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2. WHY DO WE TRADE?

2. WHY DO WE TRADE?. Why Do We Trade?. The classical theory of international trade is concerned with the following three questions: 1. What are the gains from trade?

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2. WHY DO WE TRADE?

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  1. 2. WHY DO WE TRADE? 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  2. Why Do We Trade? The classical theory of international trade is concerned with the following three questions: 1. What are the gains from trade? • In other words, if countries benefit from international trade, where do the gains come from, and how are they divided among the trading countries? 2. Why Do We Trade?

  3. Why Do We Trade?continued 2. What is the structure/pattern of trade? • In other words, which goods/services are exported, and which are imported • What are the fundamental laws that govern international allocation of resources and the flow of trade? 3. What are the terms of trade? • In other words, at what prices are the exported and imported goods exchanged? 2. Why Do We Trade?

  4. The Different Trade Theories 1. Early Trade Theory: Mercantilists 2. Classical Trade Theory: Ricardian Model (section 2.1) 3. Modern Trade Theory: Heckscher-Ohlin Model (section 2.2) 4. New Approaches to Trade Theory (section 2.3) 2. Why Do We Trade?

  5. 1. Early Trade Theory: Mercantilists • Mercantilists believed that the purpose of international trade was to keep exports greater than imports and pile up gold, and when/if deficits were created they believed that imports had to be restricted. Mercantilists maintained that the way for a nation to be rich or powerfull was to export more than import. • Mercantilists assumed trade to be a zero-sum game since they assumed that fixed amounts of goods and of gold existed in the world and that trade merely determined their distribution among the various nations 2. Why Do We Trade?

  6. Rich or Powerful nation was the nation which hasmore gold or accumulates more gold. X should be bigger than M. X reflects the money or gold which our nation gains due to sell our goods.. M is opposite of X. • The aim of the goverment • was to export more than import • *The international trade is zero • sum game. Encouraged X and restricted M 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  7. Mercantilistscontinued • But in the 1740s, David Hume explained that as quantity of money (gold) changes, so also does the price level, and the nation's real wealth is unaffected • In 1770s, Adam Smith argued that import restrictions would reduce the gains from specialization and make a nation poorer 2. Why Do We Trade?

  8. Asssumptions of Classical Trade Theory: a) two countries with fixed amount of labor,full employment b) only two products produced (wheat and cotton) and two nation, c) preferences for food and clothing are same, d)Labor theory of value e)Transport cost is equal to zero. f)Pure competition theory 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  9. Theory of Absolute Advantage The advantage in the production of a product of one country over another when it uses fewer resources to producethan the other country does. If a nation produce a good efficiently or by using less resources tahn other nations, we concluded that nation has absolute advantage. 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  10. Absolute Advantage - an Illustration Suppose country A and country B produce wheat, but that A's climate is more suited to wheat and its labor is more productive. Country A will therefore produce more wheat per acre than country B and use less labor in growing it and bringing it to the market. Country A thus enjoys an absolute advantage over country B in the production of wheat. 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  11. Example 1: Gains from Mutual Absolute Advantage Assume a) two countries with fixed amount of labor b) only two products produced (wheat and cotton), c) preferences for food and clothing are same. Which goods are produced with lower Cost in US and UK? 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  12. US has Absolute Advantage in Wheat and UK has Cloth.Because,6 is bigger than 1. The US’ quantity of Wheat is 6, UK’s is 1.The opposite is true for UK. 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  13. with opening the trade, US produce and exportwheat and UK cloth. We assume that the international price of the wheat and cloth is determined. 6W=6CUS gains 2C or ½ man. If US produce 6W by using one man hour, US produce 3 W by using additional man hour. So total W production increased 9W. 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  14. Theory of comparative advantage • Ricardo did not bother to answer this question • If a nation produce a good efficiently or by using less resources with respect to other nations, we concluded that nation has a comparative advantage. • He just assumed that the differences in comparative advantage depended on comparative difference in labor productivity (that is, differences in technology). • The international terms of trade is given. Any process or information did not given in the theory. We do not How The İnternational price occured. 2. Why Do We Trade? - 2.2 Modern Trade Theory: Heckscher-Ohlin Model

