Adobe Systems International trade 1 International trade Ricardian model History •Merkantilism • •18th/19th century – classic theory (Smith, Ricardo, Mill) • •20th century – dynamic theory of comparative advantage (Heckscher, Ohlin, Samuelson and many more) • •Limitations of theories – turbulent and changing environment International trade 2 World trade development •From 1890 until WW1 – golden age of international trade • •Great depression (1929) – Smooth-Hawley tarrifs • •Reaction of other countries • •Dramatic fall in world trade in interwar period • •Large costs to the US and the world economy International trade 3 World trade development •After WW2 - second „golden age“ of trade • •post World War II era - the General Agreement on Tariffs and Trade (GATT, 1948) was an agreement that prompted regular negotiations among a growing body of members to reduce tariffs (import taxes) on imported goods on a reciprocal basis • •1995 WTO • •Regional free trade agreements International trade 4 Approach to International Trade •Active vs. passive approach to IT in a country economy (free trade x autarky) • •Support of export • •various national institutions (CzechTrade) • •laws, certificates, advisors, etc. • •media (Japan – competitions – best exporter) International trade 5 1,34 milions of snowboards imported to US International trade 6 snowboarding_1 Reasons for Trade •Technology differences • •Different amount of resources • •Different costs of outsourcing • •Proximity of countries International trade 7 Models of International Trade •The Ricardian model examines differences in the productivity of labor (due to differences in technology) between countries. •The Heckscher-Ohlin model examines differences in labor, labor skills, physical capital, land, or other factors of production between countries. International trade 8 Opportunity cost •The opportunity cost of producing something measures the cost of not being able to produce something else with the resources used •For example, a limited number of workers could produce either roses or computers • The opportunity cost of producing computers is the amount of roses not produced. The opportunity cost of producing roses is the amount of computers not produced. • International trade 9 Opportunity Cost - Example •Suppose that in the US 10 milion roses can be produced with the same resources as 100 000 computers. •Suppose that in Colombia 10 milion roses can be produced with the same resources as 30 000 computers. •What is the opportunity cost of roses and computer in both countries? International trade 10 Comparative Advantage A country has a comparative advantage in producing a good if the opportunity cost of producing that good is lower in the country than in other countries. Back to the case with roses and computers, which country has the comparative advantage? International trade 11 Suppose initially that Colombia produces computers (30 000) and the United States produces roses (10 milion), and that both countries want to consume computers and roses. Can both countries be made better off? Hypothetical Changes in Production – intuition behind Ricardian model tbl03_01.gif In the US 10 milion roses can be produced with the same resources as 100 000 computers. In Colombia 10 milion roses can be produced with the same resources as 30 000 computers. A One-Factor Ricardian Model Assumptions: 1.Labor is the only factor of production. 2.Labor productivity varies across countries due to differences in technology, but labor productivity in each country is constant. 3.The supply of labor in each country is constant. 4.Two goods: wine and cheese. 5.Competition allows workers to be paid a wage equal to the value of what they produce, and allows them to work in the industry that pays the highest wage. 6.Two countries: home and foreign. 1. A One-Factor Ricardian Model A unit labor requirement indicates the constant number of hours of labor required to produce one unit of output. aLC is the unit labor requirement for cheese in the home country aLW is the unit labor requirement for wine in the home country. A high unit labor requirement means low labor productivity. Výsledek obrázku pro lightbulb A One-Factor Ricardian Model Labor supply L indicates the total number of hours worked in the home country (a constant number). Cheese production QC indicates how many pounds of cheese are produced. Wine production QW indicates how many gallons of wine are produced. Production Possibilities The production possibility frontier (PPF) of an economy shows the maximum amount of a goods that can be produced for a fixed amount of resources. The production possibility frontier of the home economy is: aLCQC + aLWQW ≤ L What is the maximum home cheese production? What is the maximum home wine production? Výsledek obrázku pro question mark Production Possibilities - Example Suppose that the economy´s labor supply is 1000 hours. 1 hour of labor produces one pound of cheese. 2 hours of labor produce one gallon of wine. 1. What is the PPF equation? 2. What is maximum cheese production? 