Trade Theories 1 3

7/26/2019 Trade Theories 1 3

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Trade Theories:

#1 - Mercantilism


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Defning mercantilism

Mercantilism

The theory that a countryshould accumulate fnancialwealth by amassing as many

inows o currency as possible


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Mercantilism: 16th late

18th

century nation!s wealth depends on

accumulatedtreasure "old and siler are the currency o trade

Two means o increasing a country!swealth are colonialism andinternational trade$


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Mercantilism

system o goernment institutions andpolicies designed to restrict internationaltrade

Ma%imi&e exportsthrough subsidies.

Minimi&e imports through taris anduotas

The theory thereforesays that a countryshould always hae a trade surplus$


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Mercantilism: !olicies

'orbidding colonies to trade with othernations

Monopoli&ing mar(ets with staple ports*

'orbidding trade to be carried in oreignships*

Ma%imi&ing the use o domestic resources*

lso restricting domestic consumptionwith non-tari+ barriers to trade$


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Mercantilism , -point plan

That eery inch o a country.s soil be utili&ed or agriculture/mining or manuacturing$

That all raw materials ound in a country be used in domesticmanuacture/ since fnished goods hae a higher alue than rawmaterials$

That a large/ wor(ing population be encouraged$

That all e%port o gold and siler be prohibited and all domesticmoney be (ept in circulation$

That all imports o oreign goods be discouraged as much aspossible$

That where certain imports are indispensable they be obtained atfrst hand/ in e%change or other domestic goods instead o gold

and siler$ That as much as possible/ imports be confned to raw materialsthat can be fnished 0in the home country$

That opportunities be constantly sought or selling a country.ssurplus manuactures to oreigners/ so ar as necessary/ or goldand siler$

That no importation be allowed i such goods are su2ciently and

suitably supplied at home$


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Mercantilism: "la#s

impaired economic growth

3gnores liing standards

3gnores human deelopment


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Trade Theories:

#4 - bsolute

dantage


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dam 5mith and thettac( on Mercantilism and 6conomic

7ationalism

In 1776, Adam Smith published the first modern statement ofeconomic theory,An Inquiry into the Nature and Causes of theWealth of Nations

The Wealth of Nationsattacked mercantilismthe systemof which dominated economic thought in the 1700s

mith pro!ed wrong the belief that trade was a zero sum

gamethat the gain of one nation from trade was the lossof another

"n the other hand# $oluntary e%change &trade' is apositive sum game both nations can gain


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$heory o% absolute

ad&antage dam 5mith ideas based on8

The capability o one country toproduce more o a product with thesame amount o input than anothercountry

(same thing)The ability o a countryto produce a good using ewerresourcesthan another country 9loweropportunity cost


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$heory o% absolute

ad&antage dam 5mith argued:

country should produceonly goodswhere it is most e2cient 8$ and tradeor those goods where it is note2cient

Trade between countries is/ thereore/benefcial


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$heory o% absolute

ad&antage 8 destroys the mercantilist ideasince there are gains to be had by

bothcountries party to an e%change

8 ;uestions the ob


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=onsider this simple e%ample inoling the6> and 3ndia

?nly two products are produced/ machines

and cloth 'abor is f%ed/ homogeneous within a country/

the only actor o production/ and is ullyutili&ed

Technology and production costs are constant Transportation costs are &ero and the countries

barter 9trade or goods

T@A6 B56A ?7B5?C>T6 AD7T"6


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The Production Possibilities Frontier(!!") is a cure showing the ariouscombinations o two goods that a

country can produce when all o acountry!s resources are ully employedand used in their most e2cient manner

TE6 F@?A>=T3?7 F?553B3C3T365'@?7T36@ 7A =?75T7T =?5T5

One Person Per Day of Labor Produces

Country Machines Cloth

EU 5 machines ! yards of cloth

"ndia # machines 5 yards of cloth


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(roduction (ossibilities )ur!es for the *nited tates and India





+achines

)loth

#

5!

