China Center for Economic Research Peking University International

China Center for Economic Research Peking University International Economics: Trade Theory and Policy Professor Wen Hai Spring 2003

I. INTRODUCTION 1. Importance of International Economics Why should we study international economics? • Contribution of International Trade to the Nation’s Standard of Living • Integration of the World Economy • Problems in the World Economy

2. Structure of International Economics • International Trade: Theory and Policy (Microeconomics of Open Economy) • International Finance • (Macroeconomics of Open Economy)

3. Brief History of International Trade • Brief History of the World Trade – International Trade in Ancient Times – World Trade after the 15 th Century – The Emergence of Capitalism and Industrial Revolution – International Trade after WWII

Brief History of Foreign Trade in China • A Glorious Period in Ancient China Isolations after the 16 th Century Open-door Policy under Foreign Warship Foreign Trade since 1949

5. Basic Analytical Tools • General Equilibrium Analysis • Partial Equilibrium Analysis

General Equilibrium Analysis • Supply-side: Production Possibility Frontier (PPF) • • PPF with Constant Costs PPF with Increasing Costs

• PPF with Constant Costs Qc Qw • PPF with Increasing Costs Qc Qw

Demand-side: Community Indifference Curves (CIC) – Indifference Curves (review) – Community Indifference Curves Qc Higher social welfare level CIC 3 CIC 2 CIC 1 Qw

General Equilibrium in Isolation (PPF with constant costs) • • Qc Qc 0 Autarky Equilibrium A D=S CIC 0 PPF Qw 0 Qw

General Equilibrium in Isolation (PPF with increasing costs) • • Qc Qc 0 Autarky Equilibrium A S=D CIC 0 Qw 0 PPF Qw

Partial Equilibrium Analysis Commodity markets in an Open Economy • Pw/P c Pw/P US c Pw/Pc China International Market 1. 5 S Sx . 8 Dm D Qw Qw Qw

Equilibrium with Free Trade Pw/Pc Pw/P US c Pw/Pc China S D Qw Qw Qw

Basis for Trade and Gain from Trade • Basis: lower relative price • Higher relative price export import • Gain from Trade: • In General Equilibrium Analysis: measured by increase in social utility level • In Partial Equilibrium Analysis: measured by consumer surplus , producer surplus, and net welfare change

II. TRADE THEORIES Main Issues in Trade Theory • • • Why do People Trade？－ Gain from Trade Basis for Trade? －Pattern of Trade Effects of Trade? Growth and Trade in Goods and Factor Movement

Framework of Trade Theory

The Classical Trade Theories 1. Economic Thought in International Trade before Adam Smith • Mercantilism: Older than Smith but still Alive Today

2. Adam Smith: Absolute Advantage a. Basic Assumptions ·One input: Labor (L) ·Two outputs: e. g. Wheat (QW) and Cloth (QC) ·Two Countries: e. g. US and China · Different technologies: different productivity of labor · Labor supply is fixed. No international labor movement, but free to move within the country · Full employment, perfect competition, and constant return to scale · No transportation cost · Balanced trade

b. Basis for Trade Absolute advantage in Commodity Production c. Determination of the Absolute Advantage Differences in technologies d. Measurements of Absolute Advantage: Productivity or Cost of Production Unit of labor requirement (L) in each unit of output j: a. Lj= L/Qj -- Comparing a. Lc to a*Lc and a. Lw to a*Lw

A Numerical Example Table 2 -1 Possible Output (L=L*=100) Rice (Qr) Wheet (Qw) China 100 50 US 80 100

Table 2 -2 Productivity (Qj/L) Rice Wheet China 1. 0 0. 5 US 0. 8 1. 0

Table 2 -3 Production Cost (aij) Rice Wheet China 1. 0 2. 0 US 1. 25 1. 0

Limitation of the Smith Model Table 2 -4 Production Possibility Rice (Qr) Wheet (Qw) China 100 50 US 150 100

e. Pattern of Production and Trade A country should specialized in and export the product that it has absolute advantage, and import the product that it does not have absolute advantage in production. In this case, US should export wheat and China should export rice.

