TUE 1160 International Economics by Hannele Wallenius 2

TU-E 1160 International Economics by Hannele Wallenius 2. WHY DO WE TRADE? - Part I Aalto University School of Science Department of Industrial Engineering and Management

Six Valuable Lessons of Trade Theory 1. Free trade can raise aggregate economic efficiency and aggregate economic welfare. 2. Free trade will benefit a country even if it is less efficient than all other countries in every industry. 3. Some people will suffer losses with free trade. 4. A domestic firm may lose out in international competition even if it is the lowest cost producer in the world. 5. Trade protection may, in some special cases, be beneficial for a country. 6. Although trade protection can be beneficial, the case for free trade remains strong. International Economics Hannele Wallenius

Index of Openness* Country Name Hong Kong Estonia High income: no OECD Switzerland Iceland Sweden Germany Finland Greece Low Income Turkey France United Kingdom OECD Members Middle Income India China Japan United States * 2014 International Economics Hannele Wallenius 1960 0, 00 25, 99 54, 52 86, 84 46, 44 0, 00 43, 35 24, 67 5, 73 26, 97 41, 80 23, 65 19, 74 11, 10 8, 73 21, 01 9, 17 1980 178, 38 42, 71 85, 46 69, 41 56, 90 41, 99 62, 90 44, 59 17, 09 43, 24 49, 89 37, 37 28, 45 15, 12 12, 42 27, 79 20, 07 2000 279, 12 126, 51 51, 75 98, 25 71, 95 82, 33 61, 39 74, 99 58, 42 46, 82 43, 19 55, 26 51, 83 47, 51 51, 04 26, 44 39, 75 20, 31 24, 98 * Ratio of e imports xports + t multiplie o GDP d by 10 0 2015 400, 87 154, 42 61, 56 114, 09 100, 99* 86, 45 85, 99 73, 69 63, 69 59, 68 58, 80 61, 43 56, 46 56, 71 50, 00 42, 41 40, 67 36, 78 28, 00 Some countries trade extensively, others very little. In some countries the index is very high, other rather low. How can this be understood and explained? The higher the index the larger the influence of trade on domestic activities. Source: World Bank open data 3 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage

Exports of goods and services in EU (% of GDP in 2015) Luxembourg Ireland Slovak Republic Hungary Czech Republic Belgium Netherlands Estonia Slovenia Bulgaria Denmark Austria Poland Croatia Germany Sweden Romania Portugal Finland Spain Greece Italy France United Kingdom 213. 8 124. 0 93. 5 90. 7 83. 0 82. 9 82. 5 79. 3 77. 9 64. 1 53. 4 53. 1 49. 6 49. 4 46. 8 45. 6 41. 1 40. 3 36. 6 33. 1 31. 9 30. 1 30. 0 27. 2 0. 0 50. 0 100. 0 An other measure of openness is also used: Exports/GDP; see your text book tables. 150. 0 200. 0 250. 0 Source: World Bank open data International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage 4

n n NOTE! Openness index value greater than 100 means that the country's exports are bigger than its overall level of production (GDP or GNP). Such a situation could occur if much of the economic activity of the country in question involves the assembly and export of final products made from imported raw or partially assembled materials. The value in excess of 100 comes about from the fact that output is (always) measured in terms of value added -- the value of capital and labor services devoted in this case to the assembly of goods -- while exports are measured in terms of the total value of goods -including the value of the imported parts. Clearly, in such circumstances it is quite likely for exports to be greater than value added. International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage 5

Major Topics of Trade Theory? The classical theory of international trade is concerned with the following three questions: 1. What are the gains from trade? ¨ In other words, if countries benefit from international trade, where do the gains come from, and how are they divided among the trading countries? International Economics Hannele Wallenius 2. Why Do We Trade? 6

Major Concerns of Trade Theory? continued 2. What is the structure/pattern of trade? ¨ In other words, which goods/services are exported, and which are imported? ¨ What are the fundamental laws that govern international allocation of resources and the flow of trade? 3. What are the terms of trade? ¨ In other words, at what prices are the exported and imported goods exchanged? International Economics Hannele Wallenius 2. Why Do We Trade? 7