5


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*ndia

+loth

Mach1, -

., 1

- /

0

+lothMach

1- -

8 1

6 /2 3

/ 2

- ,

"ndia $ O%%ortunity Costs

Machine & '(5 cloth

Cloth & !()) machine

EU $ O%%ortunity Costs

Machine & # cloth

Cloth & !(5 machine

*O%%ortunity Cost+ also ,no-n as *.elati/e Price+

h d t l


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+achines

)loth

#

5!

5

4hat Determines the 5lope o% the !!+

Slo%e & 0Machines10Cloth & O%%ortunity Cost of Machines

ame graph, drawn more to scale

EU2 Slo%e & O%%ortunity Cost & $!(5

"ndia2 Slo%e & O%%ortunity Cost & $!())

-his slope is also known as the # Marginal .ate of 3ransformation


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6> wor(ers are more productie inproducing machines

The 6> has an absolute ad&antagein machine production

3ndian wor(ers are more productiein producing cloth

3ndia has an absolute ad&antage

in cloth production

7bsolute 7d&antage: Froduction=onditions Ghen 6ach =ountry 3s

More 62cient in the Froduction o?ne =ommodity

T@A6 B56A ?7


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T@A6 B56A ?7B5?C>T6 AD7T"6 8

Yes, maybe that was obvious to you from

the beginning





4hat does this mean


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4hat

$heory o% absolutead&antage

dam 5mith: Gealth o 7ations(again) argued:

country should produce onlygoods where it is most e2cient/and trade or those goods whereit is not e2cient


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3-oPersons Per Day of Labor Produces




4orld Out%ut ' machines #5 yards of cloth

Assume 34O Persons %er day6 so that each %roduct can be fully %roduced

(and)

(and)

(and)

-his is a condition under Autar,y: (The

complete absence of trade)

*nder .utarky all nations can only

consume the goods they produce at

home


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Assume 34O Persons %er day6 so that each %roduct can be fully %roduced



EU ! machines ! yards of cloth

"ndia ! machines )! yards of cloth

4orld Out%ut ! machines )! yards of cloth(and)

(and)

(and)

(and)

/owe!er, if each country produces to their absolute ad!antage #below#


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T@A6 B56A ?7B5?C>T6 AD7T"6

Change in the Production of


EU 75 machines 8! yards of cloth

"ndia 8# machines 75 yards of cloth

Change in 4orld Out%ut 7) machines 75 yards of cloth

o there has ob!iously been an increase in orld "utput


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othcountries canbeneft i%trade occurs

0 produces machines andexports them to *ndia

*ndia produces cloth andexports it to the 0

T@A6 B56A ?7B5?C>T6 AD7T"6


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EU ! machines ! yards of cloth

"ndia ! machines )! yards of cloth

4orld Out%ut ! machines )! yards of cloth(and)

(and)

(and)

(and)

9o-6 su%%ose that the EU trades : ) machines to "ndia : for # yards of cloth

"ndia $ O%%ortunity Costs EU $ O%%ortunity Costs


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Machine & '(5 cloth


EU $ O%%ortunity Costs

Machine & # cloth

Cloth & !(5 machine

4orld !rice

Bac( to our opportunity costs 9aboeTrade will occur at a trading price 8

4orld !rice 8which will occurbetween these respectie RelativePrices8

)2()5.7( mEU

m

W

m

IND PPP >>

)133.0()5.0(

c

IND

c

W

c

EU

PPP >>

.lso called the *3erms of 3rade+

Loo,:

2emember this graph3


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+achines

)loth

#

5!

5

Slo%e & 0Machines10Cloth & O%%ortunity Cost of Machines

2emember this graph3

EU2 Slo%e & O%%ortunity Cost & $!(5

"ndia2 Slo%e & O%%ortunity Cost & $!())

-his slope is also known as the # Marginal .ate of 3ransformation

)133.0()5.0( cIND

c

W

c

EU PPP >>

P-


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3ntroduction: The "ains rom Trade

-he impro!ement in national welfare &forboth countries' is known as the gains

from trade


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?ne more ;uic( e%ample/ =anada

Bread 4 loaes H loaes

5teel H tons 1 ton

4hat are the EU;s relati/e %rices (opp. cost) :


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*mplications o% 7dam 5mith


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dam 5mith and Trade Barriers

mith was highly critical of trade barriers (Tariffs,Quotas, ubsidies!)