3. What is maximum wine production? Výsledek obrázku pro question mark Home’s Production Possibility Frontier fig03_01.gif Production Possibilities •The opportunity cost of cheese is how many gallons of wine Home must stop producing in order to make one more pound of cheese: aLC /aLW •This cost is constant because the unit labor requirements are both constant •The opportunity cost of cheese appears as the absolute value of the slope of the PPF QW = L/aLW – (aLC /aLW )QC Relative Prices, Wages, and Supply Let PC be the price of cheese and PW be the price of wine. Due to competition, •hourly wages of cheese makers equal the value of the cheese produced in an hour: PC /aLC •hourly wages of wine makers equal the value of the wine produced in an hour: PW /aLW Workers will choose to work in the industry that pays the higher wage. Výsledek obrázku pro lightbulb Example Suppose that cheese sells for $4/pound and wine for $7/gallon Wage paid in cheese industry? Wage paid in wine industry? What will workers do? International trade 22 Výsledek obrázku pro question mark Relative Prices, Wages, and Supply If the price of cheese relative to the price of wine exceeds the opportunity cost of producing cheese PC /PW > aLC /aLW , •then the wage in cheese will exceed the wage in wine wC =PC /aLC > PW /aLW =wW •so workers will make only cheese (the economy specializes in cheese production). • The relative price of cheese 4/7 exceeds the opportunity cost of cheese of ½ wC =4 > 3,5=wW International trade 24 What if the price of cheese drops to $3/pound? Výsledek obrázku pro question mark Production, Prices, and Wages •If the home country wants to consume both wine and cheese (in the absence of international trade), relative prices must adjust so that wages are equal in the wine and cheese industries. •If PC / aLC = PW / aLW workers will not care whether they work in the cheese industry or the wine industry, so that production of both goods can occur. •Production (and consumption) of both goods occurs when the relative price of a good equals the opportunity cost of producing that good: PC /PW = aLC /aLW Trade in the Ricardian Model If the home country is more efficient in wine and cheese production, then it has an absolute advantage in all production: its unit labor requirements for wine and cheese production are lower than those in the foreign country aLC < a*LC and aLW < a*LW where “*” notates foreign country variables. Trade in the Ricardian Model A country can be more efficient in producing both goods, but it will have a comparative advantage in only one good. Even if a country is the most (or least) efficient producer of all goods, it still can benefit from trade. Výsledek obrázku pro lightbulb Trade in the Ricardian Model •Before any trade occurs, the relative price of cheese to wine reflects the opportunity cost of cheese in terms of wine in each country. • •In the absence of any trade, the relative price of cheese to wine will be higher in Foreign than in Home if Foreign has the higher opportunity cost of cheese. • •It will be profitable to ship cheese from Home to Foreign (and wine from Foreign to Home) Gains from Trade •Consumption possibilities expand beyond the production possibility frontier when trade is allowed. • •With trade, consumption in each country is expanded because world production is expanded when each country specializes in producing the good in which it has a comparative advantage. International trade 29 Trade expands consumption possibilities in both countries fig03_04.gif International trade 30 Example What is the home country’s opportunity cost of producing cheese? Cheese Wine Home aLC = 1 hour/lb aLW = 2 hours/gallon Foreign a*LC = 6 hours/lb a*LW = 3 hours/gallon Unit labor requirements for home and foreign countries International trade 31 Výsledek obrázku pro question mark Example The home country is more efficient in both industries, but has a comparative advantage only in cheese production. 1/2 = aLC /aLW < a*LC /a*LW = 2 The foreign country is less efficient in both industries, but has a comparative advantage in wine production! International trade 32 Výsledek obrázku pro lightbulb Example •With trade, the equilibrium relative price of cheese to wine settles between the two opportunity costs of cheese. • •Suppose that the intersection of RS and RD occurs at PC /PW = 1 so one pound of cheese trades for one gallon of wine. • •Trade causes the relative price of cheese to rise in the home country and fall in foreign. International trade 33 Example •With trade, the foreign country can buy one pound of cheese for PC /PW = one gallon of wine, • •instead of stopping production of a*LC /a*LW = 2 gallons of wine to free up enough labor to produce one pound of cheese in the absence of trade. • •Suppose L* = 3,000. The foreign country can trade its 1,000 gallons maximum production of wine for 1,000 pounds of cheese, instead of the 500 pounds of cheese it could produce itself. International trade 34 Example •With trade, the home country can buy one gallon of wine for PW /PC = one pound of cheese, • •instead of stopping production of aLW /aLC = 2 pounds of cheese to free up enough labor to produce one gallon of wine in the absence of trade. • •The home