Midterm Study Notes - Chapter 5-International Trade Theory

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12 Oct 2010
MGT491 Midterm Notes ± Ch. 5: International Trade Theory
x In international trade, there are always winners and losers, but economists argue that the benefits to the
winners outweigh the costs borne by the losers, so there is still a net gain to society.
x In the long run, free trade stimulates economic growth and raises living standards
x International trade theory was the driver behind the formation of the WTO and regional trade blocs like the EU
x Mercantilism ± advocated that countries should simultaneously encourage exports and discourage imports
o Old and largely discredited, but still remains in modern political debate and in trade policies of many
x $GDP6PLWK¶VWKHRU\RIDEVROXWHDGYDQWDJH± first to explain why unrestricted free trade is beneficial to a
x Free trade ± situation where government does not attempt to influence through quotas or duties what its citizens
can buy from another country, or what they can produce and sell to another country
o Argued that the invisible hand of the market mechanism, rather than government policy, should
determine what a country imports and exports
o Imply that a laissez-faire attitude toward trade is in the best interests of a country
x Building on the theory of Smith, theory of comparative advantage by David Ricardo ± intellectual basis for the
modern argument for unrestricted free trade
x 5LFDUGRVZRUNZDVUHILQHGLQWKHth century by the Heckscher-Ohlin theory
The Benefits of Trade
x Theories of Smith, Ricardo and Heckscher-Ohlin ± identify with precision the specific benefits of international
x It is beneficial for a country to engage in international trade, even for products it is able to produce for itself ±
allows countries to specialize in the manufacture and export of products that can be produced more efficiently in
that country, while importing products that can be produced more efficiently in other counties
x Import controls may benefit particular groups (such as domestic textile businesses and their employees) by
keeping their jobs, these theories suggest that this action hurts the economy as a whole. Limits on imports are
often in the interests of domestic producers but not domestic consumers
The Pattern of International Trade
x Climate and natural resource endowments explain why certain countries produce/export the things they do
productivity; H-O theory emphasizes the interplay between the proportions in which the factors of production
(land, labour, and capital) are available in different countries and the proportions in which they are needed for
producing particular goods. ± rests on the assumption that countries have varying endowments of the various
factors of production.
x Product life cycle theory ± suggests that early in their life cycle, most new products are produced in and
exported from the country in which they were developed. As it becomes more widely accepted internationally,
production starts in other countries. Product may ultimately be exported back to the country of its original
x New trade theory ± stresses that in some cases countries specialize in the production and export of particular
products not because of underlying differences in factor endowments but because in certain industries the world
market can only support a certain number of firms
o Ex. aircraft industry
x 3RUWHUVWKHRU\RIQDWLRQDOFRPSHWLWLYHDGYDQWDJH± attempts to explain why particular nations achieve
international success in particular industries ± in addition to factor endowments, he points out the importance of
production and export of particular products.
Trade Theory and Government Policy
x All these theories agree that international trade is beneficial to a country ut lack agreement in their
recommendations for government policy
x Mercantilism ± government involvement in promoting exports and limiting imports
x Smith/Ricardo/H-O theories ± unrestricted free trade, argument is that both import controls and export
incentives are self-defeating and result in wasted resources
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intervention to support the development of certain export-oriented industries
x England, mid 16th century
x Accumulate $$, increase national wealth, prestige, power
x Advocates government intervention to achieve a surplus in the balance of trade
x No virtue in large volume of trade, recommended policies to maximize exports and minimize imports ± imports
limited by tariffs and quotes, exports were subsidized
x Flaw: viewed trade as a zero-sum game (one in which a gain by one country results in a loss by another)
x Adam smith and David Ricardo showed how this approach was short-sighted and demonstrated that trade is a
positive-sum game, where all countries can benefit
x Mercantilism is not dead
x Neo-mercantilists equate political power with economic power, and economic power with a balance-of-trade
x Many nations have adopted a neo-mercantilist strategy that is designed to simultaneously boost exports and
limit imports ± ex. China ± deliberately keeping its currency low against the US dollar in order to sell more
goods to the US, therefore getting a trade surplus and foreign exchange reserves.
x Adam smith argued that countries differ in their ability to produce goods efficiently.
manufacturers. Due to favourable climate, good soils, and accumulated expertise, the FrencKZHUHWKHZRUOV
most efficient wine producers.
