International Trade

The Economics of International Trade

tutor2u

A2 Economics

Geoff Riley, 2013

Paul Krugman on Trade

• “If there were an Economist’s Creed, it would surely contain the affirmations “I believe in the Principle of Comparative Advantage” and “I believe in Free Trade”.”

• Paul Krugman, Professor of Economics at MIT, Cambridge

Hidalgo and Economic Complexity

Ask yourself the question: If a good cannot be produced in Japan

or Germany, where else can it be made?

Global Regions

What is Free Trade?

• Trade free from artificial barriers

• Trade reflects the impact of specialisation and exchange

– Specialization: specialisation of scarce resources

– Exchange: in part based on comparative advantage in supplying different goods and services

The concept of an open economy

• In an open economy, one nation trades openly with other

– Trade in goods

– Trade in services

– Free flow of financial capital

– Free flow of labour resources

• An economy integrated with and connected to the world economy

World Trade

Time period1950-60

Volume of world trade7.7

Real GDP (world)4.5

1960-70 8.6 5.51970-80 5.3 4.11980-90 3.9 3.21990-00 6.5 2.32000-11 4.7 2.7

2001 -0.2 2.02002 3.4 2.32003 5.7 2.92004 9.7 4.02005 6.5 3.52006 8.6 4.02007 6.5 3.92008 2.3 1.32009 -12.1 -2.42010 14.0 3.82011 4.9 2.4

Volume of world merchandise exports and gross domestic product, 1950-2011, annual % change

Exports of Goods and Services

Exports of Goods and Services

Potential Advantages from Trade

• (1) Increased competition for producers– Increased market contestability

– Pressure on suppliers to keep prices down

– Improved allocative & productive efficiency• Prices closer to their factor cost

• Pressure on unit costs to fall / scale economies

• (2) Better use of scarce resources– Exploitation of comparative advantage

– Benefits from specialisation

– Trade can be an important source of economic growth and development

Potential Advantages from Trade

• (3) Dynamic Efficiency Gains– Trade speeds up the pace of technological

progress and innovation

– Transfer of ideas / technology spill-overs

– World Bank – “dynamic globalisers have achieved the fastest growth over the last twenty years”

– Greater choice for consumers

Potential Advantages of Trade

• (4) Economies of scale– Increasing returns to scale from selling to larger

markets e.g. BRICs or the EU single market

– Falling LRAC / lower real prices

– Gains in producer & consumer surplus

• (5) A stimulant to growth / recovery– Exports – an injection of AD into circular flow

– Boost to exports will have multiplier and accelerator effects on national income

– Supply-side improvements from investment and greater factor mobility between countries

Export Potential to BRICs & Beyond

Jim O’Neill

“By the end of the decade, Britain’s trade with the BRIC countries of Brazil, Russia, India and China, will account for 17pc of total exports.”

Gains from External Trade

Reduction in extreme poverty

Increased market competition

Access to new technologies

Inflows of knowledge

Economies of scale

Better use of scarce resources

Comparative Advantage

• David Ricardo, one of the founding fathers of classical economics

• Comparative advantage exists when– Relative opportunity cost of production is lower

than in another country

– A country is relatively more productively efficient than another

• Basic rule – specialise in the things that you are relatively best at

• This opens up important gains from trade

Factor endowment model

• Developed by Heckscher and Ohlin

• Countries with a relative factor abundance can specialise and trade

– Abundance of skilled labour → specialisation → export → exchange for goods and services produced by countries with abundance of unskilled labour

– Exports embody the abundant factor

– Imports embody the scarce factor

– Assumes a high degree of factor mobility

The Theory of Comparative

Advantage

Analysis of the potential gains from specialisation, trade and exchange between regions and nations

Theory of Comparative Advantage

Half of each country’s available resources are allocated to each industry

Freezers

(000s per year)

Dishwashers

(000s per year)

