Trade theory

Theories of International Trade

AG BM 338Agribusiness in the Global Economy

LEARNING OBJECTIVES

After today’s class, you should be able to:

1. Understand classical theories of international trade

2. Understand modern theories of international trade

3. Draw implications for action

Trade Balance

trade deficit - An economic condition in which a nation imports more than it exports

trade surplus - An economic conditionin which a nation exports more than it imports

balance of trade - The aggregation of buying (importing) and selling (exporting) by both sides leads to the country-level trade surplus or deficit.

Trade Theories

classical trade theories - major theories typically studied consist of mercantilism, absolute advantage, and comparative advantage

modern trade theories - major theories typically studied consist of product life cycle, strategic trade, and national competitive advantage

The Age of Mercantilism

Between 1600 and 1800 most of Western Europe pursued a policy of mercantilism

What was mercantilism? Belief that exports should exceed imports

Bullionism – the belief that the economic health of a nation was measured by the amount of precious metals (gold and silver) it possessed

Colonialism – colonies were viewed as sources of raw materials

Heavy government control of trade, with the goals of trade being the goals of governments

Absolute Advantage

Producing a good with fewer inputs (capital, labor, land, raw materials, etc.) per unit of output than other countries

If input prices are the same in two countries, the country with an absolute advantage in a good will have a lower unit cost of production for that good

Adam Smith, The Wealth of Nations, 1776 A country should produce and export products in which it has an absolute advantage

A country should import products in which it has an absolute disadvantage

Absolute Advantage: Problems

What about a country (like the U.S.) that has an absolute advantage in most products?

How can it possibly produce enough of everything to satisfy the whole world? As production increased, competition for scarce inputs would drive up production costs, taking away many absolute advantages

What about a country (like Nepal) that has an absolute disadvantage in nearly all products?

Why should its resources sit around unused? As production fell, prices of inputs would fall, lowering production costs and creating some absolute advantages

Comparative Advantage

Producing a good at a lower opportunity cost than another country

Inputs used in the production of one good aren’t available for the production of other goods

When a country produces a good, what does it give up in foregone production of other goods?

David Ricardo, The Principles of Political Economy and Taxation, 1817

A country should produce and export products in which it has a comparative advantage

A country should import products in which it has an comparative disadvantage

Opportunity Cost

opportunity cost - the cost of pursuing one activity in terms of the foregone return on the next-best alternative activity

Examples The opportunity cost of going to college is what you could have earned working full-time instead

The opportunity cost of using a plant to manufacture one product is what the company could have earned manufacturing another product at the plant instead

Numerical Example

One input (labor) Two goods (corn, timber) Two countries (A, B)

Which country has an absolute advantage in Corn production? Timber production?

Which country has a comparative advantage in Corn production? Timber production?

Country

A Country

B Hours of Labor

Required per Unit of Corn

1 2

Hours of Labor Required per Unit of

Timber 2 5

Total Hours of Labor Available

42 42

Country A Country B

Corn 0.5 units timber 0.4 units timber

Timber 2 units corn 2.5 units corn

More on Comparative Advantage

Even a country at an absolute disadvantage in everything will have a comparative advantage in something

Each country specializes in the production and export of what it does relatively well

Prices of goods and inputs in a free-market economy will adjust in order to lead to this outcome

More on Comparative Advantage

Countries rely on imports to meet consumer demands for goods in which they don’t have a comparative advantage

A country can achieve consumption levels beyond what it could achieve on its own

Government policy can alter free-market outcomes (import tariffs, import quotas, export subsidies, etc.)

Some Definitions

factor endowments - extent to which different countries possess various factors, such as labor, land, and technology

resource mobility - assumption that a resourceremoved from one industry can be moved to another

Factor Proportions (Heckscher-Ohlin) Trade Theory

A country that is relatively abundant in a factor of production should export goods that use a lot of that factor in the production process, and import other goods

Example: a country like China with a lot of labor should export labor-intensive goods

Why? If a factor is relatively abundant, it will be relatively cheap, and a country will be more globally competitive in products that use a lot of that factor

Modern Trade Theories

product life cycle theory - economic theory that accounts for changes in the patterns of trade over time

strategic trade theory - theory that suggests thatstrategic intervention by governments in certain industries can enhance their odds for international success

first-mover advantages - Advantages that first entrants enjoy and do not share with late entrants

strategic trade policy - Economic policies that provide companies a strategic advantage through governmentsubsidies

Modern Trade Theories

Theory of national competitive advantage of industries (or diamond theory)The theory that the competitive advantage of certain industries in different nations depends on four aspects that form a “diamond”

Competitive advantage is created by technological and institutional change, not just inherited from a country’s natural endowments

IN-CLASS EXERCISE

In groups of 3-5 people… Come up with three examples of imported foods eaten by people in your group Are there alternatives sources for these foods – either domestically produced or from different countries than the ones you purchase from? If so, what factors influence your purchase decisions?

Present your findings to the class