European Economics Issues Lecture 2 Why do we trade? Some parts of this lecture are drawn from material in Chapter 23.1 of Sloman (2009). For the remainder the primary source should be these notes. They are a simplified treatment of material covered in more detail in Markusen & Melvin, The Theory of International Trade

Why Do We Trade? Why individuals and countries trade:Why individuals and countries trade: Would we trade if everyone were identical?Would we trade if everyone were identical? Yes?/No?/Maybe?Yes?/No?/Maybe? One EXAMPLEOne EXAMPLE Assume Same Production Capability, BUT Different TastesAssume Same Production Capability, BUT Different Tastes Suppose that we could all produce equal numbers of apples and orangesSuppose that we could all produce equal numbers of apples and oranges BUT…….BUT……. I only like Oranges and you only like ApplesI only like Oranges and you only like Apples

Equilibrium before trade O Oranges Apples 10 Production set of both Economies

Equilibrium before trade O Oranges Apples 10 Production set of both Economies My Consumption Set

Equilibrium before trade O Oranges Apples 10 Production set of both Economies Your Consumption Set

Trade when production same + tastes differ O Oranges Apples U Sell Oranges buy Apples I Sell Apples buy Oranges

What is key assumption? Same Production PatternSame Production Pattern Equal Apples & OrangesEqual Apples & Oranges But Different TastesBut Different Tastes Same Production capability, Different TastesSame Production capability, Different Tastes If free to produce whatever we want (to match production and tastes) then no trade even if tastes differIf free to produce whatever we want (to match production and tastes) then no trade even if tastes differ So need some restriction on production for trade:So need some restriction on production for trade: In reality production capabilities are often not the same:In reality production capabilities are often not the same: –Some production fixed –Soil, natural resources, oil, minerals etc

Different Story Same Tastes in each country, (both countries like Textiles and Computers)Same Tastes in each country, (both countries like Textiles and Computers) But have different TECHNOLOGYBut have different TECHNOLOGY Suppose technology is such that Labour in Developed Country more productive than in Underdeveloped countrySuppose technology is such that Labour in Developed Country more productive than in Underdeveloped country

Pre-trade production and consumption possibilities Computers (Millions) Textiles (kilos m) a Less developed Country, population 500

Computers (Millions) Textiles (kilos m) a b Less developed country Pre-trade production and consumption possibilities

Computers (Millions) Textiles (kilos m) a b c d e f Less developed country Pre-trade production and consumption possibilities Workers can produce 1000 Kilos of textiles OR 500 Computers Or anything in between

Computers (Millions) Textiles (kilos m) a b c d e f Less developed country Pre-trade production and consumption possibilities Workers can produce 1000 Kilos of textiles OR 500 Computers Or anything in between

Computers (Millions) Textiles (kilos m) a b c d e f Less developed country Pre-trade production and consumption possibilities Workers can produce 1000 Kilos of textiles OR 500 Computers So can produce in the ratio of 2 Textiles for 1 Computer

Computers (Millions) Textiles (kilos m) a b c d e f Less developed country Pre-trade production and consumption possibilities So can produce in the ratio of 2 Textiles for 1 Computer Or it takes 2 units of textiles to purchase 1 unit of computers

Computers (Millions) Textiles (kilos m) a b c d e f Less developed country Pre-trade production and consumption possibilities Formally we say…. the RELATIVE price of Computers in terms of Textiles (not money!!) is P c /P t =2/1

Computers (Millions) Textiles (kilos m) a b c d e f Less developed country Pre-trade production and consumption possibilities Or alternatively the RELATIVE price of Textiles in terms of Computers in the LDC is P t /P c =1/2

Textiles (kilos m) Computers (Millions) Pre-trade production and consumption possibilities Developed Country can produce in the ratio of 2 Computers for 1 K of Textiles Or it takes 1 units of textiles to purchase 2 unit of computers SO it takes 1/2 units of textiles to purchase 1 unit of computers

Textiles (kilos m) Computers (Millions) Pre-trade production and consumption possibilities So the RELATIVE Price of a 1 computer in terms of textiles in the Developed Country is P c /P t =1/2

Textiles (kilos m) Computers (Millions) Pre-trade production and consumption possibilities OR the RELATIVE Price of a 1 unit of texties computer in terms of computers in the Developed Country is P t /P c =2/1

Computers (Millions) Textiles (kilos m) a b c d e f Computers (Millions) g h i j k l m Less developed country Developed country Slope 2/1 Slope 1/2 Pre-trade production and consumption possibilities