-rade barriers decrease5 peciali4ation

5 -echnological progress

5 ealth creation

-he modern !iew of trade shares miths dislike for

trade barriers


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Cabor Theory o Dalue

ssumes that labor is the onlyrelevant actor o production

This implies that the pre-trade priceo a good is determined by theamount o labor it too( to produce it$

T@A6 B56A ?7759'$0 7D=7>$7?0


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4-=ountry 5cenario

One Person Per Day of LaborProduces

Country Machines ClothU(S( 5 machines 5 yards of cloth

"ndia machine 5 yards of cloth

U(S( has an Absolute Ad/antage in both goods(


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(roduction (ossibilities )ur!es for the United Statesand "ndia



U(S( 5 machines 5 yards of cloth


+achines

)loth

5 5

5

=ra%hically ob/ious :

U(S( has an Absolute Ad/antage in both goods(


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9ne country has 7bsolute7d&antage in 9$@ goods

3n this scenario/ there is obiously noopportunity to trade8 especially not or

>$5$ 7?8 7o 8 7oIII This is not correct$ Ge

need to introduce the concept o:

+omparati&e 7d&antage






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Trade Theories:

#H - =omparatie

dantage


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Theory o +omparati&e7d&antage

Da&id Aicardo: Principles of PoliticalEconomy (1J1K

6%tended ree trade argument

5hould import e&en i% the country is moreeBcient in the product


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Ghy would trade occur i one country had anabsolute adantage in both goodsL

=omparatie dantage is the ability o acountry to produce a good at a loweropportunity costthan another country

Ge compare the degree o absoluteadantage or disadantage in the productiono goods

T@A6 B56A ?7=?MF@T3D6 AD7T"6

omparative !dvantage" #$%$ &ore


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Machine & 5 cloth

Cloth & !(# machine

US $ O%%ortunity Costs

Machine & ) cloth




U(S( 5 machines 5 yards of cloth"ndia machine 5 yards of cloth

omparative !dvantage" #$%$ &oreE'cient in the Production of oth

ommodities

U(S( has bigger Absolute Ad/antage in %roduction of Machines


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The >$5$ has a greater absoluteadantage in producing machines than isdoes in producing cloth (* more e'cient

in machines only +* more e'cient incloth)

3ndia!s absolute disadantage is smaller inproducing cloth than in producing

machines Thus the >$5$ has a comparati&e

ad&antagein machines and 3ndia has acomparati&e ad&antage in cloth

T@A6 B56A ?7=?MF@T3D6 AD7T"6


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6en though >$5$ has an absoluteadantage in both goods/ 3ndia has acomparatie adantage in cloth

production 6en i >$5$ has an absolute adantage in

both goods/ benefcial trade is possible

3 both countries speciali&e according totheir comparatie adantage/ they bothcangain rom this speciali&ation andtrade

T@A6 B56A ?7?FF?@T>73T =?5T5

Since -e are dealing -ith O%%( Costs6 -e


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One %erson Per Day of Labor Produces




-ill com%are across 5 yards of cloth

(per)

OnePerson Per Day of Labor Produces


U(S( 5 machines $5 yards of cloth

"ndia & days' $) machines 5 yards of cloth

4orld Out%ut 7# machines ! cloth

Let us allo- "ndia to %roduce cloth u% to the le/el that the U(S( can:


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hange in orld -utput Resulting from %peciali.ation !ccordingto omparative !dvantage

T@A6 B56A ?7=?MF@T3D6 AD7T"6

Change in the Production of



"ndia 8) machines 75 yards of cloth

Change in 4orld Out%ut 7# machines ! yards of cloth

T d i th @i di M d l


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Trade in the @icardian Model9cont$

country can be more e2cient inproducing both goods/ but it willhae a comparatie adantage in

only one good$

6en i a country is the most 9orleast e2cient producer o all

goods/ it still can beneft romtrade$

T@A6 B56A ?7


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T@A6 B56A ?7?FF?@T>73T =?5T5

#nit /abor osts in 01 2eveloping Economies for%elected %ectors, 0333 (Ratios relative to the #$%$)