3. Davis Ricardo: Comparative Advantage a. Basic Assumptions (the same as the Smith Model) b. Basis for Trade Comparative Advantage in Commodity Production c. Determination of the Comparative Advantage Differences in relative technologies

d. Measurements of Comparative Advantage: -- Relative productivity -- Relative production cost: a. Lw /a. Lr vs. a*Lw /a*Lr -- Opportunity cost: Qr / Qw vs. Q*r / Q*w -- Relative Price (exchange rate adjusted) Pw /Pr vs. P*w /P*r

A Numerical Example Table 2 -5 Relative Productivity Rice (Qr/L)/(Qw/L) Wheet (Qw/L)/(Qr/Qw) China 2. 0 0. 5 US 0. 8 1. 25

Table 2 -6 Relative Cost Rice a. LR/a. LW Wheet a. LW/a. LR China 0. 5 2. 0 US 1. 25 0. 8

Table 2 -7 Relative Productivity (based on Table 2 -4) Rice Wheet China 2. 0 0. 5 US 1. 5 0. 67

Limitation of the Smith Model Table 2 -4 Production Possibility Rice (Qr) Wheet (Qw) China 100 50 US 150 100

e. Pattern of Production and Trade A country should specialized in and export the product that it has comparative advantage, and import the product that it does not have comparative advantage in production. In this case, US should export wheat and China should export rice.

f. Gain from Trade: General Equilibrium Analysis Equilibrium Relative Prices and Comparative Advantage （PPF with constant costs) China Qw Q*w P*r/P*w US Pr/Pw Qr Pr/Pw < P*r/P*w Q*r

General Equilibrium with Free Trade （PPF with constant costs) Q*w Pr/Pw Qw P*r/P*w Qr Q*r

The Gains from Trade China Qw Q*w P*r/P*w US Pr/Pw CIC 1 S 0, D 0 CIC 0 Qr Q*r

1. 2 Comparative Advantage in the Hechscher. Ohlin Model a. Basic Assumptionsa. • Two inputs (factors): • Two outputs: • Production Functions: Labor (L) and Land (T) Cloth (Qc) and Food (QF) Qc = Qc (Tc, Lc), labor-intensive QF = QF (TF, LF), land intensive At any given factor price ratio w/r, TF /L F > Tc /Lc • Two Countries, e. g. US and China Different proportion of factor endowment: (T/L)US > (T/L)China; US is a T-abundant country, China is a L-abundant country • Full Employment, Perfect Competition, and Constant return to Scale

b: Basis for Trade • Comparative advantage Different relative factor endowments (different proportion) different relative factor prices different relative production costs different relative prices of products Comparative advantage in producing and exporting the product that uses its abundant recourse intensively (lower relative cost) c. Pattern of Production and Trade A country should produce more and export the product that uses its abundant recourse intensively, and import the product that uses its scarce recourse intensively. In this case, US should export wheat and China should export cloth.

2. Economies-of-Scale and Imperfect Competition Model 2. 1. Modern Trade Facts a. Rise of Intra-industrial Trade Index: T = 1 - (|X - M|/X + M) b. Development of Trade among Developed Countries.

