International Trade. Notes: trade theory. introduction

Transcription

1 International Trade trade theory introduction Size of the trade sector varies among nations. Some nations trade a great deal of their GDP to other countries. Other nations trade a relatively small fraction of their output. Mere size of trade may underestimate the importance of international trade. Nations that trade a relatively small fraction may find the cessation of trade to be very harmful. It might increase the importing nation's cost greatly if it had to produce the imported good at home. If international trade was to stop our lifestyle would change drastically because we import many minerals we simply do not have in the continental U.S. basic notion of international trade -- each nation should specialize in that which they do relatively well. Then the results of this specialization should be traded among nations. For example: Brazil -- coffee Japan -- manufacturing an illustration An illustration of the basic notion of comparative advantage: When was in seminary I was able to meet and befriend Dean Moore -- a missionary with Wycliffe to Papua New Guinea. Dean was a brilliant linguist. He had spent years developing a written language with a tribe in New Guinea and translating from Hebrew and Greek into the written language he had codified from the spoken dialect. He was very proficient with Greek. In order to finance his time at the seminary Dean worked as a roofer. While I never had the opportunity to work with Dean, I'm certain he was a very hard worker and an excellent roofer. While we lived in Lynchburg we built a house on a street called Acres Court. We built the house in the winter (the winter of 1990 had a snowy spell in late February) and closed and moved in before the contractors had finished the house. One day I came home from work and saw a couple of guys were on the roof doing some work. I did not think much about it, and went into the house to change my clothes. After a few minutes I heard the workers beating and

2 banging on a roof that did not leak and as far as I knew was in good shape. I stepped out on the from porch and yelled up to the guys on the roof and asked them what they were up to. A young man stuck his head over the side of the roof and said "I'm roofin'"! His hair was long enough to hang down over his forehead in menacing fashion. His forehead itself was elongated (at least from my vantage point) and his other features were bizarre enough for me to immediately be struck with the notion that I'd discovered the missing link (or at least a near relative). Since that time I've affectionately referred to the worker as "Neanderthal Roofer". Lets say Neanderthal has an urge to translate the New Testament from the "original tongues". While not an impossible task, he would need to learn basic English grammar before he attempted Greek grammar. While one can never be certain, I'm going to assume he would not be as efficient as Dean at Scripture translation. Furthermore, I think it is reasonable to assume that if Neanderthal and Dean were on the same roofing crew, Neanderthal would work for Dean. Dean is a better roofer than Neanderthal. That is, Dean is superior at both roofing and translation. He is better at both occupations. He can roof more squares per hour and translate more words per minute than Neanderthal. Dean has an absolute advantage over Neanderthal. Some would argue that Dean should shun Neanderthal and ignore his existence. However, if Dean and Neanderthal work together they can produce and consume more roofing and translation than if each worked independently and did not communicate and trade. This is because the amount of roofing that Dean gives up per word translated is very small compared to Neanderthal. We might loose half the roofs in Dayton if we had to wait for Neanderthal to translate his first sentence from Greek. Neanderthal's opportunity cost of translation is very high (much higher than Dean's). If one looks at the flip side, the quantity of Scripture translation Dean gives up per square of roof completed is much higher than what Neanderthal sacrifices. Dean has a comparative advantage in Scripture translation and Neanderthal has a comparative advantage in roofing. Both Dean and Neanderthal can be made better off if Dean focuses (specializes) on translation and Neanderthal focuses on roofing and they trade the results of their specialization with one another. comparative advantage absolute advantage -- a nation can produce a product with fewer resources than another nation

3 Trade does not depend on absolute advantage (as theorized by Adam Smith), but rather on comparative advantage (Smith's notion was extended by David Ricardo). principal of comparative advantage -- a principle that states that nations can gain by specialization in the production of goods that they produce relatively cheaply and exchange for goods which other nations produce relatively cheaply; produce at lower opportunity cost The following is a 2 X 2 (two products, two countries) model, but the idea generalizes to much larger and more realistic examples. The following table is based on productivity. US JAPAN (units of output per worker per day) Food 2 4 Clothing 1 6 The Japanese have an absolute advantage at producing both food and clothing -- they are more productive, more efficient at both products. Assume the US has a work force that is 4 times larger than that of Japan, US million people Japan million people therefore we may determine each country's production possibilities frontiers (PPFs). Assume that resources are perfectly substitutable between food and clothing therefore the law of increasing costs does not apply. Constant costs implies the PPFs are straight lines. This assumption is made to make it easier to draw the PPFs -- they are linear, not curvilinear -- it does not effect the outcome of the illustration. To determine the PPFs multiply the size of the labor force in each nation by the productivity data to find the intercepts of the PPFs. If one multiples number of people by output per person per day, the result is output per day.

