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ECONOMICS 3150CLecture 5

November 4

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Internal and International Trade

• Firms – competitive advantage

• Mobility of factors of production

• Trade costs including information

• Tastes – language, culture

• Market rules – laws (domestic, international), regulations; effectiveness

• Currencies – financial risks

• Domestic policies– Taxes, subsidies, tariffs

– Procurement

– Ownership restrictions

– National interest – politics and trade policies

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International Trade Theory: Objectives

• Gains from trade

• Patterns of trade

• Volumes of trade

• Intra-corporate vs. inter-corporate/firm

• Protectionism – trade policies

• Free trade agreements – FTA, NAFTA, GATT

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Critique of Traditional Trade Theory

• Competitive markets – underlying logic flawed

• Imperfect competition – competitive advantage

• Role of technology and risk taking – importance of market structure

• Culture, bureaucracy, hierarchy

• Politics and power – case of the US

• Bottom line: trade theory cannot explain RIM in Canada, Airbus in Europe, HSBC, Arcelor-Mittal in India, Dubai Aerospace, IKEA, etc.

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Overview

• 2007:– Global GDP: US$ 50 T– Global trade in goods and services: US$ 16 T

• Canada’s trade, by country/region (2007)– Total exports: $463.1 B

• US: $356.1 B (77%)• UK: $14.2 B (3%)• Non-OECD countries: $38.9 B (8%)

– Total imports: $415.0 B• US: $269.8 B (65%)• Non-OECD countries: $65.9 B (16%)

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Overview

• Canada’s trade (2007)– Balance: $48.0 B

• US: $86.3B

• EU: -$3.9 B

• Non-OECD countries: -$27.0

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Overview

• Canada’s trade, by product (2007)– Exports

• Industrial goods and materials (metals and alloys; chemicals, plastics and fertilizer, etc.): $104.4 B (23%)

• Machinery & equipment (includes aircraft): $93.4 B (20%)

• Energy products: $91.6 B (20%)

• Automotive products: $77.3 B (17%)

• Agricultural and fishing products: $34.4 B (7%)

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Overview

• Canada’s trade, by product (2007)– Imports

• Machinery & equipment: $116.6 B (28%)

• Industrial goods & materials: $85.1 B (21%)

• Automotive products: $80.0 B (19%)

• Other consumer products: $54.8 B (13%)

• Energy products: $36.6 B (9%)

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Overview

• 2005: composition of world trade– Manufactured goods – 59%

• Outsourcing – EMS, auto parts/components

• Intra-corporate – multinationals

• Competitive advantage vs. comparative advantage

– Services – 20%• Outsourcing – call centres, programming, IT support, legal,

accounting, medical

• Tradable vs. nontradable – changing over time

• Competitive advantage vs. comparative advantage

– Mining – 14%• Oil and gas dominate

– Agricultural products – 7%

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Basis for Trade

• Gravity Model– T(i, j) = Y(i)Y(j)/D(i, j)– T(i, j): value of trade between country i and j– Y: GDP– D(i, j): distance between country i and j

• 1% increase in distance between two countries is associated with 0.7-1.0% decrease in trade

• Transportation costs, similarities (familiarities) – language, tastes

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Basis for Trade

• Differences in relative prices– [P1/P2]A [P1/P2]B

– Countries differ• Resources• Culture, tastes• Demographics• Incentives/motivation

• Differences in availabilities of products (goods, services)– Companies create competitive advantages

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General Equilibrium: Closed Economy Model

• Objective: maximize production subject to resource and technology constraints production possibility frontier

• Assumptions:– Two factors of production: X1, X2

– Two goods: Y1, Y2

– Full employment

– Given state of technology: T

– No convexities – no economies of scale, no externalities

– No public goods

– Production functions: Y(i) = Fi [X1, X2, T]

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Optimization Solution: 1

• Maximize production:– Max Y1, Y2

– S.t. • production functions [Fi , i = 1,2]

• Maximum availabilities of X1, X2

• Production functions, isoquants

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Optimization Solution: 1

• Maximize production:– Max Y1

– S.t. • Y1 = F1 [X1, X2, T]

• Y2 = 0Y2

• X1 0X1

• X2 0X2

• Box diagram with isoquants

• Production possibility frontier [G(Y1, Y2)]

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PPF

• Efficient production– knowledge of production functions

– producing on frontier of production function

– given state of technology

– full employment

• PPF can also be derived by minimizing costs of producing various quantities of the two products– Min: C1X1 + C2X2

– S.t.• Y1 F1 [X1, X2, T]

• Y1 0Y1

[isoquant and isocosts]

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Optimization Solution: 2

• Optimal level of production of two products: Y1, Y2

• Maximize value of output– Max: P1Y1 + P2Y2

– S.t.: PPF

[PPF and income lines]

