Interdependence and Trade. Interdependence and the Gains from Trade Comparative Advantage. Interdependence and Trade

Transcription

1 Interdependence and Trade Interdependence and the Gains from Trade Herbert Stocker Institute of International Studies University of Ramkhamhaeng You wake up to an alarm clock made in Korea. You pour yourself some orange juice made from oranges grown in Malaysia. You put on some clothes made of cotton grown in USA and sewn in factories in Vietnam. You watch the morning news broadcast on your TV made in Japan. The bus you take is made of parts manufactured in a half-dozen different countries. Question: do you think, foreign trade can hurt a country? Under which circumstances do you think this could be possible? [Consider for example Thailand China, Thailand USA] In this chapter we will show that simple abstract models can give crystal-clear and simple answers to such complex questions! Additionally, we will introduce some useful concepts that will be helpful later. Interdependence and Trade Remember, economics is the study of how societies produce and distribute goods in an attempt to satisfy the wants and needs of its members. How do we satisfy our wants and needs in a global economy? We can be economically self-sufficient. We can specialize and trade with others, leading to economic interdependence.

2 Interdependence and Trade The theory of explains, why many economists are convinced, that free trade is better for a country as a whole than self-sufficiency! This theory applies to countries as well as to individuals or firms....this deepest and most beautiful result in all of economics. (indlay 988, S. 5) ounder: David Ricardo David Ricardo (77-8) A successful business man and brilliant economist with exceptional abilities for abstract reasoning. Main Work: Principles of Political Economy and Taxation (86) Ricardo conquered England as completely as the Holy Inquisition conquered Spain (Keynes 96, S. ) If there were an Economist s Creed, it would surely contain the affirmations I understand the Principle of and I advocate free trade. (Krugman 987, p. )

3 Who are the winners and loosers of free trade? Are poor countries worse off when trading with rich countries? (e.g. WTO-negotiations) or understanding comparative advantage we need some basic concepts, like... Production possibilities frontier Efficiency Productivity Opportunity cost Thought experiment: Imagine a lonely and beautiful island, maybe somewhere in the south sea... on this island, a lonely hunter... this man can either hunt or fish if he hunts the whole day ( hours) he can get kg meat (M). if he fishes the whole day ( hours) he can catch 5 kg fish. The hunter faces a trade-off: Hunter (A): Production possibilities: Meat ish (M) () M = 5.5M Production Possibilities rontier 5 efficient, maximal use of resources (time) technical possible, but not efficient! M

4 Definitions Production Possibilities rontier: a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and available production possibilities (only for simplification we focus on only two goods). Efficiency: if it is not possible to increase production of one good without producing less of the other good. Productivity: the amount of output produced from one unit of input, e.g. Labor productivity: the amount of output produced from each hour of a worker s time. Productivity The PP lies further to the right,... the better the economy is endowed with factors, and the higher is productivity. Increase in labor productivity in the production of only M Productivity Question (Labor-)Productivity (i.e. absolute cost advantage) is the decisive factor for the (material) standard of living! Determinants of Productivity: Physiscal Capital (machinery, etc.), Human Capital & Know-how, Quality of institutions and laws, and many more... The higher productivity, the more goods are available (or people can work less, respectively)! Our hunter can either hunt kg meat or 5 kg fish per day ( hours). What is the labor productivity if he hunts? kg meat per working hour. What is the labor productivity if he fishes?.5 kg fish per working hour.

