WEEK 2

CHAPTER 2+3
TRADE THEORY
GAINS FROM TRADE
COMPARATIVE ADVANTAGES

1
 Objectives
After this chapter, we can answer the following
questions:
(1) What constitutes the basis for trade? Or
why do nations export and import certain products?
(2) At what terms of trade are products exchanged in
the world market?
(3) What are the gains from international trade in
terms of production and consumption?
(4) What are sources of comparative advantages?

2
 Mercantilism
• Mercantilism (mid-16th century) suggests that
it is in a country’s best interest to maintain a
trade surplus - to export more than it imports.
• advocates government intervention to achieve
a surplus in the balance of trade
• Mercantilism views trade as a zero-sum game -
one in which a gain by one country results in a
loss by another.

3
 Smith’s Theory of Absolute Advantage
• Adam Smith (1776) argued that a country has
an absolute advantage in the production of a
product when it is more efficient than any
other country in producing it.
• countries should specialize in the production of goods
for which they have an absolute advantage and then
trade these goods for goods produced by other
countries.
• A country has an absolute advantage in
producing a good over another country if it
uses fewer resources to produce that good.
4
 How Does The Theory of
Absolute Advantage Work?

• If the United States can produce 13 million cell phones using

1,000 workers and Korea can produce only 12 million cell
phones using 1,000 workers, then the United States has an
absolute advantage in the production of cell phones.

• If the United States can grow 39 million apples using 1,000

workers and Korea can grow only 24 million apples using the
same amount of labor, then the United States has an absolute
advantage in apples.
5
 Examples of Absolute Advantage
• England can produce more textiles per labor
hour and Spain can produce more wine per
labor hour so England should export textiles
and import wine and Spain should do the
opposite.
• Saudi Arabia's oil reserves are abundant, giving
it an absolute advantage. That's one reason
why it exports the commodity to other nations
around the world.

6
Ricardo’s Theory of Comparative Advantage
• David Ricardo asked what happens when one
country has an absolute advantage in the
production of all goods.
• The theory of comparative advantage (1817):
countries should specialize in the production of
those goods they produce most efficiently and
buy goods that they produce less efficiently
from other countries
• even if this means buying goods from other
countries that they could produce more
efficiently at home
7
 How Does The Theory of
Comparative Advantage Work?
• A country has a comparative advantage in production of a certain product when
it can produce that product at a lower relative opportunity cost than another
country.

•To grow 39 million apples, the United States •To produce 13 million cell phones, the
must give up 13 million cell phones. United States gives up 39 million apples.
Therefore, each apple costs the United Each cell phone costs 39/13 = 3 apples.
States: 13/39 = 0.33 cell phones. •To produce 12 million cell phones, Korea
•To grow 24 million apples in Korea, 12 million gives up 24 million apples, so each cell
cell phones must be given up. Each apple phones costs Korea 24/12 = 2 apples.
costs Korea: 12/24 = 0.5 cell phones. •Korea has a comparative advantage in
•The United States has a comparative the production of cell phones, because
advantage in the production of apples, it costs Korea fewer apples to make a
because it costs the United States fewer cell phones than it costs the United
cell phones in order to make an apple than States.
it costs Korea. 8
 The Theory of Comparative Advantage
• Principle of comparative advantage
• Even if a nation has an absolute cost
disadvantage in the production of both goods
• The less efficient nation
• Specialize in and export the good in which it is relatively
less inefficient
• Where its absolute disadvantage is least
• The more efficient nation
• Specialize in and export that good in which it is relatively
more efficient
• Where its absolute advantage is greatest

9
 Production Possibilities Schedules
• Modern trade theory
• More generalized theory of comparative
advantage
• Use a production possibilities schedule
• Transformation schedule

10
 Production Possibilities Schedules
• Production possibilities schedule
• Various alternative combinations of two goods
• A nation can produce
• When all of its factor inputs
• Land, labor, capital, entrepreneurship
• Are used in their most efficient manner
• Maximum output possibilities of a nation

