Foundations of Modern Trade

Theory
Chapter TWO
Chapters objectives
Why do nations export and import certain
products?
At what terms of trade are products
exchanged in the world market?
What are the gains from international trade?
History
The Mercantilists
1500-1800
Trade balance surplus to accumulate gold and silver
Use of tariffs and quotas
Thought was trade was only good for one side; one country
benefits at the expense of the other country
Trade is a zero-sum game
The worlds wealth is fixed
David Hume
Price-specie flow mechanism
Permanent trade surplus is unsustainable (because you cant export
if no one wants to import)
There are still neo-mercantilists today!
Adam Smith: Absolute Advantage
Labor theory of value
Lower L (labor)/Q (output) ratio means lower costs
Higher Q/L ratio (inverse)
Nations specialize
A country exports goods in which it has an absolute cost
advantage
A country imports goods in which it has an absolute cost
disadvantage
World output increases when countries specialize
All nations can benefit from trade
Free trade increases competition
An example of Absolute Advantage
Output per Labor Hour
Nation Wine Cloth
US 5
bottles
20 yards
UK 15
bottles
10 yards
Gains from
specialization
Wine Cloth
US -5

(i.e., one
worker
moving
to cloth,
only -5
units)
+20
UK +15 -10
Total
gain
+10 +10
David Ricardo: Comparative Advantage
What happens if a country is more efficient than
its trading partners in the production of all
goods?
The less efficient nation has a comparative
advantage in producing and exporting the good
in which its absolute disadvantage is least
The more efficient nation should specialize in
producing the good where its absolute
advantage is the greatest.
Ricardian model
Two countries and two goods
One input: labor fixed endowment, fully
employed, homogeneous
Labor can move freely between industries but not
between countries
Fixed technology; technology is different across
countries (so gives different counties comparative
advantage)
Explains difference in Q/L across countries
TC = w*L (proportional to amount of labor used)
CRS: AC = (w*L)/Q = w/Productivity = constant
Perfect competition: P = MC
Ricardian model
Free trade: no trade barriers
Transportation costs = 0
Firms maximize profits; consumers maximize satisfaction
No money illusion; only relative prices matter
Price of good X, Px = $100
If theres a substitute good, Z, Pz=$1000
You can discern because you have a gauge for comparison;
otherwise, you cannot discern whether something is priced high
or low
Exports pay for imports and trade is balanced (because
there is no borrowing)
There is no money; instead barter
No financial markets
no savings and no borrowing
Comparative Advantage
Output per Labor Hour
Nation Wine Cloth
United States 40 bottles 40 yards
United Kingdom 20 bottles 10 yards
US has absolute advantage in producing both goods
US has comparative advantage in producing cloth
because it is 4 times more efficient than UK
UK has comparative advantage in producing wine
because its absolute disadvantage is the smallest
Wheat Autos Wheat Autos
Q/L OC Q/L OC Gains
US 60 2 120 0.5 -60 +120
Canada 160 0.5 80 2 +160 -80
World +100 +40
Another Example:
Production Possibilities Frontiers
60
120
160
80
Wheat
Wheat
Autos
Autos
United States
Canada
MRT = slope = amount of one product a nation must sacrifice to get one
additional unit of the other product
MRT = Marginal Rate of Transformation = Opportunity cost
Autos
Wheat
MRT