4 If all workers in the United States specialized in clothes production, the U.S. could produce 30 million units. If all workers in the United States specialized in food production, the U.S. could produce 60 million units. If all workers in the Japan specialized in clothes production, Japan could produce 45 million units. If all workers in the Japan specialized in food production, Japan could produce 30 million units. The slopes of the PPFs reveal opportunity costs in both the United States and Japan. The slope of the U.S.'s PPF is 1/2. This means that : In order to produce 1 unit of clothing the U.S. must give up 2 units of food. In order to produce 1 unit of food the U.S. must give up 1/2 of a unit of clothing. In the United States, clothing has a higher opportunity cost in terms of the other good produced. The slope of Japan's PPF is 3/2. This means that: In order to produce 1 unit of clothing Japan must give 2/3 of a unit of food. In order to produce 1 unit of food Japan must give 1 and 1/2 units of clothing. In Japan, food has a higher opportunity cost in terms of the other good produced.

5 Because opportunity costs between the two nations differs trade will lead to mutual gain. U.S. has the lowest opportunity cost for producing food: must give up 1/2 a unit of clothing Japan has the lowest opportunity cost for producing clothing: must give up 2/3 a unit of food Therefore the United States should specialize in food and trade to Japan for clothing and Japan should specialize in clothing and trade to the U.S. for food. terms of trade -- the number of units of one good that exchange in the market for one unit of some other good, a relative price If the two nations can trade at a ratio greater than: 1F = 1/2 C -- U.S. opportunity cost of food but less than: 1F = 1.5C -- Japan's opportunity cost of clothing both countries can gain! Suppose the two countries agree to trade at a ratio: 1F = 1C -- worldwide post trade opportunity costs Because the nations are linked through free trade, opportunity costs are normalized (made the same) worldwide. Each country can take advantage of the lower opportunity cost in the other nation. The countries are no long competing with one another, they are now cooperating through trade. Because of the enhanced production opportunities that arise from utilization of trading partner's production strengths, nations are released from their production constraints. consumption possibilities frontier (CPF) -- all the possible combinations of two goods that could be consumed by first specializing according to comparative advantage and then trading at the terms of trade CPFs are determined by the terms of trade because the terms of trade reflect the normalized worldwide opportunity costs.

6 The slopes of the CPFs are determined by the terms of trade and are hence identical between the two nations. The United States' CPF can be thought of as what is available to the United States if complete specialization occurs. The U. S. can produce 60 million units of food. The U.S. could trade each of those units of food to Japan for 1 unit of clothing and end up with 60 million units of clothing. Therefore the United states can consume at any point along the new CPF. The U.S. is better off because it can consume more of both goods. The Japanese CPF can be thought of as what is available to Japan if complete specialization occurs. Japan can produce 45 million units of clothing. Japan could trade each of those units of food to the United States for 1 unit of food and end up with 45 million units of food. Therefore, Japan can consume at any point along the new CPF. Japan is better off because it can consume more of both goods. Assume the two nations, initially (autarky -- isolation, no trade) produce and consume at pts. US1 and J1 respectively. The production and consumption points can be determined, but the analysis is beyond the scope of the course.

7 After entering into a free trade relationship with each other, Japan and the United States can consume at the points J2 and US2. US specializing in food produces 60 units and trades 25 units to Japan for 25 units clothing and hence now US2 (35F, 25C) Japan specializing in clothing produces 45 units of clothing and trades 25 of these to the US for 25 units food and hence now J2 (25F, 20C) Specialization and trade leads to an increase in joint output and consumption. Both nations are better off!