11
 FIGURE 1 Trading under constant opportunity costs

With constant opportunity costs, a nation will specialize in the product of its comparative
advantage. The principle of comparative advantage implies that with specialization and free
trade, a nation enjoys production gains and consumption gains. A nation’s trade triangle
denotes its exports, imports, and terms of trade. In a two nation, two product world, the trade
triangle of one nation equals that of the other nation; one nation’s exports equal the other
nation’s imports, and there is one equilibrium terms of trade.
12
 Production Possibilities Schedules
• Marginal rate of transformation, MRT
• The amount of one product a nation must
sacrifice to get one additional unit of the other
product
• Rate of sacrifice = opportunity cost of a product
• Absolute value of the slope of production
possibilities schedule
• For Figure 1
DWheat
MRT =
DAutos
13
 Trading Under Constant-Cost Conditions
• Constant opportunity costs
• Straight line production possibilities schedules
• Factors of production
• Perfect substitutes for each other
• All units of a given factor are of the same
quality
• Autarky
• Absence of trade

14
 Trading Under Constant-Cost Conditions
• Basis for Trade
• Principle of comparative advantage
• Direction of Trade
• Specialize and export the good with the lowest
opportunity cost
• Production Gains from Specialization
• Production gains for both countries
• Arise from the reallocation of existing resources
• Static gains from specialization
15
TABLE 1 Gains from specialization & trade: constant opportunity costs

16
 Trading Under Constant-Cost Conditions
• Consumption Gains from Trade
• Trade = consumption gains for both countries
• Consumption points
• Outside domestic production possibilities schedules
• Consume more of both goods
• Terms of trade
• Rate at which a country’s export product is
traded for the other country’s export product
• Define the relative prices of the two products

17
 Trading Under Constant-Cost Conditions
• Domestic rate of transformation
• Domestic terms of trade
• Slope of the production possibilities schedule
• Relative prices that two commodities can be
exchanged at home
• Terms of trade for exports
• More favorable than domestic terms of trade

18
 Trading Under Constant-Cost Conditions
• Trading possibilities line
• International terms of trade for both countries
• Trade triangle for a country
• Exports – along the horizontal axis
• Imports – along the vertical axis
• Terms of trade – the slope
• Complete specialization
• Produce only one product

19
 Trading Under Constant-Cost Conditions
• Domestic cost ratio
• Negatively sloped production possibilities
schedule
• Transform into a positively sloped cost-ratio line
• Outer limits for the equilibrium terms of trade
• Becomes no-trade boundary
• Region of mutually beneficial trade
• Bounded by the cost ratios of the two countries

20
FIGURE 2 Equilibrium terms-of-trade limits

The supply-side analysis of Ricardo describes the outer limits within which the equilibrium terms
of trade must fall. The domestic cost ratios set the outer limits for the equilibrium terms of trade.
Mutually beneficial trade for both nations occurs if the equilibrium terms of trade lies between
the two nations’ domestic cost ratios. According to the theory of reciprocal demand, the actual
exchange ratio at which trade occurs depends on the trading partners’ interacting demands.
21
 Trading Under Constant-Cost Conditions
• Equilibrium Terms of Trade, John Stuart Mill
(1806–1873)
• Add the intensity of the trading partners’
demands
• Determine the actual terms of trade
• The theory of reciprocal demand

22
 Trading Under Constant-Cost Conditions
• Theory of reciprocal demand
• Within the outer limits of the terms of trade
• Actual terms of trade are determined by the
relative strength of each country’s demand for the
other country’s product
• Production costs determine the outer limits of
the terms of trade
• Reciprocal demand determines what the actual
terms of trade will be within those limits

23
 Trading Under Constant-Cost Conditions
• Theory of reciprocal demand
• Best applies when both nations are of equal
economic size
• The demand of each nation - noticeable effect on
market price
• If two nations are of unequal economic size
• The relative demand strength of the smaller nation
will be dwarfed by that of the larger nation
• Domestic exchange ratio of the larger nation will prevail
• The small nation can export as much of the commodity
as it desires
24
 Venezuela and the United States
• Consider trade in crude oil and autos between Venezuela and
the United States before the rise of the Organization of
Petroleum Exporting Countries (OPEC).
• Venezuela, as a small nation, accounted for only a very small
share of the U.S.-Venezuelan market, whereas the U.S.
market share was overwhelmingly large.
• Because Venezuelan consumers and producers had no
influence on market price levels, they were in effect price
takers.
• In trading with the United States, no matter what the
Venezuelan demand was for crude oil and autos, it was not
strong enough to affect U.S. price levels.
• As a result, Venezuela traded according to the U.S. domes- tic
price ratio, buying and selling autos and crude oil at the price
levels that existed within the United States.
25
 Trading Under Constant-Cost Conditions
• The importance of being unimportant
• For two nations engaged in international trade
• Same size, similar taste patterns
• Gains from trade – shared equally between them
• One nation is significantly larger than the other
• Larger nation – attains fewer gains from trade
• Smaller nation – attains most of the gains from
trade

