Presentation on theme: "International Economics"— Presentation transcript:
1 International Economics CHAPTER ONE1International EconomicsEarly TradeTheories
2 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
3 Assume two-nation, two-good world 2.1 IntroductionBasic questions:What is the basis for trade?What are gains from trade?What is the pattern of trade?Assume two-nation, two-good world
5 2.2 The Mercantilists’ Views on Trade MercantilismEconomic 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.
6 2.2 The Mercantilists’ Views on Trade MercantilismExport 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.
7 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.
8 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 peopleCase Study 2-2 Mercantilism is Alive and Well in the Twenty-First Century
11 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.
12 2.3 Trade Based on Absolute Advantage: Adam Smith ThailandMalaysiaRice (bushels/labor hour)72Clothes (yards/labor hour)46Thailand has absolute advantage in Rice.Malaysia has absolute advantage in clothes.Both nations can gain from specialization in production and trade.
13 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:
14 2.4 Trade Based on Comparative Advantage: David Ricardo 2.4A. Law of Comparative AdvantageEven 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.
16 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.
17 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
18 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
19 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.ThailandMalaysiaPrice of 1 bushel of rice (Pr)10 baht20 bahtPrice of 1 piece of clothes (Pc)12 baht
20 2.5 Comparative Advantage and Opportunity Costs Assumptions of the Ricardian ModelOnly two nations and two goodsFree tradePerfect mobility of labor within each nation but immobility between the two nationsConstant costs of productionNo transportation costsNo technical changeThe labor theory of valueWhile assumptions (1) through (6) can easily be relaxed, assumption (7) is not valid.
21 2.5 Comparative Advantage and Opportunity Costs 2.5A. Comparative Advantage and the Labor Theory of ValueLabor theory of value: the value or price of a good depends exclusively on the amount of labor going into the production of the good.ImplicationsEither 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).
22 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:
23 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.
25 2.5 Comparative Advantage and Opportunity Costs 2.5C. The Production Possibility Frontier under Constant Costs
26 FIGURE 2-1 The Production Possibility Frontiers of the Thailand and the Malaysia
27 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.
28 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.
29 2.6 The Basis for and the Gains from Trade under Constant Costs 2.6A. Illustration of the Gains from TradeIn 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.