Why Do We Trade? International difference in autarky* price of a product S in two countries: PS/PT Finland China NSSA With trade prices start to equalize. P 0 NSS/ NSD= national supply/demand PS/PT = relative price of product S When trade starts the demand for Finish product will decrease. Country A International Economics Hannele Wallenius NSSB When trade starts the demand for Chinese product will increase. P 0 NDSA QS NDSB Country B 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage QS 8 * Autarky = closed economy = no international trade allowed in a country

n Because country B has a lower autarky (relative) price of S, it is said to have a comparative advantage in S and a comparative disadvantage in T and by same logic, country A has a comparative advantage in T and comparative disadvantage in S. n If trade would be allowed, consumers in country A would like to buy product S from country B, and prices would start to equalize. Why Are the Autarky Prices Different? 1. Differences in technology or productivity 2. Difference in resource endowments 3. Difference in demand International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage 9

Understanding the Gains from International Trade Nations (or firms in different nations) trade with each other because they benefit from it! We can divide the different trade theories in four categories. . . International Economics Hannele Wallenius 2. Why Do We Trade? 10

Different Trade Theories 1. Early Trade Theory: Mercantilists 2. Classical Trade Theory: Ricardian Model (section 2. 1) 3. Modern Trade Theory: Heckscher-Ohlin Model (section 2. 2) 4. Alternative Approaches to Trade Theory (section 2. 3) International Economics Hannele Wallenius 2. Why Do We Trade? 11

1. Early Trade Theory: Mercantilists ¨ Until mid-eighteenth century, it was believed that the purpose of international trade was to keep exports greater than imports and pile up gold, and when/if deficits were created they believed that imports had to be restricted. ¨ Mercantilists assumed trade to be a zero-sum game since they assumed that fixed amounts of goods and of gold existed in the world and that trade merely determined their distribution among the various nations. International Economics Hannele Wallenius 2. Why Do We Trade? 12

¨ But in the 1740 s, David Hume explained that as quantity of money (gold) changes, so also does the price level, and the nation's real wealth is unaffected. ¨ In 1770 s, Adam Smith argued that import restrictions would reduce the gains from specialization and make a nation poorer. He used absolute advantage to explain the benefits of trade. Theories 2 - 4 will be now discussed in more detail. . . International Economics Hannele Wallenius 2. Why Do We Trade? 13

2. Why Do We Trade? continued n 2. 1 The Law of Comparative Advantage: Absolute vs. Comparative Advantage n 2. 2 Modern Trade Theory: Heckscher-Ohlin Model n 2. 3 Alternative Trade Theories: from Practical Evidence International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage Results 14

Economic Basis for Trade What are the factors that determine how countries will specialize in international trade? David Ricardo (On the Principles of Political Economy, 1819), developed theory of comparative advantage. . . International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage 15

Economic Basis for Trade continued According to this theory, Specialization and free trade will benefit all trading partners (= real wages will rise), even those who may be absolutely less efficient producers. International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage 16

Absolute vs. Comparative Advantage Although comparative advantage is a simple concept, experience shows that it is a surprisingly hard concept for many people to understand (or accept). International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage 17

Absolute vs. Comparative Advantage continued Indeed, Paul Samuelson — the Nobel laureate economist who did much to develop the model of international trade — has described comparative advantage as the best example he knows of an economic principle that is undeniably true yet not obvious to intelligent people. International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage 18

Definition: Absolute Advantage The advantage in the production of a product enjoyed by one country over another when it uses fewer resources to produce that product than the other country does. International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage 19

Absolute Advantage - an Illustration Suppose country A and country B produce wheat, but that A's climate is more suited to wheat and its labor is more productive. Country A will therefore produce more wheat per acre than country B and use less labor in growing it and bringing it to the market. Country A thus enjoys an absolute advantage over country B in the production of wheat. International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage 20

Definition: Comparative Advantage The advantage in the production of a product enjoyed by one country over another when that product can be produced at lower cost in terms of other products than it could be in the other country. International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage 21

Comparative Advantage an Illustration • Suppose that countries C and D both produce wheat and corn and that C enjoys an absolute advantage in the production of both - that is, C's climate is better than D's, and fewer of C's resources are needed to produce a given quantity of both wheat and corn. • C and D each need to choose between planting land with wheat and corn. International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage 22

