International Economics

International Economics Topic 1: International Trade Theory and Policy

Topic 1 • What we will cover Topic 1: International Trade Theory and Policy • Interdependence and the gains from trade: production possibilities frontier, Theory of Comparative Advantage • Theory of Competitive Advantage • The Instruments of Trade Policy • Arguments for protection • Benefits of trade • GATT, WTO • EU: Free Trade Area, Customs Union

Interdependence and the gains from trade Source: “Principles of Economics” Second Edition, Mankiw, Chapter 3. (Library desk reserve) Introduction • People consume goods and services produced by many other people both in their own country and around the world • Interdependence and trade are desirable because they allow everyone to enjoy a greater quality and variety of goods

Interdependence and the gains from trade • Use an example of a simple economy: to show why people choose to depend on others for goods and services and how this choice improves their lives • Suppose: • There are only two goods in the world – meat and potatoes • There are only two people in the world – a cattle rancher and a potato farmer, each of whom would like to eat both meat and potatoes

Interdependence and the gains from trade • Gains from trade are most obvious if the rancher can produce only meat and the farmer can produce only potatoes: trade would allow them to enjoy greater variety – each could eat both meat and potatoes • Gains from trade if the rancher and the farmer are each capable of producing the other good, but only at a great cost. • The farmer is able to produce meat but he is not very good at it. • The rancher is able to produce potatoes but he is not very good at it • In this case the farmer and rancher would specialise in what they do best and then trade with each other

Interdependence and the gains from trade • But the gains from trade are less obvious when one person is better at producing every good. • Example: suppose the rancher is able to produce meat better than the farmer and grow potatoes better than the farmer. • In this case, is there still a good reason for them to trade with each other? • Answer to this questions lies on the Theory of Comparative Advantage

Interdependence and the gains from trade • Production Possibilities • Suppose the farmer and the rancher each work 40 hours a week and can devote this time to growing potatoes, producing meat or a combination of both

Interdependence and the gains from trade

Interdependence and the gains from trade • From the previous table: the rancher is obviously more productive than the farmer in both activities (rancher can produce a pound of meat in 1 hour compared to 20 hours for the farmer. Rancher can produce a pound of potatoes in 8 hours compared to 10 hours for the farmer)

Interdependence and the gains from trade • A production possibilities frontier: is a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology • We can now draw a production possibility frontier for both the farmer and the rancher

Interdependence and the gains from trade The farmer’s production possibilities frontier Meat (pounds) 2 1 0 2 Potatoes (pounds) 4

Interdependence and the gains from trade The rancher’s production possibilities frontier Meat (pounds) 40 20 0 5 Potatoes (pounds) 2 ½

Interdependence and the gains from trade • Rancher’s production possibilities frontier illustrates the amounts of meat and potatoes that the rancher can produce. • If all 40 hours are devoted to potatoes – he produces 5 pounds of potatoes and no meat • If all 40 hours are devoted to meat – he produces 40 pounds of meat and no potatoes • If the rancher divides his time equally between the two activities – he produces 2 ½ pounds of potatoes and 20 pounds of meat • The production possibility frontier shows these three possible outcomes and all other outcomes in between

Interdependence and the gains from trade • Farmer’s production possibilities frontier illustrates the amounts of meat and potatoes that the farmer can produce. • If all 40 hours are devoted to potatoes – he produces 4 pounds of potatoes and no meat • If all 40 hours are devoted to meat – he produces 2 pounds of meat and no potatoes • If the farmer divides his time equally between the two activities – he produces 2 pounds of potatoes and 1 pound of meat • The production possibility frontier shows these three possible outcomes and all other outcomes in between

Interdependence and the gains from trade • If the farmer and the rancher choose to be self-sufficient, rather than trade with each other, then each consumes exactly what he or she produces • Therefore, without trade, slides 11 and 12 show the possible combinations of meat and potatoes that the farmer and rancher can each consume.

