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Comparative Advantage. International Trade – Session 1 Daniel TRAÇA. Globalization I: Increased trade in goods and services. International Trade involves mostly exchanges among high income countries.

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comparative advantage

Comparative Advantage

International Trade – Session 1

Daniel TRAÇA

globalization i increased trade in goods and services
Globalization I: Increased trade in goods and services
  • International Trade involves mostly exchanges among high income countries.
  • Developing countries have increased their relevance, particularly East Asia, but are still a small part.
trade in services and merchandise
Trade in services and merchandise
  • Most of world trade is in goods (merchandise) – 82%.
  • Services trail behind, but are the fastest growing component.
    • Outsourcing is the latest trend
drivers of modern globalization
Drivers of Modern Globalization
  • Lower transport and communication costs
  • Development of international institutions
    • The WTO
    • Regional Trade Agreements
  • Political decisions toward de-regulation and liberalization of trade and FDI regulations
theory and practice of international trade and foreign investment what we will learn
Theory and practice of international trade and foreign investmentWHAT WE WILL LEARN…
  • Why do countries export certain goods and imports others?
  • What do countries and populations gain and loose from trade?
  • Why do multinationals exist and what are their effects?
  • Why do governments protect their industries and what are the costs and benefits?
  • What are the effects of different protectionist instruments?
  • How do the institutions that regulate global trade work?
  • What have been the economic and social consequences of the rise in trade and foreign investment with developing nations?
  • What has globalization brought to developing countries?
organization of the course
Theories of international trade

Comparative advantage

Gains from trade: static and dynamic

Losers and winners

Trade policy

Policy Instruments

The case for free-trade and exceptions

Policies for Strategic sectors

Political economy and the realist view

The effects of modern globalization

Trade and the developing countries

Multinationals and FDI

The effects in industrialized countries

Institutions of global trade

The W.T.O

Regional agreements

Organization of the course
materials and exams course website www danieltraca com
Materials and examscourse website: www.danieltraca.com
  • Download class slides before class from website
    • Also available at GES
  • Practice exams and answer keys available at website.

List of required sections available from website

  • Recommended textbook
    • “International Economics, 7th ed”by Krugman P. and Obstfeld M., Addison-Wesley
      • Available in French
    • Additional readings available at website
absolute advantage
Absolute Advantage
  • “It is the maxim of every prudent master of the family, never attempt to make at home what it will cost him more to make than buy … What is prudent in the conduct of every family can scarce be folly in that of a great kingdom If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them …”
    • Adam Smith 1776
absolute advantage1
Absolute Advantage

Output per worker (productivity)

Manufacturing

(pieces)

Food

(bushels)

NORTH

10

8

SOUTH

3

9

gains from specialization
Gains from specialization
  • North specializes in Manufacturing and South in Food
  • There is more of both goods, if specialization follows absolute advantage
comparative advantage1
Comparative Advantage
  • "A country … enabled to manufacture commodities with much less labour that her neighbours may, in return for such commodities, import a fraction of the corn required for its consumption, even if … corn could be grown with much less labour than in the country from which it was imported."
    • David Ricardo
even so there are gains from specialization

1 northerner

(Food to Manuf)

10 Food

 10 Manuf

2 southerners

(Manuf to Food)

2 x 3

6 Manuf

2 x 9

18 Food

Even so, there are gains from specialization

Output

  • A country has Comparative Advantage in a given good if its relative productivity in that good is higher than in other goods
  • Specialization according to Comparative Advantage creates value, by increasing output.

before

after

how does the market work
How does the market work?
  • Does the decentralized international market achieve this pattern of specialization? How?
  • Who benefits and who looses from international trade in the free-market?
    • Among individuals within a country?
    • Among countries?
in autarky
In Autarky...

North

Northern worker

  • They work in both sectors, and trade among them at the autarky relative price
  • The relative price
  • P=pManuf/pFood
  • In equilibrium, workers must be indifferent between the two sectors.
  • They must get the same wage

Food

South

Manuf

the prices in autarky closed economy
The prices in autarky (closed economy)

The relative price of Manuf (P) denotes how many bushels of Food for one piece of Manuf.

