Foundations of Modern Trade Theory

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Chapter 2

• Foundations of Modern Trade Theory

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• Terms of trade ????
• Mercantilists ????
• Favorable trade balance ????
• Autarky ???????
• Basis for trade ????
• Complete specialization?????
• Constant opportunity costs ??????
• Exit barriers ????
• Free trade ????
• Gains from international trade??????
• Increasing opportunity costs ??????

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• Labor theory of value ?????
• Marginal rate of transformation(MRT)
• ?????
• Partial specialization ?????
• Price-specie-flow doctrine??????
• Principle of absolute advantage??????
• Principle of comparative advantage??????
• Production gains from specialization????????
• Production possibilities schedule ???????
• Trade triangle ?????
• Trading possibilities line ???????

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2.1.1 The mercantilists

• According to the mercantilists, if a country
  could achieve a favorable trade balance, it would
  enjoy payments received from the rest of the
  world in the form of gold and silver.
• To promote a favorable trade balance, the
  mercantilists advocated government regulation of
  trade.Tariffs, quotas,and other commercial
  policies were proposed by the mercantilists to
  minimize imports in order to protect a nations
  trade position.

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2.1.2 Why nations trade Absolute advantage

• Key words
• Productivities of factor inputs????????
• Acquired advantage????
• Labor theory of value ?????

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Adam Smith

• Adam Smith,a classical economist, was a leading
  advocate of free trade. He thought
• that the free trade promoted the international
  division of labor. With free trade, nations could
  concentrate their production on goods they could
  make most cheaply, with all the consequent
  benefits of the division of labor.

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Principle of absolute advantage

• In a two-nation, two-product world, international
  trade and specialization will be beneficial when
  one nation has an absolute cost advantage ( that
  is, uses less labor to produce a unit of output )
  in one good and the other nation has an absolute
  cost advantage in the other nation has an
  absolute cost advantage in the other good.For the
  world to benefit from international division of
  labor, each nation must have a good that it is
  absolutely more efficient in producing than its
  trading partner. A nation will import those goods
  in which it has an absolute cost disadvantageit
  will export those goods in which it has an
  absolute cost advantage.

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2.1.3 Why nations trade Comparative advantage

• Key words
• Deindustrialize ?????
• Comparative advantage in nothing????

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• Ricardos comparative-advantage principle,even if
  a nation has an absolute cost disadvantage in the
  production of both goods, a basis for mutually
  beneficial trade may still exist. The less
  efficient nation should specialize in and export
  the goods in which it is relatively less
  inefficient ( where its absolute disadvantage is
  least ). The more efficient nation should
  specialize in and export that goods in which it
  is relatively more efficient ( where its absolute
  advantage is greatest ).

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2.1.4 Comparative advantage in money

• We conclude that even though the United Kingdom
  is not as efficient as the United States in the
  production of wine ( or cloth), its lower wage
  rate ( in terms of dollars ) more than
  compensates for its inefficiency. At this wage
  rate, the U.K.average cost ( in dollars) of
  producing wine is less than the U.S. average
  cost. With perfectly competitive markets, the
  U.K. selling price is lower than the U.S. selling
  price, and the United Kingdom exports wine to the
  United States.

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2.2 Production possibilities schedules

• Key words
• Production possibilities scheule???????
• Transformation schedule ????
• Hypothetical???
• Slope??
• Marginal rate of transformation (MRT)?????

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• Recognizing the shortcomings of the labor theory
  of value, modern trade theory provides a more
  generalized theory of comparative advantage. It
  explains the theory using a production
  possibilities schedule, also called a
  transformation schedule .This schedule shows
  various alternative combinations of two goods
  that a nation can produce when all of its factor
  inputs ( land, labor,capital, entrepreneurship)
  are used in their most efficient manner. The
  production possibilities shedule thus illustrates
  the maximum output possibilities of a nation.
  Note that we are no longer assuming labor to be
  the only factor input, as Ricardo did.

