International Economics Mordecai E. Kreinin Copyright ©2002 South-Western/Thomson Learning. All rights reserved. Copyright ©2002 South-Western/Thomson Learning. All rights reserved. Part I International Trade Relations Part I International Trade Relations

C1-2 CHAPTER 2 Why Nations Trade

C1-3 Sources of International Commodity Trade Data Standard International Trade Classification (SITC) Commodity Trade Statistics Main Economic Indicators U.S. Census Bureau report of exports and imports United States Commodity Imports and Exports as Related to Output Standard International Trade Classification (SITC) Commodity Trade Statistics Main Economic Indicators U.S. Census Bureau report of exports and imports United States Commodity Imports and Exports as Related to Output

C1-4 Why Nations Trade The Principle of Comparative Advantage Comparative Opportunity Cost Absolute Advantage and Wage Rates Summary of Policy Implications Dynamic Gains from International Trade The Principle of Comparative Advantage Comparative Opportunity Cost Absolute Advantage and Wage Rates Summary of Policy Implications Dynamic Gains from International Trade

C1-5 Important Concepts Comparative advantage Country “in isolation” Terms of trade Demand consideration Relative wage rates Comparative advantage Country “in isolation” Terms of trade Demand consideration Relative wage rates Anti-inflationary trade Absolute advantage Industry ranking Static gains from trade Dynamic gains from trade

C1-6 Principle of Comparative Advantage Gains from Trade Maximized profits Relative cost-price positions determined by comparative advantage Comparative Advantage, inverse of comparative cost Absolute advantage Resource or opportunity cost Direction of trade Demand Considerations Supply conditions provide trade limits Reciprocal demand determines exchange ratio Terms of Trade (export price divided by import price) Commodity gain ratio vs. utility ratio Differentiated Products Gains from Trade Maximized profits Relative cost-price positions determined by comparative advantage Comparative Advantage, inverse of comparative cost Absolute advantage Resource or opportunity cost Direction of trade Demand Considerations Supply conditions provide trade limits Reciprocal demand determines exchange ratio Terms of Trade (export price divided by import price) Commodity gain ratio vs. utility ratio Differentiated Products

C1-7 Additional Insights: Why Complete Specialization? Constant costs not real world scenario Increasing cost situations force prices in two trading countries to converge No trade inducement Prices can easily equalize before complete specialization is reached Constant costs not real world scenario Increasing cost situations force prices in two trading countries to converge No trade inducement Prices can easily equalize before complete specialization is reached

Supply Curves of Wheat and Textiles Under Constant Cost Conditions FIGURE 2.1 C1-8

C1-9 Comparative Opportunity Cost Who Exports What? Necessary to measure joint productivity of all factors (in monetary value). Unit production cost = aggregate resources used in production of one output unit Limits to Mutually Beneficial Exchange Who Exports What? Necessary to measure joint productivity of all factors (in monetary value). Unit production cost = aggregate resources used in production of one output unit Limits to Mutually Beneficial Exchange

Region of Mutually Beneficial Trade FIGURE 2.2 C1-10

C1-11 Additional Insights: Limits to Sustainable Exchange Rates Exchange rate limits can be translated from commodities to money by assigning to each commodity the price it commands in producing country More than two commodities Internal ranking—multi-industry care Examples from U.S. Trade Iron and steel Autos High Technology Exchange rate limits can be translated from commodities to money by assigning to each commodity the price it commands in producing country More than two commodities Internal ranking—multi-industry care Examples from U.S. Trade Iron and steel Autos High Technology

C1-12 Absolute Advantage and Wage Rates Absolute advantage determines relative wage rates in each country. Relative wage rate must conform to comparative advantage for mutually beneficial trade. Wage rate limits equal to and determined by productivity ratios. Exchange rate and safe ratios Expressed in terms of currencies, comparative advantage yields limits to sustainable exchange rate. Expressed in terms of labor production costs, it yields limits to wage ratio. Absolute advantage determines relative wage rates in each country. Relative wage rate must conform to comparative advantage for mutually beneficial trade. Wage rate limits equal to and determined by productivity ratios. Exchange rate and safe ratios Expressed in terms of currencies, comparative advantage yields limits to sustainable exchange rate. Expressed in terms of labor production costs, it yields limits to wage ratio.

C1-13 Summary of Policy Implications Improved resource use efficiency, raised real income Comparative advantage ranking and exchange rate determine trade Rank—distorting policies allocate resources inefficiently and reduce income to community Gainers—industries in which the country has comparative advantage Losers—industries in which the country has comparative disadvantage Policy debates result from gainers vs. losers disputes Gains outweigh losses Inflation reduction Government helps losers adjust (financial assistance, retraining) Improved resource use efficiency, raised real income Comparative advantage ranking and exchange rate determine trade Rank—distorting policies allocate resources inefficiently and reduce income to community Gainers—industries in which the country has comparative advantage Losers—industries in which the country has comparative disadvantage Policy debates result from gainers vs. losers disputes Gains outweigh losses Inflation reduction Government helps losers adjust (financial assistance, retraining)

C1-14 Dynamic Gains from International Trade Static effects—reallocation of resources Dynamic benefits—additional resources available Higher income from more efficient use of resources Increased savings, more resources available for investment Technological spillover Increased size of national market Economies of scale and benefits to economy at large Competitive pressure on prices Product improvement Technological advancement Increased labor pool Infrastructure development Inflation dampening Static effects—reallocation of resources Dynamic benefits—additional resources available Higher income from more efficient use of resources Increased savings, more resources available for investment Technological spillover Increased size of national market Economies of scale and benefits to economy at large Competitive pressure on prices Product improvement Technological advancement Increased labor pool Infrastructure development Inflation dampening

C1-15 Summary Comparative advantage determines trade Exchange ratio, determined by demand Mutual benefit of trade Ranking and limits to sustainable exchange rate Absolute advantage and wage rates Anti-inflationary Increased GDP Introduction of goods, inputs, technology Increased market size Comparative advantage determines trade Exchange ratio, determined by demand Mutual benefit of trade Ranking and limits to sustainable exchange rate Absolute advantage and wage rates Anti-inflationary Increased GDP Introduction of goods, inputs, technology Increased market size

International Trade Under Constant Opportunity Costs FIGURE 2.2A C1-16

Consumer Indifference Curve FIGURE A2-1.1 C1-17

Consumer Indifference Map FIGURE A2-1.2 C1-18

Constant Opportunity Cost (In Millions of Units) FIGURE A2-1.3 C1-19

Increasing Opportunity Cost (In Millions of Units) FIGURE A2-1.4 C1-20

Equilibrium in Isolation FIGURE 2.2A1.5 C1-21

Equilibrium with Trade: Different Transformation Curves FIGURE 2.2A1.6 C1-22

Equilibrium with Trade: Different Indifference Curves FIGURE 2.2A1.7 C1-23