Manuf

(pieces)

Food

(bushels)

P

NORTH

10

10

10/10 = 1

SOUTH

3

9

9/3 = 3

relative prices relative supply relative demand

Relative Supply (RSs)

South

PS=

3

Relative demand (RDW)

It is the same in both countries

if preferences are the same

[Manuf/Agro]S

[Manuf/Agro]N

Relative prices, relative supply, relative demand

P

Relative Supply(RSN)

North

PN=

1

Manuf/Agro

in autarky1

The Northerners trade among them at the autarky price PN = 1

The Southerners trade among them at the autarky price PS= 3

In Autarky...

Northern worker

Southern worker

South

North

Food

Food

Manuf

Manuf

wages and productivity
Wages and productivity
  • Are the wages the same in both sectors? Why?
    • If not, where are they higher? Why?
  • Are they the same in both countries? Why?
    • If not, where are they higher? Why?
the production possibility frontier and welfare

Production

Possibility Frontier

10

The choice of consumers

…determines the allocation of labor

MRS=MUFood/ MUManuf = 1/P =1

+1

-1

Equilibrium P=1, So that both goods are produced

UN

-1/PN = -1

10

The Production Possibility Frontier and Welfare

North

Manuf

Slope =

-ProdF / ProdM

Northern Workers inManuf

Northern Workers inAgro

Agro

the beginnings of trade
The beginnings of Trade…
  • Manuf is relatively cheaper in the North.
    • An enterprising Northerner takes 1 Manuf to the South and exchange it for 3 Foods.
    • Back in the North, she could sell 1 Foods for 1 Manuf with a net gain of 1 Food.
  • There are gains from exchange because prices are different: Trade occurs!
    • What happens to the relative price of Manuf in North? …
    • And in the South?
openness in the short run

2 . Prices adjust to new scarcity

P rises in the North and falls in the South

PS < 9/3

PN >10/10

Openness in the Short Run...

North

South

Food

Food

1 . Trade starts due to arbitrage

Manuf

Manuf

in the long run there is re allocation

PS < 9/3

PN >10/10

3 . Factors (workers) respond to new prices and profitability -- specialization

In the Long-Run, there is re-allocation

North

South

Each country specializes completely in, and exports, the good in which it has

comparative advantage

Food

Food

Manuf

Manuf

There is one world price, which is between the initial prices

10/10 < PW <9/3

how to determine the world price

North and South produce only Manuf

North produces Manuf only

South produces both

North and South specialize completely

1<PW <3

Relative Demand (RDW)

World

North and South produce only Food

South produces Food only

North produces both

How to determine the world price?

P

Relative Supply (RSW)

World

3

1

Manuf/Food

the gains from trade according to comparative advantage

1<PW <3

US(Food)

1<PW <3

The Gains from Trade according to Comparative Advantage

South

North

Manuf

Manuf

10

-1/PW

UN(Manuf)

-1/PN

3

PS =3

UN

PN =1

-1/PW

US

-1/PS

10

Food

9

Food

some unrealistic features of the model so far
Some unrealistic features of the model, so far…
  • What if there are transport costs?
  • What if there are more than two goods?
  • What if factors cannot adjust to other sectors?
  • What if there are more than one factor?
  • Why is there always complete specialization?
transport costs and non traded goods
Transport Costs and Non-traded goods
  • If there are transport costs, the competitiveness edge of a country must more than make up for this transport cost.
  • Otherwise, the good will not be traded, even if it is cheaper to produce in one country. This good is called non-tradable.
    • In reality, economies spend large proportions of their income in these type of goods.
  • It can become tradable, if transport costs fall or the productivity advantages widen (globalization).
global markets vs local markets tradables and non tradables
Global markets vs. local marketsTRADABLES and NON-TRADABLES
  • Tradable goods can travel across borders and have international markets that set prices.
  • Non-tradable goods have their prices set by supply and demand in local markets.
    • Often, the same good exists in different countries because it is produced locally.
  • With globalization, many goods and services have become tradable.

Non-tradables

Tradables

Goods

  • Cement
  • Housing
  • McDonalds Hamburger
  • Textiles
  • Machinery
  • Almost all goods

Services

  • Hairdressers
  • Government services
  • Auto-repair
  • Almost all services
  • Consulting
  • Banking
  • Telecom’s
  • Tourism
summary
Summary
  • Comparative advantage:
    • Consumers react to price differences and buy from lower price foreign producers the goods in which their country does not have comparative advantage (gains from exchange).
    • Producers react to price differences and allocate resources to industries where relative productivity is higher, exporting those goods (gains from specialization).
  • Every country always has an industry in which it has Comparative Advantage and it is competitive in world markets for that industry.