1. Basic concepts: absolute advantage; EC2004: International Trade Revision Topics. comparative advantage (CA); opportunity cost (OC); economies of scale (EOS); factor intensity; factor abundance. 2. Basic tools of analysis: PPF; IBC; CIC. 3. Main sources of gains from trade: gains from specialisation : under CA under EOS; gains from exchange : under CA under EOS; reduction in monopoly power (if applicable). 4. Classical theory: Labour is the only input. The marginal product of labour is constant constant OCs. Constant OCs are reflected in a linear PPF.
CA is based on the relative productivity of labour a country has lower OC for producing a good if its workers are relatively better at producing that good than the other good. Countries gain from trading with each other if their PPFs have different slopes (different OCs). Each country exports the good for which its OC is lower. Trade leads to complete specialisation. Empirical evidence. Read Topic 2 and Salvatore, ch. question 1 on Class Exercise 1. 5. Standard theory: Several inputs. 2 (skim 2.2 and 2.3); solve Diminishing marginal productivity increasing OCs. Increasing OCs are reflected in a concave (bowed out) PPF. The concept of community indifference curves (CIC) is introduced. Related concepts to PPF and CIC MRT and MRS. Autarky equilibrium tangency of CIC with PPF. Slope of common tangent equals relative price. Trade equilibrium IBC reflects consumption possibilities; tangency of CIC with IBC. Gains from trade: movement along IBC for given production point (gains from exchange). movement of production point along PPF (gains from specialisation). Note that complete specialisation might not take place. Both types of gains are created by a difference in relative prices resulting from autarky as compared to trade. With only two countries, CA will arise if the relative prices under autarky differ between the two.
When the two countries open to trade, the resulting equilibrium price will lie between the two autarky prices. The use of offer curves to analyse the 2-country equilibrium. Read Topics 3 and 4 and Salvatore, chs. 3 and 4. You can skip the partial equilibrium analysis until you get to the topic of trade interventions. Aim to be able to answer a question like question 1 on Class Exercise 2. 6. The Heckscher-Ohlin model: Can be thought of as a particular example of the standard theory. CA is based on relative endowments of two factors, e.g. labour and capital. Because of diminishing marginal productivity in each factor and differences in capital-labour intensity in each good, OCs increase with the output of a good. This is reflected in a concave PPF. Differences in the exact shape of each country s PPF reflect differences in relative factor endowments, not differences in technology. H-O theorem: each country exports the good which uses its relatively abundant factor more intensively. Trade benefits the country as a whole but affects income distribution (in what way?). Under certain assumptions (what are these and why are they important?), trade leads to equalisation of factor prices (the FPE theorem). Other results of Heckscher-Ohlin theory include Stolper-Samuelson theorem Rybczynski theorem (what are they and how do they fit into the big picture?) Read Topic 5 and Salvatore, chs. 5 (skip 5.5D), 7.2B and 8.4C. 7. Trade interventions: Trade increases a country s welfare, although some groups within the country lose out.
The most efficient way to compensate the losers is to tax the winners and distribute the proceeds to the losers. But in practise the losers put pressure on the government to restrict trade. Restriction of trade is carried out through tariffs and quotas (also VERs). Tariffs on an import competing good: raise its price in the domestic market; increase domestic production; reduce domestic consumption; reduce imports from both directions; increase government revenues. Welfare effects: loss of consumer surplus; gain in producer surplus; gain in government revenue; deadweight loss = consumption loss triangle + production loss triangle (what are these?) When a country is large, a tariff (or quota) can lower the price of its imports. This leads to smaller deadweight losses and also a beneficial terms-of-trade effect which can offset, partially or completely, the efficiency losses associated with the use of these trade instruments. But with two large countries, each has a temptation to impose a tariff. If one imposes, the other has a strong incentive to retaliate. in the end both lose out. A quota directly restricts the amount of a good that can be imported. It has similar effects as a tariff (except in one respect what is this?), except if the industry is imperfectly competitive.
Read Topic 6, (skip ERP) and remainder of Topic 4 and Salvatore, chs. 4.2, 8, 9.2-9.4. 8. Customs unions: Trade creation example: the price falls by the full amount of reduction in tariff increase in domestic consumption decrease in domestic production increase in imports unambiguous gain in welfare (analyse this). Trade diversion example: the price falls by less than the tariff reduction (why?) the price paid by importers actually goes up; the other effects are also qualitatively similar but quantitatively smaller the overall welfare change is ambiguous (analyse this). What factors affect the balance of welfare effects in the trade diversion example? What rationales might justify customs unions even if they lead to trade diversion? Read Topic 7, Salvatore, ch. 10 and K. Pilbeam notes. 9. Economies of scale (EOS) and imperfect competition: EOS can be internal or external. When internal they usually lead to an industry becoming dominated by a few large firms. Under EOS, OCs of production are decreasing. This can lead to a bowed-in PPF. Trade can take place between two countries which are identical in all respects. Not possible when trade is based on CA. Trade is driven by the reduction in OCs as each country specialises in one good.
The pattern of specialisation is indeterminate, unlike the case of CA based trade. Trade has two effects on welfare: (i) reduction in the OCs of production, (ii) changes in the relative prices faced by consumers (compared with autarky). The first effect benefits each country, the second could (in some cases) hurt one country. This again is not possible when trade is based on CA. The overall effect of trade depends on the balance of (i) and (ii). When EOS are based on industry-level externalities, a country might end up being worse off if it allows free trade. A temporary restriction on trade could make the country better off. This is the crux of the infant industry argument. Read Topic 8 (skip the discussion of monopoly) and Salvatore, ch. 6.1-6.3. 10. Topics not directly on the exam: ERP Monopoly Political economy.