Trade Comparative advantage and terms of trade 1

Trade Comparative advantage and terms of trade 1

§ Observations: § World trade grows faster than world production § Real GDP (world) is about 7 times more now than in 1950 § Volume of trade (world) is about 30 times more now than in 1950 § Canada exports (on net) § Fish § Energy § Forestry products § Canada imports (on net) § Machinery and equipment § Automotive products § Canada is a small country, in terms of trade § Does not have much influence on world prices 2

§ Why trade? § Absolute advantage § Production per unit of time § Canada vs Niger § Comparative advantage § Cost of production § Production possibility frontiers § Canada vs Niger § While it is possible for a country/individual to have no absolute advantage, there is always comparative advantage in something § Comparative, not absolute, advantage determines the gains from trade § World output increases if countries specialize according to their comparative advantage 3

§ Comparative advantage comes from: § Different factor endowment § Heckscher-Ohlin theory § Countries have comparative advantage in in the production of goods that use intensively the factors of production with which they are abundantly endowed. § Variation: different climates § Variation: human capital § Variation: acquired factors § Acquiring factors that are likely to generate large comparative advantage is becoming a policy objective throughout the world 4

§ The patterns of trade: § A country will be an exporter if it has a comparative advantage § A small country is facing world prices for the goods/services § The law of one price: if a product is traded freely throughout the world, its prices in different countries must differ by no more than cost of transporting the product between those countries § Think “a single world price” § If a product’s world price exceed the autarky price, the country exports the product § But this means the cost of producing is low for the exporter § Or, in other words, the exported has comparative advantage in producing the product § If a product’s world price is below the autarky price, the country imports the product § But this means the cost of producing is high for the exporter § Or, in other words, the exported has comparative disadvantage in producing the product 5

§ The terms of trade: § Consider the production possibility frontier again § If a country is an exporter of the product, an increase in the relative price of that product expands consumption possibilities § So we would say that their terms of trade improve/rise § If a country is an importer of the product, an increase in the relative price of that product shrinks consumption possibilities § So we would say that their terms of trade worsen/fall § In practice, there are more than two goods, so we use a set of all exports/imports § Terms of trade = 100 (index of export prices) / (index of import prices) 6