Germany 1000 500

Italy 800 200

Total Output

Theory of Comparative Advantage

Half of each country’s available resources are allocated to each industry

Freezers

(000s per year)

Dishwashers

(000s per year)

Germany 1000 500

Italy 800 200

Total Output 1800 700

Assuming Constant Returns – The Effects of Partial Specialisation

Gain in total output after specialisation

Freezers

(000s per year)

Dishwashers

(000s per year)

Germany 400 (-600) 800 (+300)

Italy 800 200

Total Output

Assuming Constant Returns – The Effects of Partial Specialisation

Gain in total output after specialisation

Freezers

(000s per year)

Dishwashers

(000s per year)

Germany 400 (-600) 800 (+300)

Italy 1600 (+800) 0 (-200)

Total Output

Assuming Constant Returns – The Effects of Partial Specialisation

Gain in total output after specialisation

Freezers

(000s per year)

Dishwashers

(000s per year)

Germany 400 (-600) 800 (+300)

Italy 1600 (+800) 0 (-200)

Total Output 2000 (+200) 800 (+100)

Assuming Constant Returns – The Effects of Partial Specialisation

Gain in total output after specialisation

Freezers

(000s per year)

Dishwashers

(000s per year)

Germany 400 (-600) 800 (+300)

Italy 1600 (+800) 0 (-200)

Total Output 2000 (+200) 800 (+100)

Beneficial Terms of Trade

• A beneficial terms of trade is an agreed rate of exchange of one product for another than leaves both countries better off from trade

• Consider the domestic terms of trade for each country– Without trade, Germany gets 2 extra freezers for

every dishwasher that is gives up

– Without trade, Italy has to give up 4 freezers for every extra dishwasher it produces

• Is there a mutually beneficial terms of trade?

Trade increases amount available in each country

Final output in after trade

Freezers

(000s per year)

Dishwashers

(000s per year)

Germany 1150

(+750 .. import)

550

(-250 ..export)

Italy 850

(-750 .. export)

250

(+250 .. import)

Total Output 2000

At start: (1800)

800

At start: (700)

Assumptions underlying theory

Constant returns to scale

Mobility of factor inputs

No externalities

Trade finance available

Barriers to trade are small

Assumptions underlying theory

Constant returns to scale

Mobility of factor inputs

No externalities

Trade finance available

Barriers to trade are small

Krugman – New Trade Theory

“In reality, world trade is dominated by rich countries trading similar goods with each other”

Assumptions underlying theory

Constant returns to scale

Mobility of factor inputs

No externalities

Trade finance available

Barriers to trade are small

Krugman – New Trade Theory

“In reality, world trade is dominated by rich countries trading similar goods with each other”

Standard theory ignores extra benefits from

(i) Consumer choice

(ii) Economies of scale

(iii) Positive trade externalities

(iv) Other dynamic effects of trade

Supply and Demand Analysis

Price

Output (Q)

Domestic Demand

Domestic Supply

World Price

Supply and Demand Analysis

Price

Output (Q)

Domestic Demand

Domestic Supply

P1

Q1

World Price

QdQs

Pw

Comparative Advantage

Unit labour costs Exchange rate Innovation

Economies of scale Sustainability Human capital

The Importance of Human Capital = More Value Added from Exports

Technology spill-overs Universities Science Parks

Precision Engineering Capital Projects Creative Industries

Economic complexity and trade

Two countries that havehigh levels of economic complexity, but still low levels of per capita income are

China and Thailand

Ask yourself the question, if you cannot produce it in China or Thailand, where

else can you produce it?

Export Patterns: Rwanda

Export Patterns: Malawi

Export Patterns: United Kingdom

Shifts in Advantage for the UK

• Long term decline in comparative advantage in many areas of manufacturing industry– Lower cost producers in SE Asia and E.Europe

– Productivity gap with other leading economies

– Strong ex. rate has damaged competitiveness

• The UK still has trade surpluses in chemicals and high knowledge manufacturing

• Main comparative advantage lies with business and financial services