Comparative Advantage - an Illustration continued • To produce more wheat, either country must transfer land from corn production and vice versa. • Suppose that in country C, a bushel of wheat has an opportunity cost of two bushels of corn. At the same time, suppose that producing a bushel of wheat in country D requires to give up only one bushel of corn D enjoys a comparative advantage in producing wheat. International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage 23

Example 1: Gains from Mutual Absolute Advantage Assume a) two countries with fixed amount of land (100 acres) and land yields given in the table below, b) only two products produced (wheat and cotton), c) preferences for food and clothing are such that both countries consume equal amounts of wheat and cotton. Production Possibilities Frontiers (PPF) before trade: International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage 24

PPF in Each Country: Example 1: Continued When there is no trade, the allocation of resources will be such that both countries will produce 150 bushels of wheat and 150 bales of cotton. Australia New Zealand Wheat 600 Both countries would produce and consume at 150, 150. Wheat W: 25 acres x 6 bu/acre W: 75 acres x 2 bu/acre C: 75 acres x 2 bales/acre C: 25 acres x 6 bales/acre 200 (150, 150) PPF 200 International Economics Hannele Wallenius Cotton 600 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage Cotton 25

Example 1: Continued ¨ Expanded possibilities after trade: If countries realize that they should specialize (Australia in cotton and New Zealand in wheat) and trade, both countries could gain. ¨ Both are now specializing: International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage 26

Example 1: Continued In this situation 300 bushels of wheat is traded for 300 bales of cotton: New Zealand Australia Wheat 600 (300, 300) 200 International Economics Hannele Wallenius Cotton 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage 600 Cotton 27

Example 1: Continued ¨ Trade enables both countries to move beyond their previous resource and productivity constraints. Ø Both countries (after trade) can consume beyond their production possibilities (PPFs)! This is the beauty of trade! International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage 28

Example 2: Gains from trade when one country has a double absolute advantage • Production Possibilities and Consumption in a Closed Economy (same assumptions as before): NZ: 50 x 6 = 300 both wheat and cotton. A: 75 x 1 = 75 wheat 25 x 3 = 75 cotton International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage 29

Example 2: Continued • When countries realize that they can benefit from specialization and trade: Only partial specialization: 75 x 6 = 450 and 25 x 6 = 150 International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage 30

Example 2: Continued If 100 bu of wheat from NZ is traded to 200 bales of cotton from Australia • Consumption after trade: Stage 3 • When countries specialize they will maximize their combined output and use resources more efficiently: both countries are better off than they were before the trade (closed economy consumptions were 300, 300 and 75, 75). Ø Both have moved beyond their own production possibilities. International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage 31

n By exposing firms and products to international competition, economies are encouraged to focus on areas of comparative advantage. This helps ensure that scarce skills and resources are deployed where they are most productive. International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage 32

International Equilibrium with Increasing Costs • Next we will extend the classical model of trade to the more general case of increasing opportunity costs and introduce demand by means of social indifference curves. Indifference Map and Consumer Equilibrium Increasing Opportunity Cost Clothing a) Product specific factors. Clothing b) Different industries use factors in different proportions. PPF Food International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage I’’’ I’ Food 33

General Equilibrium in a Small Open Economy International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage 34

Specialization Based on Comparative Advantage (countries PPF are different) and the Resulting Gains from Trade 1. Assume such a domestic price ratios that E (in US) and E* (in UK) are consumption and production in autarky (= no trade). 2. After trade production takes place in Q and Q* and consumption at S and S*, respectively. America Figure 1 (a) International Economics Hannele Wallenius Britain Figure 1 (b) 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage 35

Specialization Based on Comparative Advantage and the Resulting Gains from Trade continued • Figure 1: In autarky, America produces and consumes at E, and Britain at E*. With trade, America shifts production from E to Q and consumes at S by exporting VQ units of food to Britain in exchange for VS units of British clothing. America is better off with trade because S lies on a higher indifference curve than E. Indeed, in our illustration, America consumes more food and more clothing at S than at E. Britain shifts production from E* to Q* and consumption from E* to S*. Britain’s welfare increases also. Trade triangles SVQ and Q*V*S* are identical. International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage 36

