Running Head: INTERNATIONAL TRADE PROBLEM 2 1

Transcription

1 Running Head: INTERNATIONAL TRADE PROBLEM 2 1 International Trade Student s Name University

2 INTERNATIONAL TRADE PROBLEM The Heckscher-Ohlin Theory of Trade: The H-O theory of trade states that, given countries differ in the composition of factor endowments. A nation should export (import) those commodities in which it has abundant (scarce) factor endowment relative to other countries. The theory conjectures that trade will boost the price of the abundant factor and decrease that of the scarce factor. The theory assumes two countries, producing two goods with two production factors. In this example, given two countries: Italy and Brazil, producing wheat and scooters respectively, with two factors labor and Capital: a. PPF s for both countries. Scooters Fig-1: PPF for Italy Wheat

3 INTERNATIONAL TRADE PROBLEM 2 3 Scooters Fig-2: PPF for Brazil Wheat Given that Brazil is labor abundant and Italy is capital abundant, Brazil has a comparative advantage in the production of wheat relative to scooters. On the other hand, Italy has a comparative advantage in the production of scooters relative to wheat. The result shows that the Brazil has a lower opportunity cost of producing wheat, while Italy enjoys lower opportunity cost in the production of scooters. Thus, in fig-1, the PPF curve is steep (given scooters on y-axis and wheat on the x-axis). b. It is not easy to determine who is better off in autarky because it depends on the quantities of their factors endowments and preferences for the goods. c. According to the theory of comparative advantage, a country with a comparative advantage in the production of a good should focus on producing that good and import the good in which it faces higher production costs. In the example, Brazil has a comparative advantage in

4 INTERNATIONAL TRADE PROBLEM 2 4 the production of wheat, if world wheat prices are higher than the autarky price, then exporting wheat an importing Scooters from Italy will create trade gains for Brazil and Italy. Both countries will gain from trade if and only if the equilibrium free trade price ratio falls between the autarky prices for both countries. d. Scooters P 2 T Fig-3: Home (Brazil) P 1 T βl D 2 U 2 D1 u 1 S 1 = S 2 αl Wheat Scooters S* 2 S* 1 Fig-4: Foreign Country (Italy) βl 2 * D* 2 βl 1* * D*1 U* 2 U* 1 P 1 T P 1 T αl* Wheat

5 INTERNATIONAL TRADE PROBLEM 2 5 In fig-3 and 4, the top panels represent PPFs for both countries, as well as (parallel) world price lines and quantities traded. The initial equilibrium world relative price is denoted by, P T 1. e. This increases the world relative price of wheat to rise (and of scooters to fall). As for Brazil, the country increases its exports of wheat and imports of scooters. 2. Offer Curves a. The current contention about the Transatlantic Trade and Investment Partnership (TTIP) is raising a storm. The most affected sectors include cars, food, energy, chemicals and finance. The US is currently negotiating with the EU about eliminating customs tariffs and to harmonizing importation regulations by removing red tapes. The US argues that the European economy could earn 120 billion annually from deal that will see a huge market of 800 million consumers (Euronews, 2015). Indeed the agreement is likely to shift both the US and EU s offer curves. However, the deal faces strong opposition from France and Germany the largest EU members. One of the issues raised include possible deterioration of food quality and safety standards and workers rights. Another problem is that a majority of the EU business are small and medium enterprises (SMEs), hence, may struggle to compete with large multinationals from the US. b. Opening up huge market of more than 800 million consumers is likely to be a great boos to the trade volumes between the US and EU. Nonetheless, it is important for the two trading