MRT = 60/120 = 0.5

MRT = 160/80 = 2
Constant Opportunity Costs
Straight line Production Possibilities Frontier
(or Schedule)
In US, the relative cost of an auto is 0.5 bushels of
wheat
In Canada, the relative cost of an auto is 2 bushels
of wheat
Thus the US has a comparative advantage in
producing autos
Under free trade the US will specialize in producing
autos and will export autos
The reverse will be true for Canada
Production under autarky versus free
trade: Intersection of PPF and DD
60
120
160
80
Wheat
Wheat
Autos
Autos
United States
Canada
MRT = 60/120 = 0.5
MRT = 160/80 = 2
DD
DD
A
A
DD = Demand Diagonal (what you would demand dependent on your income)
In autarky, the US prefers to produce and consume at point A while Canada
prefers to produce and consume at point A
With free trade the US produces 120 autos and zero wheat at point B, while
Canada produces 160 bushels of wheat and 0 auto at point B
40
40
80
40
B
B
Production gains from specialization
BEFORE SPECIALIZATION
AUTOS WHEAT
UNITED STATES 40 40
CANADA 40 80
WORLD 80 120
AFTER SPECIALIZATION
AUTOS WHEAT
UNITED STATES 120 0
CANADA 0 160
WORLD 120 160
NET GAINS 40 40
Those net gains are due to the fact that resources are
used more efficiently; they are called static gains.
Trading Possibilities Line or terms of
trade Line (tt)
60
120
160
80
Wheat
Wheat
Autos
Autos
United States
Canada
MRT = 60/120 = 0.5
MRT = 160/80 = 2
DD
DD
A
A
40
40
80
40
B
B
The slope of the PPF represents the relative prices that two commodities can be
exchanged at home under autarky
The terms of trade (tt) define the relative prices at which two products trade in the
global market place
The tt line is also the Consumption Possibility Schedule (CPS) under free trade
The triangles BCD and BCD are called the trade triangles
C
C
60
100
60
D
D
tt=1:1= slope
tt=1:1= slope

Consumption gains from trade
BEFORE TRADE
AUTOS WHEAT
UNITED STATES 40 40
CANADA 40 80
WORLD 80 120
AFTER TRADE
AUTOS WHEAT
UNITED STATES 60 60
CANADA 60 100
WORLD 120 160
NET GAINS 40 40
Distributing the gains from trade
Distribution of the gains depends on the slope
of the tt line.
The slope of the tt line is the world price
The slope of the tt line depends on demand
factors (Reciprocal demand - John Stuart Mill)
The domestic cost ratios set the outer limits for
the equilibrium terms of trade; in our example:
0.5 < tt < 2
Such that the tt line (red line) lies outside the PPF
(purple line)
Implying that more can be consumed under free trade than
under no trade
The importance of being unimportant
Small countries should benefit more from
trade than large countries
The slope of the tt line is close to the MRT of the
large country
Moreover a very large country may have to
continue producing its comparative-disadvantage
good
Dynamic gains from trade
The more efficient use of resources brings
about more output and income
More income results in more savings
More savings results in more investment
More investment results in higher productivity and higher
economic growth
Additionally free trade increases the size of
the market which leads to economies of scale
Moreover free trade increases competition
which improves efficiency and innovation
Those dynamic gains could be large but hard
to measure
Changing comparative advantage
100
80
40 160
100 150
MRT = 1
MRT = 0.67
MRT = 2
MRT = 0.5

Productivity in the Japanese computer industry grows faster
than it does in the US computer industry. The OC of
producing computers in Japan is now lower than in the US.
US has lost its comparative advantage in computers and
gained comparative advantage in autos while Japan has now a
comparative advantage in producing computers.
Autos
Autos
computers
US
Japan
computers
Moving from A to B the OC of producing autos becomes larger in terms of wheat sacrificed.
The MRT of wheat into auto rises from 1 to 4.
This is the case when inputs are imperfect substitutes for each other.
The PPF is concave when viewed from the diagrams origin

21
Production possibilities schedule; increasing-cost conditions
FIGURE 2.4
Increasing cost Trading case
Production &
consumption
under autarky
Consumption
under free trade
Production
under free trade
TOT
Wheat
Autos
Autarky
relative price
United States
DD
Note that specialization
is not complete in this
model.
With increasing OC,
comparative product
prices are determined
by both supply and
demand factors.

Increasing cost trading case
Wheat
Wheat
Autos Autos
United STates
Canada
US
imports
Canada
exports
Canada imports
US exports
TOT lines (parallel)
The impact of trade on jobs
Trade influences the mix of jobs
Importance of finding a job in an industry in which
country where you live has a comparative
advantage in
Trade has a lesser impact on the overall
number of jobs