The Benefits of Trade by Elmer G. Wiens. Benefits of Increasing World Trade? Many people are skeptical about the benefits of trade. The Vancouver Sun’s.

The Benefits of Tradeby

Elmer G. Wiens

Benefits of Increasing World Trade?

• Many people are skeptical about the benefits of trade.

• The Vancouver Sun’s Stephen Hume predicts that a billion people will fall back into extreme poverty because of soaring food prices under the existing arrangements for trade among countries.

• Countries like Japan, who import a large proportion of food stuffs, are trying to increase food production to become more self-reliant.

• Why has the world moved deliberately to freer trade through international arrangements like NAFTA and the W.T.O., despite doubts about more free trade?

Canadian Goods & Services: exports, imports, balance of trade & GDP

Billions of Dollars

2003 2004 2005 2006 2007

Exports 462.5 495.3 520.4 524.7 534.7

Imports 416.9 440.7 468.2 487.7 503.4

Balance 45.6 54.6 52.2 37 31.3

GDP 1,213.2 1,290.8 1,375.1 1,446.3 1,531.4

• The production of goods and services for exports accounts for 1 / 3 of domestic production of goods and services• Canada’s balance of trade equals exports less imports.

Determinants of Canada’s Pattern of Trade

• What are the benefits of free trade?• What are the arguments against free trade?• Why does Canada export specific goods and

services?• Why does Canada import specific goods and

services?• Why are our favourite trading partners the USA,

Japan, the U.K., the E.E.C. countries, and China?

Economic Benefits of Specialization and Exchange A. Comparative Advantage – David Ricardo

B. Economies of Scale – Adam Smith

• A. Comparative Advantage: countries have differing opportunity costs of producing specific goods.

• Example: – Canada and the USA– Crude Petroleum and Automotive Products

• Canada can produce a barrel of oil at a lower cost relative to

manufacturing a car, compared to the USA.• Canada has a comparative advantage in crude oil

production. • USA has a comparative advantage in manufacturing

cars.

A. Comparative Advantage – David Ricardo

• The next slide depicts the analysis of comparative advantage of the 19th century economist, David Ricardo.

• Suppose Canada can produce 200 extra barrels of oil if it produces one less car and moves the freed-up resources into oil production.

• Canada’s opportunity cost of producing a car is 200 barrels of oil. Its opportunity cost of producing one barrel of oil is 1 / 200 of a car

• Similarly, suppose the USA’s opportunity cost of producing a car is 150 barrels of oil. Its opportunity cost of producing one barrel of oil is 1 / 150 of a car.

• Canada has a comparative advantage in oil over the USA: • -- 1 / 200 versus 1 / 150• Canada has a comparative disadvantage in cars:• -- 200 versus 150

A. Comparative Advantage – David Ricardo

Canada: Crude PetroleumUSA: Automotive Products

One

Car

One

Barrel of Oil

Canada

200

Oil Barrels

1 / 200

of a Car

USA

150

Oil Barrels

1 /150

of a Car

Crude Petroleum Production

Canadian Crude Petroleum: exports, imports, balance of trade

Billions of Dollars

2003 2004 2005 2006 2007

Exports 20.6 25.5 30.4 38.6 41.0

Imports 13.3 16.4 21.6 22.5 23.7

Balance 7.3 9.1 8.8 16.1 17.3

• Canada’s increasing exports and balance of trade in crude petroleum indicate its continuing comparative advantage in crude oil production.

• Canada exports 2.3 million barrels of petroleum to the USA each day, the USA’s top source.

Car Manufacturing

Canadian Automotive Products:exports, imports, balance of trade

Billions of Dollars

2003 2004 2005 2006 2007

Exports 87.4 90.4 88.1 82.5 77.7

Imports 76.5 77.4 78.4 79.8 80.0

Balance 10.9 13 9.7 2.7 -2.3

• Canadian exports of automotive products have fallen, while its imports have increased.

• Its balance of trade in automotive products has decreased to the point where we now have a deficit.

A. Comparative Advantage – David Ricardo Canada: Crude PetroleumUSA: Automotive Products

One

Car

One

Barrel of Oil

Canada

200

Oil Barrels

1 / 200

of a Car

USA

150

Oil Barrels

1 /150

of a Car

• It would appear that Ricardo’s theory of comparative advantage, based on opportunity costs, has some legs.

• Canadian production of crude petroleum has increased relative to the production of automotive products.

