IDEAS & THEORIES ON INTERNATIONAL TRADE. ANCIENT CHINESE TRADE Guan Zhong and the book Guan Zi (725-645 BC) Guan Zhong argued that when a good was abundant,

IDEAS & THEORIES ON INTERNATIONAL

TRADE

ANCIENT CHINESE TRADE

Guan Zhongand the book

Guan Zi(725-645 BC)

Guan Zhong argued that when a good was abundant, it became light, and its price would fall--- when the good was “locked away”, it became heavy, and the good’s price would rise

There are movements of goods into and out of markets based on their lightness and heaviness, with a tendency toward one price– equilibrium --- hence a statement of the law of supply & demand

The movement “IN and OUT” of markets was trade

The light/heavy theory

A TRANSELATED QUOTE Guan Zhong

“INDEED, IT IS THE NATURE OF MEN THAT WHENEVER THEY SEE PROFIT, THEY CANNOT HELP CHASING AFTER IT, AND WHENEVER THEY SEE HARM, THEY CANNOT HELP RUNNING AWAY. WHEN THE MERCHANT ENGAGES IN TRADE AND TRAVELS TWICE THE ORDINARY DISTANCE IN A DAY, USES THE NIGHT TO EXTEND THE DAY, AND COVERS A THOUSAND LI WITHOUT CONSIDERING IT TOO FAR, IT IS BECAUSE PROFIT LIES AHEAD. WHEN THE FISHERMAN PUTS OUT TO SEA, THE SEA MAY BE TEN THOUSAND-REN DEEP, AND WHEN HE HEADS INTO ITS WAVES AND STRUGGLES AGAINST ITS TIDES, RAISES HIS SMALL MAST AND SAILS OUT A HUNDRED LI, NEVER LEAVING THE WATER FROM MORNING TO NIGHT, IT IS BECAUSE PROFIT LIES IN THE WATER. THUS, WHEREVER PROFIT LIES, EVEN THOUGH IT BE ATOP A THOUSAND-REN PEAK, THERE IS NO PLACE PEOPLE WILL NOT CLIMB. EVEN THOUGH IT IS AT THE BOTTOM OF THE DEEPEST DEPTHS, THERE IS NO PLACE PEOPLE WILL NOT ENTER.

INDEED, THOSE WHO ARE SKILLED IN GOVERNMENT CONTROL THE PRESENCE OF WEALTH SO THAT THE PEOPLE ARE NATURALLY CONTENT. WITHOUT PUSHING THEM, THEY GO; WITHOUT PULLING THEM, THEY COME. WITHOUT TROUBLE OR WORRY, THE PEOPLE ENRICH THEMSELVES. IT IS LIKE A BIRD SITTING ON ITS EGGS; THERE IS NEITHER SHAPE NOR SOUND, BUT THE YOUNG SUDDENLY APPEAR QUITE COMPLETE”

GUAN ZHONG, GUAN ZI, VOL. II, TRANSELATED BY W. ALLYN RICKETT (PRINCETON, N.J.: PRINCETON UNIVERSITY PRESS, 1998), pp. 219-220.

MERCANTILISM

THE RISE OF THE MERCHANTS IN ECONOMIC AND SOCIAL LIFE

THE TENETS OF MERCANTILISM:

BULLIONISM – INCREASE GOLD (PRECIOUS METALS), HENCE INCREASE WEALTH OF A NATION VIA INTERNATIONAL TRADE

KEEP EXPORTS > IMPORTS – BRING IN SPECIES

INTERNATIONAL TRADE IDEAS – RESTRICTIONS ON OUTWARD MOVEMENT OF RAW GOODSKEEP DOMESTIC PRICES LOW

KEEP PRICES LOW ON INBOUND RAW INPUTS AND GOODS

COLONIZATION- MONOPOLIZE COLONIAL TRADEKEEP COLONIES DEPENDENT ON MOTHER LAND

RESTRICT COLONY MANUFACTURINGTHIS IS THE IMPACT OF THE EARLY

NAVIGATION ACT BARRIERS IN THE EARLY AMERICANCOLONIES – BRITISH SHIP MONOPOLY

MORE ON MERCANTILISM

STRONG CENTRAL GOVERNMENT – MONARCHYLANDED CLASS (LORDS), MERCHANTS BECOME RENT SEEKERS

THE “ROYAL MANUFACTURERS” THE ONLY EXPORTERSA GRANT TO SHIPPING MONOPOLY GRANTED BY THE KINGTHE KING IS A LORD WHICH KEEPS THE ARMY AND NAVY

TAXES PAID BY THE OTHER LORDS TO KEEP THE MILITARYAND THE KING IN COMFORTABLE POSITION

NEED A LARGE HARD WORKING POPULATION –HENRY VIII DECREE ON NO IDLENESS NOR BEGGING

LOW PAY TO KEEP WORKERS ENGAGED IN PRODUCTION(A SLUTSKY SUBSTITUTION EFFECT NOTION– THE INCOME

EFFECT DOMINATES THE SUBSTITUTION EFFECTOF A WAGE CHANGE--- IF PAY INCREASES, THEN

WORKERS PURCHASE MORE LEISURE--- CAN’T HAVETHAT BEHAVIOR – IT IS BACKWARD BENDING

SUPPY CURVE OF LABOR IDEA

WHO BENEFITED?

MERCHANT CAPITALISTS --- THEY BECOME PART OF SOCIETY--- THEY AREACCEPTED NOW

THE MONARCHY – GOVERNMENT OFFICIALS

THE RENT SEEKERS --- PARTICULARLY IN FRENCH MERCANTILISM

THE FRENCH HAD STRONG FEUDAL FLAVOR TO MERCANTILISM

THERE IS A LASTING IMPACT

--RENT SEEKING BEHAVIOR AND ORGANIZATION OF GOVERNMENT SUPPLYOF GOODS AND SERVICES

--INTERNATIONAL TRADE – ONE OF THE MAIN THEORIES OF INTERNATIONAL TRADE DEVELOPS

WHO BENEFITED?

MERCHANT CAPITALISTS --- THEY BECOME PART OF SOCIETY--- THEY AREACCEPTED NOW

THE MONARCHY – GOVERNMENT OFFICIALS

THE RENT SEEKERS --- PARTICULARLY IN FRENCH MERCANTILISM

THE FRENCH HAD STRONG FEUDAL FLAVOR TO MERCANTILISM

THERE IS A LASTING IMPACT

--RENT SEEKING BEHAVIOR AND ORGANIZATION OF GOVERNMENT SUPPLYOF GOODS AND SERVICES

--INTERNATIONAL TRADE – ONE OF THE MAIN THEORIES OF INTERNATIONAL TRADE DEVELOPS

MERCANTILISM – CONNECTION TO MODERN POLICYA STATEMENT BY ROBERT E. LUCAS, JR. (UNIVERSITY OF CHICAGO)

(NOBEL LAUREATE IN ECONOMICS)ON THE OCCASION OF BEING INTERVIEWED BY REASON MAGAZINE

ABOUT THE IMPACTS OF THE NEW ADMINISTRATION COMING TO POWERIN 1993 IN THE U.S.

THE QUESTION BY REASON – WHAT WILL BE THE ECONOMIC IMPACT OF THE NEW CLINTON ADMINISTRATION?

LUCAS – “IN ECONOMIC POLICY, THE FRONTIER NEVER CHANGES.THE ISSUE IS ALWAYS MERCANTILISM AND GOVERNMENT

INTERVENTION VS. LAISSEZ FAIRE AND FREE MARKETS.AND THAT’S EXACTLY WHAT’S ON THE FRONTIER RIGHT NOW WITH WITH THE NEW ADMINISTRATION. HOW MERCANTILIST ARE THEY

GOING TO BE? WE DON’T KNOW”

-This could be said of any incoming administration-This debate could apply to any government formation/operation

What do you think?