1. 4 Equilibrium Relative Prices and Comparative Advantage （PPF with increasing costs) P*w/P*c Q*c Pw/Pc Qc Qa Pw/Pc < P*w/P*c Q*a

1. 5 General Equilibrium with Free Trade （PPF with increasing costs) P*w/P*c Q*c Pw/Pc Qc Qw Q*w

1. 6 The Gains from Trade （PPF with increasing costs) P*w/P*c Q*c Pw/Pc Qc Qw Q*w

• Changes in an export market Pw/Pc Effects of Free Trade S P 1 a b P 0 D Price: Production: Consumption: Welfare Changes: P. S. +(a +b) C. S. - a net: + b Qw

• Changes in an import market Pw/Pc Effects of Free Trade S P 0 c P 1 d D Price: Production: Consumption: Welfare Changes: P. S. - c C. S. + (c + d) net: + d Qw

Gain from Exchange and from Specialization C CIC 1 B CIC 0’ A CIC 0 A: autarky B: consumption through Exchange of existing products C: consumption after specialization and free trade S: production after specialization and free trade Gain from exchange: CIC 0’ Gain from specialization: CIC 0’ CIC 1 S Production: A Consumption A S; C

1. 7 Trade based on Differences in Tastes Qc Qw

2. 4 The Terms of Trade TOT = Px / Pm Qm TOT= Px/Pm S D Qx Qx

2. 2. Economies-of-Scale Model a. Economies of Scale: external and internal External Economies of Scale External economies of scale occur when the average cost (AC) of output depends on the size of the industry, but not necessarily on the size of any one firm. An industry where economies of scale are purely external will typically consist of many small firms and be perfectly competitive. Internal Economies of Scale Internal economies of scale occur when the average cost of output depends on the size of an individual firm, but not necessarily on that of the industry. Internal economies of scale give a cost advantage over small and lead to an imperfectly competitive market structure.

b. Monopolistic-Competitive Firm with Internal Economies-of-Scale • Equilibrium of a Monopolistic Competitive Firm in a Closed Economy P, C ($) P 0 AC MC Dhome Q 0 MR 0 Q

• Equilibrium of a Monopolistic Competitive Firm in an Open Economy (with Trade in Short Run, Case 1: P ) P, C ($) P 1 P 0 AC 1 AC MC Dhome Q 0 Q 1 MR 0 MR 1 Dtotal Q

• Equilibrium of a Monopolistic Competitive Firm in an Open Economy (with Trade in Short Run, Case 2: P ) P, C ($) P 1 P 0 AC 1 AC MC Dhome Q 0 Q MR 0 1 MR 1 Dtotal Q

• Equilibrium of a Monopolistic Competitive Firm in an Open Economy (with Trade in Long Run) P, C ($) P 0 = AC 0 P 2 = AC 2 AC MC Dtotal Dhome Q 0 Q 2 MR 0 Q MR 2

3. 2 Economy-of-Scale & Intra-Industrial Trade US US 30 AC Japan 15 Q car AC Q truck Japan AC Q truck

3. Dynamic Comparative Advantage: the Product-Cycle Model 3. 1 Change in Pattern of Trade (Dynamic Pattern) Export Color TV China Japan US Import

3. 2 The Product Cycle Theory: Change in Factor Intensity Technological cycle of a new product: • Stage 1: Innovation (High technology; cost of research: R&D intensive product) • Stage 2: Tech. Diffuses (Technology becomes less important - standardized, cost of capital and skilled labor: capital and skilled-labor intensive product) • Stage 3: Tech. Stagnates (Technology embodied in purchasable equipment, cost of less skilled labor: labor intensive product)

3. 3 Dynamic Changes in Comparative Advantage • Stage 1: R&D intensive product R&D and scientists abundant country such as the US has comparative advantage • Stage 2: Capital and skilled-labor intensive product Capital and Skilled labor abundant countries such as Japan and Germany have comparative advantage • Stage 3: Labor intensive product Labor abundant countries such as China have comparative advantage

C. EFFECTS OF TRADE ON INCOME Effect of Trade on Income in the H-O Model 1. Effects of Trade on Factor Prices in Each Country 1. 1 Short-Run (no factors are mobile among sectors) Return to factors: W = P x MPL, R = P x MPT In the short run, returns to factor are determined by changes in Product Price. No changes in marginal productivity of factor Price of export product increases, both factors in the export sector gain Price of import-competing product decreases, both factors in the import-competing loss