Interdependence and the gains from trade • Specialisation and trade: • How trade expands the set of consumption opportunities: • The rancher and farmer could trade with each other and both could be made better off from the trade • Trade allows the farmer and rancher to specialise in what they do best • Lets take an example of where both the rancher and farmer would be made better off from trade

Interdependence and the gains from trade • Without trade: • If the rancher and farmer divide their time equally between the production of meat and potatoes: Farmer produces/consumes: 1lb of meat Farmer produces/consumes: 2lbs of potatoes Rancher produces/consumes: 20lbs of meat Rancher produces/consumes:2 ½ lbs of potatoes

Interdependence and the gains from trade • With trade: • Farmer could specialise in the production of potatoes only (that’s what he does best) • Farmer produces: 4 lbs of potatoes • Farmer produces: 0 lbs of meat • Then the farmer could trade 1 lb of these potatoes for 3 lbs of meat from the Rancher • Therefore, the farmer gets to eat 3 lbs of potatoes and 3 lbs of meat • The following graph of the farmer’s production possibilities frontier shows the benefit of this trade for the farmer

Interdependence and the gains from trade The farmer’s production possibilities frontier Meat (pounds) A* 3 2 A 1 0 2 3 Potatoes (pounds) 4

Interdependence and the gains from trade • With trade: • What about the rancher? • The Rancher is good at producing both potatoes and meat but he is particularly good at producing meat • Therefore, if he spends 24 hours producing meat and 16 hours producing potatoes he will produce: 24 pounds of meat and 2 pounds of potatoes • Then, the rancher gives the farmer 3 pounds of meat in exchange for 1 pound of potatoes • Therefore, the rancher gets to eat 21 pounds of meat and 3 pounds of potatoes • The following graph of the rancher’s production possibilities frontier shows the benefit of this trade for the rancher

Interdependence and the gains from trade The rancher’s production possibilities frontier Meat (pounds) 40 21 B* 20 B 0 2 ½ 3 5 Potatoes (pounds)

Interdependence and the gains from trade • With trade: • Both the rancher and the farmer can benefit because trade allows each of them to specialise in what they do best • The farmer spends more time producing potatoes, the rancher spends more time producing meat and they trade with each other

Interdependence and the gains from trade The Theory of Comparative Advantage • Two people, two products (meat and potatoes): who has the an advantage over the other in the production of meat and who has an advantage over the other in the production of potatoes? • the answer is, which person can produce the meat or the potatoes at a lower cost. • There are two ways to look at the cost of producing the meat and the potatoes • Absolute advantage and Comparative advantage

Interdependence and the gains from trade • Absolute advantage = the comparison among producers of a good according to their productivity • when comparing the productivity of one person, firm or nation to that of another, the producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good • The rancher has an absolute advantage in the production of both potatoes and meat because it takes him less time to produce both goods than the farmer

Interdependence and the gains from trade • Comparative Advantage = the comparison among producers of a good according to their opportunity cost • Rather than comparing inputs required, with comparative advantage we compare opportunity cost • Opportunity cost = whatever must be given up to obtain some item • With the rancher and the farmer, each spend 40 hours a week working. Time spent producing potatoes takes away from time available for producing meat

Interdependence and the gains from trade • Comparative Advantage • Opportunity cost measures this trade-off • Rancher’s opportunity cost: We know: 8 hours = 1lb of potatoes When the rancher spends 8 hours producing potatoes, he spends 8 hours less producing meat We know: 1 hour = 1lb of meat So, in 8 hours he could produce 8 lbs of meat Therefore, the rancher’s opportunity cost of producing 1 lb of potatoes is 8 lbs of meat

Interdependence and the gains from trade • Comparative Advantage • Farmer’s opportunity cost: We know: 10 hours = 1lb of potatoes When the farmer spends 10 hours producing potatoes, he spends 10 hours less producing meat We know: 20 hours = 1lb of meat So, in 10 hours he could produce 1/2 lb of meat Therefore, the farmer’s opportunity cost of producing 1 lb of potatoes is 1/2 lb of meat

Interdependence and the gains from trade • Comparative Advantage • The opportunity cost of meat is just the inverse of the opportunity cost of potatoes • i.e. Rancher: 1lb of potatoes costs 8 pounds of meat. Therefore, 1lb of meat costs 1/8 lbs of potatoes Farmer: 1lb of potatoes costs ½ lb of meat. Therefore, 1lb of meat costs 2 lbs of potatoes

Interdependence and the gains from trade • Comparative Advantage

Interdependence and the gains from trade • Comparative Advantage • The producer who has the smaller opportunity cost of producing a good – i.e. who has to give up less of other goods to produce it – is said to have a comparative advantage in the production of that good • The farmer has a comparative advantage in the production of potatoes • The rancher has a comparative advantage in the production of meat

