International Trade

1. International Trade

2. Introduction to Trade • Trade is not unlike normal exchange between individuals. • Few individuals are completely self-sufficient. • We specialize in production to increase the range of goods we can consume. • Individuals produce one good, sell it, and use the proceeds to consume other goods. • Countries use trade the same way • Trade expands consumption possibilities. • The gains from international trade arise from the same source that gains to individuals arise -- specialization that improves efficiency. • Trading with other countries for goods that we don't produce expands the list of goods that we can consume.

3. Introduction to Trade • Allows countries to exploit special advantages. • Population, demographics, education • Climate • Natural resources • Examples: • Wheat in Canada, US and Argentina • Oil from Middle-East • Electronics from Asia

4. Traded Goods • Most goods are traded. • Most commonly traded goods share certain characteristics. • Involve some level of production indicating intermediate or finished goods • Involve some level of specialization • Exports exploit the natural advantage of the exporting country • Imports usually are more varied than exports.

5. Role of Production in Trade • Any traded good requires some level of value added • Finished goods or intermediate goods require production or assembly • Natural resources need to be mined and/or processed • Value added process creates jobs in the exporting country

6. Specialization • Countries trade goods where specialization pays off • Indication is a lower price than what it would cost in other countries to produce the good • Allows to compete against other countries offer same or similar products • Specialization is based on natural advantage and scale of production

7. Specialization • Countries find “natural” areas of specialization • Often based on natural endowment • Again, climate, reserves of natural resources • Can be developed • Education initiatives (technical training in Japan and India) • Communication infrastructure in Korea • Tourism in Switzerland

8. Natural Advantage • Natural advantage not always tied to costs • Two sides to cost per unit • Costs of inputs, especially labor • Productivity of inputs, especially labor • High wage, high productive workers can compete with low wage, low productive workers • Issue is labor cost per unit of output

9. Simple Example • Young, inexperienced worker earning minimum wage has low productivity • Older, experienced worker earning twice minimum wage has high productivity • Labor cost per unit of output depends on relative productivity • If the older worker is twice as productive as younger worker, labor cost per unit of output is the same

10. Simple Example (cont) • Say younger worker earns $5 per hour, produces 10 units per hour. • Labor cost per unit is 50 cents • $5/10 • If older worker earns $10 per hour but produces 20 units per hour • Labor cost per unit is still 50 cents • $10/20

11. Simple Example (cont) • Is there any basis in fact to this argument? • Who is more likely to get hired? • Increases in the minimum wage often lead to fewer jobs for inexperienced workers • Training tends to increase both wages and employment • All indicate that labor cost per unit of output is lower for higher paid workers

12. Unit Labor Costs Countries with high wages tend to have high productivity Source: Wall Street Journal ("America-Firsters Have it Backward," January 16, 1996)

13. Outsourcing • Then why do we see outsourcing? • Partly due to differences in skills/outputs • The previous graph is based on average wages and average productivities • Outsourcing is usually industry specific • Started with manufacturing and repetitive task jobs • Moving to service, but still repetitive task, jobs • Much “outsourcing” is movement within US • From high wage north to low wage south

14. Outsourcing (cont) • Disrupts jobs in particular industries • Low transportation and communication costs have made it easier and cheaper • Lowers costs of production • Therefore, favors consumers of the goods • Hurts the workers who are the labor inputs • Increases the role of specialization in international trade

15. Gains from Specialization • Gains from trade do not derive from always having the country with the cheapest labor or even the cheapest overall cost of production for a specific good produce it • Cheapest producer has absolute advantage • Gains from trade come from exploiting differences in the opportunity cost of producing goods • Lowest opportunity cost has comparative advantage

16. Absolute Advantage • Absolute advantage means that a country can produce a good cheaper – in terms of the cost of inputs – than another country • Usually explained with a simple one input (usually labor) model of production • Looks at the inputs used per unit of output • Under absolute advantage, the country with the highest labor productivity would be more efficient

17. Absolute Advantage (cont) • Simple model: • Two countries: United States and United Kingdom • Two goods: Wheat and cloth • Both countries can produce both goods • Table shows the amount of output produced by each country using 1 unit of input (1 unit of labor)

18. Absolute Advantage (cont) Divide output per unit into 1 to get the input cost (labor unit cost) per unit of output The US has an absolute advantage in wheat (0.1 units of labor per bushel against 0.2 units of labor per bushel in the UK) while the UK has an absolute advantage in cloth.

19. Absolute Advantage (cont) • In terms of the input cost per unit, it is cheaper to produce wheat in the US and cloth in the UK • We would therefore expect that gains can be had by having the US produce wheat, while the UK produces cloth, and the two countries trade.