Country?oodProducts 3e>tiles Clothing

ElectricalMachinery

3rans%ortE@ui%ment

Argentina (5 (#B !( #( ('B


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T@A6 B56A ?7?FF?@T>73T =?5T5

#nit /abor osts in 01 2eveloping Economies for%elected %ectors, 0333 (Ratios relative to the #$%$)

Country?oodProducts 3e>tiles Clothing

ElectricalMachinery

3rans%ortE@ui%ment

Malaysia (!B !(5 !(B (! !(

Me>ico !(! !(BB !( (! !()

Morocco ( ()B (!5 ( !(#

9igeria !(# !(B! !( !(5 !(!

Peru (!# !(# !( !(5 !(5!

Phili%%ines !(5 !(' !(5 !(B! !((!

orea !(') !() !(# !(5 !('

3ai-an () (5 !(B! (B ('

3hailand !(# !(B' (!' !(5 !(

3ur,ey (! !( !() !(' !(5

Uruguay ( !(' !( (5# (##

Fenezuela !() !('# !( !(B !('


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5tatic "ains rom trade aregains in word output that resultrom speciali&ation and trade

Aynamic gains rom trade aregains rom trade oer time thatoccur because trade induces

greater e2ciency in the use oe%isting resources

A7M3= "375 '@?M T@A6


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ssumptions and limitations

Arien only by ma%imi&ation oproduction and consumption

?nly 4 countries engaged in production

and consumption o


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bsolute and =omparatie


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bsolute and =omparatieFroductiity dantage =ontrasted

Absolute %roducti/ity ad/antage8 /eld by acountry that produces more of a certain good perhour worked than another

Com%arati/e %roducti/ity ad/antage &orcom%arati/e ad/antage'8 /eld by a country thathas lower opportunity costs of producing a goodthan its trading partners do

Com%arati/e ad/antage allo-s a country thatlac,s absolute ad/antage to sell its %roductsabroad

One more time for practice


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One more time for practice

Out%ut %er hour of *team+Country Cars Steel GtonsH

Ia%an # #

Malaysia !(5

Ia%an $ O%%ortunity Costs

car & steel

steel & car

Malaysia $ O%%ortunity Costs

car & # steel

steel & !(5 car

Do you see any Absolute Ad/antages

Do you see any Com%arati/e Ad/antages

?utput per Eour Gor(ed


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?utput per Eour Gor(ed


Country Cars Steel GtonsH

Ia%an # #

Malaysia !(5


Country Cars Steel GtonsH

Ia%an # #

Malaysia #

4orld Out%ut 7 !

Let us allo- Malaysia to %roduce steel u% to the le/el that Ia%an can:

"ains rom Trade with


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"ains rom Trade with

ummation #

9apan has an absolute ad!antage in both cars &:;0


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Terms o Trade and "ains romTrade

The closer the terms o trade are toone country!s pre-trade price ratio/ thegreater the gain or the other country$

3mportance o being unimportantOwhen small countries trade with bigcountries/ the small countries are li(ely

to en


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6aluation o the =lassical Model

The model does not e%plain why di+erences inproductiity leels between countries e%ist$

3t ma(es e%treme and unrealistic predictions such

as countries will completely speciali&e in theproduction o e%portables only$

3t maintains that the gains rom trade are greaterbetween countries o dissimilar production

technologies 9despite the act that most tradeoccurs between A=s with similar technology andincome leels$


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6aluation 9cont$

The classical model is a useul toolbecause:

3t proides a motie or trade between

deeloped and deeloping countries

3t e%plains why high-wage countries maystill beneft rom trade een when aced

with low-wage competing countries

5ummary o the =omparatie


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5ummary o the =omparatiedantage Model

3t is not necessary or a country to possess absoluteadantage in order to participate in trade$ Ghat isre;uired is comparatie adantage in production$

country will speciali&e in and e%port that good inwhich its has comparatie adantage/ i$e$/ has alower pre-trade relatie price than in the othercountry$

The terms o trade or world price will settle betweenthe autar(y prices o the two countries and isdetermined by reciprocal demand$

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Trade Theories 1 3

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