Lec 1 Introduction Copyright 2000 SouthWestern College Publishing

Subject Outline Trade Theory Finance International Economics Trade Policy

Heckscher-Ohlin Stolper-Samuelson Factor Price Equalisation Comparative Advantage Absolute Advantage Trade Theory Rybzcynski Study Guide 1 Mercantilism Immiserising Growth

Trade Theory • Theory used to explain and predict. • What is International Trade? • Why do nations trade? • What are the gains from trade? • Who gains from trade?

Other Trade Policies Tariffs Tools of the Trade Policy Analysis Regional Trade Agreements Trade Policy International Resource Movements

Exchange Rates Current Account Deficit Finance Study Guide 3 Weeks 9 -12 Interest Arbitrage Exchange rate theorems

Heckscher-Ohlin Stolper-Samuelson Factor Price Equalisation Comparative Advantage Absolute Advantage Week 1 Mercantilism Trade Theory Rybzcynski Study Guide 1 Immiserising Growth

Trade Theory Why do Nations Trade? • Mercantilism - zero sum game - one nation gains at the expense of the other. • Adam Smith - both nations can gain from trade. • Absolute Advantage - each nation should specialise in production of the good which it is most efficient at producing.

Trade Theory Why do Nations Trade? Assumptions • Perfect Competition in Product and Factor Markets (P=MC) • Each Country has a fixed endowment of resources that are fully used and are homogeneous • Technology is Unchanging • No Transportation Costs or barriers to trade • Factors of Production are perfectly mobile between industries but are immobile between countries • 2 x 2 x 1

Trade Theory Why do Nations Trade? Mercantilism Thomas Munn (1571 -1641) The way for a nation to become rich and powerful is to export more than to import

Trade Theory Why do Nations Trade? Mercantilism ENGLAND Imports Exports FRANCE Imports Exports

Introduction Adam Smith (1723 -1790)

Introduction David Ricardo (1772 -1823)

International Economics By Robert J. Carbaugh 7 th Edition Chapter 2: Foundations of modern

Foundations of trade theory Historical development of trade theory • Mercantilism • positive trade balance • Absolute advantage (Adam Smith) • Countries benefit from exporting what they make cheaper than anyone else • Comparative advantage (David Ricardo) • Nations can gain from specialization, even if they lack an absolute advantage Carbaugh, Chap. 2 15

International Trade Theories: Mercantilism (1500 – 1750): 1. International trade is a zero-sum game: Static view of world resources: One’s gains = Other’s losses 2. Wealth: Acquisition of precious metals—gold or silver Well-being = Accumulating gold 3. Economic growth =Enhancement of power with strong army, strong navy and merchant marine, and enlargement of foreign colonies.

4. Productive = maintaining and increasing the power 5. Regulations or restrictions on importable activities 6. Favorable positive trade balance: Exports > Imports Inflows of specie (gold) Money supply increases Stimulates output and employment Economic growth

Mercantilism : Role of the government and domestic economic policy • Control the use and exchange of precious metals (Bullionism) • High tariffs, quotas on imports of consumption goods • Tax exemptions and subsidies to exports • Allows trade monopolies and monopsonies • Pursues low wage policies • Encourage large family, providing financial incentives for marriage and stimulate population growth • Emphasis the important of the merchant class

David Hume (1752): Price-Specie-Flow Mechanism Accumulate specie with internal automatic repercussions. Assumptions: 1. Link between money and price: MV = PV; Full employment; Fixed velocity of money 2. Demand for trade goods is price elastic: Stable equilibrium in trade sector. 3. Perfect competition: product and factor markets Link between prices and wages (W). 4. Gold standard exists: Gold is directly linked to money and specie.

Price-Specie-flow Mechanism: Trade surplus vis-à-vis Trade Deficit Country A Country B Step 1 : Exports > Imports Net inflow of specie Exports < Imports Net outflow of specie Step 2 : Money supply increase Money supply decrease Step 3 : Prices and wages increase Prices and wages decrease Step 4 : Increase in imports & Decrease in exports Decrease in imports and Increase in exports until Exports = Imports

Adam Smith (1723 – 1790) Laissez faire and free trade is a positive-sum game: Nation’s wealth production capacity not holdings of gold Economic growth free environment and self-interest and competition Productivity gains division of labor and specialization of labor Mutual beneficial exchange and free trade

2 Foundations of modern trade theory Copyright © 2000, South-Western College Publishing

Foundations of trade theory Historical development of trade theory • Mercantilism • positive trade balance • Absolute advantage (Adam Smith) • Countries benefit from exporting what they make cheaper than anyone else • Comparative advantage (David Ricardo) • Nations can gain from specialization, even if they lack an absolute advantage Carbaugh, Chap. 2 23

Comparative advantage Absolute & Comparative Advantage Absolute advantage: each nation is more efficient in producing one good Output per labor hour Nation Wine Cloth United States United Kingdom 5 bottles 20 yards 15 bottles 8 yards Comparative advantage: the US has an absolute advantage in both goods Output per labor hour Nation Wine Cloth United States United Kingdom Carbaugh, Chap. 2 40 bottles 40 yards 20 bottles 10 yards 24

Comparative advantage Ricardo’s Comparative Advantage in money prices Nation Labor Wage US 1 hr UK 1 hr (at $1. 6 = £ 1) $20/hr £ 5/hr $8 Carbaugh, Chap. 2 Cloth (yards) Quant. Price 40 10 10 $0. 50 £ 0. 50 $0. 80 Wine (bottles) Quant. Price 40 20 20 $0. 50 £ 0. 25 $0. 40 25

Transformation schedules Comparative advantage • Generalizes theory to include all factors, not just labor • Shows combinations of products that can be made if all factors are used efficiently • Slope, or marginal rate of transformation, shows the opportunity cost of making more of one good (how much of one good must be given up to make more of another) Carbaugh, Chap. 2 26

Comparative advantage Marginal Rate of Transformation A Wheat Slope = MRT = 0. 5 B C Carbaugh, Chap. 2 27

Comparative advantage Transformation schedules: constant opportunity costs Carbaugh, Chap. 2 Slope = 0. 5 = MRT Wheat Slope = 2. 0 = MRT 28

Comparative advantage Carbaugh, Chap. 2 S Canada S US Autos per bushel of wheat Bushels of wheat per auto Supply schedules: constant opportunity costs S S US Canada 29

Comparative advantage B’ Trading possibilities line (terms of trade 1: 1) E Wheat Trading under constant opportunity costs C D’ Trading possibilities line (terms of trade 1: 1) C’ A’ A F D Carbaugh, Chap. 2 B 30

Comparative advantage Production gains from specialization: constant opportunity costs Before Specialization After Specialization Net Gain (Loss) Autos Wheat US Canada 40 40 40 80 120 0 0 160 80 -40 80 World 80 120 160 40 40 Carbaugh, Chap. 2 31

Comparative advantage Consumption gains from trade: constant opportunity costs Before Specialization After Specialization Net Gain (Loss) Autos Wheat US Canada 40 40 40 80 60 60 60 100 20 20 World 80 120 160 40 40 Carbaugh, Chap. 2 32

Comparative advantage Carbaugh, Chap. 2 S Canada Aa’ S Aa US Autos per bushel of wheat Bushels of wheat per auto Complete specialization under constant opportunity costs Aw S US S Canada Aw’ 33

Comparative advantage Carbaugh, Chap. 2 MRT = 0. 67 Autos Changing comparative advantage MRT = 0. 5 34