1. ECON5335 - International Economics
Chapter 4
Trade Flows in Theory

2. Introduction Trade models
- usually question being asked: “why do we trade what we trade?”
- 3 very simple theoretical models
- autarky initial position
- permit trade to occur
- other question asked is “who do we trade with?”
- empirical model based on econometrics
2/14/2018

3. 1. Simplest version of the Ricardian Model
Only two goods
Meat
Potatoes
Only two people
Rancher
Farmer

4. 1. Simplest version of the Ricardian Model
If rancher (R) produces only meat
and farmer (F) produces only potatoes
then both have potential to gain from trade
If both R and F produce both meat and potatoes
Both can potentially gain from specialization and trade
Production possibilities frontier (PPF)
Various mixes of output that economy can produce if all resources used to capacity

5. Figure 1 The Production Possibilities Frontier (a)
Panel (a) shows the production opportunities available to the farmer and the rancher.

6. Figure 1 (b) The farmer’s production possibilities frontier
(c) The rancher’s production
possibilities frontier
Meat (oz) 4 8
Meat (oz) 12 24
If there is no trade, the farmer chooses this production and consumption.
If there is no trade, the rancher chooses this production and consumption. B A
Potatoes (oz) 16 32
Potatoes (oz) 24 48
Panel (b) shows the combinations of meat and potatoes that the farmer can produce. Panel (c) shows the combinations of meat and potatoes that the rancher can produce. Both production possibilities frontiers are derived assuming that the farmer and rancher each work 8 hours per day. If there is no trade, each person’s production possibilities frontier is also his or her consumption possibilities frontier.

7. 1. Simplest version of the Ricardian model
Specialization and trade
Farmer – specialize in growing potatoes
More time growing potatoes
Less time raising cattle
Rancher – specialize in raising cattle
More time raising cattle
Less time growing potatoes
Trade: 5 oz of meat for 15 oz of potatoes
Both gain from specialization and trade

8. Figure 2 (a) The farmer’s production and consumption
(b) The rancher’s production
and consumption
Meat (oz) 4 8
Meat (oz) 12 24
Farmer's production and consumption without trade
Rancher’s production with trade
Rancher’s production and consumption without trade 18
Farmer's consumption with trade 12 13 B*
Rancher’s consumption with trade A* 27 B 5
Farmer's production with trade 17 A
Potatoes (oz) 16 32
Potatoes (oz) 24 48
The proposed trade between the farmer and the rancher offers each of them a combination of meat and potatoes that would be impossible in the absence of trade. In panel (a), the farmer gets to consume at point A* rather than point A. In panel (b), the rancher gets to consume at point B* rather than point B. Trade allows each to consume more meat and more potatoes.

9. Figure 2
The proposed trade between the farmer and the rancher offers each of them a combination of meat and potatoes that would be impossible in the absence of trade. In panel (a), the farmer gets to consume at point A* rather than point A. In panel (b), the rancher gets to consume at point B* rather than point B. Trade allows each to consume more meat and more potatoes.

10. Absolute advantage Absolute advantage
Produce a good using fewer inputs than another producer

11. Table 1 The Opportunity Cost of Meat and Potatoes Opportunity cost
Whatever must be given up to obtain some item
What you give up to get something else
Measures the trade-off between the two goods that each producer faces

12. Comparative Advantage
Produce a good at a lower opportunity cost than another producer
Reflects the relative opportunity cost
Principle of comparative advantage
Each good - produced by the individual that has the smaller opportunity cost of producing that good
Developed by David Ricardo

13. Comparative Advantage
One person
Can have absolute advantage in both goods
By definition, cannot have comparative advantage in both goods
For different opportunity costs
One person - comparative advantage in one good
The other person - comparative advantage in the other good

14. Comparative Advantage
Gains from specialization and trade
Based on comparative advantage
Total production in economy rises
Increase in the size of the economic pie
Everyone – better off
Can apply to individuals, firms, and countries

15. Comparative Advantage
Trade can benefit everyone in society
Allows people to specialize
The price of trade
Must lie between the two opportunity costs
Principle of comparative advantage explains:
Interdependence – reliance on other individuals, firms or countries
Gains from trade – applies to individuals, firms and countries

16. Applications of Comparative Advantage
Should the U.S. trade with other countries?
U.S and Japan
Each produces food and cars
One American worker, one month
One car, or
Two tons of food
One Japanese worker, one month
One car
One ton of food

17. Applications of Comparative Advantage
Principle of comparative advantage
Each good – produced by the country with the smaller opportunity cost of producing that good
Specialization and trade
All countries have more food and more cars

18. What drives comparative advantage in the Ricardian model?
In theory
Clear that there are gains from specialization and trade that arise from differences in productivity of labor and capital in each sector
So in Ricardian model if we assume labor is the only factor of production then labor productivity would drive comparative advantage and determine who trades what
Total units of meat production
Labor required for each unit of food production = productivity
Total units of food production
Labor required for each unit of meat production
Total amount of labor resources
aLFQF + aLMQM = L

19. Ricardian model analytics
If the domestic country wants to consume both meat and food (in autarky), relative prices must adjust so that wages are equal in the wine and cheese industries.
If PF /aLF = PM /aLM workers will have no incentive to flock to either the food or the meat industry, thereby maintaining a positive amount of production of both goods.
PF /PM = aLF /aLM
Production (and consumption) of both goods occurs when relative price of a good equals the opportunity cost of producing that good.

