1. The Trade Theory

2. International Economics
International Trade
International Finance

3. International Trade A definition:
A study of trade (of goods and services) between nations and its economic implications
Why nations trade: gains from trade
The Trade theory
Factor movements
Free trade versus protection

4. International Finance
A definition:
A study of the financial dimension of international economic transactions among nations
Balance of payments
Exchange markets and exchange rates
The international monetary system
International monetary institutions

5. The Basic Theory of Trade
Absolute advantage in production
Comparative advantage and the gains from trade
Trade as a means to economic efficiency
Trade as a way of life
Trade and economic interdependence
Trade and economic growth

6. Early Thinking about Trade
Mercantilism
David Hume and the specie-flow mechanism
Adam Smith (1776)

7. Adam Smith’s View on Trade
"It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy.”
Adam Smith
The opportunity to trade what one has (or can produce) for what he/she does not have (or cannot produce easily) makes it rational for each person to specialize in the production of what she can produce most efficiently (least costly.)
Specialization and trade among regions and countries are based upon the same principle as among individuals.

8. Trade and “Absolute Advantage”
A nation (or country) has absolute advantage in the production of a good if, compared to another country, it uses less resources to produce it.
Example: If US uses 15 hours of labor to produce one unit of tomatoes and Mexico uses 10 hours to produce the same amount of tomatoes, Mexico has absolute advantage in the production of tomatoes.

9. Total labor: US: 240 , Mexico: 240
Under autarky:
Labor needed Output Produced
Mexico U.S Mexico U.S.
Tomatoes: 10 hrs hrs
Corn: hrs hrs
===================================
World’s output of tomatoes:
World’s output of Corn:

10. After specialization and trade:
Mexico U.S. Total World’s Output
Tomatoes
Corn
Gains from trade: = 4 units of tomatoes
= 15 units of corn
Terms of trade: The number of units of the imported good received for each unit of the exported good
Relative price: Price of one good in terms of another

11. Relative Price 4/15 = .266 unit of tomato
Relative price of one unit of corn in US before trade:
4/15 = .266 unit of tomato
(Note:Relative price of one unit of tomato in terms of corn = 15/4 = 3.75 units of corn)
Relative price of one unit of corn in Mexico before trade:
8/10 = .80 unit of tomato
(Note:Relative price of one unit of tomato in terms of corn = 10/8 = 1.25 units of corn)
Terms of Trade: <=====> .80

12. Terms of Trade: A graphical AnalysisTT
240/10 24 A 16 A TT 60 30 C C
240/8 US
Mexico
Mex Price under autarky = .8
US Price under autarky: .26
Production under autarky: A
Terms of trade after trade: TT = .50
-Slope = relative price
= MRT
(Marginal Rate of Transformation)

13. Indifference Curves
An indifference curve is a curve showing all the combinations of two goods from which a consumer derives the same level of utility.
A consumer is indifferent along any given indifference curve.
The farther an indifference curve is from the point origin the higher level of utility it represents.
The indifference curves in an indifference map never cross
A social indifference curve?

14. A Social Indifference MapT U5 U1 U3 U2 U4
U5>U4>U3>U2>U2
ΔUc
MRS =
ΔUt
Slope = MRS C

15. Mexico Under Autarky T At “a” MRS>relative cost/price
At “c” MRS<relative cost/price
At “b” MRS = relative cost/price
MRT a b U4 U3 c U2 U1 C

16. Terms of Trade: A graphical AnalysisTT 24 y A 16 t A 12 y TT 30 60 30 C C US
Mexico
US imports = Mexico’s exports = t w
US exports = Mexico’s imports = w y

17. Terms of Trade: A graphical AnalysisTT 24 A 16 A TT 60 C 30 C US
Mexico
Mex Price under autarky = .8
US Price under autarky: .26
-Slope = relative price
Production under autarky: A
Terms of trade after trade: TT = .50

18. David Ricardo and Comparative Advantage
Again consider US and Mexico.
Labor needed for one unit
Output produced
Mexico U.S Mexico U.S.
Rugs hrs hrs
Computers hrs hrs
US has absolute advantage in both goods!
US Relative price computers in terms of rugs = 10/8 = 1.25
Mexico’s Relative price computers in terms of rugs = 40/10 = 4
US has comparative advantage in computers but Mexico in rugs.

19. The Ricardian Trade ModelUS
Mexico
Rugs
Rugs TT 30 c 24 U2 U1
1.25 c k A U2 g A f U1 g
Cmp
Cmp 4 h TT f 6 24

20. Productivity, Wage, and Price
Assume the only input used in production is labor,
Marginal cost of producing good X is: W
MCx = = ax. W ; ax = 1/MPL
MPL
If Px = MC
Px Py
Wage = W = or W =
ax ay

21. ===> ---------- = --------- ax ay Px ax
In autarky under competitive conditions where uniform labor
is the only input:
Wx= Wy
Px Py
===> =
ax ay
Px ax
===> = = MRT
Py ay

22. Trade and Wage Recall: Pr Wr = ------- ar Pc Wc = ------- ac
After complete specialization and trade,
the price of “export” will go up. ==> W will go up.

23. The Effects Trade on Prices and Wages
After specialization and trade:
In US:
The output of computers will go up
The output of rugs will go down
Price of computers will go up
Price of rugs will go down
The wage will go up
Note: US is now producing only computers and
recall: W = P/a

24. After specialization and trade:
In Mexico:
The output of computers will go down
The output of rugs will go up
Price of computers will go down
Price of rugs will go up
The wage will go up
Note: Mexico is now producing only rugs and recall: W = P/a

25. Demand and Supply in Autarky
Pr/Pc
Pr/Pc S
4/5
Export
Import
1/4 D D Q Q
Rug Market in US
Rug Market in Mexico

26. International Market for Rugs
Pr/Pc S
4/5
1/4 D Q