Trade theory

Theories of International Trade AG BM 338 Agribusiness in the Global Economy

LEARNING OBJECTIVES
After today’s class, you should be able to :
Understand classical theories of international trade
Understand modern theories of international trade
Draw implications for action

Trade Balance
trade deficit - An economic condition in which a nation imports more than it exports
trade surplus - An economic condition
in which a nation exports more than it imports
balance of trade - The aggregation of buying (importing) and selling (exporting) by both sides leads to the country-level trade surplus or deficit.

Trade Theories
classical trade theories - major theories typically studied consist of mercantilism, absolute advantage, and comparative advantage
modern trade theories - major theories typically studied consist of product life cycle, strategic trade, and national competitive advantage

The Age of Mercantilism
Between 1600 and 1800 most of Western Europe pursued a policy of mercantilism
What was mercantilism?
Belief that exports should exceed imports
Bullionism – the belief that the economic health of a nation was measured by the amount of precious metals (gold and silver) it possessed
Colonialism – colonies were viewed as sources of raw materials
Heavy government control of trade, with the goals of trade being the goals of governments

Absolute Advantage
Producing a good with fewer inputs (capital, labor, land, raw materials, etc.) per unit of output than other countries
If input prices are the same in two countries, the country with an absolute advantage in a good will have a lower unit cost of production for that good
Adam Smith, The Wealth of Nations , 1776
A country should produce and export products in which it has an absolute advantage
A country should import products in which it has an absolute disadvantage

Absolute Advantage: Problems
What about a country (like the U.S.) that has an absolute advantage in most products?
How can it possibly produce enough of everything to satisfy the whole world?
As production increased, competition for scarce inputs would drive up production costs, taking away many absolute advantages
What about a country (like Nepal) that has an absolute disadvantage in nearly all products?
Why should its resources sit around unused?
As production fell, prices of inputs would fall, lowering production costs and creating some absolute advantages

Comparative Advantage
Producing a good at a lower opportunity cost than another country
Inputs used in the production of one good aren’t available for the production of other goods
When a country produces a good, what does it give up in foregone production of other goods?
David Ricardo, The Principles of Political Economy and Taxation , 1817
A country should produce and export products in which it has a comparative advantage
A country should import products in which it has an comparative disadvantage

Opportunity Cost
opportunity cost - the cost of pursuing one activity in terms of the foregone return on the next-best alternative activity
Examples
The opportunity cost of going to college is what you could have earned working full-time instead
The opportunity cost of using a plant to manufacture one product is what the company could have earned manufacturing another product at the plant instead

Numerical Example
One input (labor)
Two goods (corn, timber)
Two countries (A, B)
Which country has an absolute advantage in
Corn production?
Timber production?
Which country has a comparative advantage in
Corn production?
Timber production?

More on Comparative Advantage
Even a country at an absolute disadvantage in everything will have a comparative advantage in something
Each country specializes in the production and export of what it does relatively well
Prices of goods and inputs in a free-market economy will adjust in order to lead to this outcome

More on Comparative Advantage
Countries rely on imports to meet consumer demands for goods in which they don’t have a comparative advantage
A country can achieve consumption levels beyond what it could achieve on its own
Government policy can alter free-market outcomes (import tariffs, import quotas, export subsidies, etc.)

Some Definitions
factor endowments - extent to which different countries possess various factors, such as labor, land, and technology
resource mobility - assumption that a resource
removed from one industry can be moved to another

Factor Proportions (Heckscher-Ohlin) Trade Theory
A country that is relatively abundant in a factor of production should export goods that use a lot of that factor in the production process, and import other goods
Example: a country like China with a lot of labor should export labor-intensive goods
Why? If a factor is relatively abundant, it will be relatively cheap, and a country will be more globally competitive in products that use a lot of that factor

Modern Trade Theories
product life cycle theory - economic theory that accounts for changes in the patterns of trade over time
strategic trade theory - theory that suggests that
strategic intervention by governments in certain industries can enhance their odds for international success
first-mover advantages - Advantages that first entrants enjoy and do not share with late entrants
strategic trade policy - Economic policies that provide companies a strategic advantage through government
subsidies

Modern Trade Theories
Theory of national competitive advantage of industries (or diamond theory )
The theory that the competitive advantage of certain industries in different nations depends on four aspects that form a “diamond”
Competitive advantage is created by technological and institutional change, not just inherited from a country’s natural endowments

IN-CLASS EXERCISE
In groups of 3-5 people…
Come up with three examples of imported foods eaten by people in your group
Are there alternatives sources for these foods – either domestically produced or from different countries than the ones you purchase from?
If so, what factors influence your purchase decisions?
Present your findings to the class

Trade theory

by Mohit Kumar on Feb 25, 2011

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Trade theory — Presentation Transcript