20. Ricardian model analytics
Suppose that the domestic country has a comparative advantage in food production: its opportunity cost of producing cheese is lower than it is in the foreign country.
aLF /aLM < a*LF /a*LM
where “*” notates foreign country variables
Note here that this is the relative productivity which therefore determines comparative advantage

21. Other models Heckscher Ohlin Model (1919)
Problem with Ricardian model was that it only had one factor of production
So here a 2 good, 2 FoP model
Different rule emerges for comparative advantage
Krugman economies of scale model
Differentiated products
Economies of scale
Different results for comparative advantage

22. Factor endowment theory/H-O model
Look at abundance of FoP or resources
Country with relatively abundant amount of FoP will export good or service which is intensive in that factor
Therefore comparative advantage is in the relative abundance of the FoP
K/L ratio indicates factor abundance
If US has K/L = 0.5 and China has K/L = 0.02 then US has relatively more K and China relatively more L

23. H-O model
So China should export good which uses L intensively, and US should export good which uses K intensively
So price of K rises in US and price of L falls
Opposite happens in China: price of L rises and price of K falls
But before in autarky L was paid much less in China than in the US as so much L in China.
Implication is that there is convergence in factor prices across countries – known as “factor price equalization”

24. H-O Model
In Ricardian model no distributional consequences – here they are possible
If US exports more K intensive goods, then income earned by K goes up (conversely income earned by L goes down)
Vice versa for China
Therefore owners of K in US better off compared with L and v-v for China
Known as the “Stolper Samuelson Theory”

25. Leontief Paradox Need to test H-O theory to see if it is true
Wassily Leontief collected data for US and if H-O correct US exports should have higher K/L ratio than imports
(1947) Results: US X = $14K/L
US M = $18K/L
Was H-O wrong? Leontief called it a “paradox”.
Resolution came from widening defn of K

26. Leontief Paradox
By looking at average years of education (“human capital”) Baldwin found that greater factor intensity in exports.

27. Krugman model
Paul Krugman developed a model of trade with differentiated products. Why?
Here by trading we can expand our market and lower our costs
But depends on the size and type of economies of scale
Economies of scale – internal?
Economies of scale – external?
Linder’s theory of overlapping demands

28. Krugman model
Paul Krugman developed a model of trade with differentiated products. Why?
Here by trading we can expand our market and lower our costs
But depends on the size and type of economies of scale
Economies of scale – internal?
Economies of scale – external?
Linder’s theory of overlapping demands

29. Krugman model
Given trade begins between 2 countries with similar industries
We would expect
Total # of firms to fall
Price to fall as costs fall
Variety in each country to increase
Average size of firms to increase
Ricardian and H-O models explain “inter-industry” trade
Krugman explains “intra-industry” trade

30. The Gravity Model
3 of the top 10 trading partners with the US in 2011 were also the 3 largest European economies: Germany, UK and France.
These countries have the largest gross domestic product (GDP) in Europe.
Why does the US trade most with these European countries and not other European countries?

31. Size Matters: The Gravity Model (cont.)
In fact, the size of an economy is directly related to the volume of imports and exports.
Larger economies produce more goods and services, so they have more to sell in the export market.
Larger economies generate more income from the goods and services sold, so people are able to buy more imports.

32. Size Matters: The Gravity Model (cont.)

33. The Gravity Model Other things besides size matter for trade:
Distance between markets influences transportation costs and therefore the cost of imports and exports.
Distance may also influence personal contact and communication, which may influence trade.
Cultural affinity: if two countries have cultural ties, it is likely that they also have strong economic ties.
Geography: ocean harbors and a lack of mountain barriers make transportation and trade easier.

34. The Gravity Model (cont.)
Multinational corporations: corporations spread across different nations import and export many goods between their divisions.
Borders: crossing borders involves formalities that take time and perhaps monetary costs like tariffs.
These implicit and explicit costs reduce trade.
The existence of borders may also indicate the existence of different languages (see 2) or different currencies, either of which may impede trade more.

35. The Gravity Model (cont.)
In its basic form, the gravity model assumes that only size and distance are important for trade in the following way:
Tij = A * (Yi * Yj)/Dij
where
Tij is the value of trade between country i and country j
A is a constant
Yi the GDP of country i
Yj is the GDP of country j
Dij is the distance between country i and country j

36. The Gravity Model (cont.)
In a slightly more general form, the gravity model that is commonly estimated is
Tij = A x Yia x Yjb /Dijc
where a, b, and c are allowed to differ from 1.
Perhaps surprisingly, the gravity model works fairly well in predicting actual trade flows, as the figure above representing US–EU trade flows suggested.

37. Distance and Borders
Estimates of the effect of distance from the gravity model predict that a 1% increase in the distance between countries is associated with a decrease in the volume of trade of 0.7% to 1%.
Besides distance, borders increase the cost and time needed to trade.

38. Distance and Borders (cont.)
Trade agreements between countries are intended to reduce the formalities and tariffs needed to cross borders, and therefore to increase trade.
The gravity model can assess the effect of trade agreements on trade: does a trade agreement lead to significantly more trade among its partners than one would otherwise predict given their GDPs and distances from one another?

39. Distance and Borders (cont.)
The US has signed a free trade agreement with Mexico and Canada in 1994, the North American Free Trade Agreement (NAFTA).
Because of NAFTA and because Mexico and Canada are close to the US, the amount of trade between the US and its northern and southern neighbors as a fraction of GDP is larger than between the US and European countries.

40. Distance and Borders (cont.)

41. Distance and Borders (cont.)
Yet even with a free trade agreement between the US and Canada, which use a common language, the border between these countries still seems to be associated with a reduction in trade.
So Canadian provinces trade more with each other, than with US states, ceteris paribus

42. Distance and Borders (cont.)

43. Distance and Borders (cont.)

44. Gravity model Shows that still more likely to trade if no borders
But also shows that size and geography also matter
Gravity model tested extensively in economics literature
Shows that US’s natural trade partner is Canada and to a lesser extent Mexico