M.A. FINAL ECONOMICS - bhojvirtualuniversity.com · 2 m.a. final economics paper ii international trade and finance block 1 theory of international trade, measurement of gains and

M.A. FINAL ECONOMICS

PAPER II

INTERNATIONAL TRADE AND

FINANCE

WRITTEN BY

SEHBA HUSSAIN

EDITED BY

PROF.SHAKOOR KHAN

2

M.A. FINAL ECONOMICS

PAPER II

INTERNATIONAL TRADE AND

FINANCE

BLOCK 1

THEORY OF INTERNATIONAL TRADE,

MEASUREMENT OF GAINS AND THEORY

OF INTERVENTION

3

PAPER II

INTERNATIONAL TRADE AND FINANCE

BLOCK 1

THEORY OF INTERNATIONAL TRADE,

MEASUREMENT OF GAINS AND THEORY OF

INTERVENTION

CONTENTS

Page number

Unit 1 Theory of International trade 5

Unit 2 Measurement of gains from trade 25

Unit 3 Free trade and theories of intervention 41

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BLOCK 1 THEORY OF INTERNATIONAL TRADE,

MEASUREMENT OF GAINS AND THEORY OF

INTERVENTION

The aim of this block is to present certain theories and approaches related to theory of

international trade, measurement of gains and theory of intervention.

First unit deals with explaining the varieties of theories of international trade. Second

area of concern will be Ricardian model and theories of absolute advantage followed by

Heckscher Ohlin model. New trade theory and gravity model are explained in detailed

manner. Regulation of international trade and empirical testing of theory of absolute cost

were discussed in detail.

Unit 2 discusses concepts related to gains from trade. Measurement and distribution of

gains from trade and terms of trade will be explained in detail. Role of trade in

accelerating growth of nation is discussed in last section along with suitable examples.

The last unit that is unit 3 presents to you the basic and important concepts of free trade

and theories of intervention. Features of free trade are discussed in continuation with the

history of free trade. Economics of free trade and the basics of tariffs and trade barriers

will be other areas of discussion. Welfare implications of trade barriers; impact of tariffs

on prices and tariffs and their relevance in modern trade will be described in detailed

manner.

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UNIT 1

THEORY OF INTERNATIONAL TRADE

Objectives

After studying this unit you should be able to:

Define the theories of International trade

Understand the Ricardian model and concept of absolute and comparative advantage

Know the Heckscher and Ohlin model of trade

Explain new trade theory and gravity model of international trade

Describe regulations of international trade

Discuss the empirical testing of theory of absolute cost

Structure

1.1 Introduction

1.2 Varieties of theories of international trade

1.3 Ricardian model and theories of absolute advantage

1.4 Heckscher Ohlin model

1.5 New trade theory

1.6 Gravity model

1.7 Regulation of international trade

1.8 Empirical testing of theory of absolute cost

1.9 Summary

1.10 Further readings

1.1 INTRODUCTION

International trade is exchange of capital, goods, and services across international borders

or territories. It refers to exports of goods and services by a firm to a foreign-based buyer

(importer) in most countries; it represents a significant share of gross domestic product

(GDP). While international trade has been present throughout much of history (see Silk

Road, Amber Road), its economic, social, and political importance has been on the rise

in recent centuries.

Industrialization, advanced transportation, globalization, multinational corporations, and

outsourcing are all having a major impact on the international trade system. Increasing

international trade is crucial to the continuance of globalization. International trade is a

major source of economic revenue for any nation that is considered a world power.

Without international trade, nations would be limited to the goods and services produced

within their own borders.

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International trade is in principle not different from domestic trade as the motivation and

the behavior of parties involved in a trade do not change fundamentally regardless of

whether trade is across a border or not. The main difference is that international trade is

typically more costly than domestic trade. The reason is that a border typically imposes

additional costs such as tariffs, time costs due to border delays and costs associated with

country differences such as language, the legal system or culture.

Another difference between domestic and international trade is that factors of production

such as capital and labor are typically more mobile within a country than across

countries. Thus international trade is mostly restricted to trade in goods and services, and

only to a lesser extent to trade in capital, labor or other factors of production. Then trade

in goods and services can serve as a substitute for trade in factors of production. Instead

of importing a factor of production, a country can import goods that make intensive use

of the factor of production and are thus embodying the respective factor. An example is

the import of labor-intensive goods by the United States from China. Instead of importing

Chinese labor the United States is importing goods from China that were produced with

Chinese labor.

International trade is also a branch of economics, which, together with international

finance, forms the larger branch of international economics.

The first purpose of trade theory is to explain observed trade. That is, we would like to

be able to start with information about the characteristics of trading countries, and from

those characteristics deduce what they actually trade, and be right. Thats why we have a

variety of models that postulate different kinds of characteristics as the reasons for trade.

Secondly, it would be nice to know about the effects of trade on the domestic economy.

A third purpose is to evaluate different kinds of policy. Here it is good to remember that

most trade theory is based on neoclassical microeconomics, which assumes a world of

atomistic individual consumers and firms. The consumers pursue happiness

(maximizing utility) and the firms maximize profits, with the usual assumptions of

perfect information, perfect competition, and so on. In this world choice is good, and

restrictions on the choices of consumers or firms always reduce their abilities to

optimize. This is essentially why this theory tends to favor freer trade.

1.2 VARIETIES OF THEORIES OF INTERNATIONAL TRADE

Neoclassical theory has been successful because it is simple (though it may not always

look simple when youre learning it). For example most neoclassical trade theories

assume that the world only has two countries (which means that country As exports must

be country Bs imports). They also usually assume only two commodities in

international trade. If you try to generalize by adding more countries or commodities,

the math breaks down and you dont get clear results.

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One of the most important, and limiting, assumptions in neoclassical trade theory is that

firms produce under conditions of perfect competition. Any industry that is controlled by

a small number of firms is not perfectly competitive. There is a whole area of economics,

initially developed by Joan Robinson in the 1920's, that explores what happens under

imperfect competition. We wont get into it in this course, but if there are significant

economies of scale (which means that per-unit costs are smaller for bigger firms), then

you can get very different policy recommendations out of your model.

Does this mean that the simple neoclassical models are useless? No. Their most

important use is as a way to help you think through a set of issues. Neoclassical theory is

especially good at pointing out the links between different markets. But you should be

suspicious if you hear anyone saying that a theory shows that one policy or another is

the right one in the real world.

The most famous neoclassical model is also the simplest the model developed by the

English political economist David Ricardo in the early 1800s. Its simple because

Ricardo assumes that there is only one factor of production (i.e. type of input)

labor. This model makes the point that trade should, in principle; benefit both parties

even if one is more efficient. More sophisticated models were developed in the current

century as economists learned more maths. The best-known is the Heckscher-Ohlin

model, named after a couple of Swedish economists, which is often called Heckscher-

Ohlin-Samuelson (HOS) because of the important contributions made by the U.S.

economist Paul Samuelson. HOS includes two factors of production (e.g. labor and

land), and it shows that particular factors of production may be hurt by trade, though it

still agrees with Ricardo that there are overall gains from trade.

There are many other varieties of trade theory, making different assumptions and getting

different results. One kind that has gotten a lot of attention in recent years assumes

increasing returns to scale, which means that large producers are more efficient than

smaller producers. Ricardo, as noted above, assumed constant scale returns.

Neoclassical theories like HOS assume decreasing returns and get generally similar

results. If you allow increasing returns then bigger is better, and one nation may end up

dominating an industry, but it's hard to say which nation will do so. In this case, the

ability to intimidate and bluff may be important. So increasing returns undermines the

ability of theory to explain or predict observed trade. Perhaps more seriously, scale

economies may stack the deck against late-developers.