AND THE DEBATE GOES ON

Adam Smith --attack on Mercantilism--

In 1776, Adam Smith published the first modern statement of economic theory, An Inquiry into the Nature and Causes of the Wealth of Nations• The Wealth of Nations attacked mercantilism—the

system of nationalistic economics that dominated economic thought in the 1700s

• Smith proved wrong the belief that trade was a zero sum game—that the gain of one nation from trade was the loss of another

• Trade is a positive sum game—both nations gain

THE MERCANTILIST BELIEVED THAT WHAT YOU GOT IN TRADE, SOME OTHER NATION DID NOT GET ----

ASSUMED THE ZERO-SUM GAME --- ONE NATION HAS DIABOLICALLY OPPOSED PREFERENCES FROM

ANOTHER NATION

SPAIN

STRATEGY A B C

I 1, -1 6, -6 0, 0

FRANCE II 2, 2 0, 0 3, - 3

III 3, - 3 2, - 2 4. -4

PAYOFFS SUM TO ZERO IN A ZERO-SUM GAME FOR ANY SET OF PAYOFFS

THE SOLUTION IS A MIXED STRATEGY --- AN ATTEMPT TO MASK THE STRATEGIES ON THE PART OF THE PARTICIPANTS

FRANCE CHOOSES I (1/6 PROBABILITY), II ( DOES NOT CHOOSE) , III (5/6 PROBABILITY)

SPAIN CHOOSES A (2/3 PROBABILITY), B (1/3 PROBABILITY), C (DOES NOT CHOOSE)

A Bit of Game Theory here

CONSTANT SUM GAME PAYOFFS SUM TO SOME CONSTANT k, BUT k COULD BE 0

What was Smith implying here?

Access to foreign markets helps create wealth• In the extreme, If no nation imports, every

company will be limited by the size of its home country market

• Imports enable a country to obtain goods that it cannot make itself or can make only at very high costs --- consumers have a variety of choices of goods --- consumer economic welfare increases

• Trade barriers decrease the size of the potential market, hampering the prospects of specialization, technological progress, mutually beneficial exchange, and, ultimately, wealth creation

DAVID HUME – PHILOSOPHER – ECONOMISTONE-SIDED TRADE SOLUTION IS A DILEMMA

Free Trade Restricted trade

Free Trade 50, 50 20, 60

Restricted trade 60, 20 27, 27

MORE GAME THEORY ----NASH EQUILIBRIUM --- DO THE BEST YOU CAN THOUGH IT MAY NOT BE AN OPTIMUM POSITION– NO PLAYER HAS INCENTIVE TO MOVE FROM THE NASH EQUILIBRIUMDOMINANT STRATEGY– ONE PLAYER PLAYS A STRATEGY IRRESPECTIVE OF THE STRATEGY CHOICE OF THEIR COMPETITOR PLAYER

DAVID HUME SUGGESTED RESTRICTED TRADE IS A ZERO-SUM GAME OR LEADS TO A PRISONER’S DILEMMA IN MODERN NASH GAME THEORY ANALYSIS

PAYOFFSSTRATEGIES

The Solution is a restricted trade strategy-restricted trade strategy

What is this game theory bit?? What is a Nash

equilibrium?A Nash equilibrium is an action exercised from which there is no incentive to move --- in a game there are players (firms, consumers, etc), say player A, B, C, etc, actions taken by the players, say a = (a1, . . an) and payoffs given by π = f(a1, . . an), where, f( . . . ) means “function of”

A Nash equilibrium exists in actions if:π = f(a1, ., ai-1, ai*, . . an) >= π = f(a1, ., ai-1, ai, . . an) , that is, the payoff to a player, πA = f(a1, ., ai-1, ai*, . . an) of all actions including action ai* is greater than the payoff with out action ai* for player A as π = f(a1, ., ai-1, ai, . . an)