5 Production Possibilities Production Possibilities Quiz: Which points are technical possible? Y C B G D J A E H N M I K L X Solution: A,B,D,E,,M,H,I,K Quiz: Which points are technical efficient? Y C B G D J A E H N M I K L X Solution: B,D,,H,K Production Possibilities Production Possibilities Quiz: Which points are technical inefficient? Y C B G D J A E H N M I K L X Solution: A,E,M,I Quiz: Which points are technical impossible to realize? Y C B G D J A E H N M I K L X Solution: C,G,J,N,L

6 Opportunity Cost Opportunity Cost If we decide for one alternative, we have usually to sacrifice other alternatives, since our resources (e.g. time, money,...) are scarce. There is a trade-off between alternatives. The Opportunity cost of one chosen alternative are the cost of the next best alternative we had to sacrifice. If our lonely hunter wants one additional kg fish he has to sacrifice kg meat (i.e. he must fish additional hours instead of hunting!) The opportunity cost of kg fish is kg meat. If our lonely hunter wants an additional kg meat he must sacrifice.5 kg fish (i.e. hunt additional hour instead of fishing!) The opportunity cost of kg meat is.5 kg fish. Opportunity Cost......is the slope of the production possibilities frontier! = 5.5M or M = 5 M M = = = + M =.5 M = + = M Opportunity Cost The slope of the production possibilities frontier measures the opportunity cost! The slope is the derivative of a function = 5.5M Opportunity cost of Meat: d dm =.5 M = Opportunity cost of ish: dm d = Opportunity cost of fish is the reciprocal of opportunity cost of meat.

7 Slope and Angle The slope of a linear function can also be calculated as the tangent of an angle: Hypotenuse α Adjacent Opposite leg tanα = Opposite leg Adjacent = Slope Opportunity Cost 5 α M Opportunity cost of meat: = 5.5M d dm =.5 tanα = Opposite leg Adjacent = 5 =.5 One kg meat costs the lonely hunter.5 kg fish! Opportunity Cost Opportunity Cost 5 β M Opportunity cost of fish: M = dm d = Opposite leg tanβ = Adjacent = 5 = One kg fish costs the lonely hunter kg meat! ish () β α Meat (M) Production possibility frontier of Mr. isher from the neighboring island: d = M, dm = Opposite leg tanα = = Adjacent = dm M =.5, d =.5 Opposite leg tanβ = = Adjacent =.5

8 Productivity Opportunity Cost Labor productivity in the production of... ish Meat Hunter.5 kg ish/hour kg Meat/Hour isher. kg ish/hour. kg Meat/Hour The hunter is more productive in hunting and fishing! (and has therefore probably a higher standard of living) Should the fisher and hunter trade with each other??? Labor productivity in the production of... ish Meat Hunter.5 kg ish/hour kg Meat/Hour isher. kg ish/hour. kg Meat/Hour Hunter isher Opportunity Cost of ish Meat kg Meat/Hour kg Meat.5 kg ish/hour.5 kg ish.5 kg ish/hour = kg ish kg Meat/Hour = kg Meat. kg Meat/Hour.5 kg Meat. kg ish/hour kg ish = =. kg ish/hour kg ish. kg Meat/Hour kg Meat Opportunity Cost Comparative Adv. Opportunity Cost of Meat ish Hunter.5 kg ish kg Meat isher kg ish.5 kg Meat The hunter has lower opportunity costs in producing meat (for one additional kg meat the hunter has to sacrifice.5 kg fish, the fisher has to sacrifice kg fish for one additional kg meat). It follows automatically, that the fisher has lower opportunity costs in producing fish! Example: Opportunity Cost of Meat of ish ish γ δ β α Meat Meat: α < β Hunter ish: δ < γ isher

9 Two Kinds of Cost Absolute Cost: how many hours are needed to produce one unit of a good. Absolute Advantage: the country with the higher productivity has an absolute advantage! Opportunity Cost: which alternatives we have to give up to produce one more unit of a good (i.e. how many units of the other good have to be sacrificed to produce this one more unit)? : the country with the lower opportunity cost has an comparative advantage! Opportunity Cost Comparative Adv. or the gains from trade is not productivity (or absolute cost) relevant, but only opportunity cost! Everyone should specialize in the production of the good, where he or she has the lower opportunity cost!!! Since opportunity cost is the slope of the production possibilities frontier, both parties will gain as long as the exchange ratio is between the slopes of the individual production possibilities frontiers! Example Autarkie (no trade): Consumption possibilities = Production possibilities Production Trade Consumption Hunter 6 kg Meat 6 kg Meat kg ish kg ish isher kg ish kg ish.5 kg Meat.5 kg Meat Example: Autarky (no trade): ish Meat Production and Consumption under autarky (Any other point on the PP is possible as well.)