1.3 RICARDIAN MODEL AND THEORIES OF ABSOLUTE

ADVANTAGE

The Ricardian model focuses on comparative advantage and is perhaps the most

important concept in international trade theory. In a Ricardian model, countries specialize

in producing what they produce best. Unlike other models, the Ricardian framework

predicts that countries will fully specialize instead of producing a broad array of goods.

http://en.wikipedia.org/wiki/Comparative_advantage

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Also, the Ricardian model does not directly consider factor endowments, such as the

relative amounts of labor and capital within a country. The main merit of Ricardin model

is that it assumes technology differences between countries. Technology gap is easily

included in the Ricardian and Ricardo-Sraffa model (See the next subsection).

The Ricardian model makes the following assumptions:

1. Labor is the only primary input to production (labor is considered to be the ultimate source of value).

2. Constant Marginal Product of Labor (MPL) (Labor productivity is constant, constant returns to scale, and simple technology.)

3. Limited amount of labor in the economy 4. Labor is perfectly mobile among sectors but not internationally. 5. Perfect competition (price-takers).

The Ricardian model measures in the short-run, therefore technology differs

internationally. This supports the fact that countries follow their comparative advantage

and allows for specialization.

In economics, the law of comparative advantage refers to the ability of a party (an

individual, a firm, or a country) to produce a particular good or service at a lower

opportunity cost than another party. It is the ability to produce a product most efficiently

given all the other products that could be produced. It can be contrasted with absolute

advantage which refers to the ability of a party to produce a particular good at a lower

absolute cost than another.

Comparative advantage explains how trade can create value for both parties even when

one can produce all goods with fewer resources than the other. The net benefits of such

an outcome are called gains from trade. It is the main concept of the pure theory of

international trade.

1.3.1 Origins of the theory

Comparative advantage was first described by Robert Torrens in 1815 in an essay on the

Corn Laws. He concluded it was to England's advantage to trade with Portugal in return

for grain, even though it might be possible to produce that grain more cheaply in England

than Portugal.

However the term is usually attributed to David Ricardo who explained it in his 1817

book On the Principles of Political Economy and Taxation in an example involving

England and Portugal. In Portugal it is possible to produce both wine and cloth with less

labor than it would take to produce the same quantities in England. However the relative

costs of producing those two goods are different in the two countries. In England it is

very hard to produce wine, and only moderately difficult to produce cloth. In Portugal

both are easy to produce.

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Therefore while it is cheaper to produce cloth in Portugal than England, it is cheaper still

for Portugal to produce excess wine, and trade that for English cloth. Conversely England

benefits from this trade because its cost for producing cloth has not changed but it can

now get wine at a lower price, closer to the cost of cloth. The conclusion drawn is that

each country can gain by specializing in the good where it has comparative advantage,

and trading that good for the other.

Examples

The following hypothetical examples explain the reasoning behind the theory. In

Example 2 all assumptions are italicized for easy reference, and some are explained at the

end of the example.

Example 1

Two men live alone on an isolated island. To survive they must undertake a few basic

economic activities like water carrying, fishing, cooking and shelter construction and

maintenance. The first man is young, strong, and educated. He is also, faster, better, more

productive at everything. He has an absolute advantage in all activities. The second man

is old, weak, and uneducated. He has an absolute disadvantage in all economic activities.

In some activities the difference between the two is great; in others it is small.

Despite the fact that the younger man has absolute advantage in all activities, it is not in

the interest of either of them to work in isolation since they both can benefit from

specialization and exchange. If the two men divide the work according to comparative

advantage then the young man will specialize in tasks at which he is most productive,

while the older man will concentrate on tasks where his productivity is only a little less

than that of the young man. Such an arrangement will increase total production for a

given amount of labor supplied by both men and it will benefit both of them.

Example 2

Suppose there are two countries of equal size, Northland and Southland, that both

produce and consume two goods, Food and Clothes. The productive capacities and

efficiencies of the countries are such that if both countries devoted all their resources to

Food production, output would be as follows:

Northland: 100 tonnes

Southland: 400 tonnes

If all the resources of the countries were allocated to the production of Clothes, output

would be:

Northland: 100 tonnes

Southland: 200 tonnes

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Assuming each has constant opportunity costs of production between the two products

and both economies have full employment at all times. All factors of production are

mobile within the countries between clothing and food industries, but are immobile

between the countries. The price mechanism must be working to provide perfect

competition.

Southland has an absolute advantage over Northland in the production of Food and

Clothing. There seems to be no mutual benefit in trade between the economies, as

Southland is more efficient at producing both products. The opportunity costs shows

otherwise. Northland's opportunity cost of producing one tonne of Food is one tonne of

Clothes and vice versa. Southland's opportunity cost of one tonne of Food is 0.5 tonne of

Clothes. The opportunity cost of one tonne of Clothes is 2 tonnes of Food. Southland has

a comparative advantage in food production, because of its lower opportunity cost of

production with respect to Northland. Northland has a comparative advantage over

Southland in the production of clothes, the opportunity cost of which is higher in

Southland with respect to Food than in Northland.

To show these different opportunity costs lead to mutual benefit if the countries

specialize production and trade, consider the countries produce and consume only

domestically. The volumes are:

Production and consumption

before trade

Food Clothes

Northland 50 50

Southland 200 100

TOTAL 250 150

This example includes no formulation of the preferences of consumers in the two

economies which would allow the determination of the international exchange rate of

Clothes and Food.

Given the production capabilities of each country, in order for trade to be worthwhile

Northland requires a price of at least one tonne of Food in exchange for one tonne of

Clothes; and Southland requires at least one tonne of Clothes for two tonnes of Food. The

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exchange price will be somewhere between the two. The remainder of the example works

with an international trading price of one tonne of Food for 2/3 tonne of Clothes.

If both specialize in the goods in which they have comparative advantage, their outputs

will be:

Production after trade

Food Clothes

Northland 0 100

Southland 300 50

TOTAL 300 150

World production of food increased. Clothing production remained the same. Using the

exchange rate of one tonne of Food for 2/3 tonne of Clothes, Northland and Southland are

able to trade to yield the following level of consumption:

Consumption after trade

Food Clothes

Northland 75 50

Southland 225 100

World total 300 150

Northland traded 50 tonnes of Clothing for 75 tonnes of Food. Both benefited, and now

consume at points outside their production possibility frontiers.

http://en.wikipedia.org/wiki/Production_possibility_frontier

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Assumptions in Example 2

Two countries, two goods - the theory is no different for larger numbers of

countries and goods, but the principles are clearer and the argument easier to

follow in this simpler case.

Equal size economies - again, this is a simplification to produce a clearer

example.

Full employment - if one or other of the economies has less than full

employment of factors of production, then this excess capacity must usually be

used up before the comparative advantage reasoning can be applied.

Constant opportunity costs - a more realistic treatment of opportunity costs the

reasoning is broadly the same, but specialization of production can only be taken

to the point at which the opportunity costs in the two countries become equal.

This does not invalidate the principles of comparative advantage, but it does limit

the magnitude of the benefit.

Perfect mobility of factors of production within countries - this is necessary to

allow production to be switched without cost. In real economies this cost will be

incurred: capital will be tied up in plant (sewing machines are not sowing

machines) and labour will need to be retrained and relocated. This is why it is

sometimes argued that 'nascent industries' should be protected from fully

liberalised international trade during the period in which a high cost of entry into

the market (capital equipment, training) is being paid for.

Immobility of factors of production between countries - why are there

different rates of productivity? The modern version of comparative advantage

(developed in the early twentieth century by the Swedish economists Eli

Heckscher and Bertil Ohlin) attributes these differences to differences in nations'

factor endowments. A nation will have comparative advantage in producing the

good that uses intensively the factor it produces abundantly. For example:

suppose the US has a relative abundance of capital and India has a relative

abundance of labor. Suppose further that cars are capital intensive to produce,

while cloth is labor intensive. Then the US will have a comparative advantage in

making cars, and India will have a comparative advantage in making cloth. If

there is international factor mobility this can change nations' relative factor

abundance. The principle of comparative advantage still applies, but who has the

advantage in what can change.