  15. Comparative Advantage - an Illustration • Suppose that countries C and D both produce wheat and corn and that C enjoys an absolute advantage in the production of both - that is, C's climate is better than D's, and fewer of C's resources are needed to produce a given quantity of both wheat and corn • C and D each need to choose between planting land with wheat and corn 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  16. Comparative Advantage The advantage in the production of a product enjoyed by one country over another when that product can be produced at lower cost in terms of other goods than it could be in the other country. Which goods are produced with lower Cost in US and UK? 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  17. Us has comporative Advantage in Wheat and UK has Cloth.Because,6/1 is bigger 4/2,or 6/1 is bigger than 4/2. The US’ absolute advantage in Wheat is 6, UK’s is 2. US produced much more wheat, US is 3 times productive in producing wheat than Cloth with respect to UK. 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  18. with opening the trade, US produce and exportwheat and UK cloth. We assume that the international price of the wheat and cloth is determined. 6W=6C 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  19. If The US exchanges 6W for more than 4C, IT gains more advantage due to international trade and UK has advantage, If It give up less than 12Cfor 6W.4C<6W<12C 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  20. Opportunity cost • Opportunity cost is the sacrifice made when selecting one product or service over another. • Or OC is The quantity of good which we give up to produce more another. • Because The resources are scarce to fulfill the all needs. 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  21. Table 2.4 Maximum Amount First, We determine maximum amount of Wheat and Cloth produced by US Second, We draw a line by using two points which are showed us maximum quantities 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  22. Us has comporative Advantage in Wheat and UK has Cloth.Because,180/120 is bigger than 60/120,or 3/2 is bigger than ½. The US’ advantage in Wheat is 1.5, UK’s is 0.5. US produced wheat 1.5 times than Cloth. And UK produced wheat 0.5 times than cloth. 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  23. Comparative Advantage and Opportinity Cost In C, We have not enough resources to reach it. In D, We do not utilize Our resources fully. How do We understand the CA? The distance of 0-120 is smaller than 0-180 in US. The distance of 0-120 is bigger than 0-60 in UK. US has a CA in producing and trading W, and UK has Cloth. US UK Cloth Cloth 120 C 120 B(40,40) A(90,60) PPF D Wheat 0 0 180 Wheat 60 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  24. But We must utilitize our resources fully. B is not available. We have no extra resources for B. N1 want to produce more X than it do before So The production of Y decreased. We have a new combination. Y Nation 1 A • 60 • 50 • 30 • 5 B D X • 10 20 25 27 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  25. Opportunity cost • Opportunity cost is the sacrifice made when selecting one product or service over another. • Or OC is The quantity of good which we give up to produce more another. 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  26. But We must utilitize our resources fully. B is not available. We have no extra resources for B. N1 want to produce more X than it do before So The production of Y decreased. We have a new combination. Y Nation 1 A • 60 • 50 • 30 • 5 B D X • 10 20 25 27 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  27. Constant Opportunity Cost in A tan = C/W= (120-60)/(90-0)= 60/90=2/3 Cloth tan = tan  US 120 60 20 in B tan = C/W= (120-20)/(150-0)= 100/150=2/3 A(90,60)   B 90 150 180 Wheat The OC is the slope of the PPF or The Slope of it is equal to tangent of the function in some points like A or B. 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  28. Opportunity cost • Opportunity cost is the slope of the Transformation Curve. • For US • OC= C/W=2/3 • It means that US must give up 2/3 Cloth to produce 1 Wheat additionally. 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  29. Opportunity cost • Opportunity cost is the slope of the Transformation Curve. • For UK • OC= C /W=2 • It means that UK must give up 2 Cloth to produce 1 Wheat additionally. 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  30. Constant Opportunity Cost tan = tan  We say that The OC is constant in the every points on the line. 1.Factor of Production, Neither perfect substitution nor used in fixed proportion. 2. The production factor has same quality. We assume that have two production factors to produce wheat. One is the Labor and second is the robot or machine. The Total productivity of Labor is 100 unit and We use in production 100 labor. The Total productivity of Robot or machine is 1000 unit and We use in production 1. The average productivity of robot is 1000/1=1000 and Labor is 100/100=1 And APR is bigger than Labor. So We used robot to produce wheat. The Wheat is Machine intensive good in this situation. But If The TPL is 100000, APL will 1000 like Robot. So in this situation Both Robot and Labor may be used production of wheat. Both is perfect subsititues or same quality. 