• Max utility– Max: U(Y1, Y2)

– S.t.: PPF

• Solution: GE model with perfect competition P1, P2, C1, C2, Y1, Y2

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Changes in Relative Prices

• Equilibrium P2/P1 will change if:

– Change in shape of PPF• Change in relative availabilities of X1, X2

• Change in production functions

• Change in state of technology

– Changes in tastes

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Basis for Trade

• Different relative prices– Different technologies – different p.f., different states of technology

– Different relative quantities of factors of production

– Different tastes – different utility functions

– Absence of perfect competition: monopolistic markets

• Different products– Different factors of production

– Absence of perfect competition

• Low trade costs– Transportation costs

– Trade barriers

– Other – hedging, insurance, etc.

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Basis for Trade

• Bottom Line: firms produce goods – Firms need info on products (characteristics, p.f.); technology – Agents need info on relative and absolute prices and access to

distribution channels in foreign countries

• Value chain: production of final product entails various intermediate stages – examples: gasoline at retail; laptops; autos; cell phones; aircraft – Trade in intermediate products– Trade in intermediate services

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Comparative Advantage Models

1. Single Factor, Ricardian Model• Assumptions:

– One factor of production: X1

– Two goods: Y1, Y2

– Constant returns to scale [Y = F(X1), δ=1]

– PF: Yi = i1 X1 [i1: units of product i per unit of factor of production 1]

• Resulting PPF:– Y1/ i1 + Y2/ 21 0X1

– Opportunity cost of Y1 in terms of Y2: 21/ 11

– No adjustment problems since sole factor of production can move costlessly and instantaneously between products

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Single Factor Ricardian Model

• Utility maximization optimal production and consumption point, P1, P2– Slope of straight line PFF:

• P2/P1 11/ 21

– Relationship between relative prices and opportunity costs

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Single Factor Ricardian Model

• Two countries, two products, one factor of production– Conditions for pre-trade relative prices to differ [i.e. {P1/P2}A

{P1/P2}B]

• Different production functions: i1(A) i1(B)

• Different tastes will not produce different relative prices

• Comparative advantage– Country has comparative advantage in product with lower relative

opportunity cost

– Country A has comparative advantage in product 1 if • [21/ 11 ]A < [21/ 11]B

• {P1/P2}A < {P1/P2}B

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Single Factor Ricardian Model

• Trade between A and B will equalize relative prices {P1/P2}A = {P1/P2}B

– Equilibrium relative prices post-trade between original pre-trade ratios

– If A is large country and B a small country, equilibrium relative prices post-trade closer to pre-trade ratio in A

• Specialization – small country, not necessarily for large country– Transportation costs– Protection of industries

• Terms of trade: price of exported product relative to price of imported product– For country: P1/P2

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Single Factor Ricardian Model

• Gains from trade– Consumption, production – pre-trade and post-trade

– Exports, imports

– Higher level of utility, higher level of real income/GDP

• Equilibrium in currency market will result in current account balance = 0– Total value of exports = total value of imports

– D/S of country’s currency depend upon current account transactions only

– For Country A: P1AEX(Y1) = P2BIM(Y2)E*

– With no trade costs: P1A = P1BE* and P2A = P2BE*

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Single Factor Ricardian Model

• Conclusions:– Extreme degree of specialization

– No impact on distribution of income within each country – no losers (full employment, one factor of production)

– Gains from trade

– No explanation of differences in production functions and relative and absolute productivities

– Volumes of exports and imports not determined

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Extension of Ricardian Model

• Many products (i = 1, N), one factor of production

• Assumptions:– Constant returns to scale

– Perfect competition: Pi = MCi

– MCi = P(X1)/i1

• Allocation of production in two country world (A, B)– Product i produced in country with lower MC

– Produced in A: {P(X1)E/ i1}A < {P(X1)/ i1}B

{[P(X1)]AE /[P(X1)]B} < {i1}A / {i1}B

– Produced in B: {[P(X1)]AE /[P(X1)]B} >{i1}A / {i1}B

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Extension of Ricardian Model

• Order the products 1 to N so that {11}A / {11}B < {21}A / {21}B < …….. < {N1}A /

{N1}B

• All products 1 through K are produced in B and exported by B:{[P(X1)]AE /[P(X1)]B} > {K1}A / {K1}B and

{[P(X1)]AE /[P(X1)]B} < {K+11}A / {K+11}B

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Extension of Ricardian Model

• Products K+1 through N are produced and exported by A– Not all products may be traded – depends upon

trade costs non-traded products – Specialization, but if B is a large country, B

also may produce, but not export some or all of the products 1 through K

– Assumes that E is at equilibrium level so that value of A’s exports = value of B’s imports

– If value of E changes so too does cut-off point “K”