Negligible Transport Cost - Cost is not a cause of concern when countries

decided to trade. It is ignored and not factored in.

Assume that half the resources are used to produce each good in each

country. This takes place before specialization.

Perfect competition - this is a standard assumption that allows perfectly efficient

allocation of productive resources in an idealized free market.

Example 3

The economist Paul Samuelson provided another well known example in his Economics.

Suppose that in a particular city the best lawyer happens also to be the best secretary, that

http://en.wikipedia.org/wiki/Paul_Samuelsonhttp://en.wikipedia.org/wiki/Economics_(textbook)

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is he would be the most productive lawyer and he would also be the best secretary in

town. However, if this lawyer focused on the task of being an attorney and, instead of

pursuing both occupations at once, employed a secretary, both the output of the lawyer

and the secretary would increase.

1.3.2 Effects on the economy

Conditions that maximize comparative advantage do not automatically resolve trade

deficits. In fact, in many real world examples where comparative advantage is attainable

may in fact require a trade deficit. For example, the amount of goods produced can be

maximized, yet it may involve a net transfer of wealth from one country to the other,

often because economic agents have widely different rates of saving.

As the markets change over time, the ratio of goods produced by one country versus

another variously changes while maintaining the benefits of comparative advantage. This

can cause national currencies to accumulate into bank deposits in foreign countries where

a separate currency is used.

Macroeconomic monetary policy is often adapted to address the depletion of a nation's

currency from domestic hands by the issuance of more money, leading to a wide range of

historical successes and failures.

1.3.3 Criticism

Development economics

The theory of comparative advantage, and the corollary that nations should specialize, is

criticized on pragmatic grounds within the import substitution industrialization theory of

development economics, on empirical grounds by the SingerPrebisch thesis which states

that terms of trade between primary producers and manufactured goods deteriorate over

time, and on theoretical grounds of infant industry and Keynesian economics. In older

economic terms, comparative advantage has been opposed by mercantilism and economic

nationalism. These argue instead that while a country may initially be comparatively

disadvantaged in a given industry (such as Japanese cars in the 1950s), countries should

shelter and invest in industries until they become globally competitive. Further, they

argue that comparative advantage, as stated, is a static theory it does not account for the

possibility of advantage changing through investment or economic development, and thus

does not provide guidance for long-term economic development.

Free mobility of capital in a globalized world

Ricardo explicitly bases his argument on an assumed immobility of capital:

" ... if capital freely flowed towards those countries where it could be most

profitably employed, there could be no difference in the rate of profit, and no

other difference in the real or labour price of commodities, than the additional

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quantity of labour required to convey them to the various markets where they

were to be sold."

He explains why from his point of view (anno 1817) this is a reasonable assumption:

"Experience, however, shows, that the fancied or real insecurity of capital, when not

under the immediate control of its owner, together with the natural disinclination which

every man has to quit the country of his birth and connexions, and entrust himself with all

his habits fixed, to a strange government and new laws, checks the emigration of capital."

Some scholars, notably Herman Daly, an American ecological economist and professor at

the School of Public Policy of University of Maryland, have voiced concern over the

applicability of Ricardo's theory of comparative advantage in light of a perceived increase

in the mobility of capital: "International trade (governed by comparative advantage)

becomes, with the introduction of free capital mobility, interregional trade (governed by

Absolute advantage)."

Adam Smith developed the principle of absolute advantage. The economist Paul Craig

Roberts notes that the comparative advantage principles developed by David Ricardo do

not hold where the factors of production are internationally mobile. Limitations to the

theory may exist if there is single kind of utility. The very fact that people want food and

shelter already indicates that multiple utilities are present in human desire. The moment

the model expands from one good to multiple goods, the absolute may turn to a

comparative advantage. However, global labor arbitrage, where one country exploits the

cheap labor of another, would be a case of absolute advantage that is not mutually

beneficial.

Economist Ha-Joon Chang criticized that the comparative advantage principle may have

helped developed countries maintain relative advancedness of technology and industry

over developing countries. In his book Kicking Away the Ladder, Chang argued that all

major developed countries, including the United States and United Kingdom, used

interventionist, protectionist economic policies in order to get rich and then tried to forbid

other countries from doing the same. For example, according to the comparative

advantage principle, developing countries with a comparative advantage in agriculture

should continue to specialize in agriculture and import high-technology widgits from

developed countries with a comparative advantage in high technology. In the long run,

developing countries would lag behind developed countries, and polarization of wealth

would set in. Chang asserts that premature free trade has been one of the fundamental

obstacles to poverty alleviation in many developing world. Recently, Asian countries

such as South Korea, Japan and China have utilized protectionist economic policies in

their economic development.

1.3.4 Modern development of the Ricardian model

The Ricardian trade model was studied by Graham, Jones, McKenzie and others. All the

theories excluded intermediate goods, or traded input goods such as materials and capital

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goods. McKenzie(1954), Jones(1961) and Samuelson(2001)emphasized that considerable

gains from trade would be lost once intermediate goods were excluded from trade. In a

famous comment McKenzie (1954, p.179) pointed that "A moment's consideration will

convince one that Lancashire would be unlikely to produce cotton cloth if the cotton had

to be grown in England."

Recently, the theory was extended to the case that includes traded intermediates. Thus the

"labor only" assumption (#1 above) was removed from the theory. Thus the new

Ricardian theory, or the Ricardo-Sraffa model, as it is sometimes named, theoretically

includes capital goods such as machines and materials, which are traded across countries.

In the time of global trade, this assumption is much more realistic than the Heckscher-

Ohlin model, which assumes that capital is fixed inside the country and does not move

internationally.

1.4 HECKSCHER-OHLIN MODEL

In the early 1900s an international trade theory called factor proportions theory emerged

by two Swedish economists, Eli Heckscher and Bertil Ohlin. This theory is also called the

Heckscher-Ohlin theory. The Heckscher-Ohlin theory stresses that countries should

produce and export goods that require resources (factors) that are abundant and import

goods that require resources in short supply. This theory differs from the theories of

comparative advantage and absolute advantage since these theory focuses on the

productivity of the production process for a particular good. On the contrary, the

Heckscher-Ohlin theory states that a country should specialise production and export

using the factors that are most abundant, and thus the cheapest. Not to produce, as earlier

theories stated, the goods it produces most efficiently.

The Heckscher-Ohlin model was produced as an alternative to the Ricardian model of

basic comparative advantage. Despite its greater complexity it did not prove much more

accurate in its predictions. However from a theoretical point of view it did provide an

elegant solution by incorporating the neoclassical price mechanism into international

trade theory.

The theory argues that the pattern of international trade is determined by differences in

factor endowments. It predicts that countries will export those goods that make intensive

use of locally abundant factors and will import goods that make intensive use of factors

that are locally scarce. Empirical problems with the H-O model, known as the Leontief

paradox, were exposed in empirical tests by Wassily Leontief who found that the United

States tended to export labor intensive goods despite having capital abundance.

The H-O model makes the following core assumptions:

1. Labor and capital flow freely between sectors 2. The production of shoes is labor intensive and computers is capital intensive 3. The amount of labor and capital in two countries differ (difference in

endowments)

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4. free trade 5. technology is the same across countries (long-term) 6. Tastes are the same.

The problem with the H-O theory is that it excludes the trade of capital goods (including

materials and fuels). In the H-O theory, labor and capital are fixed entities endowed to

each country. In a modern economy, capital goods are traded internationally. Gains from

trade of intermediate goods are considerable, as it was emphasized by Samuelson (2001).

