ECON5335 - International Economics

Chapter 4

Trade Flows in Theory

Trade models- usually question being asked: “why do we

trade what we trade?”- 3 very simple theoretical models- autarky initial position- permit trade to occur- other question asked is “who do we trade

with?”- empirical model based on econometrics

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Only two goodsMeatPotatoes

Only two peopleRancherFarmer

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If rancher (R) produces only meatand farmer (F) produces only potatoesthen both have potential to gain from trade

If both R and F produce both meat and potatoesBoth can potentially gain from specialization and trade

Production possibilities frontier (PPF) Various mixes of output that economy can produce if all resources used to capacity

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5

The Production Possibilities Frontier (a)

Panel (a) shows the production opportunities available to the farmer and the rancher.

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Panel (b) shows the combinations of meat and potatoes that the farmer can produce. Panel (c) shows the combinations of meat and potatoes that the rancher can produce. Both production possibilities frontiers are derived assuming that the farmer and rancher each work 8 hours per day. If there is no trade, each person’s production possibilities frontier is also his or her consumption possibilities frontier.

(b) The farmer’s production possibilities frontier

(c) The rancher’s production possibilities frontier

Meat (oz)

0

4

8

Potatoes (oz)

16 32

A

If there is no trade, the farmer chooses this production and consumption.

Meat (oz)

0

12

24

Potatoes (oz)24 48

B

If there is no trade, the rancher chooses this production and consumption.

Specialization and tradeFarmer – specialize in growing potatoes

More time growing potatoes Less time raising cattle

Rancher – specialize in raising cattleMore time raising cattle Less time growing potatoes

Trade: 5 oz of meat for 15 oz of potatoesBoth gain from specialization and trade

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8

The proposed trade between the farmer and the rancher offers each of them a combination of meat and potatoes that would be impossible in the absence of trade. In panel (a), the farmer gets to consume at point A* rather than point A. In panel (b), the rancher gets to consume at point B* rather than point B. Trade allows each to consume more meat and more potatoes.

(a) The farmer’s production and consumption

(b) The rancher’s production and consumption

Meat (oz)

0

4

8

Potatoes (oz)

16 32

A

Farmer's production and consumption without trade

Meat (oz)

0

12

24

Potatoes (oz)

24 48

B

Rancher’s production and consumption without trade

Farmer's production with trade

5

17

A*

Farmer's consumption with trade 13

18

12 27

B* Rancher’s consumption with trade

Rancher’s production with trade

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The proposed trade between the farmer and the rancher offers each of them a combination of meat and potatoes that would be impossible in the absence of trade. In panel (a), the farmer gets to consume at point A* rather than point A. In panel (b), the rancher gets to consume at point B* rather than point B. Trade allows each to consume more meat and more potatoes.

Absolute advantageProduce a good using fewer inputs than another producer

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The Opportunity Cost of Meat and Potatoes

Opportunity cost• Whatever must be given up to obtain some item• What you give up to get something else• Measures the trade-off between the two goods that each

producer faces

Comparative advantageProduce a good at a lower opportunity cost than another producerReflects the relative opportunity cost

Principle of comparative advantageEach good - produced by the individual that has the smaller opportunity cost of producing that goodDeveloped by David Ricardo

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One personCan have absolute advantage in both goodsBy definition, cannot have comparative advantage in both goods

For different opportunity costsOne person - comparative advantage in one goodThe other person - comparative advantage in the other good

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Gains from specialization and tradeBased on comparative advantageTotal production in economy rises

Increase in the size of the economic pieEveryone – better off

Can apply to individuals, firms, and countries

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Trade can benefit everyone in societyAllows people to specialize

The price of tradeMust lie between the two opportunity costs

Principle of comparative advantage explains:Interdependence – reliance on other individuals, firms or countriesGains from trade – applies to individuals, firms and countries

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Should the U.S. trade with other countries?U.S and Japan

Each produces food and carsOne American worker, one month

One car, orTwo tons of food

One Japanese worker, one month One carOne ton of food

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Principle of comparative advantageEach good – produced by the country with the smaller opportunity cost of producing that good

Specialization and tradeAll countries have more food and more cars

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In theoryClear that there are gains from specialization and trade that arise from differences in productivity of labor and capital in each sectorSo in Ricardian model if we assume labor is the only factor of production then labor productivity would drive comparative advantage and determine who trades what

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Total units of meat production

Labor required for each unit of food production = productivity

Total units of food production

Labor required for each unit of meat production

Total amount of labor resourcesaLFQF + aLMQM = L

If the domestic country wants to consume both meat and food (in autarky), relative prices must adjust so that wages are equal in the wine and cheese industries.

If PF /aLF = PM /aLM workers will have no incentive to flock to either the food or the meat industry, thereby maintaining a positive amount of production of both goods.

PF /PM = aLF /aLM

Production (and consumption) of both goods occurs when relative price of a good equals the opportunity cost of producing that good.