This position may not be an optimum such as maximum profit or maximum economic welfare, but there is no incentive to move from this position --- if this occurs for all players, then a Nash equilibrium exists

One can also find a similar “resting point” if a player chooses action set (a1, ., ai-

1, ai*, . . an) irrespective of what other players choose – This is the property of arriving at a solution by dominance in action strategies --- the set (a1, ., ai-1, ai*, . . an) is dominant over other play action

ABSOLUTE ADVANTAGE & COMPARATIVE ADVANTAGE

A nation has Absolute productivity advantage if it produces more of a certain good per hour worked than another (other inputs could be used in the example in addition to labor) -- Adam Smith

A nation has Comparative productivity advantage (or comparative advantage) if it has lower opportunity costs of producing a good than its trading partners

– David Ricardo Comparative advantage allows a country

that lacks absolute advantage to sell its products abroad

Let Output = Q, Input = X,PQ = price of Q, W = cost of

input

Absolute advantage:• Greatest Q/X of trading nations, or

greatest average product• Or lowest X/Q ---- lowest input

per unit of output Comparative advantage:

• Lowest opportunity cost of trading nations

• Or PQ =(X/Q)(W) is lowest, or lowest pre-trade price of trading nations, PQ=(X/Q)(W)

Notice that comparative advantage also incorporates absolute advantage• PQ= (X/Q)(W), since input per unit

of output, (X/Q), is contained within the idea of comparative advantage

Notice also that these ideas are mainly based on production efficiency

A nation may not have any absolute advantage, but may have a sector that has least disadvantage and can trade

The idea of absolute advantage

NATION

PRODUCT A B

SOYBEANS LABOR REQUIRED

3 UNITS PER UNIT OF OUTPUT

12 UNITS PER UNIT

OF OUTPUT

TEXTILES 6 UNITS PER UNIT OF OUTPUT

4 UNITS PER UNIT OF OUTPUT

Which nation has absolute advantage in soybeans?

Which nation has absolute advantage in textiles?

Nation A has absolute advantage in soybean production, while nation B has absolute advantage in textile production (lowest labor employed per unit of each output)

NATION A HAS ABSOLUTE ADVANTAGE IN SOYBEANS

NATION B HAS ABSOLUTE ADVANTAGE IN TEXTILES

SO THE NATIONS SHOULD SPECIALIZE IN THE PRODUCT THAT HAS ABSOLUTE ADVANTAGE

HOW? MOVE 6 UNITS OF LABOR FROM TEXTILES IN NATION A TO BE USED IN THE PRODUCTION OF SOYBEANS --- SO THIS NATION LOSES 1 UNIT OF TEXTILES (6 UNITS OF LABOR PER 1 UNIT OF TEXTILES), BUT GAINS 2 UNITS OF SOYBEANS (3 UNITS OF LABOR TO PRODUCE 1 UNIT OF SOYBEAN OUTPUT)

WHAT THEN IS THE GAIN IN NATION A? – 1 OF TEXTILES AND + 2 OF SOYBEANS FOR AN OVERALL GAIN OF +1

WHAT ABOUT NATION B?

MOVE LABOR FROM SOYBEANS (12 UNITS OF LABOR PER 1 UNIT OF OUTPUT) INTO PRODUCING TEXTILES

NATION B, IN THIS CASE WOULD LOSE 1 UNIT OF SOYBEANS, BUT GAIN 3 UNITS OF TEXTILES PRODUCTION (4 UNITS OF LABOR PER 1 UNIT OF OUTPUT)

SO NATION B LOSES 1 UNIT OF SOYBEANS BUT GAINS 3 UNITS OF TEXTILES--- THE NET GAIN IS + 2

THERE IS A COMPLETE SPECIALIZATION

DEMAND FOR TEXTILES IN A FALLS, BECAUSE NATION A CAN GET THE TEXTILES CHEAPER FROM NATION B PRODUCERS OF TEXTILES

WORKERS LEAVE TEXTILES AND GO TO THE SOYBEAN SECTOR IN NATION A

THE OPPOSITE HAPPENS IN NATION B --- WORKERS MOVE TO THE TEXTILE INDUSTRY---- TEXTILE DEMAND HAS RISEN BECAUSE NATION A WANTS THE TEXTILES --- SOYBEAN PRODUCTION FALLS BECAUSE LABOR HAS MOVED TO TEXTILES

