International Economics CHAPTER ONE 1 International Economics Early Trade Theories

In this chapter: 2.1 Introduction 2.2 The Mercantilists’ Views on Trade 2.3 Trade Based on Absolute Advantage: Adam Smith 2.4 Trade Based on Comparative Advantage: David Ricardo 2.5 Comparative Advantage and Opportunity Costs 2.6 The Basis for and the Gains from Trade under Constant Costs

Assume two-nation, two-good world 2.1 Introduction Basic questions: What is the basis for trade? What are gains from trade? What is the pattern of trade? Assume two-nation, two-good world

Korea’s Top 10 export items (%) Rank 1970 1980 1990 2000 2006 Item Share 1 Textiles 40.8 Garments 16.0 11.7 Semiconductor 15.1 12.8 2 Plywood 11.0 Steel Plate-rolled Products 5.4 7.0 Computer 8.5 Automobile 9.5 3 Wigs 10.8 Footwear 5.2 6.6 7.7 Wireless telecom 8.3 4 Iron ores 5.9 Vessel 3.6 Video Apparatus 5.6 Petrochemical products 5.3 8.2 5 Electronic goods 3.5 Audio Apparatus 3.4 4.4 4.9 4.2 6 Confectionery 2.3 Man made filament fabrics 3.2 3.9 4.6 7 Footwears 2.1 Rubber Products 2.9 3.8 Synthetic Resin 8 Tobaccos 1.6 Woods & Wood items 2.8 Flat penal display 9 Iron products 1.5 2.6 2.7 10 Metal products 2.5 3.0 Parts of Automobile 3.3 Total 81.1 47.6 53.4 56.6 60.0 Source : KOTIS

2.2 The Mercantilists’ Views on Trade Mercantilism Economic philosophy in 17th and 18th centuries, in England, Spain, France, Portugal and the Netherlands. Belief that nation could become rich and powerful only by exporting more than it imported.

2.2 The Mercantilists’ Views on Trade Mercantilism Export surpluses brought inflow of gold and silver. Trade policy was to encourage exports and restrict imports. One nation gained only at the expense of another.

2.2 The Mercantilists’ Views on Trade Mercantilists measured wealth of a nation by stock of precious metals it possessed. Today, we measure wealth of a nation by its stock of human, man-made and natural resources available for producing goods and services. The greater the stock of resources, the greater the flow of goods and services to satisfy human wants, and the higher the standard of living.

2.2 The Mercantilists’ Views on Trade A nation can gain in international trade only at the expense of other nations. i.e., “Trade is a zero-sum game.” Criticism: (1) The measure of the wealth of a nation? (2) Rulers vs. common people Case Study 2-2 Mercantilism is Alive and Well in the Twenty-First Century

2.3 Trade Based on Absolute Advantage: Adam Smith A nation has absolute advantage over another nation if it can produce a commodity more efficiently. When one nation has absolute advantage in production of a commodity, but an absolute disadvantage with respect to the other nation in a second commodity, both nations can gain by specializing in their absolute advantage good and exchanging part of the output for the commodity of its absolute disadvantage. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

2.3 Trade Based on Absolute Advantage: Adam Smith Example: Canada is efficient in growing wheat, inefficient in growing bananas. Nicaragua is efficient in growing bananas, inefficient in growing wheat. Canada has absolute advantage in wheat, Nicaragua has absolute advantage in bananas. Mutually beneficial trade can take place if both countries specialize in their absolute advantage. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

2.3 Trade Based on Absolute Advantage: Adam Smith Specialization and trade advantage both countries. Adam Smith and other classical economists advocated policy of laissez-faire, or minimal government interference with economic activity. Free trade would cause world resources to be utilized most efficiently, maximizing world welfare.

2.3 Trade Based on Absolute Advantage: Adam Smith Thailand Malaysia Rice (bushels/labor hour) 7 2 Clothes (yards/labor hour) 4 6 Thailand has absolute advantage in Rice. Malaysia has absolute advantage in clothes. Both nations can gain from specialization in production and trade.

2.3 Trade Based on Absolute Advantage: Adam Smith With trade, the Thailand would specialize in the production of rice and exchange part of it for Malaysian clothes. The opposite is true for the Malaysia. If Thailand exchanges 5R for 5C, the Thailand gains 1C or saves 1/4 hour of labor time. Similarly the Malaysia also gains. (Explain!) This slide and the next contain a list of some topical issues that macro can help students understand. Feel free to substitute others as new issues emerge. Note: Absolute advantage can explain only a very small part of world trade. Examples:

2.4 Trade Based on Comparative Advantage: David Ricardo 2.4A. Law of Comparative Advantage Even if one nation is less efficient than (has absolute disadvantage with respect to) the other nation in production of both commodities, there is still a basis for mutually beneficial trade.

2.4 Trade Based on Comparative Advantage: David Ricardo Thailand Malaysia Rice (bushels/labor hour) 5 1 Clothes (yards/labor hour) 4 2 Opportunity Cost Thailand Malaysia 1 Rice =4/5= 0.8 C =2/1= 2 C 1 Clothes = 5/4= 1.25 R =1/2= 0.5 R Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

2.4 Trade Based on Comparative Advantage: David Ricardo Malaysia has absolute disadvantage in both goods. Thailand has comparative advantage in Rice. Malaysia has comparative advantage in Clothes. With trade, the Thailand would specialize in the production of Rice and exchange part of it for Malaysian clothes. The opposite is true for Malaysia. Assuming that both countries agreed to do trade at the (commodity) exchange rate of 5R with 5C. Initially, without trade, Thailand can exchange 5R with 4C domestically. This means with trade, Thailand can gain profit of 1C or save a quarter (1/4) of an hour of labour.