country can trade its _____ pounds maximum production of cheese for _____ gallons of wine, instead of the ____ gallons of wine it could produce itself. International trade 35 Relative Wages •Relative wages are the wages of the home country relative to the wages in the foreign country. •Productivity (technological) differences determine relative wage differences across countries. •The home wage relative to the foreign wage will settle in between the ratio of how much better Home is at making cheese and how much better it is at making wine compared to Foreign. •Relative wages cause Home to have a cost advantage in only cheese and Foreign to have a cost advantage in only wine. International trade 36 Relative Wages Suppose that PC = $12/pound and PW = $12/gallon. •Since domestic workers specialize in cheese production after trade, their hourly wages will be PC/aLC = $12 /1= $12 •Since foreign workers specialize in wine production after trade, their hourly wages will be PW/a*LW = $12/3 = $4 •The relative wage of domestic workers is therefore $12/$4 = 3 International trade 37 Relative Wages •The relative wage lies between the ratio of the productivities in each industry. • •The home country is 6/1 = 6 times as productive in cheese production, but only 3/2 = 1.5 times as productive in wine production. • •The home country has a wage 3 times higher than the foreign country. International trade 38 Relative Wages •These relationships imply that both countries have a cost advantage in production. •High wages can be offset by high productivity. •Low productivity can be offset by low wages. • •In the home economy, producing one pound of cheese costs $12 (one worker paid $12/hr) but would have cost $24 (six paid $4/hr) in Foreign. • •In the foreign economy, producing one gallon of wine costs $12 (three workers paid $4/hr) but would have cost $24 (two paid $12/hr) in Home. International trade 39 Relative Wages Because foreign workers have a wage that is only 1/3 the wage of domestic workers, they are able to attain a cost advantage in wine production, despite low productivity. Because domestic workers have a productivity that is 6 times that of foreign workers in cheese production, they are able to attain a cost advantage in cheese production, despite high wages. International trade 40 Do wages really reflect productivity? Do relative wages reflect relative productivities of the two countries? Evidence shows that low wages are associated with low productivity. Other evidence shows that wages rise as productivity rises. International trade 41 figProd_wages.gif International trade 42 Everything clear? J International trade 43 Misconceptions about Comparative Advantage 1. 1.Free trade is beneficial only if a country is more productive than foreign countries. International trade 44 Misconceptions about Comparative Advantage 2. 2.Free trade with countries that pay low wages hurts high wage countries. 3. While trade may reduce wages for some workers, thereby affecting the distribution of income within a country, trade benefits consumers and other workers. Consumers benefit because they can purchase goods more cheaply. Producers/workers benefit by earning a higher income in the industries that use resources more efficiently, allowing them to earn higher prices and wages. International trade 45 Misconceptions about Comparative Advantage 3.Free trade exploits less productive countries whose workers make low wages. 4. While labor standards in some countries are less than exemplary compared to Western standards, they are so with or without trade. Are high wages and safe labor practices alternatives to trade? Deeper poverty and exploitation may result without export production. Consumers benefit from free trade by having access to cheaply (efficiently) produced goods. Producers/workers benefit from having higher profits/wages—higher compared to the alternative. International trade 46 Transportation Costs and Non-traded Goods The Ricardian model predicts that countries completely specialize in production. But this rarely happens for three main reasons: 1.More than one factor of production reduces the tendency of specialization 2.Protectionism 3.Transportation costs reduce or prevent trade, which may cause each country to produce the same good or service. Nontraded goods and services (e.g. haircuts and auto repairs) exist due to high transport costs. 1. International trade 47 Empirical Evidence Do countries export those goods in which their productivity is relatively high? International trade 48 fig03_06.gif Empirical Evidence A very poor country like Bangladesh can have comparative advantage in clothing despite being less productive in clothing than other countries such as China because it is even less productive compared to China in other sectors. International trade 49 tbl03_03.gif Key points The main implications of the Ricardian model are well supported by empirical evidence: productivity differences play an important role in international trade comparative advantage (not absolute advantage) matters for trade International trade 50 Výsledek obrázku pro lightbulb Questions? International trade 51