1.4.1 Reality and Applicability of the Heckscher-Ohlin Model

The Heckscher-Ohlin theory is preferred to the Ricardo theory by many economists,

because it makes fewer simplifying assumptions. In 1953, Wassily Leontief published a

study, where he tested the validity of the Heckscher-Ohlin theory. The study showed that

the U.S was more abundant in capital compared to other countries; therefore the U.S

would export capital- intensive goods and import labour-intensive goods. Leontief found

out that the U.S's export was less capital intensive than import.

After the appearance of Leontief's paradox, many researchers tried to save the Heckscher-

Ohlin theory, either by new methods of measurement, or either by new interpretations.

Leamer emphasized that Leontief did not interpret HO theory properly and claimed that

with a right interpretation paradox did not occur. Brecher and Choudri found that, if

Leamer was right, the American workers consumption per head should be lower than the

workers world average consumption.

Many other trials followed but most of them failed. Many of famous textbook writers,

including Krugman and Obstfeld and Bowen, Hollander and Viane, are negative about

the validity of H-O model.. After examining the long history of empirical research,

Bowen, Hollander and Viane concluded: "Recent tests of the factor abundance theory [H-

O theory and its developed form into many-commodity and many-factor case] that

directly examine the H-O-V equations also indicate the rejection of the theory."

Heckscher-Ohlin theory is not well adapted to the analyze South-North trade problems.

The assumptions of HO are less realistic with respect to N-S than N-N (or S-S) trade.

Income differences between North and South is the one that third world cares most. The

factor price equalization [a consequence of HO theory] has not shown much sign of

realization. HO model assumes identical production functions between countries. This is

highly unrealistic. Technological gap between developed and developing countries is the

main concern of the poor countries.

1.4.2 Specific factors model and Factor-Price Equalization

The fourth major theorem that arises out of the Heckscher-Ohlin model is called the

factor-price equalization theorem. Simply stated the theorem says that when the prices of

the output goods are equalized between countries as they move to free trade, then the

prices of the factors (capital and labor) will also be equalized between countries.

17

This implies that free trade will equalize the wages of workers and the rents earned on

capital throughout the world.

The theorem derives from the assumptions of the model, the most critical of which is the

assumption that the two countries share the same production technology and that markets

are perfectly competitive.

In a perfectly competitive market the return to a factor of production depends upon the

value of its marginal productivity. The marginal productivity of a factor, like labor, in

turn depends upon the amount of labor being used as well as the amount of capital. As the

amount of labor rises in an industry, labor's marginal productivity falls. As the amount of

capital rises, labor's marginal productivity rises. Finally the value of productivity depends

upon the output price commanded by the good in the market.

In autarky, the two countries face different prices for the output goods. The difference in

prices alone is sufficient to cause a deviation in wages and rents between countries,

because it affects the marginal productivity. However, in addition, in a variable

proportions model the difference in wages and rents also affects the capital-labor ratios in

each industry, which in turn affects the marginal products. All of this means that for

various reasons the wage and rental rates will differ between countries in autarky.

Once free trade is allowed in outputs, output prices will become equal in the two

countries. Since the two countries share the same marginal productivity relationships it

follows that only one set of wage and rental rates can satisfy these relationships for a

given set of output prices. Thus free trade will equalize goods prices and wage and rental

rates.

Since the two countries face the same wage and rental rates they will also produce each

good using the same capital-labor ratio. However, because the countries continue to have

different quantities of factor endowments, they will produce different quantities of the

two goods.

Global Competitiveness Index (2006-2007): competitiveness is an important determinant

for the well-being of states in an international trade environment.

In this model, labor mobility between industries is possible while capital is immobile

between industries in the short-run. Thus, this model can be interpreted as a 'short run'

version of the Heckscher-Ohlin model. The specific factors name refers to the given that

in the short-run, specific factors of production such as physical capital are not easily

transferable between industries. The theory suggests that if there is an increase in the

price of a good, the owners of the factor of production specific to that good will profit in

real terms.

Additionally, owners of opposing specific factors of production (i.e. labor and capital) are

likely to have opposing agendas when lobbying for controls over immigration of labor.

Conversely, both owners of capital and labor profit in real terms from an increase in the

http://en.wikipedia.org/wiki/Global_Competitiveness_Indexhttp://en.wikipedia.org/wiki/Competitiveness

18

capital endowment. This model is ideal for particular industries. This model is ideal for

understanding income distribution but awkward for discussing the pattern of trade.

1.4.3 StolperSamuelson theorem and factor price

The StolperSamuelson theorem is a basic theorem in trade theory. It describes a relation

between the relative prices of output goods and relative factor rewards, specifically, real

wages and real returns to capital.

The theorem states that under some economic assumptions (constant returns, perfect

competition) a rise in the relative price of a good will lead to a rise in the return to that

factor which is used most intensively in the production of the good, and conversely, to a

fall in the return to the other factor.

It was derived in 1941 from within the framework of the HeckscherOhlin model by Paul

Samuelson and Wolfgang Stolper, but has subsequently been derived in less restricted

models. As a term, it is applied to all cases where the effect is seen. Ronald W. Jones and

Jos Scheinkman (1977) show that under very general conditions the factor returns

change with output prices as predicted by the theorem. If considering the change in real

returns under increased international trade a robust finding of the theorem is that returns

to the scarce factor will go down, ceteris paribus. A further robust corollary of the

theorem is that a compensation to the scarce-factor exists which will overcome this effect

and make increased trade Pareto optimal.

The original HeckscherOhlin model was a two factor model with a labour market

specified by a single number. Therefore, the early versions of the theorem could make no

predictions about the effect on the unskilled labour force in a high income country under

trade liberalization. However, more sophisticated models with multiple classes of worker

productivity have been shown to produce the StolperSamuelson effect within each class

of labour: Unskilled workers producing traded goods in a high-skill country will be worse

off as international trade increases, because, relative to the world market in the good they

produce, an unskilled first world production-line worker is a less abundant factor of

production than capital.

The StolperSamuelson theorem is closely linked to the factor price equalization

theorem, which states that, regardless of international factor mobility, factor prices will

tend to equalize across countries that do not differ in technology.

Derivation

Considering a two-good economy that produces only wheat and cloth, with labour and

land being the only factors of production, wheat a land-intensive industry and cloth a

labour-intensive one, and assuming that the price of each product equals its marginal

cost, the theorem can be derived.

The price of cloth should be:

http://en.wikipedia.org/wiki/Tradehttp://en.wikipedia.org/wiki/Real_wagehttp://en.wikipedia.org/wiki/Real_wagehttp://en.wikipedia.org/wiki/Economichttp://en.wikipedia.org/wiki/Heckscher%E2%80%93Ohlin_modelhttp://en.wikipedia.org/wiki/Paul_Samuelsonhttp://en.wikipedia.org/wiki/Paul_Samuelsonhttp://en.wikipedia.org/wiki/Wolfgang_Stolperhttp://en.wikipedia.org/wiki/Ronald_W._Joneshttp://en.wikipedia.org/wiki/Jos%C3%A9_Scheinkmanhttp://en.wikipedia.org/wiki/International_tradehttp://en.wikipedia.org/wiki/Ceteris_paribushttp://en.wikipedia.org/wiki/Compensationhttp://en.wikipedia.org/wiki/Pareto_optimalhttp://en.wikipedia.org/wiki/Heckscher%E2%80%93Ohlin_modelhttp://en.wikipedia.org/wiki/First_worldhttp://en.wikipedia.org/wiki/Factor_price_equalization_theoremhttp://en.wikipedia.org/wiki/Factor_price_equalization_theorem

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(1)

with P(C) standing for the price of cloth, r standing for rent paid to landowners, w for

wage levels and a and b respectively standing for the amount of land and labour used.

Similarly, the price of wheat would be:

(2)

with P(W) standing for the price of wheat, r and w for rent and wages, and c and d for the

respective amount of land and labour used.

If, then, cloth experiences a rise in its price, at least one of its factors must also become

more expensive, for equation 1 to hold true, since the relative amounts of labour and land

are not affected by changing prices. It can be assumed that it would be labour, the

intensively used factor in the production of cloth that would rise.