2.4 Trade Based on Comparative Advantage: David Ricardo Without trade, Malaysia requires five hours of labour if it wants to produce 5R. The five hours of labour can actually be utilised to produce 10C of clothes (since 1 hour of labour produces 2C). Malaysia can then export 5C to Thailand as stated in the exchange agreement. Thus, with trade, Malaysia can obtain a profit by saving 5C or equivalent to 2.5 hours of labour. This means Malaysia can save 5C or 2.5 hour of labour when trade takes place. Thus, the range of trade terms acceptable by both countries are : 4C < 5R < 10C

2.4 The comparative advantage of using money If we assume that the level of wages in Thailand is 50 baht per hour and one hour of labour produces 5R. So, the price of 1R is 10 baht (50 baht/5) or Pr = 10 baht. Since an hour of labour produces 4C, so the price for 1C is 12.5 baht (50 baht/4) or Pc = 12.5 baht. Assume that the rate of wages in Malaysia is RM4 per hour and an hour of labour produces 1R. So, the price of 1R is RM4 or Pr = RM4. Since an hour of labour produces 2C, so the price of 1C is RM2 (RM4/2) or Pc = RM2

2.4 The comparative advantage of using money Assuming that the currency exchange rate is RM1 = 5 baht. Given that Pr = RM4 and Pc = RM2 in Malaysia, we can change the price in terms of Thailand baht. Thailand Malaysia Price of 1 bushel of rice (Pr) 10 baht 20 baht Price of 1 piece of clothes (Pc) 12 baht

2.5 Comparative Advantage and Opportunity Costs Assumptions of the Ricardian Model Only two nations and two goods Free trade Perfect mobility of labor within each nation but immobility between the two nations Constant costs of production No transportation costs No technical change The labor theory of value While assumptions (1) through (6) can easily be relaxed, assumption (7) is not valid.

2.5 Comparative Advantage and Opportunity Costs 2.5A. Comparative Advantage and the Labor Theory of Value Labor theory of value: the value or price of a good depends exclusively on the amount of labor going into the production of the good. Implications Either labor is the only factor of production or labor is used in the same fixed proportion in the production of all goods. Labor is homogeneous (i.e., of only one type).

2.5 Comparative Advantage and Opportunity Costs Neither of these implications is true, and hence we cannot base the explanation of comparative advantage on the labor theory of value. Use the opportunity cost theory to explain the comparative advantage. 2.5B. The Opportunity Cost Theory - G. Herberler, The Theory of International Trade, 1936. - The opportunity cost theory: the cost of a good is the amount of a second good that must be given up to release just enough resources to produce one additional unit of the first good.  - Examples:

2.5 Comparative Advantage and Opportunity Costs The original idea of comparative advantage was based on the labor theory of value: The value or price of a commodity depends exclusively on the amount of labor used to produce it. Can use the opportunity cost theory to explain comparative advantage: The cost of a commodity is the amount of a second commodity that must be given up to release just enough resources to produce one additional unit of the first commodity.

2.5 Comparative Advantage and Opportunity Costs Production Possibilities Frontier A curve that shows alternative combinations of the two commodities a nation can produce by fully using all resources with best available technology. Constant opportunity costs arise when: 1. Resources are either perfect substitutes for each other or used in fixed proportion in production of both commodities, and 2. All units of the same factor are homogeneous. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

2.5 Comparative Advantage and Opportunity Costs 2.5C. The Production Possibility Frontier under Constant Costs

FIGURE 2-1 The Production Possibility Frontiers of the Thailand and the Malaysia

2.5 Comparative Advantage and Opportunity Costs Downward slope: If a nation wants to produce more of a good, it must give up some of the other good. Straight line: Opportunity costs are constant. That is, for each additional 1R to be produced, Thailand. must give up (4/5)C and the Malaysia must give up 2C, no matter from which point on its production possibility frontier the nation starts.

2.5 Comparative Advantage and Opportunity Costs 2.5D. Opportunity Costs and Relative Commodity Prices - The opportunity cost is given by the (absolute) slope of the production possibility frontier. - This is also called as the marginal rate of transformation. - Explain:   (PR/Pc)Thailand = 10/12.5 = 0.8 (PR/Pc)Malaysia = 4/2 = 2 - Note that under constant costs, Pw/Pc is determined exclusively by production considerations in each nation.

2.6 The Basis for and the Gains from Trade under Constant Costs 2.6A. Illustration of the Gains from Trade In the absence of trade, a nation’s production possibilities frontier also represents its consumption frontier. Increased output resulting from specialization and trade represents nations’ gains from trade, allowing nations to consume outside production possibilities frontier.

FIGURE 2-2 The Gains from Trade.

2.6 The Basis for and the Gains from Trade under Constant Costs Under constant cost conditions, nations will completely specialize in their comparative advantage . With complete specialization in both nations, the equilibrium-relative commodity price of each commodity lies between the pretrade relative commodity price in each nation. 2.6B. Relative Commodity Prices with Trade Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

2.7 Empirical Tests of the Ricardian Model McDougall (1951 and 1952) Argued that costs of production would be lower in the U.S. in industries where U.S. labor was more than twice as productive as U.K. labor. Found positive relationship between labor productivity and exports; industries with relatively productive labor in U.S. have higher ratios of U.S. to U.K. exports, supporting Ricardian theory of comparative advantage. Results supported by Balassa, Stern and Golub in later studies. Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

FIGURE 2-4 Relative Labor Productivities and Comparative Advantage–United States and United Kingdom.

2.7 Empirical Tests of the Ricardian Model Figure 2.4. Relative Labor Productivities and Comparative Advantage – Japan and Korea