20. Effect of Trade on Consumption • Suppose the US has 100 units of labor input and the UK has 75 units of labor input. • Then we can find the PPFs for each country by noticing how many units of input are needed for each unit of output. • US can produce at most 1000 units of wheat or 600 units of cloth • UK can produce at most 375 units of wheat or 750 units of cloth

21. Effect of Trade on Consumption cloth cloth US UK 750 750 600 375 wheat 750 1000 wheat White lines show original PPFs US can produce 1000 bushels of wheat, UK 750 yard of cloth and trade (red lines) Suppose they agree to trade one yard of cloth for 1 bushel of wheat And US still has some wheat or more cloth or both (yellow line)

22. Absolute Advantage: the ability to produce a good at a lower input cost Comparative Advantage: the ability to produce a good at a lower opportunity cost

23. Absolute Advantage and Trade • It is always beneficial for at least one partner to specialize. • Consumption of both can increase. • Rate of trade is between the slopes of the PPFs • UK slope was 2 cloth for 1 wheat • US rate was 0.6 cloth for 1 wheat • Rate of trade between (we chose 1) makes both better off. • Notice, slope of PPF shows opportunity cost – which is the real key for trade!

24. Absolute Advantage and Trade (cont) • When two countries each has an absolute advantage in different goods, each country should specialize in the good for which it has the absolute advantage • UK had absolute advantage in cloth, so specialized in cloth • US had absolute advantage in wheat, so specialized in wheat. • With more inputs available, could produce more cloth if it wanted more than UK could give.

25. Comparative Advantage • But what if one country has absolute advantage in both goods? • Does that mean there are no gains from trade? NO! Trade is still beneficial. • The theory of comparative advantage shows that even in this case, trade is advantageous. • Gains from trade are really always based on comparative advantage. • When the countries share absolute advantage, we just have a special case of comparative advantage.

26. Comparative Advantage • Comparative advantage is based on opportunity cost, not absolute cost. • Opportunity cost is how much of one good must be given up to get one unit of the other • It is the slope of the PPF • In our example, the opportunity cost of one bushel of wheat is • 2 units of cloth in the UK • 0.6 units of cloth in the US • So wheat is cheaper to produce in the US • With absolute advantage, comparative advantage is easy.

27. Comparative Advantage Opportunity cost of wheat = cloth/wheat Opportunity cost of cloth = wheat/cloth

28. Comparative Advantage • US has the lower opportunity cost of per bushel of wheat (0.6 yards of cloth compared to 2 yards of cloth) • UK has the lower opportunity cost of per yard of cloth (0.5 bushels of wheat compared to 1.67 bushels of wheat) • If different countries have the absolute advantage, each will have the comparative advantage

29. Comparative Advantage • Now compare the United Kingdom to Argentina • Argentina has an absolute advantage in both goods.

30. Comparative Advantage • Units of input per one unit of output • Notice, Argentina can produce both goods cheaper • So has an absolute advantage in both In the next slide, we’ll compute the COMPARATIVE ADVANTAGE by seeing the internal opportunity costs of wheat and cloth

31. Comparative Advantage Argentina has a comparative advantage in wheat, but the United Kingdom has a comparative advantage in cloth.

32. Two Ways to Compute Opportunity Cost of Wheat • Divide cloth output per unit of labor by wheat output per unit of labor. • In the UK we get 10 yards/5 bushels which equals 2 yards of cloth per bushel of wheat • In Argentina we get 60/100=0.6 • Divide labor units per unit of wheat by labor units per unit of cloth. • In the UK we get 0.2/0.1 which again equals 2 yards of cloth per bushel of wheat. • In Argentina we get 0.01/0.0167=0.6

33. Comparative Advantage • Even though Argentina has an absolute advantage in both wheat and cloth, it has a comparative advantage only in wheat. • It is almost always true that one country will have the comparative advantage in one good, and the other country the comparative advantage in the other good. • Unless the opportunity cost is the same in both countries.

34. Comparative Advantage • Country with the lowest opportunity cost should produce that good • Argentina should produce wheat • United Kingdom should produce cloth • Of course, this is an ideal, over-simplification • There is no complete specialization • But we do see Argentina more likely to produce wheat, and the UK cloth, because of comparative advantage.

35. Comparative Advantage and Trade • The terms of trade will be between the internal opportunity costs • UK has opportunity cost for one yard of cloth equal to 0.5 bushels of wheat • Argentina has an opportunity cost for one yard of cloth equal to 1.67 bushels of wheat • Terms of trade will be between 0.5 bushels of wheat per yard of cloth and 1.67 bushels of wheat per yard of cloth. • Prices will reflect this terms of trade.

36. Effect of Trade on ConsumptionAssume UK has 75 units of input and Argentina has only 10 cloth cloth Argentina UK 750 750 600 375 wheat 750 1000 wheat White lines show original PPFs Argentina can produce 1000 bushels of wheat, UK 750 yard of cloth and trade (red lines) Suppose they agree to trade one yard of cloth for 1 bushel of wheat And Argentina can still produce more wheat or more cloth or both (yellow line)

37. Real Life Examples • Japanese worker on average is 20 percent less productive than US worker • In food manufacturing, the Japanese worker is 60 percent less productive that US worker • But in automobile and steel, the Japanese worker is more productive than US worker • So Japan exports steel and cars to US, and imports food

38. Real Life Examples II • Both Mexico and India have significantly lower rates of pay and productivity than the US • 1996 unit labor cost in India was just less than that in the US • 1996 unit labor cost in Mexico was about 80% of that in the US • Patterns of trade reflect comparative advantage, not absolute advantage

39. Real Life Example II (cont) Patterns of trade between the United States and India, and the United States and Mexico reflect difference in comparative advantage, not in absolute advantage (January – August, 2004)