International trade - theory and challenges

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International trade - theory and challenges
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The conventional economics view

• Every individual seeks the most advantageous
  employment for his capital.
• Study of his own advantage necessarily leads him
  to prefer that employment most advantageous to
  society - Adam Smith, 1776

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• Models from economics generally assume that if
  everyone pursues self-interest, things will work
  out for good
• May assume adherence to some straightforward
  ethical principles

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Overview of Trade Theory

• Free Trade occurs when a government does not
  attempt to influence, through tariffs, quotas, or
  other means,
• what citizens can buy from other countries or
• produce and sell to other countries
• The Benefits of Trade allow countries to be
  richer by specializing in products they can
  produce most efficiently

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Trade Theory-Overview

• The history of government involvement in trade
  presents mixed evidence
• There are lots of problems with trade
• There may be some ways that some governments can
  make things better by intervening (that is, by
  not practicing free trade)
• But government intervening in free trade is
  definitely dangerous
• Restrictions on trade have
• kept some countries very poor
• contributed to huge depressions

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Mercantilism Mid-16th Century

• Till the 16th century, philosophers didnt
  theorize much about trade
• Then mercantilists sought what we now call
  development, teaching that a nations wealth
  depends on accumulated treasure
• Gold and silver are the currency of trade
• Mercantilists argued their countries should run a
  trade surplus
• Maximize export through subsidies
• Minimize imports through tariffs and quotas
• Flaw zero-sum game
• Mercantilists neglected to see the benefits of
  trade

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Theory of Absolute Advantage

• Adam Smith argued (Wealth of Nations, 1776)
  Capability of one country to produce more of a
  product with the same amount of input can vary
• A country should produce only goods where it is
  most efficient, and trade for those goods where
  it is not efficient
• Trade between countries can, therefore, benefit
  both sides
• Example Portugal/wine vs. England/wool
• Ghana/cocoa vs.South Korea/rice

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Absolute Advantage and the Gains From Trade
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Theory of Absolute Advantage
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There may also be long-term benefits to free
trade

• As people specialize and seek higher incomes,
  they may learn to do their specialties better

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Comparative Advantage

• Suppose one country is more efficient than
  another in everything?
• There are still global gains to be made if a
  country specializes in products it produces
  relatively more efficiently than other products

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• David Ricardo (Principles of Political Economy,
  1817)
• A country should import products for which it is
  relatively inefficient even if the country is
  more efficient in the products production than
  country from which it is buying
• Trade is a positive-sum game

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Comparative Advantage and the Gains From Trade
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Theory of Comparative Advantage
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• Countries have comparative advantage in goods for
  which the opportunity cost of production is
  relatively low
• That is, those that can be produced by giving up
  relatively little in production of other goods

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• This means your country has comparative
  advantage in the product or service where the
  ratio Resources required in your country .
  Resources required in the other country
• is low

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How Comparative Advantage works
Ghana has absolute advantage in both cocoa and
rice, but its comparative advantage is in cocoa.
Korea has comparative advantage in rice .
Cocoa
20 tons
Let Korea specialize in rice Ghana expands
cocoa production to replace all Korean cocoa
production lost
15 tons
Ghana
Then Ghana can replace all Korean cocoa
production and the countries have more of both
goods.
5 tons
Korea
15 tons
10 tons
3.75 tons
Rice
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The country less efficient in everything will be
poor

• But it would be even poorer if it did not trade

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Assumptions

• This is a very simple case, but the basic
  conclusions are generally valid and are used in
  setting international policy
• Were assuming no transportation costs
• Were simplifying by not talking about currencies
  
• Were assuming constant returns to scale
• Were assuming resources can move freely from
  production of one good to another
• Were not thinking about effects on income
  distribution

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• Under free trade, the country that is less
  efficient will have low wages
• It will be able to sell the products where it has
  comparative advantage without any special tariff
  or subsidy protection
• But it may need to work on infrastructure,
  institutions, and education for trade
• China, India both sell cheap manufactured goods
• China sells more because it has better
  transportation infrastructure and government
  that supports manufactured exports

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Simple Ways to make the Comparative Advantage
Model more realistic

• Immobile resources
• Resources do not always move easily from one
  economic activity to another
• So some rice farms will persist in Ghana no
  matter what
• (Rice farmers will be losers as cheap rice comes
  from Korea)
• Diminishing returns
• Diminishing returns to specialization suggests
  that after some point, the more units of a good
  the country produces, the greater the additional
  resources required to produce an additional item