10 Example With Trade: for simplicity we assume an exchange ratio : Consumption possibilities > Production possibilities Production Trade Consumption Hunter kg Meat kg Meat 8 kg Meat kg ish + kg ish kg ish isher kg ish kg ish kg ish kg Meat + kg Meat kg Meat Gains from Trade: Hunter: isher: + kg Meat +.5 kg Meat Example: Trade with an exchange ratio : (assumption) ish Meat Production and Consumption under autarky Production with trade Consumption with trade Result Question Not the location of the production possibilities frontier (productivity) is decisive whether trade is advantageous, but the slope of the production possibilities frontier (i.e. Opportunity Cost)! Should George Clooney iron his shirts himself, even if he should be a world champion in ironing?

11 Without trade production possibilities determine consumption possibilities! Without Trade: Production possibilities = Consumption possibilities Trade allows to increase consumption possibilities! With Trade: Consumption possibilities > Production possibilities ree trade makes both parties better off, since trade allows to make a more efficient use of the available resources!!! Absolute vs. Summing up... Whenever the opportunity cost of two trading partners differ both parties will profit from trade! A country could have an absolute disadvantage in the production of all goods, but it is logically impossible that a country has an comparative disadvantage in the production of all goods! or the gains from trade only comparative advantages are relevant, absolute advantage is irrelevant! An Example : Example Productivities: Amount produced Endowment with labor: in one hour England: hours Cheese Bread England Spain: hours Spain 5 England s production possibility frontier is B =.5C Spain s production possibility frontier is B = /6C Why?

12 : Example Productivities: Amount produced in one hour Cheese Bread England Spain 5 B 5 6 C Endowment with labor: England: hours Spain: hours Engl.: B = /C Spain: B = /6C : Example PP England: B = /C or C = B Opportunity cost of Bread in England: OCB = C/h B/h = C B = dc db = C/B PP Spain: B = /6C or C = 6 6B Opportunity cost of Bread in Spain: OCB = C/h 5B/h = 6C B = dc db = 6C/B : Example : Example PP England: B = /C or C = B Opportunity cost of Cheese in England: OCC = B/h C/h = B C = db dc = /B/C PP Spain: B = /6C or C = 6 6B Opportunity cost of Cheese in Spain: OCC = 5B/h C/h = B 6C = db dc = /6B/C England has lower opportunity cost in the production of bread, and should therefore specialize in the production of bread. Spain has lower opportunity cost in the production of cheese, and should therefore specialize in the production of cheese. Trade will make the world a better place, since England and Spain as countries are better of by specializing and trading. However, British cheese maker and Spanish baker will not be amused!

13 Summary ree trade can increase welfare of all trading partners, since free trade allows a more efficient allocation of resources! By a more efficient allocation of resources it is usually possible to produce more of both goods! However, some groups may loose, though the gains of the Winners will generally exceed to losses of the losers; more on this later Nonlinear PP Production possibilities frontier are often bowed outward. One reason for this is, that opportunity cost often increase as more resources go in the production of one good. Opportunity cost are measured as the slope of a tangent in the relevant point! M Sources of International Trade: Example of David Ricardo: England and Portugal trade cloth for wine. Specialization necessitates structural change! People have to change jobs, and if they are not mobile between industries many will loose their jobs!!! Structural change implies adjustment costs in the short run, but can increase welfare in the long run! International differences in climate and natural resources. Technology. actor endowments: The relationship between comparative advantage and factor availability is found in an influential model of international trade, the Heckscher-Ohlin model.