6 INTERNATIONAL TRADE PROBLEM 2 6 partners to straighten out standards and legal hurdles before ratifying the deal. Also, considering the competition from large multinationals, the EU can modify the deal to protect small firms in its region. 3. Theory of Comparative Advantage and the Neo Classical Theory of Trade a. The theory of comparative advantage argues that explains trade based on labor productivities, assuming differences in technology among trading countries. On the other hand, the new classical theory of trade explains trade based on relative factor endowments, with the assumption of identical technologies. Secondly, the comparative advantage theory assumes constant opportunity cost with regards to product substitutability; hence, trade leads to complete specialization in production. On the other hand, the neoclassical theory, assumes increasing opportunity cost, as result, incomplete specialization. Given the assumption of constant opportunity cost in the comparative advantage model, market equilibrium is solely determined by the position of the demand curve. On the other hand, under the neoclassical theory both supply and demand curves determine the market equilibrium. Another difference is that the comparative model places no restrictions on tastes or preferences, while the neoclassical assumes identical tastes. Finally, the comparative advantage theory assumes that trade benefits all trading partners, but the neoclassical theory argues that trade benefits those with the abundant factor and harms those with scarce.

7 INTERNATIONAL TRADE PROBLEM 2 7 b. Which is better? Given the assumptions, it is clear that the comparative advantage theory is deficient and invalid in the contemporary world. Nonetheless, the neoclassical theory also has weaknesses such as assuming equal tastes and preferences but is much more potent than the comparative advantage theory. Thus, the theory of comparative advantage ought to be dismissed in favor of the neoclassical theory. 4. Mention if True or False: a. In Autarky, producer and consumer equilibrium are at the same points on the PPF and CIC. TRUE: In autarky, producers and consumers come together to trade their goods. The terms of trade represents the amount of commodities that exchanged in the domestic barter market. b. The theory of Comparative Advantage states that free trade benefits the exporting countries. FALSE: Under competitive advantage, both importing and exporting countries benefits given that everyone specializes in what they produce best. c. The Neoclassical Trade Theory states that trade arises due to different amounts of labor and capital in a country. TRUE: The neoclassical trade theory is based on the differences in factor endowments in this case trade and labor.

8 INTERNATIONAL TRADE PROBLEM 2 8 d. The H-O theory states that trade arises due to different PPFs in a country. TRUE: The theory is based on trade due to differences in factor endowment that allows trade to take place. e. An increase in incomes in Thailand shifts its offer curve, and this will affect the Terms of Trade of its trading partner, Indonesia. TRUE: The shift in income symbolizes increase in the demand for goods, some of which may include the goods originating from Indonesia 5. (10 points) Definitions: a. Production Possibilities Frontier This is a boundary between the combinations of goods and services that can be produced and those that cannot be produced, given different combinations of production factors. b. Comparative Advantage Comparative advantage occurs when one nation commands superiority in the production of a commodity over another due to lower opportunity cost of production. c. Theory of Absolute Advantage This theory suggests that a country that is able to produce commodities more effectively relative to other countries should continue to produce those commodities because it enjoys an absolute advantage.

9 INTERNATIONAL TRADE PROBLEM 2 9 d. Input-Output ratio This is a measure of productivity and efficiency in production and is expressed as the ratio of output to inputs utilized in the production process. e. Terms of trade The value of a nation s exports relative to imports. It is computed by finding the ratio of exports to imports, multiplied by 100. A terms of trade (TOT) less than 100%, implies that the country is importing more than it is exporting. f. Constant Opportunity Costs Constant opportunity occurs where; as production increases, the opportunity cost of producing an extra unit of the good remains constant. g. Increasing Opportunity Costs Unlike constant opportunity costs, increasing opportunity cost assumes that as the production of a certain good increases, the opportunity cost of producing an extra unit of the good also increases. h. Gains from Trade Gain from trade refers to net benefits to trading partners emanating from trading activities that allow for an increase in voluntary trading. i. Trade Triangle

10 INTERNATIONAL TRADE PROBLEM 2 10 Trade triangle is the region that represents the increase in consumer surplus and producer surplus resulting from increased trade liberalization. j. Offer Curve An offer curve represents the quantity of a commodity that a trading unit exports (offers) relative to each quantity that it imports.

11 INTERNATIONAL TRADE PROBLEM 2 11 References Euronews (2015, February 2). EU-US trade: Hopes and fears. Retrieved March 2, 2015, from