8 Autarky Free Trade Food Clothing import-export link Foreign nations trade so they may obtain foreign currency to purchase goods produced in the foreign nation. Therefore the exports and imports of a nation are tightly linked. Nations must export goods in order to obtain foreign currency to import goods. If a nation does not import goods foreigners will have no currency to buy the nation's exports. producer benefits from exports In this situation, where the domestic nation has a comparative advantage in production of the commodity (this is shown by production at a lower price than world competitors) with trade domestic consumers pay a higher price. The world price (Pw) is greater than the national price (Pn) means local consumers will purchase less and will suffer a loss in consumer surplus equal to the area PwacPn. Local consumers lose this because they must pay a higher price for a smaller quantity. Prior to trade domestic consumers consumed amount Qn at a price of Pn. After trade they consume Q1 at a price of Pw. The quantity Q2 - Q1 is exported by local producers. Importation is unambiguously bad for consumers But producers receive a higher price and sell a larger quantity. Because the world price (Pw) is higher than the national price ( Pn)

9 there is a gain to producers equal to PwbcPn. They sell a larger quantity and receive a higher price. Local producers sell an amount Q2 (they export Q2 - Q1) at the higher world price (Pw). There is a net gain to society equal to : PwbcPn - PwacPn = abc In the long run consumers gain as import competitive industries prices fall. Even if a nation imported no products from foreign nations, the country as a whole would gain. Free trade is beneficial to a country. consumer benefits from imports In this situation, where the domestic nation is at comparative disadvantage in production of the commodity (this is shown by production at a higher price than world competitors) with trade domestic consumers pay a lower price. The world price (Pw) is smaller than the national price (Pn) means local consumers will purchase more and will gain consumer surplus equal to the area PnabPw. Local consumers gain this because they are able to pay a lower price for a larger quantity. Prior to trade domestic consumers consumed amount Qn at a price of Pn. After trade they consume Q2 at a price of Pw. The quantity Q2 - Q1 is imported into the local economy. Importation is unambiguously good for consumers But producers receive a lower price and sell a smaller quantity. Because the world price (Pw) is lower than the national price (Pn) there is a loss to producers equal to PnacPw. They sell a smaller

10 quantity and receive a lower price. They are no longer protected by global competition. Local producers sell an amount Q1 at the lower world price (Pw). There is a net gain to society equal to : PnabPw - PnacPw = abc Even if a nation exported no products to foreign nations, the country as a whole would gain. Free trade is beneficial to a country. trade restrictions commercial policy -- government policy toward international trade Despite the benefits from free trade most nations impose restrictions to free trade. tariff tariff -- a tax levied on goods imported into a country Also, foreign demand for our exports drops as trading partners are deprived of foreign exchange. Therefore we produce less in areas where we have a comparative advantage and more in areas where we are relatively inefficient.

11 import quota another form of a trade restriction is: import quota -- a specific quantity of a good permitted to be imported into a country in a given year A quota may be worse than a tariff because there is no market reaction whatsoever. Approximately 2% of our aggregate output is lost to tariffs and quotas annually. arguments for trade restrictions 1. national defense -- the product is necessary for national defense 2. industrial diversity -- protection encourages diversity; U.S. is already diversified 3. infant industry -- must protect our young industries, they cannot compete in the hard cruel world; tariffs are hard to remove once industry has "matured" 4. anti-dumping dumping -- sale of a good by a foreign supplier in another country at a price (therefore below cost) lower than the supplier sellers at the home market Dumping may lead to monopolization of an industry, if it does not then dumping is not bad for the economy. trade barriers and jobs Trade restrictions represent potential political gain for politicians. Those harmed by a protectionist policy will bear a relatively small and difficult to identify cost. The cost of commodities imported will increase with a tariff. consumers may not even be aware of what part of the price they are paying is due to trade restrictions. Many people end up paying a little bit to account for the increase in costs. Special interest groups will be very aware of what is happening in their industry -- benefits of protection will be very visible and relatively large for each individual compared with costs to consumers. A representative democracy will produce trade restrictions even when the tariff or quota hurts the economy as a whole.

12 the world trade organization The World Trade Organization's web site is very informative. The World Trade Organization (WTO) is the only international organization dealing with the global rules of trade between nations. Its main function is to ensure that trade flows as smoothly, predictably and freely as possible. The World Trade Organization came into being in One of the youngest of the international organizations, the WTO is the successor to the General Agreement on Tariffs and Trade (GATT) established in the wake of the Second World War. Over three quarters of WTO members are developing or least developed countries. Special provisions for these members are included in all the WTO agreements.