When wages rise, rent must fall, in order for equation 2 to hold true. But a fall in rent also

affects equation 1. For it to still hold true, then, the rise in wages must be more than

proportional to the rise in cloth prices.

A rise in the price of a product, then, will more than proportionally raise the return to the

most intensively used factor, and a fall on the return to the less intensively used factor.

1.5 NEW TRADE THEORY

New Trade theory tries to explain several facts about trade, which the two main models

above have difficulty with. These include the fact that most trade is between countries

with similar factor endowment and productivity levels, and the large amount of

multinational production (i.e. foreign direct investment) which exists. In one example of

this framework, the economy exhibits monopolistic competition and increasing returns to

scale. There are three basic theories that global marketer has to comprehend: 1.

Comparative Advantage Theory 2. Trade or product trade cycle theory 3. Business

orientation theory

1.6 GRAVITY MODEL

The Gravity model of trade presents a more empirical analysis of trading patterns rather

than the more theoretical models discussed above. The gravity model, in its basic form,

predicts trade based on the distance between countries and the interaction of the

countries' economic sizes. The model mimics the Newtonian law of gravity which also

considers distance and physical size between two objects. The model has been proven to

be empirically strong through econometric analysis. Other factors such as income level,

diplomatic relationships between countries, and trade policies are also included in

expanded versions of the model.

http://en.wikipedia.org/wiki/Monopolistic_competitionhttp://en.wikipedia.org/wiki/Law_of_gravityhttp://en.wikipedia.org/wiki/Econometric

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1.7 REGULATION OF INTERNATIONAL TRADE

Traditionally trade was regulated through bilateral treaties between two nations. For

centuries under the belief in mercantilism most nations had high tariffs and many

restrictions on international trade. In the 19th century, especially in the United Kingdom,

a belief in free trade became paramount. This belief became the dominant thinking

among western nations since then. In the years since the Second World War,

controversial multilateral treaties like the General Agreement on Tariffs and Trade

(GATT) and World Trade Organization have attempted to promote free trade while

creating a globally regulated trade structure. These trade agreements have often resulted

in discontent and protest with claims of unfair trade that is not beneficial to developing

countries.

Free trade is usually most strongly supported by the most economically powerful nations,

though they often engage in selective protectionism for those industries which are

strategically important such as the protective tariffs applied to agriculture by the United

States and Europe. The Netherlands and the United Kingdom were both strong advocates

of free trade when they were economically dominant, today the United States, the United

Kingdom, Australia and Japan are its greatest proponents. However, many other countries

(such as India, China and Russia) are increasingly becoming advocates of free trade as

they become more economically powerful themselves. As tariff levels fall there is also an

increasing willingness to negotiate non tariff measures, including foreign direct

investment, procurement and trade facilitation. The latter looks at the transaction cost

associated with meeting trade and customs procedures.

Traditionally agricultural interests are usually in favour of free trade while manufacturing

sectors often support protectionism. This has changed somewhat in recent years,

however. In fact, agricultural lobbies, particularly in the United States, Europe and Japan,

are chiefly responsible for particular rules in the major international trade treaties which

allow for more protectionist measures in agriculture than for most other goods and

services.

During recessions there is often strong domestic pressure to increase tariffs to protect

domestic industries. This occurred around the world during the Great Depression. Many

economists have attempted to portray tariffs as the underlining reason behind the collapse

in world trade that many believe seriously deepened the depression.

The regulation of international trade is done through the World Trade Organization at the

global level, and through several other regional arrangements such as MERCOSUR in

South America, the North American Free Trade Agreement (NAFTA) between the

United States, Canada and Mexico, and the European Union between 27 independent

states. The 2005 Buenos Aires talks on the planned establishment of the Free Trade Area

of the Americas (FTAA) failed largely because of opposition from the populations of

Latin American nations. Similar agreements such as the Multilateral Agreement on

Investment (MAI) have also failed in recent years.

http://en.wikipedia.org/wiki/List_of_bilateral_free_trade_agreementshttp://en.wikipedia.org/wiki/Mercantilismhttp://en.wikipedia.org/wiki/Tariffhttp://en.wikipedia.org/wiki/United_Kingdomhttp://en.wikipedia.org/wiki/Free_tradehttp://en.wikipedia.org/wiki/Second_World_Warhttp://en.wikipedia.org/wiki/Multilateralhttp://en.wikipedia.org/wiki/General_Agreement_on_Tariffs_and_Tradehttp://en.wikipedia.org/wiki/World_Trade_Organizationhttp://en.wikipedia.org/wiki/Free_tradehttp://en.wikipedia.org/wiki/Developing_countrieshttp://en.wikipedia.org/wiki/Developing_countrieshttp://en.wikipedia.org/wiki/Protectionismhttp://en.wikipedia.org/wiki/United_Stateshttp://en.wikipedia.org/wiki/United_Stateshttp://en.wikipedia.org/wiki/Europehttp://en.wikipedia.org/wiki/Netherlandshttp://en.wikipedia.org/wiki/Australiahttp://en.wikipedia.org/wiki/Japanhttp://en.wikipedia.org/wiki/Trade_facilitationhttp://en.wikipedia.org/wiki/Transaction_costhttp://en.wikipedia.org/wiki/Customshttp://en.wikipedia.org/wiki/Recessionhttp://en.wikipedia.org/wiki/Great_Depressionhttp://en.wikipedia.org/wiki/MERCOSURhttp://en.wikipedia.org/wiki/North_American_Free_Trade_Agreementhttp://en.wikipedia.org/wiki/European_Unionhttp://en.wikipedia.org/wiki/Free_Trade_Area_of_the_Americashttp://en.wikipedia.org/wiki/Free_Trade_Area_of_the_Americashttp://en.wikipedia.org/wiki/Multilateral_Agreement_on_Investmenthttp://en.wikipedia.org/wiki/Multilateral_Agreement_on_Investment

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1.7.1 Risk in international trade

Companies doing business across international borders face many of the same risks as

would normally be evident in strictly domestic transactions. For example,

Buyer insolvency (purchaser cannot pay);

Non-acceptance (buyer rejects goods as different from the agreed upon

specifications);

Credit risk (allowing the buyer to take possession of goods prior to payment);

Regulatory risk (e.g., a change in rules that prevents the transaction);

Intervention (governmental action to prevent a transaction being completed);

Political risk (change in leadership interfering with transactions or prices); and

War and Acts of God.

In addition, international trade also faces the risk of unfavorable exchange rate

movements (and, the potential benefit of favorable movements).

1.8 EMPIRICAL TESTING OF THEORY OF ABSOLUTE COST

During the seventeenth and eighteenth centuries the dominant economic philosophy was

mercantilism, which advocated severe restrictions on import and aggressive efforts to

increase export. The resulting export surplus was supposed to enrich the nation through

the inflow of precious metals. Adam Smith (1776), who is regarded as the father of

modern economics, countered mercantilist ideas by developing the concept of absolute

advantage. He argued that it was impossible for all nations to become rich

simultaneously by following mercantilist prescriptions because the export of one nation is

another nations import. However, all nations would gain simultaneously if they practiced

free trade and specialized in accordance with their absolute advantage. Table I,

illustrating Smiths concept of absolute advantage, shows quantities of wheat and cloth

produced by one hours work in two countries, the United States and the United

Kingdom.

TABLE 1

Absolute

advantage

Wheat (bushel/hr) 6 1

Clothes (yards/hr) 4 5

US UK

22

Division of labor and specialization occupy a central place in Smiths writing. Table I

indicates what the international division of labor should be, as the United States has an

absolute advantage in wheat and the U.K. has an absolute advantage in cloth. Smiths

absolute advantage is determined by a simple comparison of labor productivities across

countries.

