantage (CA) can be the driving forces for trade. The theory of absolute advantage was given by Adam Smith in 1776. David Ricardo contributed to the theory of comparative advantage in 1817. Smaller opportunity cost (OC) determines comparative advantage, which in turn determines specialization and trade between countries.

Theories of International Trade Absolute advantage is the ability of a country to produce a good using fewer inputs than another country. Comparative advantage is the ability of a country to produce a good at a lower opportunity cost than another country.

Understanding Trade A Farmer and a rancher work 8 hours per day need to consume both potatoes and meat.

3 Scenarios The farmer can only produce potatoes, and the rancher can only produce meat. Absolute advantage (AA) gains from trade obvious. Both can produce both, but the farmer is good at producing potatoes, and so is the rancher at meat. Specialization and trade  gains from trade exist. The rancher is better at producing every good. Rancher’s AA in both. Gains from trade less obvious!

Issues with the scenarios The first scenario is uncommon. There is no problem in defining the direction of trade with the second scenario. However, determining the gains from trade from the third scenario is difficult. Hence, we illustrate this case with an example.

The PPF Farmer can produce 1 oz of potatoes in 15 minutes and 1 oz of meat in 60 minutes. Rancher can produce 1 oz of potatoes in 10 minutes and 1 oz of meat in 20 minutes. Note: In practice, one developed country (e.g. the U.S.) can make both computers and garments better than a developing country (e.g. Bangladesh). But still they trade. Why? Let’s see.

Production & Consumption: No Trade: Autarky 4 hours for each of the goods by each individual Show the production and the consumption points The farmer produces 16 oz of potatoes, and 4 oz of meat. The rancher produces 24 oz of potatoes, and 12 oz of meat. Total potatoes = 40, total meat = 16

Rancher calculates: Both the farmer and the rancher were passing days in autarky. One day, the rancher approached to the farmer with a new calculation: Farmer works full-time in potatoes, and gets 4*8 = 32. Rancher works 2 hrs in potatoes, 6 hrs in meat, gets 6 *2 = 12 potatoes and 3*6 = 18 meat. Under trade: total potatoes= 44 total meat = 18 Under no trade: ,, = 40 ,, ,, = 16

Now trade begins Farmer can keep 16+1 = 17 oz of potatoes, export the rest (32 – 17) = 15 oz of potatoes. Rancher can get (15 + 12) = 27 oz of potatoes, and can export 5 oz of meat and consume the rest (18 - 5)= 13 oz of meat. Everyone is better-off in both lines of consumption! Gains from Trade = Extra = 4 oz of potatoes and 2 oz of meat

Question If one person is good at producing every good, then how can we determine specialization?

Who should produce potatoes? Two possible answers: Who can produce at lower cost  absolute advantage (AA) Who can produce at lower opportunity cost  comparative advantage (CA)  guideline for specialization Draw Production Possibility Frontier (PPFs) and Find the Opportunity Costs (OCs)

PPFs & OC Farmer’s Opportunity cost of potato = simply the slope of the PPF = 8/32 = ¼ =0.25. Meat 24 PPFRancher 8 PPFFarmer 32 48 Potatoes

OC of potatoes Farmer = ¼ oz of meat Rancher = ½ oz of meat As a result, the farmer should specialize in potatoes.

OC of meat Farmer = 4 oz of potatoes Rancher = 2 oz of potatoes As a result the rancher should specialize in meat.

Gains from Trade Gains from specialization and gains from trade are based not on Absolute Advantage (AA), but on Comparative Advantage (CA). When everyone produces based on smaller OC, CA reveals. Total production of the economy goes up. Thus, trade can make everyone better-off.

Summary points Why do we choose to be interdependent? 3 Scenarios on Trade Lower Cost  AA Lower OC  CA Trade can make everyone better-off.

Activity/Homework Kim works 4 hours a day. He takes 30 minutes to make a book and 60 minutes to make a pen. Draw Kim’s PPF. Find the OC of book and pen for Kim.

Activity/Homework 1. Country A takes 40 minutes to make a car, and 30 minutes to make a computer. Country B takes 48 minutes to make a car, and 40 minutes to make a computer. Total work time is 4 hours for both. Draw PPFA and PPFB in one diagram having car in the X- axis. Show the numbers and labels.

Activity/Homework In reference to the previous problem: 2. a) What is the OCCAR for Country A? b) What is the OCCAR for Country B? Express in number, not in fraction. c) Is there any possibility of trade? If so, which country will export car?