Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Ad Advanced dI International t ti lE Economics i

ECON 758
Professor Yamin Ahmad

I This In Thi Lecture L t

Formal Approach to General Equilibrium Analysis The Classical Model:

B k Background: d M Mercantilism tili Assumptions Adam Smiths Absolute Advantage g Ricardos Comparative Advantage Specialization in Production

L t Lecture 3: 3
The classical model of International Trade

International Terms of Trade and the Gains from Trade

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Formal Approach to General Equilibrium Analysis

First First, we need to specify the Economic Environment, Environment which includes details of the scenario we are looking at. These details include:

Formal Approach to General Equilibrium Analysis Second Second, we need to characterize the equilibrium, which includes providing a description p of:

Assumptions we make Production Details:- details of firms problem (profit maximization); production processes (within each country); constraints faced by firms (resource constraints, technology) Consumer Details:- description of the problem faced by (utility y maximization) ) consumers (

Outcome of the firms p problem:- p profit maximization Outcome of the consumers problem:- utility maximization

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Example: Characterization of Autarky Example:Equilibrium Economic Environment:

Ch Characterization t i ti of fA Autarky t k E Equilibrium ilib i

An Autarky Equilibrium is an allocation {X1,X X2,Y Y1,Y Y2} and a set of prices {p1,p2} such that: Producers maximize profits given the equilibrium prices Consumers maximize utility subject to their budget constraint and given equilibrium prices Markets clear clear, i.e. i e prices {p1,p p2} are such that: X 1 = Y1 X 2 = Y2
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2 countries, 2 consumption goods: X1,X2 Production technology and resource constraint described by a Production Possibilities Frontier for each country, which shows combinations of goods Y1,Y2. Preferences described by indifference curves Perfect P f t competition. titi Consumption C ti goods d are tradeable

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Development of Classical Theory of International Trade

Mercantilism M tili Additional assumptions Adam Smith Smiths s Absolute Advantage Model David Ricardo Ricardos s Comparative Advantage Model

M Mercantilism: tili 1500AD 1750AD

Prevailed mostly in England and Europe A system of government institutions and policies designed to restrict international trade. The source of a countrys y wealth is gold g or money. y Two means of increasing g a countrys y wealth are colonialism and international trade. A country must export more and import less.

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

M Mercantilism: tili 1500AD 1750AD

View was one country gains at the expense of another ( - a zero sum game!) Practices included:

Ad Adam Smith S ith

Attacked the mercantilist system Advocated free international trade

Taxes on imported goods Bans on importation of other goods Special laws and taxes designed to favor certain industries at the expense of others

Emphasi Emphasized ed ad advantages antages of specialization speciali ation and international division of labor whereby nations specialize in the production of only a few goods

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

R Recall ll P Previous i A Assumptions ti

1 Rational Behavior 1. 2. Two Country, Two Good World 3 No 3. N M Money Ill Illusion i 4. Fixed Resources and Technology 5. Perfect Competition y of Resources Within A 6. Perfect Mobility Country 7. National Indifference Curves
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Additi Additional l Assumptions A ti

Assumption 8 Resources cannot move between countries.

Guarantees a nation nations s PPF does not change shape or location once international trade begins

Assumption 9 There are no trade barriers barriers.

Rules out things like tariffs and quotas (for the moment) )

Assumption 10 Transportation Costs are Zero

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

A Assumptions ti of f the th Classical Cl i lM Model d l

Assumption 11 Labor is the only relevant resource.

Ab l t Ad Absolute Advantage t
Define: The ability of a country to produce a good using fewer productive inputs than is possible anywhere p y else in the world. Ad Adam Smiths S ith principle i i l countries t i should h ld specialize in the production of goods in which they have an absolute advantage advantage.

Labor Theory of Value states that the pre-trade price of a good is determined by the amount of labor it took to produce it.

Assumption 12 Constant returns to scale between labor and output prevails prevails.