Smiths theory of absolute advantage predicts that the United States will produce only

wheat (W) and the U.K. will produce only cloth (C). Both nations would gain if they

have unrestricted trade in wheat and cloth. If they trade 6W for 6C, then the gain of the

United States is 1/2 hours work, which is required to produce the extra 2C that it is

getting through trade with the U.K. Because the U.K. stops wheat production, the 6W it

gets from the United States will save six hours of labor time with which 30C can be

produced. After exchanging 6C out of 30C, the U.K. is left with 24C, which is equivalent

to almost five hours labor time.

Nations can produce more quantities of goods in which they have absolute advantage

with the labor time they save through international trade. Though Smith successfully

established the case for free trade, he did not develop the concept of comparative

advantage. Because absolute advantage is determined by a simple comparison of labor

productivities, it is possible for a nation to have absolute advantage in nothing. In Table I,

if the labor productivity in cloth production in the United States happened to be 8 instead

of 4, then the United States would have absolute advantage in both goods and the U.K.

would have absolute advantage in neither.

Adam Smith, however, was much more concerned with the role of foreign trade in

economic development and his model was essentially a dynamic one with variable factor

supplies, as pointed out by Hla Myint (1977).

David Ricardo (1817) was concerned with the static resource allocation problem when he

defined the concept of comparative advantage, which is determined not by absolute

values of labor productivity but by labor productivity ratios. Ricardo would have

interpreted the numbers in Table I by pointing out that, whereas U.S. labor in wheat

production is 1.5 (= 6/4) times as productive as it is in cloth production, the U.K.s labor

productivity in wheat is only one fifth of its labor productivity in cloth. Therefore, the

United States has comparative advantage in wheat and by inverting these ratios one can

show that the U.K. has comparative advantage in cloth.

This pattern of comparative advantage will not be affected if the United Sates has

absolute advantage in both wheat and cloth, which will be the case if we raise U.S. labor

productivity in cloth from 4 to 8. This is because 3/4 will still be greater than 1/5. The

rationale of labor productivity ratios comes from Ricardos labor theory of value.

Ricardo treated labor as the only source of value, as all other factors of production (such

as capital) are also produced by labor. Thus the price of a good (P) is simply equal to the

wage rate (w) times the labor (L) used in production, divided by output (Q), as profit is

zero in competitive markets: P = (w L)/Q. Because the average productivity of labor is a

23

= Q / L, P = w / a. If the labor market is competitive, the wage rate paid in all industries

will be the same. Therefore, the ratio between the price of wheat (Pw) and the price of

cloth (Pc) will be equal to the ratio between average productivity of labor in cloth (ac)

and average productivity of labor in wheat (aw): [Pw / Pc] = [ac / aw]. This creates a

direct link between comparative advantage and relative commodity prices in a

competitive economy. If the United States has comparative advantage in wheat

production, wheat will be relatively cheaper in the United States than in the U.K., which

provides the basis for trade.

Ricardos theory of comparative advantage creates hope for technologically backward

countries by implying that they can be a part of world trading system even though their

labor productivity in every good may be lower than that in the developed countries. In the

Ricardian model, trade is a win-win situation, as workers in all trading countries are able

to consume more of all goods. Ricardo was blissfully unaware of the complications that

would be created if his model included another factor such as capital, and if the producers

had responded to changes in factor price ratio in favor of the cheaper factor. It was

Wolfgang Stolper and Paul A. Samuelson (1941) who later discussed the effect of

international trade on income distribution.

The comparative advantage model has many unrealistic assumptions, which ignore the

fact that the real world consists of many countries producing many goods using many

factors of production. Each market is assumed to be perfectly competitive, when in

reality there are many industries in which firms have market power. Labor productivity is

assumed to be fixed and full employment is guaranteed. The model assumes that

technology differences are the only differences that exist between the countries. Finally,

in a dynamic context, comparative advantage changes, as trade in goods and capital alter

the trading countries factor endowments.

Hajime Oniki and Hirofumi Uzawa (1965) have shown in a formal model how trade and

economic growth continuously change patterns of trade and specialization. In spite of its

shortcomings, some of which have been removed by subsequent research (see Chipman

19651966), Ricardos model carries a message that cannot be ignored. Ricardos most

important contribution lies in the fact that he was the first economist to link specialization

with opportunity cost, which is the basis of modern trade theory. As for empirical testing

of Ricardos theories, G. D. A. MacDougall (19511952) demonstrated that trade

between the United States and the U.K. in 1937 followed Ricardos prediction. As a

matter of fact, Ricardian theory performs better in empirical testing than most other

theories.

Activity 1

1. What do you understand by theories of trade? Discuss Ricardo Model in detail along with suitable examples.

2. What are the assumptions in Heckscher Ohlin model of trade? 3. Discuss the difference between new trade theory and the gravity model. 4. Write a brief note on empirical testing of theory of absolute cost.

24

1.9 SUMMARY

The unit started with the discussion of trade theories and variety of these theories. In the

next section Ricardian model of absolute advantage was dealt. In a Ricardian model,

countries specialize in producing what they produce best. Unlike other models, the

Ricardian framework predicts that countries will fully specialize instead of producing a

broad array of goods. The next concern was Heckscher and Ohlin model. The theory

argues that the pattern of international trade is determined by differences in factor

endowments. It predicts that countries will export those goods that make intensive use of

locally abundant factors and will import goods that make intensive use of factors that are

locally scarce. New trade theory was discussed followed by the gravity model.

Regulations of International trade were explained in detail and finally empirical testing of

theory of absolute cost was revealed.

1.10 FURTHER READINGS

Guillory, Gil (March 25, 2005). "comparative advantage versus absolute advantage". Mises Economics Blog. Ludwig von Mises Institute.

Harrington, James W. "International Trade Theory". Geography 349 Absolute advantage. University of Washington

Carbaugh, Robert J. (2005). "International Economics". Foundations of trade theory 10th edition. Thomson/South-Western.

Joshi, Rakesh Mohan, (2009) International Business, Oxford University Press, New Delhi and New York

Frances Stewart, Recent Theories of International Trade: Some Implications for the South, Henryk Kierzkowski(Ed.) 1989 Monopolistic Competition and

International Trade, Oxford University Press

http://en.wikipedia.org/wiki/Factor_endowmentshttp://en.wikipedia.org/wiki/Factor_endowmentshttp://en.wikipedia.org/wiki/Good_(economics)http://blog.mises.org/archives/003386.asphttp://blog.mises.org/archives/003386.asphttp://faculty.washington.edu/jwh/349lec03.htmhttp://econ-server.umd.edu/~araujo/courses/econ340/slides/Chapter2.pdf

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UNIT 2

MEASUREMENT OF GAINS FROM TRADE

Objectives

After studying this unit you should be able to:

Understand the approach of gains from trade

Know the methods of measurement and distribution of gains from trade

Appreciate the approaches terms of trade

Describe the role of trade in the growth of the economies

Structure

2.1 Introduction

2.2 Measurement and distribution of gains from trade

2.3 Terms of trade

2.4 Trade as an engine of economic growth

2.5 Summary

2.6 Further readings

2.1 INTRODUCTION

Gains trade in economics refers to net benefits to agents from voluntary trading with each

other. It is commonly described as resulting from:

specialization in production from division of labor, economies of scale, and

relative availability of factor resources and in types of output by farms,

businesses, location, and economies

a resulting increase in total output possibilities

trade through markets from sale of one type of output for other, more highly

valued goods.

Market incentives, such as reflected in prices of outputs and inputs, are theorized to

attract factors of production, including labor, into activities according to comparative

advantage, that is, for which they each have a low opportunity cost. The factor owners

then use their increased income from such specialization to buy more-valued goods of

which they would otherwise be high-cost producers, hence their gains from trade. The

concept may be applied to an entire economy for the alternatives of autarky (no trade) or

trade. A measure of total gains from trade is the sum of consumer surplus and producer

profits or, more roughly, the increased output from specialization in production with

resulting trade. Gains from trade may also refer to net benefits to a country from lowering

barriers to trade such as tariffs on imports.