26
 Trading Under Constant-Cost Conditions
• Terms-of-Trade Estimates
• Commodity terms of trade
• Barter terms of trade
• Measure of the international exchange ratio
• Measures the relation between the prices a nation
gets for its exports and the prices it pays for its
imports

Export Price Index

Terms of trade = ´ 100
Import Price Index

27
 Trading Under Constant-Cost Conditions
• Improvement in a nation’s terms of trade
• Rise in its export prices
• Relative to its import prices
• A smaller quantity of export goods sold abroad
• Required to obtain a given quantity of imports
• Deterioration in a nation’s terms of trade
• Rise in its import prices
• Relative to its export prices
• Purchase of a given quantity of imports
• Sacrifice of a greater quantity of exports
28
 Commodity terms of trade, 2008 (2000 =
100)
• TABLE 2

29
 Commodity terms of trade, 2008 (2000 =
100)
• Using the terms-of-trade formula, we find that
the U.S. terms of trade improved by 14 percent
[(167/147) × 100 = 114] over the period 2000–
2008.
• This means that to purchase a given quantity
of imports, the United States had to sacrifice
14 percent fewer exports;
• Conversely, for a given number of exports, the
United States could obtain 14 percent more
imports.

30
 Dynamic Gains From Trade
• Dynamic gains from international trade
• More efficient use of an economy’s resources
• Higher output and income
• More saving, More investment
• Higher rate of economic growth
• Higher productivity
• Economies of large-scale production
• Increased competition

31
 Changing Comparative Advantage
• Patterns of comparative advantage change
over time
• Productivity increases
• Production possibilities schedule changes
• More output can be produced - with the same
amount of resources
• Producers - need to hone their skills to
compete in more profitable areas

32
FIGURE 3 Changing comparative advantage

If productivity in the Japanese computer industry grows faster than it does in the U.S.
computer industry, the opportunity cost of each computer produced in the United States
increases relative to the opportunity cost of the Japanese. For the United States,
comparative advantage shifts from computers to autos.

33
Trading Under Increasing-Cost Conditions
• Increasing opportunity costs
• Concave production possibilities schedule
• Bowed outward from the diagram’s origin
• Inputs are imperfect substitutes for each other
• MRT rises
• Absolute slope of the production possibilities
schedule

34
FIGURE 4 Production possibilities schedule; increasing-cost conditions

Increasing opportunity costs lead to a production possibilities schedule that is concave,

viewed from the diagram’s origin. The marginal rate of transformation equals the (absolute)
slope of the production possibilities schedule at a particular point along the schedule.
35
Trading Under Increasing-Cost Conditions
• Increasing-Cost Trading Case
• One country specializes in producing one good
• The other country specializes in producing the
other good
• Specialization continues in both nations until
• Relative cost of one good is identical in both
nations
• One country’s exports of one good are precisely
equal to the other country’s imports of the good
• Same domestic rates of transformation
36
FIGURE 5 Trading under increasing opportunity costs

With increasing opportunity costs, comparative product prices in each country are
determined by both supply and demand factors. A country tends to partially specialize in the
product of its comparative advantage under increasing cost conditions.
37
Trading Under Increasing-Cost Conditions
• Production gains
• More of each good is being produced
• Consumption gains
• Both countries consume more of at least one
good
• The trade triangle
• Exports, imports, and terms of trade
• Same for both countries