• How long will this trend continue?

B. Economies of Scale – Adam Smith

• The 18th century economist, Adam Smith, explained the notion of economies of scale in the Wealth of Nations.

• A firm can obtain cost advantages of expanding output if by increasing its fixed costs it shifts its short-run average total cost curve down and to the right along its long-run average cost curve.

• To achieve these economies of scale, automotive manufactures close inefficient plants in Canada and upgrade to more efficient plants in the USA.

• In the diagram of the next slide, I approximate the LRAC by a quadratic function.

• A firm can chose its SRAC by choosing its fixed costs – plant and equipment.

Economic Benefits of Specialization and Exchange

B. Economies of Scale – Adam Smith

• B. Economies of Scale: cost advantage of expansion of output by a firm that shifts its short-run average total cost curve (SRAC) down and to the right along its long-run average cost curve (LRAC).

B. Economies of Scale: Sources

• Specialized machinery and production lines with greater investment in capital equipment and automation.

• Skilled, specialized, and trained labour force working with machinery.

• Research and development making the technological improvements possible.

• Managerial innovations• Lower per unit marketing costs as advertising is spread over

greater output• Access to lower cost financing, e.g. borrowing at lower interest

rates. • Let’s look at the effects of economies of scale on

opportunity costs!

One

Car

One

Barrel of Oil

Canada

220

Oil Barrels

1 / 220

of a Car

USA

140

Oil Barrels

1 /140

of a Car

B: Comparative Advantage: Economies of Scale ExploitedCanada: Crude PetroleumUSA: Automotive Products

• In this scenario, on the one hand when the USA’s automotive industry exploits economies of scale, American comparative advantage in cars increases.

• On the other hand, Canada’s comparative advantage in oil increases as Canada’s automotive industry becomes less efficient.

USA Automotive Industry: Limits to Specialization

• The diagram on the next slide depicts the following situation:

• Assume three major firms behave competitively in the USA’s automotive industry.

• Short-run equilibrium obtains for each firm where Price = Marginal Cost, with Marginal Cost increasing.

• The demand function is mildly quadratic. So, at the equilibrium price output level, industry marginal revenue is positive and the elasticity of demand is greater than one in absolute value.

• Long-run equilibrium obtains when further expansion of plant and equipment moves the SRAC curves upward and to the right, as the opportunity cost of producing cars increases.

• Long-run and short-run diseconomies limit the extent of specialization.

Limits to Specialization: Short RunDiminishing marginal returns to variable inputs

Firms produce where marginal cost = price with mc increasing

U.S.A. Automobile Industry Competitive Version

Unexploited Economies of Scale: Opportunity Costs

One Car One Barrel of Oil

Canada 200 Oil Barrels 1 / 200 of a Car

USA 150 Oil Barrels 1 /150 of a Car

One Car One Barrel of Oil

Canada $10,000 $50

USA $9,000 $60

Average $9,500 $55

Unexploited Economies of Scale: Monetary Costs

• As a review, let’s convert the opportunity cost tables to monetary costs.

• If the cost of producing a Canadian car is $10,000, then the cost of producing one barrel of oil is $10,000 / 200 = $50. If the cost of producing an American car is $9,000, then the cost of one barrel of oil is $9,000 / 150 = $60.

• Buying oil in Canada and selling it in the US could obtain a profit. Buying cars in the US and selling them in Canada could obtain a profit.

Question: Part A. Complete the bottom table.

Exploited Economies of Scale

Opportunity Costs

One Car One Barrel of Oil

Canada 220 Oil Barrels 1 / 220 of a Car

USA 140 Oil Barrels 1 /140 of a Car

One Car One Barrel of Oil

Canada $11,000 ?

USA ? $60

Average ? ?

Monetary costs

Question: Part B.

• What are the assumptions underlying Ricardo’s theory of the benefits of trade due to comparative advantage?

• Describe Ricardo’s model as set out in your textbook.

- Write a two page essay to hand in at your next

class.

Works consulted

• Krugman, Paul. Pop Internationalism. Cambridge: MIT Press.

• Wonnacott, P., R. Wonnacott, and A. Blomqvist, Economics. Toronto: McGraw-Hill.

• Wikipedia: The Free Encyclopedia: Various Web Pages

• Statistics Canada: Various Publications.

• Next topic:1. Efficiency gains to producers from exports.2. Efficiency gains to consumers from imports.