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26

From publication of Adam Smith's The Wealth of Nations in 1776, it has been widely

argued, that, with competition and absent market distortions, such gains are positive in

moving toward free trade and away from autarky or prohibitively high import tariffs.

Rigorous early statements of the conditions under which this proposition holds are found

in Samuelson in 1939 and 1962. For the analytically tractable general case of Arrow-

Debreu goods, formal proofs came in 1972 for determining the condition of no losers in

moving from autarky toward free trade. It does not follow that no tariffs are the best an

economy could do. Rather, a large economy might be able to set taxes and subsidies to its

benefit at the expense of other economies. Later results of Kemp and others showed that

in an Arrow-Debreu world with a system of lump-sum compensatory mechanisms,

corresponding to a customs union for a given subset set of countries (described by free

trade among a group of economies and a common set of tariffs), there is a common set of

world' tariffs such that no country would be worse off than in the smaller customs union.

The suggestion is that if a customs union has advantages for an economy, there is a

worldwide customs union that is at least as good for each country in the world

2 . 2 M E A S U R E M E N T A N D D I S T R I B U T I O N O F

G A I N S F R O M T R A D E

There are potentially many gains in economic welfare to be achieved through free trade:

Greater choice of products for consumers

Increased competition for producers

Other countries can supply certain products more efficiently

Trade speeds up the pace of technological progress and innovation

Businesses are better placed to exploit economies of scale

Political benefits from expansion of global trade

The theory of comparative advantage can show these gains from trade: The diagrams

below take you through an example:

Establishing the comparative advantage:

http://en.wikipedia.org/wiki/Adam_Smithhttp://en.wikipedia.org/wiki/The_Wealth_of_Nationshttp://en.wikipedia.org/wiki/Distortions_(economics)http://en.wikipedia.org/wiki/Free_tradehttp://en.wikipedia.org/wiki/Tariffshttp://en.wikipedia.org/wiki/Arrow-Debreu_modelhttp://en.wikipedia.org/wiki/Arrow-Debreu_modelhttp://en.wikipedia.org/wiki/Lump_sum_taxhttp://en.wikipedia.org/wiki/Customs_union

27

With half their economic resources allocated to each product, Germany can produce more

of both freezers and dishwashers than Italy. But Italy is closest to Germany in producing

freezers. The opportunity cost of each extra freezer for Italy is 1/4 dishwasher, whereas

for Germany the opportunity cost is 1/2 of a dishwasher. Italy should therefore specialise

in the production of freezers. Germany has a comparative advantage in freezers.

The effects of specialisation

Specialisation has led to an increase in output of both goods (pre specialisation output is

shown in brackets at the bottom of the table)

Gains from trade between the two countries

28

For mutually beneficial trade to take place an acceptable term of trade between freezers

and dishwashers has to be established. Both countries stand to gain from a swap of 3

freezers for 1 dishwasher. The allocation of output after trade has taken place is shown in

the table above.

The main reason why the presence of economies of scale can generate trade gains is

because the reallocation of resources can raise world productive efficiency. Basic

Assumptions

Suppose there are two countries, the US and France, producing two goods, clothing and

steel, using one factor of production, labor. Assume the production technology is

identical in both countries and can be described with the following production functions.

Production of Clothing:

US France

where

QC = quantity of clothing produced in the U.S.

LC = amount of labor applied to clothing production in the U.S.

29

aLC = unit-labor requirement in clothing production in the U.S. and France ( hours of labor

necessary to produce one rack of clothing)

and where all starred variables are defined in the same way but refer to the process in

France. Note that since production technology is assumed the same in both countries, we

use the same unit-labor requirement in the US and the French production function.

Production of Steel: The production of steel is assumed to exhibit economies of scale in

production.

US France

where

QS = quantity of steel produced in the U.S.

LS = amount of labor applied to steel production in the U.S.

aLS(QS) = unit-labor requirement in steel production in the U.S. ( hours of labor necessary

to produce one ton of steel). Note, it is assumed that the unit labor requirement is a

function of the level of steel output in the domestic industry. More specifically we will

assume that the unit-labor requirement falls as industry output rises.

Resource Constraint: The production decision is how to allocate labor between the two

industries. We assume that labor is homogeneous and freely mobile between industries.

The labor constraints are given below.

US France

where L is the labor endowment in the US and L* is the endowment in France. When the

resource constraint holds with equality it implies that the resource is fully employed.

Demand: We will assume that the US and France have identical demands for the two

products.

A Numerical Example

30

We proceed much as Ricardo did in presenting the argument of the gains from

specialization in one's comparative advantage good. First we will construct autarky

equilibrium in this model assuming that the two countries are identical in every respect.

Then we will show how an improvement in world productive efficiency can arise if one

of the two countries produces all of the steel that is demanded in the world.

Figure 1

Suppose the exogenous variables in the two countries take the values in the following

table.

US

L = 100

France

L* = 100

Let the unit-labor requirement for steel be read off of the adjoining graph. The graph

shows that when 50 tons of steel are produced by the economy, the unit-labor

requirement is 1 hour of labor per ton of steel. However, when 120 tons of steel are

produced, the unit-labor requirement falls to hour of labor per ton of steel.

An Autarky Equilibrium

The US and France, assumed to be identical in all respects, will share identical autarky

equilibria. Suppose the equilibria are such that production of steel in each country is 50

tons. Since at 50 tons of output, the unit-labor requirement is 1, it means that the total

amount of labor used in steel production is 50 hours. That leaves 50 hours of labor to be

allocated to the production of clothing, which with a unit-labor requirement of 1 also,

means that total output of clothing is 50 racks. The autarky production and consumption

levels are summarized below.

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Autarky Production/Consumption

Clothing

(racks)

Steel (tons)

US 50 50

France 50 50

World Total 100 100

The problem with these initial autarky equilibria is that because demands and supplies are

identical in the two countries, the prices of the goods would also be identical. With

identical prices, there would be no incentive to trade if trade suddenly became free

between the two countries.

Gains from Specialization

Despite the lack of incentive to trade in the original autarky equilibria, we can show,

nevertheless, that trade could be advantageous for both countries. All that is necessary is

for one of the two countries to produce all of the good with economies of scale and let the

other country specialize in the other good.

For example, suppose we let France produce 120 tons of steel. This is greater than the

100 tons of world output of steel in the autarky equilibria. Since the unit-labor

requirement of steel is when 120 tons of steel are produced by one country, the total

labor can be found by plugging these numbers into the production function. That is, since

QS* = LS

*/aLS, QS* = 120 and aLS = , it must be that LS

* = 60. In autarky it took 100 hours

of labor for two countries to produce 100 tons of steel. Now it would take France 60

hours to produce 120 tons. That means more output with less labor.

If France allocates its remaining 40 hours of labor to clothing production and if the US

specializes in clothing production, then production levels in each country and world totals

after the reallocation of labor would be as shown in the following table.

Reallocated Production

Clothing

(racks)

Steel (tons)

US 100 0

France 40 120

World Total 140 120

32

The important result here is that it is possible to find a reallocation of labor across

industries such that world output of both goods rises. Or in other words, there is an

increase in world productive efficiency.

If output of both goods rises then surely it must be possible to find a term of trade such

that both countries would gain from trade. For example, if France were to export 60 tons

of steel and import 30 racks of clothing then each country would consume 70 units of

clothing (20 more than in autarky) and 60 tons of steel (10 more than in autarky).

The final conclusion of this numerical example is that when there are economies of scale

in production then free trade, after an appropriate reallocation of labor, can improve

national welfare for both countries relative to autarky. The welfare improvement arises

because by concentrating production in the economies of scale industry in one country,

advantage can be taken of the productive efficiency improvements.