Constant returns implies a fixed ratio between the labor used and the output level produced.
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Note: These lecture notes are incomplete without having attended lectures

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

T bl 1 Table 1:Illustration Ill t ti of f Ab Absolute l t Ad Advantage t

Country America Soybeans Toys 3 6 Britain 12 4

T bl 1 Table 1: Ill Illustration t ti of f Ab Absolute l t Ad Advantage t

Country America Soybeans Toys Conclusions: America is more efficient at producing Soybeans (require ( q less workers to p produce a units worth), ) hence has an absolute advantage in Soybeans Britain is more efficient at producing Toys, hence has an absolute b l t advantage d t i T in Toys 3 6 Britain 12 4

Table 1: Table of unit labor requirements for two goods:

Shows how many labor hours it takes to produce one unit of a good

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

R Recall ll
Adam Smiths Smith s principle countries should specialize in the production of goods in which they have an absolute advantage. Rather than in autarky (no trade), suppose each country specializes in the production of the good where they have an absolute advantage i advantage, i.e. e

T bl 2 Table 2: W World ld G Gains i F From T Trade d

Per Unit Gain In Soybeans Change In America Change In Britain Change In World +2 -1 +1 In Toys -1 +3 +2

America produces Soybeans Britain p produces Toys y

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Note: World output rises!

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Note: These lecture notes are incomplete without having attended lectures

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

What a Causes Each ac Cou Country y to Follow Its Absolute Advantage?

Market forces combined with free trade Given that the labor cost equals the wage rate (W) p times the amount of labor input:

Ab l t Ad Absolute Advantage t ( (cont.) t)

In country B:

PS / PT in B = (WB 12) /(WB 4) = 12 / 4 = 3

Since P / P in A < P / P in B, S T S T A is the lower (opportunity) cost producer of Soybeans and has an absolute advantage in S b Soybeans

PS = WA hours SA = WA 3 PT = WA hoursTA = WA 6 Then, PS / PT in A = (WA 3) ) / (WA 6) ) = 3/ 6 =1/ 2

Hence, opportunity cost of S (in terms of T) is !

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

S Summary of f Smiths S ith P Principle i i l

For various reasons such as different technologies and climate, countries will produce different goods. World output will increase if countries specialize in their absolute advantage products. This situation is the natural outcome of market forces combined with free trade. A g good is cheapest p in the country that has absolute advantage in its production.

Q Question ti
Unit Labor Requirements France Bread Cheese 4 2 Table 4: Country Germany 1 1

Consider the table 3 above. Which country has an absolute advantage in Bread? Which country has an absolute advantage in Cheese? Can C these countries benefit f from f trade?... ?

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

What a If O One e Cou Country y Has as Absolute bso u e Advantage in Both Goods?
Answer:

C Comparative ti Ad Advantage t
Unit Labor Requirements France Bread Cheese 4 2 Table 4: Country Germany 1 1

Yes! David Ricardo in the early 1800s concluded that both countries gain from trade

David Ricardos Law of Comparative Advantage :

countries should specialize where they have their greatest absolute advantage (if they have absolute advantage in both goods) or in their least absolute disadvantage (if they have absolute advantage in neither good). good)
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Germany has an absolute advantage in production of both goods! Germany has a comparative advantage in bread Why?...

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

C Comparative ti Ad Advantage: t Q Question ti

Unit Labor Requirements America Soybeans Toys 3 6 Table 5: Country Britain 12 8

Ga s From Gains o Trade ade Based ased O On Co Comparative pa a e Advantage

Unit Labor Requirements Change In America Ch Change I In B Britain it i Change in World Table 6: Per Unit Gain In Soybeans In Toys +2 -1 1 +1 -1 +1.5 15 +0.5

Do any of the countries have an absolute advantage in the production of Soybeans and Textiles? Do any of the countries have a comparative advantage in either good? If so so, which?
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Once again, world production increases, despite one country y having g an absolute advantage g in both g goods! Specialization leads to a greater number of products.
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

Ge e a Equilibrium General qu b u So Solution u o o of the e Classical Trade Model

Assume labor endowments for each country:

Ge e a Equilibrium General qu b u So Solution u o o of the e Classical Trade Model

Using the unit labor requirements from table 5: Country A: 12000 labor hours

A has 12,000 labor hours B has 9,600 labor hours

Straight-line Production Possibilities Frontier (PPF)

If only S produced: Total # S = 12000/3 = 4000 If only T produced: Total # T = 12000/6 = 2000 Opportunity cost of S (in terms of T) = 1/2