1. 2 Long-Run (all factors are able to move among sectors) The Stolper-Samuelson (S-S) Theorem Free trade raises the return to the factor used intensively in the rising-price sector (export sector) and lowers the return to factor used intensively in the falling-price (import competing sector) Magnification Effect Changes in returns to factors are greater than the changes in product prices

2. Effects of Trade on Factor Prices in Both Countries The Factor Price Equalization Theorem Under the assumptions of H-O model, free trade will equalize not only commodity prices but also factor prices. All labors will earn the same wage rate and all units of capital (or land) will earn the same profit (or rental returns) in both countries regardless of the factor supplies or the demand patterns in the two countries.

Effect of Trade in the Specific Factor Model 1. Basic Assumption of the Model Three inputs (factors): Mobile factor: Specific Factors: Two outputs: Labor (L) Capital (K) and Land (T) Manufacture (QM) Food (QF) Production Functions: QM = f (K, LM) QF = f (T, LF) Full Employment: L M+ L F = L Perfect Competition and Constant return to Scale

2. Production possibility Frontier in the Specific Factors Model 2. 1 Qm The Production Function Qm(K, Lm) Lm

2. 2 The Marginal Product of Labor MPLm Lm

2. 3 Production Possibility Frontier Qf PPF Qm Lf Lm

3. The Allocation of Labor and Determination of Wage 3. 1 Allocation of Labor W W W* Pm. MPLm Pf MPLf Lf Lm

3. 2 Effects of Price Changes • An Equal Proportional Change in Prices W W W*’ W* P’m. MPLm P’f MPLf Pm. MPLm Pf MPLf Lf Lm

• An Equal Proportional Change in Prices No changes in labor allocation no changes in output Nominal Wage (W) Profit (RK) Rent (RT) In real term, not affected

• A Change in Relative Price (say Pf 10%) W W W*’ W* P’f MPLf Pm. MPLm Pf MPLf Lf Lm

• A Change in Relative Price (say Pf 10%) LM and LF W (< 10%), RT QM and QF (> 10%), RK In real term, T gains K loses L is ambiguous (depending on using what price to measure)

3. 3 Effects of International Trade • Trade and Relative Prices Before trade: (PF/PM)A < (PF/PM) J After trade: (PF/PM)A = (PF/PM) world = (PF/PM) J Relative Price of Export • Income Distribution (same effect of relative price change) Specific factor in export sector gains Specific factor in import sector loses Ambiguous effects on mobile factor

3. 4 • Effects of Economic Growth A Change in Capital Stock W W W*’ W* Pf MP’Lf Pm. MPLm Pf MPLf Lf Lm

• K the same effects as PM on Labor allocation, production, and nominal returns to factors. However, the returns to labor in real terms increase since there is no price change

• A Change in Labor Supply L , labor and output in both sectors , L loses, both K and T gain W W W* W*’ Pm. MPLm Pf MPLf Lf Lm

D. GROWTH AND TRADE Growth and Trade in the H-O Model 1. Definition of Growth and Types of Growth 1. 1 Increases in factor endowments and Factor-saving technological progress 1. 2 Biased economic growth: Export Expanding (EE) Growth vs. Import Replacing (IR) Growth

2. Effects of Growth in a Small Country 2. 1 IR Growth Qc TOT D 2 D 1 S 2 S 1 Qw

2. 2 EE Growth Qc D 2 TOT D 1 S 2 Qw

The Rybczynski Theorem postulates that at constant commodity prices, an increase in the endowment of one factor will increase by a greeter proportion the output of the commodity intensive in that factor and will reduce the output of the other commodity.

3. Effects of Growth in a Large Country 3. 1 IR Growth Qc D 2 TOT D 1 S 2 S 1 Qw

3. 2 EE Growth Qc TOT D 2 D 1 S 2 Qw

3. 3 A Special Case in the EE Growth - Immiserizing Growth Qc TOT D 2 D 1 S 2 Qw