Computers (Millions) Textiles (kilos m) a b c d e f Computers (Millions) g h i j k l m Less developed country Developed country Slope 2/1 Slope 1/2 Pre-trade production and consumption possibilities Developed countries relative pre-trade price = P c /P t =1/2 Less-Developed countries relative pre- trade price = P c /P t = 2

Computers (Millions) Textiles (kilos m) a b c d e f Computers (Millions) g h i j k l m Less developed country Developed country Slope 2/1 Slope 1/2 So C is relatively cheap in the Developed countries (it has a comparative advantage in Computers) And relatively expensive in the Less-Developed countries whereas Textiles are relatively cheaper. (The LDC is LESS BAD at Textiles and therefore Textiles are its comparative advantage)

Effect of trade on consumption possibilities Textiles (kilos m) Computers (Millions) Textiles (kilos m) Computers (Millions) Less developed country Developed country Slope 1/1 Possibilities have clearly risen So cant be worse off!!

Computers (Millions) Textiles (kilos m) a b c d e f Computers (Millions) g h i j k l m Less developed country Developed country Slope 2/1 Slope 1/2 If there is no trade (the country is in Autarky) then the production possibility frontier in each case also represents the consumption possibilities. The bundle each consumes will depend on tastes but production and consumption will be the same.

Computers (Millions) Textiles (kilos m) a b c d e f Computers (Millions) g h i j k l m Less developed country Developed country Slope 2/1 Slope 1/2 If we now allow free trade between the two countries, the free trade price must lie between the two sets of AUTARKY prices

Computers (Millions) Textiles (kilos m) a b c d e f Computers (Millions) g h i j k l m Less developed country Developed country Slope 2/1 Slope 1/2 If we now allow free trade between the two countries, the free trade price must lie between the two sets of AUTARKY prices

Computers (Millions) Textiles (kilos m) a b c d e f Computers (Millions) g h i j k l m Less developed country Developed country Slope 2/1 Slope 1/2 If we now allow free trade between the two countries, the free trade price must lie between the two sets of AUTARKY prices

Effect of trade on consumption possibilities Computers (Millions) Textiles (kilos m) Computers (Millions) Less developed country Developed country

Effect of trade on consumption possibilities Textiles (kilos m) Computers (Millions) Textiles (kilos m) Computers (Millions) Less developed country Developed country Slope 1/1 Possibilities have clearly risen So cant be worse off!!

Effect of trade on consumption possibilities Computers (Millions) Textiles (kilos m) Computers (Millions) Less developed country Developed country Imports 600 Exports600 Exports 600 x y Imports 600

Developed Country is better at producing both Textiles AND Computers – –It has an absolute advantage in both – –Initially c = 1600 t = 400 – –But it has a comparative advantage in producing computers – –Specialise in producing 2400 computers – –Exports 600c, Imports 600t: c = 1800 t = 600 – –Less Developed Country initially t = 200, c = 400, – –If it now produces textiles = 1000 – –Exports 600t, Imports 600c: t = 400 c= 600, – –DC gains 200c and 200t, LDC gains 200c and 200t Developed Country is better at producing both Textiles AND Computers – –It has an absolute advantage in both – –Initially c = 1600 t = 400 – –But it has a comparative advantage in producing computers – –Specialise in producing 2400 computers – –Exports 600c, Imports 600t: c = 1800 t = 600 – –Less Developed Country initially t = 200, c = 400, – –If it now produces textiles = 1000 – –Exports 600t, Imports 600c: t = 400 c= 600, – –DC gains 200c and 200t, LDC gains 200c and 200t

THE ADVANTAGES OF TRADE 1. Production (& technology) the same but fixed - tastes different = TRADE 2. Production, technology the same, but can produce any combination you want = No Trade 3. Technology Different, tastes same - Trade – –absolute advantage & comparative advantage 4. NEXT: Technology the same, tastes the same but endowment of resources (e.g Capital & Labour or skilled labour) different. 1. Production (& technology) the same but fixed - tastes different = TRADE 2. Production, technology the same, but can produce any combination you want = No Trade 3. Technology Different, tastes same - Trade – –absolute advantage & comparative advantage 4. NEXT: Technology the same, tastes the same but endowment of resources (e.g Capital & Labour or skilled labour) different.