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• 2?21.jpg(figure 2.1)

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2.3 Trading under constant-cost conditions

• Key words
• Trading under constant-cost conditions???????????
  ?
• Constant opportunity costs??????
• Pedagogical tool????
• Vice versa ???????
• Supplu schedule ????
• Autarky??????
• Production gain????
• Consumption alternatives????
• Terms of trade????

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2.3.1 Constant costs

• There are two reasons for constant costs.
• First, the factors of production are perfect
  substitutes for each other. Second, all units of
  a given factor are of the same quality.

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2.3.2 The basis for trade and direction of trade

• 2.jpg(figure 2.2)
• According to the principle of comparative
  advantage, this situation provides a basis for
  mutually favorable trade owing to the differences
  in the countries relative costs.

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2.3.3 Production gains from specialization

• The law of comparative advantage asserts that
  with trade each country will find it favorable to
  specialize in the production of the goods of its
  comparative advantage and will trade part of this
  for the goods of its comparative disadvantage.

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2.3.4 Consumption gains from trade

• Under constant-cost conditions, the slope of the
  production possibilities schedule defines the
  domestic rate of transformation, which
  represents the relative prices at which two
  commodities can be exchanged at home.

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2.3.5 Distributing the gains from trade

• The Untited States might trade at a terms of
  trade coinciding with its domestic rate of
  transformation, but at no terms of trade less
  favorable than that. The same reasoning also
  applies to Canada.
• The domestic transformation rates of the United
  States and Canada clearly represent the limits
  within which the international terms of trade
  must fall.

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2.3.6 Complete specialization

• See Figure 2.3.
• Accoring to the principle of comparative
  advantage, complete specialization occurs under
  constant opportunity costs. Because production
  costs do not change with the level of output, a
  nation does not lose its comparative advantage (
  or disadvantae) as it produces more ( or less )
  of a product.

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2.4 Productivity and comparative advantage2.4.1
Changing comparative advantageFigure 2-4.The
change in manufacturing productivity thus
results in a change in the direction of trade.
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2.4.2 U.S.Manufacturing productivity trends
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2.5 Trade restrictions

• The principle of comparative advantage under
  constant costs suggests that trading nations will
  achieve the greatest possible gains from trade
  when they completely specialize in the production
  of the commodities of their comparative
  advantage.
• One factor that limits specialization is the
  restrictions governments impose on the movement
  of commodities among nations. By reducing the
  overall volume of trade, trade restrictions tend
  to reduce the gains from trade.

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2.6 Trading under increasing cost conditions

• See figure 2.6.
• The preseding section illustrated the
  comparative-advantage principle under
  constant-cost conditions. But in the real world,
  a goods opportunity cost may increase as more of
  it is produced.
• The principle of comparative advantage must be
  illustrated in a slightly modified form.

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• 2.6.1 Increasing costs
• The marginal rate of transformation equals the (
  absolute) slope of the production possibilities
  schedule. Under increasing costs, a products
  supply schedule is upward sloping,suggesting that
  unit costs rise with the level of output. The
  vertical portion of the auto supply schedule
  corresponds to the endpoint of the production
  possibilities schedule of which all resources are
  devoted to auto production.

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• Increasing costs represent the usual case in the
  real world. In the overall economy, increasing
  costs may result when inputs are imperfect
  substitutes for each other. As auto production
  rises and wheat production falls in Figure 2.6,
  inputs that are less and less adaptable to autos
  are introduced into that line of production. To
  produce more autos requires more and more of such
  resources and thus an increasingly greater
  sacrifice of wheat.

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• 2.6.2 Increasing cost grading case
• See Figure 2.7.
• The process of specialization continues in both
  nations until (1) the relative cost of autos is
  identical in both nations and (2)U.S. exports of
  autos precisely equal Canadas imports of autos,
  and conversely for wheat.
• Assume that this situation occurs when the
  domestic rated of transformation ( domestic terms
  of trade) of both nations converge at the rate
  given by line tt. At this point of convergence,
  the United States produces at point B, which
  Canada produces at ppint B.Line tt becomes the
  international terms of-trade line for the U.S.
  and Canada it coincides with each nations
  domestic terms of trade. The international
  terms of trade are favorable to both nations
  since tt is steeper than t(us) and flatter than
• t (c).