Suppose that the domestic country has a comparative advantage in food production: its opportunity cost of producing cheese is lower than it is in the foreign country.

aLF /aLM < a*LF /a*

LM

where “*” notates foreign country variables

Note here that this is the relative productivity which therefore determines comparative advantage

Heckscher Ohlin Model (1919)Problem with Ricardian model was that it only had one factor of productionSo here a 2 good, 2 FoP modelDifferent rule emerges for comparative advantage

Krugman economies of scale modelDifferentiated productsEconomies of scaleDifferent results for comparative advantage

Look at abundance of FoP or resourcesCountry with relatively abundant amount of FoP will export good or service which is intensive in that factorTherefore comparative advantage is in the relative abundance of the FoPK/L ratio indicates factor abundanceIf US has K/L = 0.5 and China has K/L = 0.02 then US has relatively more K and China relatively more L

So China should export good which uses L intensively, and US should export good which uses K intensivelySo price of K rises in US and price of L fallsOpposite happens in China: price of L rises and price of K fallsBut before in autarky L was paid much less in China than in the US as so much L in China.Implication is that there is convergence in factor prices across countries – known as “factor price equalization”

In Ricardian model no distributional consequences – here they are possibleIf US exports more K intensive goods, then income earned by K goes up (conversely income earned by L goes down)Vice versa for ChinaTherefore owners of K in US better off compared with L and v-v for ChinaKnown as the “Stolper Samuelson Theory”

Need to test H-O theory to see if it is trueWassily Leontief collected data for US and if H-O correct US exports should have higher K/L ratio than imports(1947) Results: US X = $14K/L

US M = $18K/LWas H-O wrong? Leontief called it a “paradox”.Resolution came from widening defn of K

By looking at average years of education (“human capital”) Baldwin found that greater factor intensity in exports.

Paul Krugman developed a model of trade with differentiated products. Why?Here by trading we can expand our market and lower our costsBut depends on the size and type of economies of scaleEconomies of scale – internal? Economies of scale – external?Linder’s theory of overlapping demands

Paul Krugman developed a model of trade with differentiated products. Why?Here by trading we can expand our market and lower our costsBut depends on the size and type of economies of scaleEconomies of scale – internal? Economies of scale – external?Linder’s theory of overlapping demands

Given trade begins between 2 countries with similar industriesWe would expect

Total # of firms to fallPrice to fall as costs fallVariety in each country to increaseAverage size of firms to increase

Ricardian and H-O models explain “inter-industry” tradeKrugman explains “intra-industry” trade

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3 of the top 10 trading partners with the US in 2011 were also the 3 largest European economies: Germany, UK and France.

These countries have the largest gross domestic product (GDP) in Europe.

Why does the US trade most with these European countries and not other European countries?

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In fact, the size of an economy is directly related to the volume of imports and exports.

Larger economies produce more goods and services, so they have more to sell in the export market.

Larger economies generate more income from the goods and services sold, so people are able to buy more imports.

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Other things besides size matter for trade:

1. Distance between markets influences transportation costs and therefore the cost of imports and exports.

Distance may also influence personal contact and communication, which may influence trade.

2. Cultural affinity: if two countries have cultural ties, it is likely that they also have strong economic ties.

3. Geography: ocean harbors and a lack of mountain barriers make transportation and trade easier.

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4. Multinational corporations: corporations spread across different nations import and export many goods between their divisions.

5. Borders: crossing borders involves formalities that take time and perhaps monetary costs like tariffs.

These implicit and explicit costs reduce trade. The existence of borders may also indicate the existence of different languages (see 2) or different currencies, either of which may impede trade more.

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In its basic form, the gravity model assumes that only size and distance are important for trade in the following way:

Tij = A * (Yi * Yj)/Dij

where Tij is the value of trade between country i and country jA is a constantYi the GDP of country iYj is the GDP of country jDij is the distance between country i and country j

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In a slightly more general form, the gravity model that is commonly estimated is

Tij = A x Yia x Yj

b /Dijc

where a, b, and c are allowed to differ from 1.

Perhaps surprisingly, the gravity model works fairly well in predicting actual trade flows, as the figure above representing US–EU trade flows suggested.

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Estimates of the effect of distance from the gravity model predict that a 1% increase in the distance between countries is associated with a decrease in the volume of trade of 0.7% to 1%.

Besides distance, borders increase the cost and time needed to trade.

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Trade agreements between countries are intended to reduce the formalities and tariffs needed to cross borders, and therefore to increase trade.

The gravity model can assess the effect of trade agreements on trade: does a trade agreement lead to significantly more trade among its partners than one would otherwise predict given their GDPs and distances from one another?

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The US has signed a free trade agreement with Mexico and Canada in 1994, the North American Free Trade Agreement (NAFTA).

Because of NAFTA and because Mexico and Canada are close to the US, the amount of trade between the US and its northern and southern neighbors as a fraction of GDP is larger than between the US and European countries.

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Yet even with a free trade agreement between the US and Canada, which use a common language, the border between these countries still seems to be associated with a reduction in trade.So Canadian provinces trade more with each other, than with US states, ceteris paribus

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Shows that still more likely to trade if no bordersBut also shows that size and geography also matterGravity model tested extensively in economics literatureShows that US’s natural trade partner is Canada and to a lesser extent Mexico