NOTICE --- THIS WORKS IF THE LABOR IS MOBILE --- THE PROBLEM THAT ARISES IS IN THE CASE WHERE LABOR IS IMMODILE EITHER BECAUSE OF LACK OF SKILLS OR THE IMPOSITION OF RESTRICTIONS ON LABOR MOBILITY BETWEEN SECTOR AND NATIONS

NATION

PRODUCT BRAZIL MEXICO

SOYBEANS LABOR REQUIRED

3 UNITS PER UNIT OF OUTPUT

12 UNITS PER UNIT

OF OUTPUT

SHOES 6 UNITS PER UNIT OF OUTPUT

8 UNITS PER UNIT OF OUTPUT

WHAT IS GOING ON HERE?

IT APPEARS THAT BRAZIL HAS ABSOLUTE ADVANTAGE IN BOTH SOYBEANS & SHOES

WHAT NOW?

MEXICO DOES HAVE LEAST DISADVANTAGE IN PRODUCING SHOES AND COULD TRADE IN SHOES SINCE BRAZIL WOULD WANT TO CONCENTRATE ON THE BIG ADVANTAGE THEY HAVE IN PRODUCING SOYBEANS --- BOTH CAN TRADE WITH EACH OTHER AND OTHER NATIONS (THE LATTER ACTION DEPENDING ON COMPARATIVE ADVANTAGE AS WELL)

This is where comparative advantage takes hold

SUPPOSE AN ANOTHER EXAMPLE:

THERE ARE TWO NATIONS, MARYDOM AND HEYBIA, AND TWO PRODUCTS, DAIRY PRODUCTS AND COMPUTER CHIPS. THE AVERAGE PRODUCTS OF LABOR FOR THE TWO PRODUCTS IN EACH NATION ARE GIVEN IN THE TABLE BELOW

NATION

PRODUCTMARYDOM HEYBIA

DAIRY PRODUCTS

3 2.4

COMPUTER CHIPS

4 2

IN WHICH PRODUCT DOES EACH NATION HAVE COMPARATIVE ADVANTAGE? WHICH NATION ACCORDING TO COMPARATIVE ADVANTAGE SHOULD HAVE THE HIGHER WAGE?? Look again --- we are now in average product terms here

FANTASTIC NIGHT LIFE IN THIS HAVEN

NATION

PRODUCTMARYDOM HEYBIA

DAIRY PRODUCTS3 2.4

COMPUTER CHIPS4 2

MARYDOM APPEARS TO HAVE ABSOLUTE ADVANTAGE IN BOTH INDUSTRIES --- BUT MARYDOM HAS COMPARATIVE ADVANTAGE IN PRODUCING COMPUTER CHIPS --- HEYBIA HAS COMPARATIVE ADVANTAGE IN PRODUCING DAIRY PRODUCTS

MARYDOM SHOULD HAVE THE HIGHER WAGE --- THE LOWER LIMIT ON THE RELATIVE HIGHER WAGE WOULD BE 3 / 2.4 = 1.25, OR THE WAGE IN MARYDOM SHOULD BE NOT LESS THAN 1.25 TIMES THE WAGE ( OR 25% HIGHER) IN HEYBIA--- BUT THE WAGE IN MARYDOM COULD BE UPWARD TO 4 / 2 = 2 TIMES HIGHER THAN THE WAGE IN HEYBIA, BUT NOT MORE THAN THAT AS JUSTIFIED BY THE PRODUCTIVITY DIFFERENCE IN MARYDOM RELATIVE TO HEYBIA