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Production Possibility Frontier Under
Diminishing Returns
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Because their theory showed big gains from trade,
Smith Ricardo advocated free trade

• They believed that if people were left to trade
  on their own, they would naturally trade the
  goods in which their countries had comparative
  advantage
• Every individual seeks the most advantageous
  employment for his capital.
• Study of his own advantage necessarily leads him
  to prefer that employment most advantageous to
  society - Adam Smith, 1776

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• They didnt advocate that government ensure that
  the right kind of trade take place
• They believed that if governments put no barriers
  in place, businesspeople would make theright
  kind of trades because it would be in their
  economic interest.

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Additional Simple Extensions of the Comparative
Advantage Model

• Free trade (open economies)
• Free trade might increase a countrys stock of
  resources (as labor and capital arrives from
  abroad)
• Increase the efficiency of resource utilization
  inside each country as well as between them

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Influence of Free Trade on PPF
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Paradox US exported labor-intensive goods when
it had lots of capital

• The U.S. seems to be good at inventing new
  products
• The important factors may be highly specialized
• Software design engineers
• Or the U.S. may have a unique constellation of
  factors that produces new products
• Production of the new products tends to be labor
  intensive at first
• The U.S. imports older, heavy industrial products

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When Intervention May Help

• Infant industry
• Oldest argument for protection - Alexander
  Hamilton, 1792
• Hamilton said that US textile machinery
  industries were infants
• They needed protection to give them time to learn
  to be competitive
• If given time, they would learn to compete
• WTO rules allow countries to protect infant
  industries

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Infant industry protection is only good if it
helps the industry become efficient

• Japanese automakers were protected with infant
  industry tariffs for 20 years, became world
  leaders
• Brazil automakers worlds 10th largest auto
  industry wilted when protection eliminated

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New Trade Theory (developed 1970s after)

• In industries with high fixed costs
• Specialization increases output,
• The ability to achieve economies of scale
  increases through exporting
• Learning effects are high.
• These cost savings come from learning by doing

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New Trade Theory-Applications

• In many industries, world demand will support few
  competitors
• Successful firms may emerge because of
  First-mover advantage
• Economies of scale may preclude new entrants
• Role of the government becomes significant
• Some argue that it generates a need for
  government intervention and strategic trade
  policy

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When Intervention May Help

• Strategic trade policy
• Government should use subsidies to protect
  promising firms in newly emerging industries with
  substantial scale economies
• Governments may benefit if they support domestic
  firms to overcome barriers to entry created by
  existing foreign firms
• Airbus in Europe
• Didnt work for U.S. in flat panel displays

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Development of the World Trading System

• Intellectual arguments for free trade
• Adam Smith and David Ricardo 1776-1820s
• Free trade emerged gradually as government policy
  in Britain, the leading nation in the 19th
  century
• Repeal of the Corn Laws (1846) allowed free trade
  in food
• Leading European nations maintained free trade
  through late 19th Century to WW I

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Development of the World Trading System

• Great Depression
• US stock market collapse (1929)
• Partial recovery
• Congress adopted the Smoot-Hawley tariff (1930)
• Almost every industry had its made to order
  tariff
• Foreign response was to impose own barriers
• Everyones exports tumbled
• Depression continued almost till World War II

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Development of the World Trading System

• No one wanted to repeat the mistakes of the 1930s
• General Agreement on Tariffs and Trade (GATT) -
  multilateral agreement established in 1948 under
  US leadership
• Big conference at Bretton Woods, NH, during WW II
• Objective was to liberalize trade by eliminating
  tariffs, subsidies, and import quotas
• 19 original members grew to 120

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Development of the World Trading System

• GATT used rounds of talks to gradually reduce
  trade barriers
• Mutual tariff reductions negotiated
• Dispute resolution only if complaints were
  received
• Uruguay Round GATT 1986-93

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The World Trade Organization

• The WTO was created (1995) during the Uruguay
  Round of GATT to police and enforce GATT rules
• Most comprehensive trade agreement in history
• Formation of WTO had an impact on
• Agriculture subsidies (stumbling block US/EU)
• Applying GATT rules to services and intellectual
  property
• Strengthening of monitoring and enforcement

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