Different set of indifference curves! Same Production Technique in Both Countries, Trade Based on Different Taste Figure 2 Clothing America In autarky US produces and consumes at A and UK at B. After free trade both will produce at Q but consume at A’ and B’, respectively. Britain Again both countries can consume beyond their production possibilities. Food International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage 37

Trade Based on Different Taste continued • Figure 2: Trade based on different tastes. America and Britain share the same production frontier MN (= same technology in both countries). In autarky, America produces and consumes at A, and Britain at B. With free trade, both countries produce at Q, but America consumes at A’ and Britain at B’. Trade triangles A’VQ and QSB’ are identical. International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 1 The Law of Comparative Advantage 38

2. WHY DO WE TRADE? n 2. 1 The Law of Comparative Advantage: Absolute vs. Comparative Advantage n 2. 2 Modern Trade Theory: Ohlin Model n 2. 3 Alternative Trade Theories: Results from Practical Evidence International Economics Hannele Wallenius Heckscher- 2. Why Do We Trade? - 2. 2 Modern Trade Theory: Heckscher. Ohlin Model 39

What are the ultimate determinants of comparative advantage? • Ricardo did not bother to answer this question. • He just assumed that the differences in comparative advantage depended on comparative difference in labor productivity (that is, differences in technology), but he did not explain the basis for these differences. Implicit reason in his example was climate. . . International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 2 Modern Trade Theory: Heckscher. Ohlin Model 40

What are the ultimate determinants of comparative advantage? continued ¨ It remained to Heckscher and Ohlin to offer an explanation for comparative advantage. ¨ And this theory has become, since 1930 s, the orthodox explanation of the ultimate cause of international trade. Eli Heckscher (1879 - 1952) International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 2 Modern Trade Theory: Heckscher. Ohlin Model Bertil Ohlin (1899 -1979) 41

What are the ultimate determinants of comparative advantage? continued ¨ Their basic idea is: 1. Commodities differ in their factor requirements. 2. Countries differ in their factor endowments. International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 2 Modern Trade Theory: Heckscher. Ohlin Model 42

What are the ultimate determinants of comparative advantage? continued A country has comparative advantage in those commodities that use its abundant factors intensively. • This is why labor-abundant countries, such as India and China export footwear, rugs, textiles, and other labor intensive commodities; and landabundant countries, such as Argentina, Australia, and Canada, export meat, wheat, wool, and other land-intensive commodities. International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 2 Modern Trade Theory: Heckscher. Ohlin Model 43

The Basic Assumptions of the Heckscher. Ohlin Model: 1. Number of countries, factors, and commodities are all two (often referred to as the 2 x 2 model). 2. Technology is the same in both countries. 3. Constant returns to scale 4. Strong factor intensity 5. Incomplete specialization International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 2 Modern Trade Theory: Heckscher. Ohlin Model 44

The Basic Assumptions of the Heckscher. Ohlin Model continued: 6. Perfect competition 7. Factors are perfectly mobile within each country but perfectly immobile between countries. 8. Tastes are largely similar between countries. 9. Free trade 10. Transportation costs are zero. International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 2 Modern Trade Theory: Heckscher. Ohlin Model 45

Heckscher-Ohlin Theorem with a Single Technique • The structure of trade, in general, can be traced back to differences in factor endowments, technology, and tastes. • Since Heckscher-Ohlin theory assumes that technology and tastes are similar between countries, it attributes the comparative advantage to differences in factor endowments. International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 2 Modern Trade Theory: Heckscher. Ohlin Model 46

Heckscher-Ohlin Theorem with a Single Technique continued In summary, the capital-abundant country exports the capital-intensive commodity, and the labor-abundant country exports the labor-intensive commodity. International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 2 Modern Trade Theory: Heckscher. Ohlin Model 47

Example 1: Factor Endowments and Production-Possibilities n n One country Required inputs per unit of output: International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 2 Modern Trade Theory: Heckscher. Ohlin Model 48

Example 1: Continued Cloth • M 600 Capital constraint 225 • 150 J • JEH is the PPF 0 E Labor constraint • 150 G H • 200 450 Steel Figure 3 International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 2 Modern Trade Theory: Heckscher. Ohlin Model 49