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  31. Relative Commodity Price Transaction or Trade is realeased, When The value of good bougt and selled are equal. In this example, We have two goods, W and C. And The value of the Wheat is Pw*Qw and Cloth, Pc*Qc. If the Pw*Qw is bigger than Pw*Qw, The seller of the W does not sell it. So either Pw or Qw inceased. And Pw*Qw is equal to Pc*Qc. Pw*Qw =Pc*Qc. Pw/Pc=Qc/Qw. The price and quantitiy has negatively related. The price of the cloth is up in the first indentity and quantity of cloth is down in the second identity. 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  32. Relative Commodity Price Cloth US in A tan = C/W= (120-60)/(90-0)= 60/90=2/3 120 60 tan = Qc/Qw And Pw/Pc or relative Commodity price. A(90,60)  90 180 Wheat If we sell valuable good, We will want to sell less. The relative price is negatively related with relative quantity. For US, The prices is Pw/Pc and Uk is opposite. 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  33. Comparative Advantage and Opportinity Cost 70W=70C UK US Cloth Cloth autorky E(0,120) 120 120 60 C(110,70) F(50,70) A(90,60) D(40,40) PPF B(180,0) 90 180 Wheat 60 Wheat 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  34. US ‘ gain from trade may be estimate with 110-90 and 70-60, 20W and 10C are the gain of US because of International Trade.UK, 70-40 and 50-40, 20W and 10C.Both Nations may consume more C and W due to International Trade. A and D B and E F and C 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  35. Relative Commodity Prices Sw(US+UK) Pw/Pc 1 2/3 Dw(US+UK) 180 240 Wheat 120 C 120 C Complete Specialization 180 W 60 C 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  36. Relative Commodity Prices Sc(US+UK) Pc/Pw 1 1/2 Dc(US+UK) 120 240 Cloth 120 C 120 C Complete Specialization 180 W 60 C 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  37. TT, 180W=180C Wheat US UK A B 180 60 C 120 180 Cloth The Range of Mutual Benefit is 120C 180W 360C and Total benefit is 240C, US take 60C and Uk take 180C.UK has more benefit than UK. Which prices is close to terms of trade in international trade? US’ price is close to TT. So US has a smaller benefit from trade. A Nation take much more gain than the other nation When its price is close to TT. 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  38. İmportance of Being Unimportant Sw(US+UK) Pw/Pc 1 2/3 Dw(US+UK) 180 240 Wheat 120 C 120 C No Complete Specialization 180 W 60 C 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  39. International Equilibrium with Increasing Costs Indifference Map and Consumer Equilibrium Increasing Opportunity Cost Clothing Clothing a) Product specific factors. b) Different industries use factors in different proportions. I’’’ I’’ PPF I’ Food Food 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  40. But We must utilitize our resources fully. B is not available. We have already use all resources. So The production of Y decreased. We produce more X We meet a new combination. Y Nation 1 A • 60 • 50 • 30 • 5 B D X • 10 20 25 27 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  41. International Equilibrium with Increasing Costs Y Y Nation 1 Nation 2 A • 60 • 50 • 30 • 5 B C D X X • 10 20 25 27 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  42. Opportunity cost and MRT • Opportunity cost is the slope of the Transformation Curve. MRT has same meaning. • For Nation 1. • From A to B, OC= Y/X=60-50/20-10=1 • From C to D, OC= Y/X=30-5=27-25=12.5 • The Opportinity cost increased, When we moves right over the PPF. The slope of PPF is called as MRT. 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  43. Community Indiffrence Curve Indifference Map The CIC which is far from the orgin signs more social welfare than other. The slope of CIC equal to MRS. Y Clothing I’’’ I’’ I’ X Food 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  44. International Equilibrium with Increasing Costs Px/Py = terms of trade in US Px/Py=1/4, and X is chepear than Y. And Px/Py is 4, and Y is chepar than X in Uk. PA is smaller than PB in isolation. Y Clothing Pb=1/4 A(50,60) B(40,80) Pa=4 I’ X Food 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  45. General Equilibrium in a Small Open Economy İn A, 50,60 İn B, Incomplete Specialization 130,20 130-60=70 X (Exp) 20+60= 80 Y.(Imp) 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  46. General Equilibrium in a Small Open Economy İn D, 80,40, İn A, Incomplete Specialization 40,120 120-60=60 Y (Exp) 40+60= 100 X.(Imp) 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  47. General Equilibrium in a Small Open Economy İn A, 50,60, Production does not change. İn T, 30,80 So The consumption of Y increase. Gains from exchange But in A The slope of the PPF is smaller than TT. So B and E 60 imp, 50 exp. 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  48. Same Production Technique in Both Countries, Trade Based on Different Taste Figure 2 America Clothing Britain Food 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  49. Trade Based on Different Taste continued • Figure 2: Trade based on different tastes. America and Britain share the same production frontier MN. In autarky, America produces and consumes at A, and Britain at B. With free trade, both countries produce at Q, but America consumes at A’ and Britain at B’. Trade triangles A’VQ and QSB’ are identical. 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  50. General Equilibrium in a Small Open Economy 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

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