o The English had an absolute advantage in the production of textiles, the French had an absolute
advantage in the production of wine
o Country has an absolute advantage in the production of a product when it is more efficient than any
other country in producing it.
x Countries should specialize in the production of goods for which they have an absolute advantage, and then
trade these for goods produced by other countries
x Country should never produce goods at home that it can buy at a lower cost from other countries
x By specializing in the production of goods in which each has an absolute advantage, both countries benefit by
engaging in trade
x Production possibility frontier PPF ± graph that shows the different combinations of goods that a country can
produce given the inputs required and the total resources available
o If neither country trades with any other, each country must divide its resources to produce
everything it needs, can produce much less of everything
o If they focus on producing what they do best, they can make much more and export that which they
x As a result of specialization and trade, output of both products is increased, consumers in both nations are able
to consume more Æ therefore trade is a positive-sum game, produces net gains for all involved
absolute advantage in the production of all goods
x Makes sense for a country to specialize in the production of those goods that it produces most efficiently, and to
buy the goods that it produces less efficiently from other countries, even if this means buying goods from other
countries that it could produce more efficiently itself. Æ Without trade, combined production is lower; each
country must consume what it produces. With trade, two countries can increase their combined production of
goods, and consumers in both nations can consumer more of both goods.
The Gains from Trade
x If each country produces what they have the comparative advantage at producing, this increases output.
x Combined output of both countries is increased.
x Both countries benefit - consumption in both countries can increase as a result of specialization and trade
x Potential world production is greater with unrestricted free trade than it is with restricted trade
even in countries that lack an absolute advantage in any good
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x The theory of comparative advantage suggests that trade is a positive-sum gave in which all countries that
participate realize economic gains
Qualifications and Assumptions
x This model has been simplified in assuming that there are only 2 countries and 2 goods
o Assumed no transportation costs between countries
o Assumed no differences in prices of resource in different countries, exchange rates, assuming they
can be swapped on a one-to-one basis
o Assumed that resources can move freely from production of one good to another within a country
o Assumed constant returns to scale ± specialization has no effect on the amount of resources
required, in reality: both diminishing and increasing returns to specialization exist ± amount required
may increase or decrease as a nation specializes in production of that good
a country uses its resources
o Assumed no effects of trade on income distribution
x Conclude that free trade is mutually beneficial ± this basic model can be generalized to the world with many
countries producing many different goods
x Suggested that in certain circumstances, a rich country might actually be worse off by switching to free trade
with a poor nation
Extensions of the Ricardian Model
x Relax the assumptions that resources move freely from the production of one good to another within a country,
that there are constant returns to scale, aQGWKDWWUDGHGRHVQWFKDQJHDFRXQWU\VVWRFNRIUHVRXUFHVRUWKH
efficiency with which they are used.
x Immobile Resources:
o Ex. often a country will produce less of some labour-intensive goods like textiles, and more of
knowledge-intensive goods like computer or biotech products. Country as a whole will gain, but
textile producers will lose.
o Creates friction and human suffering
o Theory predicts that the benefits of free trade outweigh the costs by a significant margin, but this
o Political opposition for adoption of free trade usually comes from those whose jobs are most at risk
o Governments sometimes help to ease the transition by helping retrain those people who lost their
jobs as a result of the move to free trade system
x Diminishing Returns
o Constant returns to specialization ± units of resources required to produce a good are assumed to
o More realistic to assume diminishing returns to specialization ± occur when more units of resources
are required to produce each additional unit of goods.
o PPF for diminishing returns looks like right side of a rainbow arch
o Diminishing returns are more realistic because:
Not all resources are of the same quality ± as a country tries to increase its output of a
certain good, it is increasingly likely to draw on marginal resources whose productivity is
not as great than those initially employed. (ex. might have to use less fertile land to expand
farming space), must use more land to produce the same amount of product as you could
in a smaller space of better land.
Different goods use resources in different proportions ± ex. amount of land required vs.
amount of labour required.
o Not feasible for a country to specialize to the degree suggested by the simple Ricardian model
above, because diminishing returns to specialization suggests that gains from specialization are
likely to be exhausted before specialization is complete
o Worthwhile to specialize until the point where diminishing returns outweigh the resulting gains from
x Dynamic Effects and Economic Growth:
which it utilizes those resources
o Opening an economy to trade is likely to generate dynamic gains:
abroad become available for use
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