38
TABLE 2 Gains from specialization and trade: increasing opportunity costs

39
Trading Under Increasing-Cost Conditions
• Partial Specialization
• Each country specialize only partially
• In the production of the good in which it has a
comparative advantage
• Increasing costs - mechanism that forces costs
in two trading nations to converge
• Basis for further specialization ceases to exist
• Both nations will produce some of each good

40
Trading Under Increasing-Cost Conditions
• Partial Specialization
• Not all goods and services are traded
internationally
• Differing tastes for products
• Most products are differentiated

41
 More Than Two Products

• When two countries produce a large number

of goods, the operation of comparative
advantage
• requires that the goods be ranked by the
degree of comparative cost.
• Each country exports the product(s) in which it
has the greatest comparative advantage.
• Conversely, each country imports the
product(s) in which it has greatest comparative
disadvantage.
42
More Than Two Products

43
FIGURE 8 Multilateral trade: U.S., Japan, and OPEC

When many countries are involved in international trade, the home country will likely find it
advantageous to enter into multilateral trading relations with a number of countries. This
figure illustrates the process of multilateral trade for the United States, Japan, and OPEC.

44
 More Than Two Countries

• A nation will realize a trade surplus (exports of

goods exceed imports of goods) with trading
partners that buy a lot of the things that it
supplies at low cost.
• A nation will realize a trade deficit (imports of
goods exceed exports of goods) with trading
partners that are low-cost suppliers of goods
that it imports intensely.

45
SOURCES OF COMPARATIVE ADVANTAGE

46
 Factor Endowments
• Factor-endowment theory
• Heckscher-Ohlin theory
• Immediate basis for trade: difference between
pre-trade relative product prices of trading
nations
• Prices depend on the production possibilities
curves and tastes and preferences (demand
conditions) in the trading countries
• Production possibilities curves depend on
technology and resource endowments

47
 Factor Endowments
• Factor-endowment theory
• Ultimate determinants of comparative
advantage
• Technology
• Resource endowments
• Demand
• Assumption: technology and demand are
approximately the same between countries

48
 Factor Endowments
• Factor-endowment theory
• Resource-endowment ratio
• Determines comparative advantage
• Export the product that uses a large amount of
its relatively abundant resource
• Import the product which in production uses
the relatively scarce resource

49
TABLE 3.1 Producing aircraft and textiles: factor endowments
in the United States and China

50
 Factor Endowments
• Effect of resource endowments on
comparative advantage

51
TABLE 3.2 Capital stock per worker of selected countries, 1997*

52
FIGURE 3.1 The factor-endowment theory

A country exports the good whose production is intensive in its relatively abundant factor. It
imports the good whose production is intensive in its relatively scarce factor.

53
 Factor Endowments
• Factor-Price Equalization
• Redirect demand away from the scarce
resource
• Toward the abundant resource in each nation
• Trade leads to factor-price equalization
• The cheap resource becomes relatively more
expensive
• The expensive resource becomes relatively less
expensive
• Until price equalization occurs
54
FIGURE 3.2 The factor-price equalization theory (a)

By forcing product prices into equality, international trade also tends to force factor prices
into equality across countries.
55
FIGURE 3.2 The factor-price equalization theory (b)

By forcing product prices into equality, international trade also tends to force factor prices
into equality across countries.

56
 Factor Endowments
• Factor-Price Equalization
• Real world – no full factor-price equalization
• Uneven ownership of human capital
• Education, training, skill, and the like
• Not all countries use the same technology
• New and better technology replaces older technologies
– faster in developed countries
• Transportation costs and trade barriers
• Reduce the volume of trade

57
TABLE 3.4 Indexes of hourly compensation, manufacturing
workers, 2006 (U.S.=100)

58
 Factor Endowments
• Stolper-Samuelson Theorem
• Extension of the theory of factor-price
equalization
• An increase in the price of a product
• Increases the income earned by resources that are
used intensively in its production
• A decrease in the price of a product
• Reduces the income of the resources that it uses
intensively
• Some people will suffer losses from free trade
59
 Factor Endowments
• Magnification effect of Stolper-Samuelson
theorem
• The change in the price of a resource
• Is greater than the change in the price of the
good
• That uses the resource relatively intensively in
its production process