2.3 TERMS OF TRADE

In international economics and international trade, terms of trade or TOT is the relative

prices of a country's export to import. "Terms of trade" are sometimes used as a proxy for

the relative social welfare of a country, but this heuristic is technically questionable and

should be used with extreme caution. An improvement in a nation's terms of trade (the

increase of the ratio) is good for that country in the sense that it has to pay less for the

products it imports. That is, it has to give up fewer exports for the imports it receives.

2.3.1 The term

"Terms of trade" takes a plural form. However, it is a single number that represents the

ratio of the relative prices.

Significance

Changes in a country's terms of trade can have important effects on its balance of

payments and on its economic growth. Deterioration in the NBTT, for example, will

worsen a country's trade balance -- unless it is offset by an increase in export volume --

so that in order to restore balance it will need to export more and/or import less. Since

domestic investment in most developing countries depends heavily on imported capital

equipment, spare parts, etc., any substantial cut in imports will hit investment and thereby

restrict, or even reduce, economic growth. Conversely, a substantial improvement in a

country's NBTT, or in its ITT, would allow it to expand imports, including imports of

capital equipment, and thus lay a basis for continued, or accelerated, economic growth in

the future.

The terms of trade measures the rate of exchange of one good or service for another when

two countries trade with each other.

For international trade to be mutually beneficial for each country, the terms of trade must

lay within the opportunity cost ratios for both countries.

http://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/International_tradehttp://en.wikipedia.org/wiki/Social_welfarehttp://en.wikipedia.org/wiki/Importhttp://en.wikipedia.org/wiki/Export

33

We calculate the terms of trade as an index number using the following formula:

Terms of Trade Index

ToT = 100 x Average export price index / Average import price index

If export prices are rising faster than import prices, the terms of trade index will rise.

This means that fewer exports have to be given up in exchange for a given volume of

imports.

If import prices rise faster than export prices, the terms of trade have deteriorated. A

greater volume of exports has to be sold to finance a given amount of imported goods and

services.

The terms of trade fluctuate in line with changes in export and import prices. Clearly the

exchange rate and the rate of inflation can both influence the direction of any change in

the terms of trade.

2.3.2 Oil prices and the terms of trade

Many developing countries are heavily dependent on exporting oil. And volatility in

international commodity markets creates serious problems with these countries terms of

trade. In the chart below, notice how closely the annual % change in the terms of trade

follows the movement in oil export prices.

When oil values collapsed in 1998, developing countries faced the enormous problem of

having to export much more oil to pay for a given volume of imports. The worsening in

the terms of trade will have adversely affected living standards in these countries. There

has been a sharp rebound in global oil prices this year, helping to boost the terms of trade

for oil exporters.

2.3.3 Terms of trade for developing nations

Developing countries can be caught in a trap where average price levels for their main

exports decline in the long run. This depressed the real value of their exports and worsens

the terms of trade. A greater volume of exports have to be given up to finance essential

imports of raw materials, components and fixed capital goods.

The problems intensified in 1998 with the collapse in the currencies of many Asian

developing countries. A big fall in the terms of trade signifies a reduction in real living

standards since imports of goods and services have become relatively more expensive.

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Figure 2

2.3.4 Terms of trade and competitiveness

Consider the effects of a large fall in the value of the exchange rate. The effect should be

a fall in export prices and a rise in the cost of imports. This worsens the terms of trade

index. But the lower exchange rate restores competitiveness for a country since demand

for exports should grow and import demand from domestic consumers should slow

down.

Much depends on how producers respond to the lower exchange rate. And for countries

without a diversified industrial base, the decline in earnings from each unit of exports has

a damaging effect on output, investment and employment.

2.3.5 Two country model CIE economics

In the simplified case of two countries and two commodities, terms of trade is defined as

the ratio of the price a country receives for its export commodity to the price it pays for

its import commodity. In this simple case the imports of one country are the exports of

the other country. For example, if a country exports 50 dollars worth of product in

exchange for 100 dollars worth of imported product, that country's terms of trade are

50/100 = 0.5. The terms of trade for the other country must be the reciprocal (100/50 =

2). When this number is falling, the country is said to have "deteriorating terms of trade".

If multiplied by 100, these calculations can be expressed as a percentage (50% and 200%

respectively). If a country's terms of trade fall from say 100% to 70% (from 1.0 to 0.7), it

has experienced a 30% deterioration in its terms of trade. When doing longitudinal (time

series) calculations, it is common to set the base year to make interpretation of the results

easier.

In basic Microeconomics, the terms of trade are usually set in the interval between the

opportunity costs for the production of a given good of two countries.

35

Terms of trade is the ratio of a country's export price index to its import price index,

multiplied by 100

2.3.6 Multi-commodity multi-country model

In the more realistic case of many products exchanged between many countries, terms of

trade can be calculated using a Laspeyres index. In this case, a nation's terms of trade is

the ratio of the Laspeyre price index of exports to the Laspeyre price index of imports.

The Laspeyre export index is the current value of the base period exports divided by the

base period value of the base period exports. Similarly, the Laspeyres import index is the

current value of the base period imports divided by the base period value of the base

period imports.

Where

price of exports in the current period

quantity of exports in the base period

price of exports in the base period

price of imports in the current period

quantity of imports in the base period

price of imports in the base period

Basically: Export Price Over Import price times 100 If the percentage is over 100% then

your economy is doing well (Capital Accumulation) If the percentage is under 100% then

your economy is not going well (More money going out then coming in)

2.3.7 Other terms-of-trade calculations

1. The net barter terms of trade is the ratio (expressed as a percentage) of relative export and import prices when volume is held constant.

2. The gross barter terms of trade is the ratio (expressed as a percent) of a quantity index of exports to a quantity index of inputs.

3. The income terms of trade is the ratio (expressed as a percent) of the value of exports to the price of imports.

4. The single factorial terms of trade is the net barter terms of trade adjusted for changes in the productivity of exports.

5. The double factorial terms of trade adjusts for both the productivity of exports and the productivity of imports.

2.3.8 Limitations

http://en.wikipedia.org/wiki/Laspeyres_index

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Terms of trade should not be used as synonymous with social welfare, or even Pareto

economic welfare. Terms of trade calculations do not tell us about the volume of the

countries' exports, only relative changes between countries. To understand how a

country's social utility changes, it is necessary to consider changes in the volume of trade,

changes in productivity and resource allocation, and changes in capital flows.

The price of exports from a country can be heavily influenced by the value of its

currency, which can in turn be heavily influenced by the interest rate in that country. If

the value of currency of a particular country is increased due to an increase in interest rate

one can expect the terms of trade to improve. However this may not necessarily mean an

improved standard of living for the country since an increase in the price of exports

perceived by other nations will result in a lower volume of exports. As a result, exporters

in the country may actually be struggling to sell their goods in the international market

even though they are enjoying a (supposedly) high price. An example of this is the high

export price suffered by New Zealand exporters since mid-2000 as a result of the

historical mandate given to the Reserve Bank of New Zealand to control inflation.

In the real world of over 200 nations trading hundreds of thousands of products, terms of

trade calculations can get very complex. Thus, the possibility of errors is significant.

2.4 TRADE AS AN ENGINE OF ECONOMIC GROWTH

The Classical and Neo Classical economists believed that participation in international

trade could be a strong positive force for economic development. There are some related

reasons that can be analyzed to support this argument. One approach to development is to

concentrate in producing export in industrial sector. Promoting exports could directly

lead to economic development either through encouraging production of goods for export

or allowing accumulation of foreign exchange which enables importation of capital

inputs indispensable for export. Moreover, such trade may result in facilitates more

diffusion of knowledge, enhance efficiency of input. Hence, pace the progress of

economic development. In any of these three cases, international trade can be described

as an engine of growth. (See Hogendorn, 1996, Cyper & Dietz, 1997).

There are various standard methods that have been test