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Trade Theory

Trade Theory. Why is trade mutually beneficial? Sources: Baumol, Blinder and Scarth 1988 Economics: Principles and Policy Dicken 1998 Global Shift: Transforming the World Economy. David Ricardo. 1772-1823 The Principles of Political Economy and Taxation (1817)

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Trade Theory

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  1. Trade Theory Why is trade mutually beneficial? Sources: Baumol, Blinder and Scarth 1988 Economics: Principles and Policy Dicken 1998 Global Shift: Transforming the World Economy

  2. David Ricardo • 1772-1823 • The Principles of Political Economy and Taxation (1817) • Law of Comparative Advantage

  3. Why trade? • Global resources are not equally distributed: oil, water, forests • Natural endowments are also uneven: climate, terrain • Labour quality varies from place to place: skills, productivity, and wages • Specialization permits greater output per unit of input

  4. A Fallacy • Nothing new is produced by trading therefore, if one party gains, the other must lose • Zero-sum game: one nation’s gain must be another nation’s loss • “Beggar thy neighbour,” Adam Smith’s term for mercantilist approach to trade policy

  5. International vs Intranational Trade • Why is international trade different? • Interprovincial trade takes place within a single sovereign territory, one nation’s government • Currency is the same in intranational trade • Labour and capital are relatively mobile within a nation and between regions

  6. Absolute advantage Output from 1 Person-year of Labour • Canada has an absolute advantage in wheat • Honduras has an absolute advantage in bananas • 50 years of labour are required in Canada to produce 500 kg of bananas • 10 years of labour are required in Honduras to produce 300 kg of wheat

  7. Absolute Advantage • It seems obvious that Canada and Honduras will both be better off if they specialize in wheat and bananas (respectively) and trade • Absolute advantage results from the difference in their factor endowments, mainly climate, soils, and geomorphology • But what if one country could produce both products more efficiently? Should they trade? • Yes!

  8. The Principle of Comparative Advantage • A country (or region) should specialize in producing and exporting those products in which it has a comparative, or relative cost, advantage compared with other countries and should import those goods in which it has a comparative disadvantage.

  9. Ricardo’s Famous Example of Comparative Advantage • England and Portugal are the classic examples • Labour is the only factor input • Cloth and wine are the only products

  10. The Arithmetic of Comparative Advantage 1 • In England, 10 kms of cloth or 1 bbl of wine • In Portugal, 12 kms of cloth or 6 bbls of wine • So Portugal is more efficient at making both products! • But it will pay for Portugal to specialize in wine and England to specialize in cloth…why?

  11. The Arithmetic of Comparative Advantage 2 • How much more efficient is Portugal than England? • in cloth, 12/10, 120% more efficient • in wine, 6/1, 600 percent more efficient • So Portugal has a comparative advantage in wine • It is much more efficient at wine making • And England has a comparative advantage in cloth • It is only slightly less efficient at cloth making

  12. Imagining Specialization • Imagine that Portugal switches one week of labour out of cloth and into wine, losing 12 kms of cloth and gaining 6 bbls of wine • And England switches two weeks of labour out of wine and into cloth, losing 2 bbls of wine and gains 20 kms of cloth

  13. Gains from Specialization • The world gains 8 kms of cloth and 4 bbls of wine from the same labour force!

  14. Opportunity Costs • In England, having an additional bbl of wine means doing without 10 kms of cloth. Therefore • The opportunity cost of 1 bbl of wine is 10/1 = 10 kms of cloth • In Portugal, the opportunity cost of 1 bbl of wine 12/6 = 2 kms of cloth • Measured in opportunity costs, wine is cheaper in Portugal • And cloth is cheaper in England

  15. Trade makes both nations better off.Thus: • England should specialize in producing cloth and export some of it • Portugal should specialize in producing wine and export some of it

  16. But all this assumes… • Factors of production are immobile • Transportation costs are zero • Technology is constant in both time and space • Perfect competition of classical trade theory denies economies of scale

  17. However, • Capital and labour are mobile to some degree • Transportation costs are vital in many industries e.g. concrete blocks • Technology spreads unevenly • Economies of scale are real

  18. The plot thickens… • Specialization efficiencies are enhanced by economies of scale • But the gains to specialization begin to decline as the resources switched from one product to another are not perfect substitutes or infinitely transferable • Actual prices and quantities traded depend on supply and demand

  19. So what does all this mean for regions? • Heckscher-Ohlin Theory (1933) • Factor endowments vary from region to region • A country (region) should export those goods which use intensively the factors of production with which it is best endowed and import those goods which require factors of production with which it is poorly endowed.

  20. In light of the H-O Theory, let’s speculate on Canada’s trade structure. What are your hypotheses? • What is our balance of trade in livestock? • What is our balance of trade in agricultural produce and crude resource products? • What is our balance of trade in intermediate goods? • What is our balance of trade in manufactured goods for final sale to consumers?

  21. Canada’s International Trade Balance, 2001($ 000,000) Source: Statistics Canada 2003, Cansim II Table 228

  22. Canada’s International Trade Balance, 2001($ 000,000) Source: Statistics Canada 2003, Cansim II Table 228

  23. Canada’s International Trade Balance, 2001($ 000,000) Source: Statistics Canada 2003, Cansim II Table 228

  24. Implications • These lessons were an integral part of an age of nineteenth century liberalism. • Corn Laws 1815 to protect large landowners, repealed 1846 by urban industrial interests • Yet Protectionism in Canada from National Policy of 1879 until 1989 (?) • Neoliberalism: a new doctrine based in part on Ricardian concept of Comparative Advantage

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