60
 Factor Endowments
• Policy implications of Stolper-Samuelson
theorem
• Even though free trade may provide overall
gains for a country
• There are winners and losers
• Owners of relatively abundant resources
• Favor free trade
• Owners of relatively scarce factors
• Favor trade restrictions

61
 Factor Endowments
• International trade - substitute for migration?
• Immigrants
• Help the economy grow
• Increasing the size of the labor force
• Take low skilled jobs few native-born Americans are
available to work
• Take jobs that contribute to the United States being
a leader in technological innovation

62
 Factor Endowments
• International trade
• Substitute for the movement of resources from
one country to another
• International movements in resources are not
essential
• International trade in products can achieve the
same result
• Complement labor migration, short and near-
long terms
• Expanding trade – some unemployed workers
• Forced to seek employment abroad

63
 Factor Endowments
• Specific-factors theory
• Income distribution effects of trade
• In the short term
• When resources are immobile among industries
• Resources specific to import-competing
industries
• Lose as a result of trade
• Resources specific to export industries
• Gain as a result of trade

64
 Skill as Source of Comparative Advantage
• Exports of the U.S.
• Not intensive in physical capital
• Intensive in human capital
• Skill intensive
• Countries with highly educated workers
• Exports concentrated in skill-intensive goods
• Countries with less educated workers
• Export goods that require little skilled labor

65
FIGURE 3.4 Education, skill intensity, and U.S. import
shares, 1998

The figure suggests that countries that are abundant in skilled labor capture larger shares of
U.S. imports in industries that intensively use those factors. Conversely, countries that are
abundant in unskilled labor capture larger shares of U.S. imports in industries that intensively
use those factors.
66
 Increasing Returns to Scale
• Increasing-returns trade theory
• Nations with similar factor endowments
• Negligible comparative-advantage differences
• May find it beneficial to trade
• Because they can take advantage of massive
economies of scale
• Produce that good in great quantity at low average
unit costs
• Trade those low-cost goods to other nations

67
FIGURE 3.5 Economies of scale as a basis for trade

By adding to the size of the domestic market, international trade permits longer production
runs by domestic firms, which can lead to greater efficiency and reductions in unit costs.

68
 External Economies of Scale
• The average cost of the typical firm decreases
• As the output of the industry within this area
increases
• Concentration of an industry’s firms in a
particular geographic
• Larger pools of a specialized type of worker
• New knowledge about production technology
spreads among firms in the area

69
 Intra-industry Trade
• Intra-industry specialization, trade
• Production of particular products or groups of
products within a given industry
• The opening up of trade does not generally
result in the elimination or wholesale
contraction of entire industries within a nation
• The range of products produced and sold by
each nation changes
• Emphasized by advanced industrial nations

70
 Intra-industry Trade
• Intra-industry specialization, trade
• Involves flows of goods with similar factor
requirements
• Conducted mostly among industrial countries
• Similar resource endowments
• Firms – oligopolies
• Trade in homogeneous goods
• Transportation costs
• Seasonal

71
 Intra-industry Trade
• Intra-industry specialization, trade
• Trade in differentiated products
• Unmet need
• Overlapping demand segments in trading nations
• Economies of scale
• Fewer adjustment problems

72
TABLE 3.7 Intra-industry trade examples: selected U.S. exports
and imports, 2007 (in millions of dollars)

73
 Technology: The Product Cycle Theory
• Technological innovations
• Different nations, at different rates of speed
• Result in:
• New methods of producing existing commodities
• Production of new commodities
• Commodity improvements
• Often transitory

74
 Technology: The Product Cycle Theory
• Product life cycle theory
• Predictable trade cycle:
1. Manufactured good is introduced to home
market
2. Domestic industry shows export strength.
3. Foreign production begins
4. Domestic industry loses competitive
advantage
5. Import competition begins
75
 Technology: The Product Cycle Theory
• International product cycle
• U.S. and Japanese radio manufacturers
• U.S. and Japanese pocket calculators
manufacturers