Slope of PPF = pre-trade relative price (PS /PT )

Country B: 9600 labor hours

Autarky or pre-trade equilibrium (consumption and production)

If only S produced: Total # S = 9600/12 = 800 If only T produced: Total # S = 9600/8 = 1200 Opportunity cost of S (in terms of T) = 3/2

Tangency point of PPF and Social Indifference Curve (SIC)

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

P t d Equilibria Pre-trade E ilib i

T T

I t International ti l Terms T of f Trade T d

Terms of Trade (TOT) the relative (world) price at which trade occurs between countries, , PSW/PTW
L (PS/PT)B=3/2

(PS/PT)A=1/2

J SIC1A SIC1
B

Th The TOT will ill lie li between b t the th autarky t k prices i of f the two countries; in our example, (As ( price) ) < TOT O < 3/2 / (Bs ( price) )
S

Country A
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Country B
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

P t t d Equilibrium Post-trade E ilib i

The country with a lower autarky price of a good has comparative advantage in that good. With constant opportunity cost (straight-line PPF), the country will completely specialize in its comparative advantage product once trade begins. With trade, , the country y will now consume on the TOT line which represents its Consumption Possibility Frontier (to be defined later).
T

P t t d Equilibrium Post-trade E ilib i

T TOT(|slope|=3/4) M

I R K SIC2A SIC1A

SIC B SIC1B 1 TOT(|slope|=3/4) (| p | )

Country A
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Country B
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

E Economic i I Intuition t iti

Country A: pre-trade relative price, (PS/PT)A=1/2 Country C t B: B pre-trade t d relative l ti price, i (PS/PT)B=3/2 3/2 Autarky price of S is lower in A than B B. Thus Thus, demand for S will rise in A and fall in B, leading to a rise in (PS/PT)A in country A. Autarky price of T is lower in B than A. Thus demand for T will fall in A and rise in B, leading to a decline in (PS/PT)B in country B. This occurs until (PS/PT)A=(PS/PT)B =PSW/PTW
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S Some Definitions D fi iti

Consumption Possibilities Frontier:- refers to the various combinations of goods that a country can obtain by taking advantage of international trade. Trade Triangle a geometric device that shows the amounts a country is willing to trade at a particular world price.

The trade triangle shows the desired exports and imports of a country given the terms of trade.

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

P t t d Equilibrium Post-trade E ilib i

T TOT(|slope|=3/4)
Exports of T in Country B

T d Triangle Trade Ti l
In the international trade equilibrium, the countries trade triangles are congruent (i.e. identical).
N

T M

R SIC2A
Imports of T in Country A Imports of S in Country B

SIC1B TOT(|slope|=3/4) (| p | )

Walras Law states that if there are n markets in the world and any n-1 of these markets are in equilibrium, then so too will be th nth market. the k t

Exports of S in Country A

Country A
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Country B
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

How o Ca Can Trading ad g Equilibrium qu b u Be e Attained?

Reciprocal demand the process of interaction of international demand and supply necessary to produce an equilibrium world price. In a country where there is an excess demand for a product, its price will rise In a country where there is an excess supply for a product, its price will fall.

S Summary of f Ricardos Ri d M Model d l

It t is s not ot necessary ecessa y for o a cou country t y to possess abso absolute ute advantage in order to participate in trade. What is required is comparative advantage in production. A country will specialize in and export that good in which its has comparative advantage, i.e., has a lower pre-trade relative price than in the other country. The terms of trade or world price will settle between the autarky prices of the two countries and is determined by reciprocal demand.
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Note: These lecture notes are incomplete without having attended lectures

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

G i f Gains from Trade T d

Who benefits from international trade? D Do both b h countries i gain i from f trade?... d ? O Or is i one country made better off at the expense of the other?

G i f Gains from Trade T d

1. Production Gain:
Free international trade leads to specialization of production in each countrys comparative advantage good In many cases, this amounts to an increase in total world output Points I and N on the post-trade graph are up and to the right of K and L respectively Thus they depict consumption bundles that contain more of S and T than under autarky
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2. Consumption Gain:

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

T Terms of f Trade T d and d Gains G i from f Trade T d

A couple of points to note: The closer the terms of trade are to one countrys preprice ratio, , the g greater the g gain for the other trade p country. Importance of being unimportant when small countries trade with big countries, the small countries are likely to enjoy most of the mutual gains from trade.