Example 1: Continued • Figure 3: Derivation of the production-possibilities frontier. If the economy had an unlimited supply of capital (labor), it would be able to produce along the labor constraint JG (capital constraint MH). When the supplies of both factors are limited, both constraints become binding and the production frontier coincides with the heavy kinked line JEH. Because steel is capital intensive relative to cloth, the capital constraint is steeper than the labor frontier. International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 2 Modern Trade Theory: Heckscher. Ohlin Model 50

Heckscher-Ohlin Theorem with a Single Technique Figure 4 Cloth Since same tastes in both countries, only one set of communal indifference curves. Before trade, America produces and consumes at R, and Britain at Q*. With free trade, America shifts production to Q and consumption to C. Britain maintains production at Q* but consumes at C*. Steel Figure 4 International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 2 Modern Trade Theory: Heckscher. Ohlin Model 51

Heckscher-Ohlin Theorem with a Single Technique • Figure 4: Production frontiers JQH and J*Q*H* reflect the fact that America is endowed with more capital than Britain, while Britain is endowed with more labor than America. Before trade, America produces and consumes at R, and Britain at Q*. With free trade, America shifts production to Q and consumption to C. Britain maintains production at Q* but shifts consumption to C*. Trade triangles CQV and Q*C*V* are identical. America exports steel, and Britain cloth. International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 2 Modern Trade Theory: Heckscher. Ohlin Model 52

Heckscher-Ohlin Theorem with Many Techniques Cloth Before trade, America produces and consumes at R, and Britain at R*. With free trade, America produces at Q and consumes at C, and Britain at Q* and C*, respectively. Figure 5 International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 2 Modern Trade Theory: Heckscher. Ohlin Model Steel 53

Heckcher-Ohlin Theorem with Many Techniques • Figure 5: Production frontier JH of America (the capitalabundant country) is skewed along the axis for steel (the capital-intensive commodity); and the production frontier J*H* of Britain (the labor-abundant country) is skewed along the axis for cloth (the labor-intensive commodity). Before trade, America produces and consumes at R, and Britain at R*. With free trade, America produces at Q and consumes at C, and Britain at Q* and C*, respectively. Trade triangles CQV and Q*C*V* are identical, America exports steel, and Britain cloth. International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 2 Modern Trade Theory: Heckscher. Ohlin Model 54

Derivation of Offer Curves and the International Equilibrium Figure 6 (b) 2. At p = 3, America shifts production to Q and consumption to S. 3. And at p = 4, R and K, respectively. 1. In autarky (p = 2) US produces and consumes at E. Food America’s imports of clothing Clothing Figure 6 (a) US offer curve America’s exports of food TOT = Terms of Trade = ratio of export and import prices International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 2 Modern Trade Theory: Heckscher. Ohlin Model 55

Derivation of Offer Curves and the International Equilibrium continued • Figure 6: Derivation of America’s offer curve. At the Autarkic relative price of food (p), assumed to be equal to 2, America produces and consumes at E in panel (a), and trades at the origin of panel (b). At p=3, America shifts production to Q and consumption to S in panel (a), and trades at S in panel (b). Similarly, at p=4, America produces at R and consumes at K in panel (a), and trades at K in panel (b). Trade triangles SVQ and KGR are identical to triangles SJO and KLO, respectively. The locus of all trade points (such as S and K) in panel (b) is America’s offer curve. International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 2 Modern Trade Theory: Heckscher. Ohlin Model 56

International Equilibrium Clothing America’s imports Britain’s exports Figure 7 Here the offer curves of two trading countries define the international equilibrium at K. Food America’s exports Britain’s imports International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 2 Modern Trade Theory: Heckscher. Ohlin Model 57

Derivation of Offer Curves and the International Equilibrium continued • Figure 7: International equilibrium occurs at K, where the offer curves intersect. America exports OL units of food to Britain and imports OL* units of clothing from Britain. The slope of terms-of-trade line TOT 3 gives equilibrium terms of trade OL*/OL. International Economics Hannele Wallenius 2. Why Do We Trade? - 2. 2 Modern Trade Theory: Heckscher. Ohlin Model 58

End of Fun! On next lecture: 2. WHY DO WE TRADE? - Part II International Economics Hannele Wallenius 2. Why Do We Trade? 59