Interdependence and the gains from trade • Comparative Advantage • Unless two people have exactly the same opportunity cost, one person will have a comparative advantage in one good, and the other person will have a comparative advantage in the other good • Differences in opportunity costs and comparative advantage create the gains from trade • Benefits arise when each person/nation specialises in the production of the good in which they have a comparative advantage (i.e. lowest opportunity cost) and then trading some of the production of this good for other goods in which they don’t have a comparative advantage

Interdependence and the gains from trade • Comparative Advantage: • Trade makes everyone better off because it allows people to specialise in those activities in which they have a comparative advantage • The principle of comparative advantage applies to countries and economists use this principle to advocate free trade among countries

Topic 1 • What we will cover Topic 1: International Trade Theory and Policy • Interdependence and the gains from trade: production possibilities frontier, Theory of Comparative Advantage • Theory of Competitive Advantage • The Instruments of Trade Policy • Arguments for protection • Benefits of trade • GATT, WTO • EU: Free Trade Area, Customs Union

Theory of Competitive Advantage Source: Porter, M. (1990), “The Competitive Advantage of Nations”, London: Macmillan (Available in the library) • According to Porter, no nation can be internationally competitive in all sectors/industries • Focus: Porter draws from empirical studies of ten different countries to decipher the reasons why some nations advance and prosper • Focus is on competitiveness or the competitive advantage of nations.

Theory of Competitive Advantage • In examining the competitiveness of nations he sought to emphasise the role of industries and firms • According to Porter (1990), the competitiveness of a nation can be defined and measured in terms of its productivity level (defined broadly as the efficiency of production and also the quality and features of products). • A nation’s competitiveness is interpreted as the productivity of firms within particular industries • Core of Porter’s theory: role of the home-base in fostering competitiveness in particular industries and firms from four main attributes

Theory of Competitive Advantage • There are four main attributes of the home-base (the nation’s environment) that fosters competitiveness in particular industries and firms: • Home factor conditions, • Home demand conditions, • The presence of related and supporting industries, • Firm strategy, structure and home rivalry of the nation’s environment

Theory of Competitive Advantage • These four attributes are known collectively as the Diamond model. • Home factor conditions • A nation’s firms can gain a competitive advantage if the appropriate mix of factors (which is industry-specific) is present in the home nation Factors: • human resources (e.g. skilled workers), • physical resources (e.g. abundance of water, land or power sources), • capital resources (e.g. access to finance), • knowledge resources (e.g. availability of technical knowledge through public research institutes) and • infrastructure (quality and cost of telecommunications systems).

Theory of Competitive Advantage 2. Home Demand conditions • The size, growth and nature of home demand (i.e. customers/buyers) and the importance of home demand relative to other nations • Sophistication and demanding levels of home buyers will impact the firm’s innovativeness and makes them more competitive (influences the quality/standard of products that the firms produce) • Geographical proximity to demanding buyers is vital for the continuous upgrading of firms within an industry

Theory of Competitive Advantage 3. The presence of related and supporting industries • The presence of a nearby highly competitive supplier base allows for the efficient and rapid availability of sophisticated inputs for the firm (vertical buyer/supplier linkages). • Access to inputs is not the only aspect that is important but also the suppliers’ involvement in the firms’ process of innovation is of significant benefit to them. The exchange of knowledge and ideas. • If firms within the same or related industries are located close to each other, they can form formal or informal linkages between for the exchange of knowledge and ideas that leads to a higher level of innovation and gives them a competitive advantage (horizontal linkages)

Theory of Competitive Advantage 4. Firm strategy, structure and home rivalry • Firm strategy and structure is influenced by the external environment. (e.g. hierarchical vs. flat organisations). Strategy and structure should suit the industry within the firm operates • Nature of competition/rivalry in its immediate external environment is particularly important for firms in achieving a competitive advantage • Competition in close proximity provides pressure for firms to continuously upgrade, improve and innovate, which will lead to a nation having a competitive advantage in this industry over other nations

Theory of Competitive Advantage • While the four facets of the Diamond are the primary determinants of competitive advantage in a nation, a subordinate role is given to chance events and government in influencing competitiveness. • Chance events are unpredictable occurrences (e.g. wars, shifts in financial markets) that influence the competitive position of an industry in a particular region.

International Economics