MBASess1BComp09

Session 1-09 MBA Global Professor Augustine H H Tan 1

MBA Global Economy

Session 1B

Foundations of Modern Trade Theory


Introduction

Basis for tradeWhy do nations export and import?

Terms of tradeGains from international trade

Specific to production and consumption


Modern Trade Theory Historical Development

The MercantilistsConcern: Regulation of domestic and international affairs to promote national interestsSolution: Strong foreign-trade sector

Favorable trade balanceAdvocated government regulation of trade


Historical Development……..

Criticism of Mercantilist policies David Hume’s price-specie-flow doctrine

Favorable trade balance possible only in the short run; over time it would automatically be eliminated

Adam Smith’s “The Wealth of Nations”Challenged the static view of wealthDynamic view

International trade increases the level of productivity within a country, which in turn increases world output


Why Nations Trade: Absolute Advantage

Adam Smith Free trade and international division of laborCost differences govern movement of goodsProductivities of factor inputs represent the major determinant of production costDetermination of competitiveness from the supply side of the marketConcept of cost: Labor theory of value

Labor is the only factor of production and is homogeneousCost depends on labor requirements


Why Nations Trade…………..

Principle of absolute advantage Import goods in which a nation has an absolute cost disadvantageExport those goods in which it has an absolute cost advantage(Example: Table 2.1)



Why Nations Trade……….

David Ricardo: Comparative advantageMutually beneficial trade can occur even when one nation is absolutely more efficient in the production of all goods

Less efficient nation: Specialize in and export the good in which it is relatively less inefficientMore efficient nation: Specialize in and export that good in which it is relatively more efficient

Examples of comparative advantages (Table 2.2)



Why Nations Trade?

Assumptions of Ricardo’s model:World consists of two nations, each using a single input to produce two commoditiesLabor is the only input Labor can move freely among industries within a nation but is incapable of moving between nationsLevel of technology is fixed for both nationsCosts do not vary with level of production and are proportional to the amount of labor used


Why Nations Trade……….

Assumptions of Ricardo’s model (cont.):Perfect competition prevails in all marketsFree trade occurs between nationsTransportation costs are zeroFirms make production decisions to maximize profits; consumers maximize satisfaction through consumption decisionsThere is no money illusionTrade is balanced, no flows of money between nations

Comparative-advantage principle (Table 2.3)



Production Possibilities Schedules

Used to explain comparative advantage Shows production combinations of two goods when all factor inputs are used most efficiently Illustrates the maximum output possibilitiesMarginal rate of transformation (MRT)

Amount of one product a nation must sacrifice to get one additional unit of the other product

Hypothetical production possibilities schedules for the U.S and Canada: (Figure 2.1)



Trading Under Constant-Cost Conditions

Principle of comparative advantage under constant opportunity costs

Basis for trade and direction of tradeGains from trade

Two reasons for constant costs:Factors of production are perfect substitutes for each otherAll units of a given factor are of the same quality


Trading Under Constant-Cost Conditions…….

Basis for trade and direction of tradeRelative costs (Figure 2.1)

Point A – U.S: 40 autos and 40 bushels of wheat Point Al

– Canada: 40 autos and 80 bushels of wheatRelative cost of producing an additional auto

0.5 bushels of wheat for the United States 2 bushels of wheat for Canada

Direction of tradeUnited States specializing in and exporting autos Canada specializing in and exporting wheat



Production gains from specializationRefer (Figure 2.1)

United States moves from production point A to B, totally specializing in auto productionCanada totally specializes in wheat production by moving from Al to Bl

Summary of production gains (Table 2.4a)



Trading Under Constant-Cost Conditions……..

Consumption gains from trade (Figure 2.1)Specialization and trade

Achieve consumption points outside domestic production possibilities schedules

Terms of trade: Rate at which its export product is traded for the other country’s export product

Determines the set of post-trade consumption points Defines the relative prices at which two products are traded

Trading possibilities line: Line tt represents the international terms of trade for both countries


Trading Under Constant-Cost Conditions……

Consumption gains from trade (Figure 2.1)

Trade triangle: The triangle BCD (BlC

lD

lfor Canada)

showing the U.S. Exports (along the horizontal axis), Imports (along the vertical axis), and Terms of trade (the slope)

Consumption gains from trade for each country and the world as a whole (Table 2.4b)Complete specialization

Exception: One of the countries is too small to supply the other with all of its needs


Trading Under Constant-Cost Conditions……

Distributing the gains from tradeDomestic cost conditions (Figure 2.2)

Domestic cost ratios set the outer equilibrium terms of trade

Domestic cost-ratio line: The no-trade boundary

International terms of trade has to be better than or equal to the rate defined by domestic price lineRegion of mutually beneficial trade is bounded by cost ratios


Absolute Advantage Matters For Wages



Trading Under Constant-Cost Conditions…..

