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Trade Theories 1 3
Trade Theories 1 3
#1 - Mercantilism
Defining mercantilism
Mercantilism
The theory that a country
should accumulate financial
wealth by amassing as many
inflows of currency as possible
Mercantilism
A system of government institutions and
policies designed to restrict international
trade
Maximize exports through subsidies.
Minimize imports through tariffs and
quotas
Mercantilism: Policies
Forbidding colonies to trade with other
nations
Monopolizing markets withstaple ports;
Forbidding trade to be carried in foreign
ships;
Maximizing the use of domestic resources;
Also restricting domestic consumption
withnon-tariff barriers to trade.
Mercantilism: Flaws
impaired economic growth
Ignores living standards
Ignores human development
Trade Theories:
#2 - Absolute
Advantage
Theory of absolute
advantage
Adam Smith ideas based on
The capability of one country to
produce more of a product with the
same amount of input than another
country
(same thing) The ability of a country
to produce a good using fewer
resources than another country (lower
opportunity cost)
Theory of absolute
advantage
Adam Smith argued:
A country should produce only goods
where it is most efficient . and trade
for those goods where it is not
efficient
Trade between countries is, therefore,
beneficial
Theory of absolute
advantage
TRADE BASED ON
ABSOLUTE ADVANTAGE
Consider this simple example involving the
EU and India
Only two products are produced, machines
and cloth
Labor is fixed, homogeneous within a country,
the only factor of production, and is fully
utilized
Technology and production costs are constant
Transportation costs are zero and the countries
barter (trade) for goods
TRADE BASED ON
ABSOLUTE ADVANTAGE
EU
India
2 machines
Country
15 yards of
cloth
Machines
Cloth
EU
5 machines
10 yards of cloth
India
2 machines
15 yards of cloth
Machines
Cloth
EU
5 machines
10 yards of cloth
India
2 machines
15 yards of cloth
10
15
Cloth
EU
India
Cloth
Cloth
Mach
Mach
10
0
15
0
8
7.5
1
6
0
2
4
2
Opportunity Cost also known0
as Relative Price
India - Opportunity Costs
EU - Opportunity Costs
Machine
Cloth
1
2
3
4
5
= 2 cloth
= 0.5 machine
Machines
EU: Slope = Opportunity Cost = -0.5
2
10
15
Cloth
TRADE BASED ON
ABSOLUTE ADVANTAGE
Yes, maybe that was obvious to you from
the beginning
Machines
Cloth
EU
5 machines
10 yards of cloth
India
2 machines
15 yards of cloth
What ???
Theory of absolute
advantage
Adam Smith: Wealth of Nations
(again) argued:
A country should produce only
goods where it is most efficient,
and trade for those goods where
it is not efficient
Assume TWO Persons per day, so that each product can be fully produced
Machines
EU
5 machines
India
2 machines
World Output
7 machines
Cloth
(and)
(and)
(and)
10 yards of cloth
15 yards of cloth
25 yards of cloth
Assume TWO Persons per day, so that each product can be fully produced
Machines
EU
5 machines
India
2 machines
World Output
7 machines
Cloth
(and)
(and)
(and)
10 yards of cloth
15 yards of cloth
25 yards of cloth
Machines
EU
10 machines
India
0 machines
World Output
10 machines
Cloth
0 yards of cloth
30 yards of cloth
(and)
30 yards of cloth
.
TRADE BASED ON
ABSOLUTE ADVANTAGE
So there has obviously been an increase in World Output!!
Machines
Cloth
EU
+5 machines
10 yards of cloth
India
2 machines
+5 yards of cloth
TRADE BASED ON
ABSOLUTE ADVANTAGE
Both countries can benefit if
trade occurs
EU produces machines and
exports them to India
India produces cloth and
exports it to the EU
Machines
Cloth
EU
5 machines
(and)
10 yards of cloth
India
2 machines
(and)
15 yards of cloth
World Output
7 machines
(and)
25 yards of cloth
Machines
EU
10 machines
India
0 machines
World Output
10 machines
Cloth
0 yards of cloth
30 yards of cloth
(and)
30 yards of cloth
.
Now, suppose that the EU trades 3 machines to India for 12 yards of cloth?
.
EU - Opportunity Costs
Machine
Cloth
= 2 cloth
= 0.5 machine
World Price
Back to our opportunity costs (above)
Trade will occur at a trading price
World Price which will occur
between these respective
Also calledRelative
the Terms of Trade
Prices
m
IND
(7.5) P P (2)
m
W
m
EU
P (0.5) P P
c
EU
c
W
c
IND
(0.133)
Look
P (0.5) P P
c
EU
c
W
c
IND
(0.133)
Machines
EU: Slope = Opportunity Cost = -0.5
Pw
2
10
15
Cloth
Bread
Steel
Output/hour
worked
EU
Canada
2 loaves
3 loaves
3 tons
1 ton
What are the EUs relative prices (opp. cost) Bread? Steel?
What are Canadas relative prices (opp. cost) Bread? Steel?
Who has absolute advantage in Bread?
Who has absolute advantage in Steel?
