Saturday, April 17, 2010

Gains from International Trade

OKAY! Let's talk turkey about international trade.

Over time, while world GDP had been increasing at a fairly constant rate, world trade has increased exponentially!

Canada is, itself, involved in quite a bit of international trade (we export and import quite a lot of goods)

David Rciardo was an economist of lore (1772-1823), and he was a major proponent of international trade. He wrote "Current comparative advantage is a major determinant of trade under free-market conditions."

Economists who advocated world trade often promoted teachings which led to real changes, such as England repealing its corn laws and moving towards a more open economy (an open economy is one which engages in international free trade, and realizes certain advantages from this, known as the gains from trade).

GAINS FROM TRADE: These are increases in total economic output due to efficiency advantages resulting from local economies engaging in specialization and trade of goods in which they have a comparative advantage.

COMPARATIVE ADVANTAGE: A situation where one local economy can produce a certain good at a lower opportunity cost than other economies (i.e., if it is less expensive for Canada to grow wheat than it is for Haiti to grow wheat, then we would state that Canada has a comparative advantage in wheat)

WHAT IS THE LOGIC BEHIND INTERNATIONAL TRADE? It's the same logic which states that interpersonal trade will be beneficial!
-When there is no trade on an interpersonal level, each individual has to be self-sufficient: they must provide for all of their own needs
-Trade allows individuals to specialize in providing goods and services which they can produce or provide efficiently, and then trade those for goods and services which they are less proficient at providing.

For an example, if I am a Doctor, I could be very very good at fixing coronary blockages, but terrible at fixing pipes. Trade means that I can simply make money by acting as a doctor, and then trade this money to "borrow" a trained plumber, thus saving me hours of frustration and reading complicated instructions. In this situation, both me and the plumber are providing the services which we are most efficient in, and because I don't have to waste time learning how to fix pipe and he doesn't have to waste time memorizing human anatomy, the overall economic output between the two of us is higher! We are more efficient when we can divide and conquer! =D

Well... interregional and international trade follows the same logic!

There are two different sources of gains from international trade:

1- The fact that different local economies have different resource endowments (and therefore can benefit from specializing in producing products which fit well with regional endowments, both natural and acquired)

2- The fact that international trade leads to a larger market for products means that local firms can realize reductions in production costs due to increased production (they are able to achieve economies of scale)


ABSOLUTE ADVANTAGE: This is when one country (or economy), compared to another, can produce more of a good from the same inputs

So, lets say that given the same inputs...

Canada can produce 10 bushels of wheat or 6 lengths of cloth
England can produce 5 bushels of wheat or 10 lengths of cloth

Canada has an absolute advantage over England in terms of wheat, and England has an absolute advantage of Canada in terms of cloth. Here, we have a situation of reciprocal advantage (each country is more adept at producing a different good), and thus it will be advantageous for England and Canada to trade!


Because each unit of input which Canada switched from cloth production to wheat production leads to 6 fewer cloths, but 10 more wheat. Similarly, each unit of input which England switched from wheat production to cloth production leads to 5 fewer wheat and 10 more cloth. The net effect of this is that the world production of both wheat and cloth has increased if both the countries specialize in what they are best at producing: there are worldwide gains from specialization.

But English and Canadian consumers want to purchase both goods... so unless these countries are able to trade, this specialization would not be practical.



Lets say that using one unit of input...

Canada can produce 100 bushels of wheat or 60 lengths of cloth
England can produce 5 units of wheat or 10 length of cloth

Here, Canada has can absolute advantage in both wheat and cloth (so Canada is more efficient at producing either of these products). Some people might think that Canada should thus not engage in trade... but they would be WRONG! Dead WRONG!

Canada can produce 20 times as much wheat at England, but only 6 times as much cloth using one unit of input. From this, we can surmise that Canada has a COMPARATIVE ADVANTAGE in wheat, while England has a comparative advantage in cloth.

Each country should trade goods in which it has a comparative advantage. Trade, in this case, increases the world's per-capita GDP. Comparative advantage is a necessary and sufficient condition for trade. Absolute advantages (in the absence of comparative advantages) do no lead to gains from trade.

How do we figure out which product a country has a comparative advantage in?

Easy! You just calculate the opportunity cost of producing any one good. Given the previous example, the OC of producing 100 bushels of wheat in Canada is 60 lengths of cloth, so the opportunity cost of each bushel of wheat is 0.6 lengths of cloth. Similarly, the OC of producing is length of cloth is 1.67 bushels of wheat for Canada. The opportunity cost for England of producing 1 length of cloth is 0.50 bushels of wheat, and the opportunity cost for England of producing 1 bushel of wheat is 2 lengths of cloth!