76
 Dynamic Comparative Advantage:
Industrial Policy
• Dynamic comparative advantage
• Comparative advantage in a particular industry
• Can be created
• Mobilization of skilled labor, technology, and capital
• Industrial policy
• Government is actively involved in creating
comparative advantage
• Strategy to revitalize, improve, and develop an
industry
77
 Dynamic Comparative Advantage:
Industrial Policy
• Industrial policy
• Tax incentives, R&D subsidies, loan guarantees,
low-interest-rate loans, trade protection
• Requires government to identify the “winners”
• And encourage resources to move into industries
with the highest growth prospects

78
 Government Subsidies Support
Boeing and Airbus
• Industrial policy
• Government subsidies – commercial jetliner
industry
• World’s manufacturers of commercial jetliners
• Oligopolistic market
• Dominated by
• Boeing of the United States
• Airbus Company of Europe

79
 Government Regulatory Policies
• Government regulations
• Workplace safety
• Occupational Safety and Health Administration
• Product safety
• Consumer Product Safety Commission
• Clean environment
• Environmental Protection Agency
• May improve the wellbeing of the public
• Can result in higher costs for domestic firms
80
TABLE 3.8 U.S. Steelmakers complain about regulatory burdens
Below are some examples of U.S. regulations affecting domestic steel producers:

•Health Care. U.S. steel companies spent more than $1.5 billion for health care in 2003 for
workers, retirees, and dependents. This adversely affects the competitiveness of U.S. steel
companies vis-à-vis foreign competitors, many of whose health care costs are borne by
government through general tax revenues.

•OSHA. The complexity and cost of compliance with Occupational Safety and Health
Administration (OSHA) regulations continue to increase. Many OSHA rules do not have a
sound scientific or medical basis and thus are impractical and cost ineffective.

•Electricity Policy. Electricity is a major component of steel-manufacturing costs, but it cannot

be purchased on a competitive basis as are other commodities.

•Global Climate Change. Efforts by the United States to achieve a seven percent decrease in
greenhouse gas emissions from 1990 levels by the year 2012, as dictated by the Kyoto
Protocol, could result in $5 billion in extra annual energy costs for U.S. steel companies.

•Clean Air. Proposed tighter standards for pollutants could place much of the United States—
including many steel industry sites—in nonattainment areas. The result would be enormous
new costs for steel, with no comparable requirements for U.S. trading partners.
81
FIGURE 3.6 Trade effects of governmental regulations

The imposition of government regulations (clean environment, workplace safety, product

safety) on U.S. steel companies leads to higher costs and a decrease in market supply. This
imposition detracts from the competitiveness of U.S. steel companies and reduces their share
of the U.S. steel market.

82
 Transportation Costs
• Transportation costs
• Costs of moving goods
• Freight charges
• Packing and handling expenses
• Insurance premiums
• An obstacle to trade
• Impede the realization of gains from trade
liberalization

83
 Transportation Costs
• Differences across countries in transport costs
• Source of comparative advantage
• Affect the volume and composition of trade
• Trade effects of transportation costs
• The high-cost importing country
• Produce more, consume less, and import less
• The low- cost exporting country
• Produce less, consume more, and export less

84
 FIGURE 3.7 Free trade under increasing-cost conditions

In the absence of transportation costs, free trade results in the equalization of prices of traded
goods, as well as resource prices, in the trading nations. With the introduction of transportation
costs, the low cost exporting nation produces less, consumes more, and exports less; the high
cost importing nation produces more, consumes less, and imports less. The degree of
specialization in production between the two nations decreases as do the gains from trade.
85
 Transportation Costs
• Transportation costs
• Reduce the volume of trade
• Reduce the degree of specialization in
production
• Reduce the gains from trade
• One possible reason for international wage
differential

86
 Transportation Costs
• Falling transportation costs since 1965
• Imports - more competitive in U.S. markets
• Higher volume of trade for U.S.
• Due to technological improvements
• Large dry-bulk containers
• Large scale tankers
• Containerization
• Wide-bodied jets
• Telecommunications

87
TABLE 3.9 Size of transportation costs, selected countries, 2007

88
 Transportation Costs
• Growing international trade
• Falling transportation costs
• Worldwide decrease in trade barriers
• Economic opening of nations that have
traditionally been minor players

89
 Transportation Costs
• Terrorist attack
• Added costs
• Slowdowns for U.S. freight system
• Security can become a new kind of trade
barrier

90