Given 2 working hours per country what is the maximum world output?
TRADE BASED ON
ABSOLUTE ADVANTAGE
2-Country Scenario
One Person Per Day of Labor
Produces
Country
Machines
Cloth
U.S.
5 machines
15 yards of cloth
India
1 machine
5 yards of cloth
Machines
Cloth
U.S.
5 machines
15 yards of cloth
India
1 machine
5 yards of cloth
Graphically obvious
U.S. has an Absolute Advantage in both goods.
1
5
15
Cloth
Machines
Cloth
U.S.
5 machines
15 yards of cloth
India
1 machine
5 yards of cloth
Comparative Advantage
Trade Theories:
#3 - Comparative
Advantage
Theory of Comparative
Advantage
David Ricardo: Principles of Political
Economy (1817)
TRADE BASED ON
COMPARATIVE ADVANTAGE
Why would trade occur if one country had an
absolute advantage in both goods?
Comparative Advantage is the ability of a
country to produce a good at a lower
opportunity cost than another country
We compare the degree of absolute
advantage or disadvantage in the production
of goods
Machines
Cloth
U.S.
5 machines
15 yards of cloth
India
1 machine
5 yards of cloth
1 Machine = 3 cloth
1 Cloth
= 0.33 machine
1 Machine = 5 cloth
1 Cloth = 0.2 machine
TRADE BASED ON
COMPARATIVE ADVANTAGE
The U.S. has a greater absolute
advantage in producing machines than is
does in producing cloth (5x more efficient
in machines only 3x more efficient in
cloth)
Indias absolute disadvantage is smaller in
producing cloth than in producing
machines
Thus the U.S. has a comparative
advantage in machines and India has a
comparative advantage in cloth
TRADE BASED ON
OPPORTUNITY COSTS
Even though U.S. has an absolute
advantage in both goods, India has a
comparative advantage in cloth
production
Even if U.S. has an absolute advantage in
both goods, beneficial trade is possible
If both countries specialize according to
their comparative advantage, they both
can gain from this specialization and
trade
Machines
Cloth
U.S.
5 machines
15 yards of cloth
India
1 machine
5 yards of cloth
Let us allow India to produce cloth up to the level that the U.S. can
Machines
Cloth
U.S.
5 machines
India (3 days)
-3 machines
World Output
+2 machines
(per)
15 yards of cloth
0 cloth
.
TRADE BASED ON
COMPARATIVE ADVANTAGE
Change in World Output Resulting from Specialization According
to Comparative Advantage
Change in the Production of
Country
Machines
Cloth
U.S.
+5 machines
15 yards of cloth
India
3 machines
+2 machines
0 yards of cloth
TRADE BASED ON
OPPORTUNITY COSTS
Unit Labor Costs in 24 Developing Economies for
Selected Sectors, 2000 (Ratios relative to the U.S.)
Country
Food
Products
Textiles
Clothing
Electrical
Machinery
Transport
Equipment
Argentina
1.95
1.28
0.64
2.11
1.78
Bolivia
0.61
0.76
0.65
1.00
1.34
Brazil
0.74
0.65
0.47
0.81
0.53
Chile
0.80
0.89
0.51
0.90
0.74
Columbia
0.62
0.66
0.47
1.01
0.97
Cote dIvoire
1.50
1.06
1.02
1.34
1.69
Ecuador
0.88
0.30
0.34
1.20
0.55
Egypt
1.45
1.21
0.38
1.10
0.71
Ghana
0.82
0.96
0.60
0.39
1.63
India
1.29
1.57
0.47
0.98
1.43
Indonesia
1.71
0.42
0.45
0.62
0.26
Kenya
1.31
2.20
0.96
0.74
3.34
TRADE BASED ON
OPPORTUNITY COSTS
Unit Labor Costs in 24 Developing Economies for
Selected Sectors, 2000 (Ratios relative to the U.S.)
Country
Food
Products
Textiles
Clothing
Electrical
Machinery
Transport
Equipment
Malaysia
1.08
0.59
0.84
1.01
0.69
Mexico
0.90
0.88
0.64
1.06
0.43
Morocco
1.61
1.38
1.05
1.49
0.92
Nigeria
0.29
0.80
0.11
0.56
0.04
Peru
1.02
0.62
0.46
0.95
0.50
Philippines
0.65
0.67
0.59
0.80
0..40
Korea
0.73
0.63
0.62
0.56
0.71
Taiwan
1.93
1.45
0.80
1.81
1.17
Thailand
0.92
0.87
1.07
0.65
0.41
Turkey
1.09
0.96
0.43
0.97
0.65
Uruguay
1.64
0.74
0.69
1.52
1.22
Venezuela
0.93
0.72
0.49
0.68
0.17
Cars
Steel (tons)
0.5
1 car = 1 steel
1steel = 1 car
1 car = 2 steel
1steel = 0.5 car
Cars
Steel (tons)
0.5
Let us allow Malaysia to produce steel up to the level that Japan can
Cars
Steel (tons)
Japan
Malaysia
World Output
+1
Malaysias Price
Evaluation (cont.)
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