R l ti Relationship hi Between B t Trade T d and dW Wages

What does the classical theory say about the relationship between international trade and factor payments? p y Recall that we have assumed:

perfect competition in both industries labor is the only factor of production

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

R l ti Relationship hi Between B t Trade T d and d Wages W

With these assumptions assumptions, wages must be equal in both industries within a country (although not necessarily equal across countries). Given the following pre-trade relationships:

T d and Trade dW Wages ( (cont.) t)

Following the line of comparative advantage and given an exchange rate E which translates Bs currency units into As:

Substituting the information from (3.1) into the above inequalities:

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

T d and Trade dW Wages ( (cont.) t)

Solving So g t the e syste system o of inequalities equa t es (3 (3.3) 3) simultaneously, we get:

T d and Trade dW Wages ( (cont.) t)

According to Equation (3 (3.5), 5) in order for trade to occur based on comparative advantage, As workers must earn more than Bs workers. Why? Because of differences in labor productivities. As A s workers are more productive than B Bs s workers workers. What happens if wages get out of line with productivity levels?

or, after combining terms:

The center term is called the relative wage ratio, or As wage rate divided by Bs wage (expressed in terms of As currency)

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

E Example l
Suppose that wages in country A rise to 5 times the wages in country B B, i i.e. e W A = 5 x E x WB What will be the pattern of pre-trade prices in the two countries? Consider prices in country A in terms of wages in country B:

E Example l ( (cont.) t)
Compare that to the level of pre-trade prices in country B (measured in terms of country ( y As currency): y)

E PSB = 12 E WB E PTB = 8 E WB
Pre-trade prices are higher for both goods in country A than country B.

This is because the true wage differential between both countries exceeds the maximum productivity differential

PSA = WA 3 = (5 E WB ) 3 = 15 E WB

Country B has an incentive to sell both goods goods, and country A none. Hence:

PTA = WA 6 = ( 5 E WB ) 6 = 30 E WB
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Country B will run a balance of trade surplus (exports > imports) Country A will run a balance of trade deficit (imports > exports)
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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

T Two Valuable V l bl L Lessons

For trade to occur between countries with different labor productivities, wages must be higher g in one country y than in the other. A country t can lose l its it comparative ti advantage d t if wages get out of line with productivity.

Q Question: ti World W ld S Supply l

Unit Labor R Requirements i Soybeans Toys America aSA = 3 aTA = 6 Table 5: C Country Britain aSB = 12 aTB = 8

Recall R ll th the unit it l labor b costs t i in t table bl 5 5. Once again, assume labor endowments for each country:

A has 12,000 labor hours B has 9,600 labor hours

What does the world PPF look like?

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Professor Yamin Ahmad, Advanced International Economics ECON 758

Professor Yamin Ahmad, Advanced International Economics ECON 758

W ld S World Supply l ( (cont.) t)

Let PSW and PTW denote the world prices for S and T If PSW/PTW < aSA/aTA<aSB/aTB

E l ti of Evaluation f the th Classical Cl i lM Model d l

The model does not explain why differences in productivity levels between countries exist. It makes extreme and unrealistic predictions such as countries will completely specialize in the production of exportables only. It maintains that the g gains from trade are g greater between countries of dissimilar production technologies (despite the fact that most trade occurs between Developed p Countries with similar technology gy and income levels).
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America specializes in Toys Britain specializes in Toys

If PSW/PTW = aSA/aTA<aSB/aTB

America produces both Soybeans and Toys Britain specializes in Toys

America specializes in Soybeans Britain specializes in Toys

If < aSA/aTA< PSW/PTW <aSB/aTB

Etc Etc

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Professor Yamin Ahmad, Advanced International Economics ECON 758

E l ti ( Evaluation (cont.) t)
The classical model is a useful tool because:

It provides a motive for trade between developed and developing countries It explains why high-wage countries may still benefit from trade even when faced with low-wage competing countries

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