Equilibrium terms of tradeMill’s theory of reciprocal demand

Within the outer limits of the terms of trade, the actual terms of trade is determined by the relative strength of each country’s demand for the other country’s product (Figure 2.2)

Importance of being unimportantLarger nation attains fewer gains from trade while the smaller nation attains most of the gains



Terms-of-trade estimatesCommodity terms of trade (barter terms of trade)

Improvement: Rise in export prices relative to import prices over a time period Deterioration: Rise in import prices relative to export prices over a time period

Commodity terms of trade for selected countries (Table 2.5)



Dynamic Gains from Trade

Effect of trade on growth rate and thus on the volume of additional resources

Higher output and income resulting in savings and consequent investments Better supplier match for importsEconomies of large-scale productionIncreased competition

Impact on productivity, quality, and prices


Global Competition

Productivity gains for US Iron Ore workersIncreased competitive pressure on U.S. iron ore producers in the 1980sWorkers agreed to changes in work rules that enhanced labor productivity


Changing Comparative Advantage

Comparative advantage can vanish if productivity growth lags

Pressure on producers to reinvent themselves

Case: Semiconductor industry in the U.S.

Production possibilities schedules, for computers and automobiles, of the U.S. and Japan under constant opportunity cost (Figure 2.3)



Trading Under Increasing-Cost Conditions

Increasing opportunity costsConcave production possibilities schedule (Figure 2.4)

Principle of diminishing marginal productivitySupply factors as well as demand factors have to be considered



Increasing-Cost Trading Case

Process of specialization continues in both nations (Figure 2.5) until:

The relative cost of autos is identical in both nationsU.S. exports of autos precisely equal Canada’s imports of autos, and conversely for wheatProduction gains from specialization (Figure 2.6a)

Consumption gains from trade (Figure 2.6b)




Partial Specialization

Reason for partial specializationIncreasing costs constitute a mechanism that forces costs in two trading nations to convergeWhen cost differentials are eliminated, the basis for further specialization ceases to exist

Highly probable that both nations will produce some of each good


Impact of Trade on Jobs

Standard trade theoryExtent to which an economy is open:

Influences the mix of jobs Can cause dislocation in certain areas or industriesHas little effect on the overall level of employment


Impact of Trade on Jobs…………

Principle of comparative advantageTrade influences the mix of jobs

Shifting of workers and capital to more productive industries

Data suggests little impact on the overall number of jobs (Figure 2.6)



Comparative Advantage Extended to Many Products

More than two productsRank goods by degree of comparative cost (Example: Figure 6.7)

Each country exports the product(s) in which it has the greatest comparative advantageEach country imports the product(s) in which it has greatest comparative disadvantage

Cutoff point between exports and importsDepends on the relative strength of international demand for the various products



Comparative Advantage Extended to Many Countries

More than two CountriesAdvantageous for a country to enter into multilateral trading relationships (Figure 2.8)

Surpluses with trading partners that buy its exportsDeficits with trading partners that supply low-cost items imported

Bilateral agreements that balance exports and imports would:

Reduce volume of trade and specialization Hinder movement of resources to their highest productivity



Exit Barriers

Exit barriers hinder the necessary market adjustmentsVarious cost conditions make lengthy exit a rational response Case: U.S. steel industry

Nature of labor costs and benefitsPenalties for terminating contractsExpenses associated with writing off assetsEnvironmental costs Low realization on sale of assets


Comparative Advantage: Job Outsourcing [Offshoring]

Movement of factors of production around the globe Weakens comparative advantageDevelopments that caused major changes:

Strong educational systems produce skilled workers in developing nations, who work at lower cost Internet technology New political stability that permits free movement of technology and capital

American workers will encounter direct world competition at almost every job category


Advantages of Outsourcing [Offshoring]

Reduced costs and increased competitivenessCreation of new export requirementsRepatriated earningsOther contentions:

U.S. companies will become less competitive if they cannot outsource jobs

This will weaken the economy and threaten more jobs

Job losses tend to be temporary Creation of new industries and products leading to more lucrative jobs for Americans


Outsourcing and the U.S. Automobile Industry

Ford Motor CompanyEarly days: Assembly lineEmergence of competition and increased sophistication requirements

Number of tasks outgrew number of operations in a plant

Outsourcing of non-core tasksExternal suppliers contribute about 70 percent of a Ford vehicle

Reduction in costs and improvement in quality


Problems of Outsourcing

Loss of jobs Declining demand for low-skilled American workersShift of demand for high-skilled workers to cheaper substitutes in Asia

Risks to wagesDeclining wages of low-skilled workers both in real terms and relative to the wages of skilled workers

Measures to lessen the adverse effects of people suffering job losses





US Share of World Output

30% –

25% –

20% –

15% –

10% –

5% –

0 –

1820 1870 1913 1950 1973 1998

Percentage of World Output


World Export & GDP Growth

500 –

450 –

400 –

350 –

300 –

250 –

200 –

150 –

100 –

Vo

lum

e

1975 1980 1985 1990 1995 2000 2005

World Exports World GDP


Global Exports of Services

Sawyer, International Economics, 3rd ed. Pearson


Openness of Economies



Openness of Economies….



Openness of Economies….



Global Exports


25% –

20% –

15% –

10% –

5% –

0% –1975 1980 1985 1990 1995 2000 2005

Exports as a Percent of GDP

MBASess1BComp09

Documents

nations trade

beneficial trade

international trade

nations export

mba global economysession

markets free trade

money illusion trade

terms of trade gains