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Part 1

Part 1. I NTERNATIONAL T RADE T HEORY. T rade T heories. Early Trade Theories The Classical Theory of Trade Absolute Advantage (Smith) Model Comparative Advantage (Ricardian) Model and some extensions Reciprocal Demand Principle. T rade T heories. 3. Neoclassical Trade Theory

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Part 1

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  1. Part 1 INTERNATIONAL TRADE THEORY

  2. Trade Theories • Early Trade Theories • The Classical Theory of Trade • Absolute Advantage (Smith) Model • Comparative Advantage (Ricardian) Model and some extensions • Reciprocal Demand Principle

  3. Trade Theories 3. Neoclassical Trade Theory • Factor Endowment and the Heckscher-Ohlin Model • The Factor-Price Equalization Theorem 4. Modern Trade Theories • Intra-industry Trade • Imperfect Competition and Economies of Scale • Dynamic International Trade Theory (Product Cycle, etc) • New Development in International Trade Theory

  4. Issues Mainly Discussed • Why do countries trade(gain from trade)? • What are the bases for trade? ——Price differences  Supply side (cost): Technology Factor Endowment Production scale  Demand side: Income Preference • What are the changes in trade pattern? • What are the effects of trade?

  5. CHAPTER 2 Classical Trade Models

  6. Objective 1. Understand how everyone can benefit from voluntary trade. 2. Learn the meaning of absolute and comparative advantage. 3. Recognize how comparative advantage forms the basis upon which specialization and exchange benefit trading partner. 4. Be able to apply the theory of comparativeadvantage to real-world situations

  7. Classical Trade Models • Absolute Advantage Theory (Smith’s Model, AA Model) • Comparative Advantage Theory (Ricardian Model, CA Model) • Other Classical Trade Theories

  8. Smith’s Model • Adam Smith • Basic Assumptions • Basis for Trade: Absolute advantage • Measurements of absolute advantage • A numerical example • Pattern of Production & Trade • Graphical Representation • Gain from the Trade

  9. In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, Adam Smith performed a detailed analysis of trade and economic interdependence, which economists still adhere to today. Adam Smith (1723-1790)

  10. Basic Assumptions 1. Supply (Producer) • 2*2*1 model • One input: Labor(L) • Two outputs: Wheat (Qw) and Cloth (Qc) • Two countries:US and China • Fixed input marginal product • Constant return to scale. 2. Demand (Consumer) Income budget constraint —— no lending or loaning

  11. Basic Assumptions 3. Trade • No transport or transaction costs • Trade balance • Factors of production are perfectly mobile within nation, but not between nations 4. Market structure Full Employment, Perfect Competition 5. Technology Different technologies different productivity of labor

  12. Basis for Trade 1. Difference in Technology  Different Productivity • Different Production cost • Different Commodity price • International trade 2. Absolute Advantage

  13. Absolute Advantage • A country is said to have an absolute advantageover another country in the production of a commodity if it can produce a larger amount of the commodity than other country with the same amount of resources. A reciprocal absolute advantage • Two countries are said to have a reciprocal absolute advantageover each other if each country has an absolute advantage over the other in producing one of the two commodities.

  14. Measurements of absolute advantage • Productivity: If , China has an absolute advantage in product cloth. • Production cost (measured by input): aLQ = (labor required in each unit of output) c c

  15. Measurements of absolute advantage • Commodity price:  where W is wage rate. Given a fixed W, P is positively related to production cost aLQ

  16. A numerical example In this case, China has an absolute advantage in producing cloth and the US has an absolute advantage in growing wheat. (presentation of China & USA)

  17. Pattern of Production & Trade • “Each country should specialize in and export the Product in which it has an absolute advantage” • Pattern of Production:in this case, China should specialize in production of cloth and US should produce wheat. • Pattern of Trade:China should export cloth and import wheat. US should import cloth and export wheat.

  18. Graphical Representation(1) Some Conceptions • Returns to scale • Constant Returns of Scale • Increasing Returns of Scale • Decreasing Returns of Scale • Production Possibility Frontier or Curve (PPF or PPC)： Points describing alternative combinations of output levels for two different products to be produced by given resources

  19. C C C Q Q Q Constant Returns Increasing Returns Decreasing Returns Qw Qw QC QC PPF PPF

  20. Graphical Representation(1) Some Conceptions 3. Community Indifference Curve (CIC) Higher Satisfaction CIC2 CIC1 CIC the points describing same level of satisfaction (or utility) by given resource.

  21. Graphical Representation(1) Some Conceptions 4. Equilibrium in Autarky PPF CIC

  22. Slope = Cost of 1C = 0.5W 50 100 Graphical Representation(2) PPF of China & USA China Wheat • Max. amount of Wheat can be produced: 50W 1C • Max. amount of Cloth can be produced: 100C PPFChina Cloth 0

  23. Graphical Representation(2) PPF of China & USA USA Wheat • Max. amount of wheat can be produced: 100W 1C 100 Slope = Cost of 1C =1.25W Note: The PPC with a gentler slope will have a comparative advantage in food production. PPFUSA • Max. amount of Cloth can be produced: 80C 0 Cloth 80

  24. Graphical Representation(3) Equilibrium without trade China Wheat 50 CIC PPFChina EChina 25 Cloth O 50 100

  25. Graphical Representation(3) Equilibrium without trade USA Wheat 100 CIC PPFUSA EUSA 50 Cloth O 80 40

  26. Graphical Representation(3) Equilibrium with trade Wheat TOT=1 100 China CChina 50  PPFChina EChina Import 25 PChina Export Cloth 0 50 100

  27. Graphical Representation(3) Equilibrium with trade Wheat PUSA USA 100 Export 50 PPFUSA CUSA  Import EUSA TOT=1 0 Cloth 40 50 80 100

  28. Gain From the Trade(1) Consumption P=Produce;C=Consumer;Labor both 100 Labor be used equally on the production of C&W Exchange Rate (TOT) must between 0.8~2 China & USA Consumption Gains: Both consume more（China 25 more wheat ; US 10 more cloth）.

  29. Exchange Rate (TOT) China exchange 100 unit Cloth for Wheat not less than 50 unit, or else produce Wheat itself； USA exchange 100 unit Wheat for Cloth not less than 80 Unit, or else produce Cloth itself； So the exchange rate of Cloth/Wheat must between 0.8 (=80/100) and 2 (=100/50)。

  30. Gain From the Trade(2) Production When Autarky, the total productions of Cloth is 90 (=50+40), that of Wheat is 75 (=25+50); When Trade, the total productions of Cloth is 100 (>90), that of Wheat is 100 (>75). So the world has production gains from trade.

  31. Summary • Given that two countries have a reciprocal absolute advantage over each other, if each specializes in producing the commodity in which it has an absolute advantage, • then the world’s total output will increase • and each country will gain by being able to consume more than autarky.

  32. Implications of Smith’s Theory Access to foreign markets helps create wealth • If no nation imports, every country will be limited by the size of its home country market • More importantly, the macro division of labor will be limited by the extent of the market • Imports enable a country to obtain goods that it cannot make itself or can make only at very high costs • Trade barriers decrease the size of the potential market, hampering the prospects of specialization, technological progress, mutually beneficial exchange, and, ultimately, wealth creation.

  33. Limitation of the Smith’s Model compare In this case, the US has the absolute advantage in both goods (it is very common for a developed country to have absolute advantages in most sectors). According to the Smith theory, there will be no trade.(Really?)

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