Brian David ButlerMiami Campus FacilitatorInternational Economics & Trade (Prof. Grosse)

Email: bdbutler@global.t-bird.eduhome: 305-396-6116

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Session #5

Trade class objectives:• Theories:

– Who trades with whom…and why?– Purpose of theories?

• Policy decisions• Strategy decisions for countries

• Practical application for real business: – Learn theories

• (but don’t base short term import/export theories on them)

– buy cheap sell expensive.

Theories

• Gravity model – mass + distance

Trade: what benefits?

1. Greater diversity of products 2. Economies of scale

– bigger market, drives costs down)– Greater efficiency in large plants (autos, example)– Advantage to specialize in fewer products, and trade– Don’t need factory in each country…less cost…

3. Competition = innovation– Kills off lazy & stupid

4. Avoid inefficient costs of protectionism– Tariffs, quotas, export subsidies, etc…

Trade: why controversial?

1. Local industry harmed?– Unfair competition /imperfect competition– Dumping– State enterprise vs. private enterprise

2. Unfair Income distribution– Convergence of relative prices…leads to effects on

relative earnings of land & labor…leads to …– Trade tend to make low skilled workers in the US worse

off, while making high-skilled workers better off.

Anti-trade movement:

– Special interests• Pain is localized, benefit is generalized• Motivation of few vs. many• Protect income of certain interest groups

– Political process• Buy votes with protectionism

For initial discussion…

1. “free trade is mutually beneficial for all countries” i.e. both countries are better off

2. “the freer the trade, the more both countries benefit”

– Agree? disagree? Limitations?

• Insight:– “Trade between two countries can benefit

BOTH countries if each country exports the goods in which it has a comparative advantage”

– If you learn one economic principle in this class, it should be this one!

Trade: Comparative Advantage:

History:

– Adam Smith (1776) – Absolute cost advantage Theory

– England absolute = Machinery– France absolute = Wine– Should each specialize + Trade …obvious!

Trade: Absolute Advantage:

History:

– David Ricardo (1817) – Relative cost advantage

But, this time… Portugal is Absolute in BOTH

– Trade …not obvious!

Trade: Comparative Advantage:

Portugal has 120/80 = 1.5x advantage in winePortugal has 100/90 = 1.1x advantage in cloth

….so, they have a comparative better advantage in wine

Trade recommendation: specialize + trade for cloth

Comparative Advantage cont’d:

Comparative Advantage Example:

Appliances Bananas USA 200* 100Honduras 60 80

*Max # units per year:

Note: US absolute better at both

example:

A B USA 200 100Honduras 60 80

Relative: 200/60 100/80 advantage USA: = 3.33x = 1.25x

333% more efficient

Note: USA has BIGGER advantage in appliances

Question:

• Will both countries really be better off if each specializes in “comparative advantage” and if they engage in free trade?

• If so, by how much?

With no trade:

Production if both countries specialize + tradeA B

USA 200 0Honduras 0 80 total = 200 + 80 = 280

Production / consumption with NO tradeA B

USA 120 40Honduras 40 30 total = 160 + 70 = 230

How much SHOULD they trade?

• Need to trade enough to meet minimum consumption desires of both countries.

• All extra = surplus• So, if the US makes 200 (A), and Honduras

wants 40, then 40 = min export…can keep 160…which is more than could be kept without trade

• Benefit from trade! (more goods overall)

example:

1. The numbers in the table refer to the number of airplanes, and millions of bushels with complete specialization.

2. Which country has:• Absolute advantage?• Comparative advantage?

Airplanes applesFrance 18 241USA 12 198

example:

Comparative: =18/12 = 241/198= 1.5 =

1.22

• Absolute advantage? France in both• Comparative? France has comparative

advantage in Airplanes, USA in apples

Airplanes applesFrance 18 241USA 12 198

• What exchange rates will produce 2way trade, assuming these prices:

Airplanes applesFrance* price € 100m €7.47USA* price $90 m $5.4

USD / Euro = $90 / 100 =7.47/5.45

Trade range= US$ 0.90 < x < US$0.73• If USD weaken to $1 / euro…it would limit

French airplane exports to USA. • If USD strengthens to $0.5 /euro…it would limit

US exports of apples

Barriers to gains?

• Limitations on comparative advantage:– Trade barriers (tariffs, quotas, etc)– Limits on labor mobility, – Limits on ability to shift production from one

industry to other…

Comparative vs. Absolute?

Heckscher-Ohlin Theory: -Takes what Ricardo did-But adds….factor product proportions

-Land, resources, minerals, etc…

Trade: definitions

• Import tariff: taxes levied on imports…raises the price of imported goods inside country vs price outside

• Export subsidy: payments given to domestic producers who sell abroad…incentive to export…effect is to raise prices at home

• Terms of trade: relative prices of a country's exports to imports

Trade: Comparative Advantage:

– “undeniably true yet not obvious to intelligent people” Samuelson

– Opportunity costs= trade off• Ex: opportunity cost of roses in terms of computers• Ex: 10 million roses (resources to grow) = 100,000

computers• So, opportunity cost of 10 mm roses = 100k computers• But, other country might have different ratio…

– 10 mm roses = just 30 k computers– So, other country should grow roses!– Each specialize, Import + increase world production!