Equilibrium before trade O Textiles Computers Suppose Computers need mostly capital and textiles need mostly labour, and suppose Developed country has mostly capital and the less developed country has mostly labour

Equilibrium before trade O Textiles Computers Suppose initially each country put exactly half their workers in to producing computers and textiles DC LDC

Labour abundant LDC O Textiles Computers LDC If capital and labour were used in the same ratio in both industries then if I want to produce more T or more C then move in a straight line either way along the production frontier

Labour abundant LDC O Textiles Computers LDC But if Textiles are more labour intensive then can produce more, And if computers are capital intensive cannot produce as much So Production frontier looks like…

Labour abundant LDC O Textiles Computers LDC Alternative explanation: As we move down from the spot, to produce more computers we are allocating more capital & workers but since capital is relatively scarce, capital per worker is lower, so not getting much extra production.

Labour abundant LDC O Textiles Computers LDC AND…. As we move UP from the spot, to produce more textiles, we are allocating more workers and capital but workers per machine is rising, so can produce more.

Capital abundant Developed Country O Textiles Computers LDC For DC Textiles are more labour intensive so produce……. LESS DC

Capital abundant Developed Country O Textiles Computers LDC And since Computers are more capital intensive can produce……. MORE So Production frontier looks like… DC

O Textiles Computers LDC Assume initially that each country produces & consumes at the dots DCTrade

O Textiles Computers LDC DC Note in LDC Computers will be RELATIVELY expensive, e.g, P c /P t = 2/1 while in DC they will be relatively cheap e.g. P c /P t =1/2

O Textiles Computers LDC Now suppose we allow free trade……. And have a common price that lies in between DC

O Textiles Computers LDC Now suppose we allow free trade……. And have a common price that lies in between DC LDC EXPORT IMPORT DC EXPORT DC IMPORTS

Trade when have different factor endowments Even if technology and tastes are the same, different factor endowments means different production possibilities.Even if technology and tastes are the same, different factor endowments means different production possibilities. Again this creates possible comparative advantages and hence benefits from trade.Again this creates possible comparative advantages and hence benefits from trade. In the example, both countries gain by producing more of the good in which they have the abundant factor and engaging in trade.In the example, both countries gain by producing more of the good in which they have the abundant factor and engaging in trade. This was probably believed to be the dominant source of gains from trade in the original EU.This was probably believed to be the dominant source of gains from trade in the original EU.

Comparative Advantage or Why might prices differ – Summary 1-5? 1. Different tastes1. Different tastes –(same Technology & Factors) 2. Different technology or physical capabilities2. Different technology or physical capabilities –(Patented R&D, Land/Minerals) 3. Differences in Factor Endowments3. Differences in Factor Endowments –Labour/Capital/Skilled labour 4. Differences in Taxes -4. Differences in Taxes - –e.g. Corporation tax, alcohol, cigs, petrol 5. (Differences in) competition5. (Differences in) competition –(Monopoly pushes prices up) 6. One Special case: Can trade even if we are identical6. One Special case: Can trade even if we are identical –Increasing Returns to Scale

Returns to Scale Constant returns to scaleConstant returns to scale –Double the factory, double the workforce, double the machinery Get double the production Increasing returns to scaleIncreasing returns to scale –Double the factory, double the workforce, double the machinery Get MORE THAN DOUBLE the production Why might this happenWhy might this happen –Internal Economies –More efficient work practice and specialisation of workers –Bigger buying power for materials or better distribution networks –External Economies –Government invests in training or infrastructure

Identical technology, endowments and tastes BUT increasing returns to scale. O Aeroplanes Computers

Identical technology, endowments and tastes BUT increasing returns to scale. O Aeroplanes Computers Germany & UK Initially both Germany and UK produce Aeroplanes and computers Now suppose UK specialises in Aeroplanes and gains increasing returns to scale

Identical technology, endowments and tastes BUT increasing returns to scale. O Aeroplanes Computers Germany & UK Similarly, Germany specialises in Computers Overall EU(?) Production Frontier now moves out and gains increasing returns to scale

O Aeroplanes Computers Germany & UK Now Germany exports Computers and imports Aeroplanes German Exports IMPORTSIMPORTS UK ExportsUK Exports While the UK exports Aeroplanes and imports Computers UK IMPORTS Identical technology, endowments and tastes BUT increasing returns to scale.

O Aeroplanes Computers Germany & UK So Even when identical specialisation and Trade allows welfare gains German Exports IMPORTSIMPORTS UK ExportsUK Exports UK IMPORTS