The opportunity cost of wheat is lower in Canada than in England, so Canada has a comparative advantage in wheat
The opportunity cost of cloth is lower in England than in Canada, so England has a comparative advantage in cloth

The point: opportunity cost depends on relative costs, no absolute costs!


*to note: increased production does not necessarily lead to increased consumption, and standard of living depends on consumption rather than production (so a country could produce a whole lot of products, but if its workers make very low factor incomes, and are hence unable to consume many goods, that country's standard of living may still be extremely low.)


If Canada can produce 100 wheats or 60 cloths given one unit of input
and England can produce 10 wheats or 6 cloths given one unit of input

Canada has the same absolute advantage of England in terms of both products, but each country has the same opportunity costs in terms of producing each good. Because of this, specialization and trade will NOT lead to any gains for either country, nor will it increase world output of either product.

There are other reasons in addition to comparative advantage that can make it beneficial to engage in specialization and trade

Basically, whenever OC's differ for the same products between different countries, specialization (and subsequent trade) leads to an increase in net production of goods, and as a result, a decrease in costs, because of...

1: Economies of Scale- Trade creates a larger market for domestic producers (who, after international trade, provide products for consumers around the world instead of just domestically)

2: Product Differentiation- A large international market for any type of product leads to further specialization, or product differentiation. For an example, in Europe, each country specializes in intra-industry trade. Between Canada and the U.S., each country specializes in a different type of car.

3: Learning by doing- Larger international markets lead to specialization, which leads to "accumulated experience". For an example, the silicon valley area of the United States has gained a reputation for computerized innovation, and as a result of that specialization, people from that area gain experience over time, and become better-equiped to compete in that industry.

Economies of Scale = Production moves to the bottom of the LRAC
Learning by Doing = The entire LRAC shifts downward, so any level of production costs less



1: Natural Factor Endowments
-This is how traditional economists explained comparative advantages
-What each country is "born with"
-This includes both natural resources and climates, as well as social patterns and institutional set-ups
-This natural resource advantage translates into cost advantages (i.e., a very fertile country will not incur as many costs growing food as an arid country)

2: Acquired Comparative Advantages
-This is a newer idea: what each country DEVELOPS can lead to a comparative advantage in certain products
-For an example, social fixtures such as education, healthcare, and social services can create more productive workers
-Research and development can also lead to innovations and localized experience which gives certain nations comparative advantages in certain sectors (like Canada and aerospace engineering, or Korea and shipbuilding)



We know that countries should specialize and then trade in goods in which they have a comparative advantage.

So... do countries actually export those goods in which they have a comparative advantage? The answer is YESSSSSSS!

THE LAW OF ONE WORLD PRICE: Internationally traded goods sell at the same price, regardless of which country they are sold in, assuming
-zero transport costs
-it is actually the same good
-competitive markets
-the good is tradable

World price simply equates global supply and demand for any product to determine the equilibrium price


If one country has a comparative advantage in a certain product which would potentially lead to a lower domestic price for this product than the world price level, instead of simply selling the product at the domestic price level, that country will sell that product on the world market at the (higher) world price level: the domestic excess supply will get sold off on the international market.

THE THEORY OF COMPARATIVE ADVANTAGE IS STILL RELEVANT~!! Sources of those competitive advantages may have changed over the years, but the basic premise of this theory still holds true!


TERMS OF TRADE: These determine how the gains from trade are shared- in other words, how will the gains in world per-capita GDP be shared among the trading nations.

The Terms of Trade = the ratio of (the price of exports / the price of imports)
The relative international price of imports (how many imports can be purchased per unit of export)

If the terms of trade increase, this is favorable for the nation in question, because they are able to get more imports per export. The reverse is true if the terms of trade decrease.

Unfavorable terms of trade will not be conducive to trade! Basically, if the terms of trade make it so that the OC of obtaining imports is equal to or greater than the OC of producing a product domestically, the country in question will not trade for that product! There needs to be a win-win situation (terms of trade which allow for both countries to enjoy lowered OCs) in order to trade to occur.


International Trade and the PPC:

When there is trade, consumption can differ from production! This means that trade can facilitate changes in production which allow for patterns of consumption which lie outside the PPC!

The slope of the dotted line = the terms of trade (tt)

Basically, given any point on the original PPC, international trade allows that country to trade products with another country at a rate which differs from that given on the PPC (which is usually convex). As you can see, if the country in the diagram specializes and trades, it can reach point B!

By specializing (changing production), countries can optimize their production in order to best take advantage of good terms of trade!

NOTE: Which country wins depends on the terms of trade (the slope of the line). Also, the consumption pattern (the point on the CPC) which each country settles into will depend on their preferences between the two products being compared.
Also, most countries have increasing OCs with increased specialization, and thus they have convex PPCs

That's all for now!

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