1/25/2011. Introduction to International Trade. Basic Theory of Trade

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1 Introduction to International Trade Comparative Advantage and the Patterns of International Trade The Standard Trade Model and International Factor Movements A Trade-based Model of Exchange Rates Why Do Countries Trade? Countries have a comparative advantage (CA) for several reasons: Differences in labor productivity Differences in factor proportions Unique resources Absolute advantage affects real income, but not CA. Countries may also have a competitive advantage due to: Monopoly Power Internal economies of scale (size of firm) External economies of scale (size of industry) Learning curve (experience) Differences in tariffs, subsidies, taxes, et cetera Countries may also have differences in preferences. Basic Theory of Trade For simplicity, we often assume no transportation costs, no import tariffs, constant returns to scale and non-increasing marginal products, homogeneous products with competitive markets, full employment, no externalities, full information, and no international flows of savings. In ECON 462, we explore these assumptions and their possibilities. We usually start by comparing a country in autarky (total self-reliance) to perfect free trade, with a simple 2 country, 2 good, 2 factor model. 1

2 A Basic Neoclassical Model of Trade (Heckscher-Ohlin-Samuelson) Two countries, Home and Foreign. Two factors, K and L. Home is K-abundant. Two goods, X and Y, where X is relatively K-intensive and Y is relatively L-intensive. Under autarky, Home has cheaper K and more expensive L, cheaper X and more expensive Y. Viceversa for Foreign. With X on the horizontal axis, Home would have a flatter PPF (X is K-intensive, Home is K-abundant), and Foreign a steeper one. The PPF has a rising MRT, and relative prices determine the economy s output Food production, Qy V = P X Q X + P Y Q Y = P X D X + P Y D Y Isovalue lines Q Q Y/ / Q X = - P X /P Y Cloth production, Qx An Increase in the Relative Price of Cloth Affects Relative Supply Qy Q 1 VV 1 (PC/PF) 1 Q 2 VV 2 (PC/PF) 2 Qx 2

3 Relative Prices and Demand The value of an economy's demand (consumption, investment) equals the value of its production: P X Q X + P Y Q Y = P X D X + P Y D Y = V The economy s choice of a point on the isovalue line depends on the tastes of its consumers, which can be represented graphically by a series of indifference curves. If trade were possible, the maximum isovalue line represents a consumption possibilities frontier. Indifference curves An indifference curve represents all combinations of good (X,Y) demand that would yield the same utility. A topographic map of indifference curves exists for all possible combinations. Indifference curves are always downward sloping, and they never cross. Increases in one or the other good result in higher utility. The curve gets steeper as you add more Y, and flatter as you add more X. 3

4 Production, Consumption, and Trade in the Standard Model Qy Indifference curves Food imports D Q Cloth exports Cloth production, Qx The Welfare Effect of Changes in the Terms of Trade Terms of trade The price of the good a country initially exports divided by the price of the good it initially imports. A rise in the terms of trade increases a country s welfare, while a decline in the terms of trade reduces its welfare. A country benefits from trade if it can export a good at a higher relative price than it cost to produce at autarky, and import a good at a lower relative price. If a country is already trading, an increase (decrease) in its terms of trade will improve (reduce) its welfare. Results from the model Trade leads to convergence in relative output prices. If factors are equal in productivity across countries, trade leads to convergence in relative factor prices; if not, then trade leads to convergence in relative effective factor prices. Gains from trade are mutually beneficial, but division of gains between countries depends on many things. When there is more than one factor, any change leads to winners and losers, though under trade winners gain more in total than losers lose. 4

5 More results Competitive markets are most efficient, but gains from trade exist even when markets are not perfect, e.g., monopolies, monopolistic competition, externalities. If factors are immobile in short run and factor prices are inflexible, any change (to or from free trade) can lead to temporary unemployment. Barriers to trade reduce amount of trade, but not direction. Imports and exports fall together, and balance is not affected. In our basic model Home will import Y from Foreign, export X to Foreign. Relative prices equalize: X and Y prices are determined by rising marginal costs. Factor prices equalize: as Home produces more X, Home s K will rise in price, L will become cheaper; viceversa for Foreign. Both countries can consume beyond what they can produce: mutual gains from trade. Nominal prices are determined by money supply. Exchange rates equate nominal prices, leading to purchasing power parity. Commercial Policy Protectionism benefits scarce factors, and industries which compete with imports, but it harms abundant factors, the exporting sectors, those who buy importable goods, and (usually) overall efficiency. When externalities are present, protectionism may have positive effects, but it is usually a second-best policy. Countries large enough to change their terms of trade may benefit from protectionism, but by less than their trading partners are harmed. 5

6 Labor and Capital Flows in the Trade Model Trade in goods is a perfect substitute for trade in factors, at least when factors are equally productive. Trade in factors changes the future PPF. Capital flows are made through transfers of savings. These transfers change the balanced trade condition: Px(Qx - Dx) - Py(Dy - Qy) + SF = 0; where SF = net inward flows of foreign savings. If this borrowing must be repaid in future, this will reverse the balance of trade then. Production, Consumption, and Trade with a Foreign Savings Inflow Qy Food imports D Indifference curves Q (P X Q X + P Y Q Y ) + SF = P X D X + P Y D Y NX = P X (Q X - D X ) - P Y (D Y - Q Y ) NX + SF = 0 (P X Q X + P Y Q Y ) = (P X D X + P Y D Y ) + NX Cloth exports Cloth production, Qx Why do Factors move? Labor seeks higher wages. Capital-abundant countries have higher wages except under free trade, and more developed countries usually have higherproductivity labor. Most factor flows are in capital, however. Machines don t get up and move, but investors may allow existing capital to depreciate, and move their savings to another country, to be invested there instead. 6

7 Why do Savings flow abroad? Higher return on investment: capital scarcity vs. use productivity. Capital flight from countries with high taxes, poor macroeconomic management (i.e., inflation, devaluation), poor protection of property rights, or excessive risk. Flight to Quality. Portfolio diversification. Prepayment of import contracts. Short-term speculation, hedging. Foreign Direct Investment - managerial control over foreign ops. Official reserve asset purchases by central banks to manage exchange rate, or to keep a cushion against forced devaluation. Unilateral Transfers (private remittances, aid). Putting Exchange Rates in the Basic Model Model predicts equation of relative prices: Px/Py = Px* / Py* We then find nominal prices: M V = PQ = PxQx + Py Qy (+ Pz Qz +.) Q is found on the PPF, and M and V must be given. If there are no tariffs or transaction costs, we can assume the Law of One Price: Px = E Px*, Py = E Py* Purchasing Power Parity: P = E P*, where P and P* are price indices. If trade is not perfect, then there is still some E which solves the foreign trade and savings equation: Px(Qx - Dx) (E Py*)(Dy - Qy) + SF = 0 7