International Trade (AgEc442) Handout - Haramya University PDF

HARAMAYA UNIVERSITY COLLEGE OF AGRICULTURE AND ENVIRONMENTAL SCIENCES SCHOOL OF AGRICULTURAL ECONOMICS AND AGRIBUSINESS A Guiding Handout for the Course International Trade (AgEc442) February, 2013  UNIT ONE: CONCEPTS OF INTERNATIONAL TRADE...

HARAMAYA UNIVERSITY COLLEGE OF AGRICULTURE AND ENVIRONMENTAL SCIENCES SCHOOL OF AGRICULTURAL ECONOMICS AND AGRIBUSINESS A Guiding Handout for the Course International Trade (AgEc442) February, 2013  UNIT ONE: CONCEPTS OF INTERNATIONAL TRADE 1.1Definition of International Trade International trade deals with business transactions between citizens of different nations and with considerations of commercial diplomacy which usually springs from it. Specifically, the subject, international trade deals with the pure theory of trade, the theory of commercial policy, foreign exchange markets and the balance of payments, and adjustment in the balance of payments. The pure theory of trade analyzes the basis for and the gains from trade. The theory of commercial policy examines the reasons for and the effects of trade restrictions. Foreign exchange markets are the framework for the exchange of one national currency for another, while the balance of payments measures a nation's total receipts from the total payments to the rest of the world. Finally, adjustment in the balance of payments is concerned with the mechanisms for correcting balance-of payments disequilibria (i.e., deficits and surpluses) under different international monetary systems and their effect on a nation's welfare. The pure theory of trade and the theory of commercial policies are the microeconomic aspects of, international economics because they deal with individual nations treated as single units and with the (relative) price of individual commodities. On the other hand, since the balance of payments deals with total receipts and payments while adjustment policies affect the level of national income and the general price index, they represent the macroeconomic aspects of international economics. 1.2 Features of Inter-regional and International Trade Inter-regional trade refers to trade between regions within a country. Thus inter-regional trade is domestic or internal trade. International trade, on the other hand, is trade between two nations or countries. 1.3 Difference between Inter-Regional and International Trade Factor Immobility: factors of production are freely mobile within each region as between places and occupations and immobile between countries entering into international trade. 1 Differences in Natural Resources: Different countries are endowed with different types of natural resources. Hence they tend to specialize in production of those commodities in which they are richly endowed and trade them with others where such resources are scarce. Those countries can trade each other's commodities on the bases of comparative cost differences in the production of different commodities. Geographical and Climatic Differences: Every country can’t produce all the commodities due to geographical and climatic conditions, except at possibly prohibitive costs. Different Markets: International markets are separated by difference in languages, usages, habits, tastes, fashions etc. Even the systems of weights and measures and pattern and styles in machinery and equipment differ from country to country. Mobility of Goods: The mobility of goods within a country is restricted by only geographical distances and transportation costs. But there are many tariff and non tariff barrier on movement of goods between countries. Difference currencies: The principal differences between inter-regional and international trade lies in use of different currencies in foreign trade, but the same currency in domestic trade. Problem of Balance of Payments: The problem of balance of payments is perpetual in internationa1 trade while regions within a country have no such problem. This is because there is greater mobility of capital within regions than between countries. Different Transport Costs: Trade between countries’ involves high transport costs as against inter-regionally within a country because of geographical distances between different countries. Different Economic Environment: Countries differ in their economic environment which affects their trade relations. The legal framework, institutional set-up, monetary, fiscal and commercial policies, factor endowments, production techniques, nature of products, etc. differ between countries. 2 Different National Policies: Another difference between inter-regional and international trade arises from the fact that policies relating to commerce, trade, taxation, etc. are the same within a country but differ from one country to another. 1.4 Reasons for international trade and its significance In general, the immediate cause for trade among nations is difference in the prices of goods and services among nations. Nations differ in resource endowments, the level of technology and technical skills or know how. Moreover, nature has distributed resources unevenly in the world which makes production of some goods in some countries impossible. Thus, international trade has enabled the world nation to consume those goods and services which they themselves could not produce. UNIT TWO: CLASSICAL AND NEO-CLASSICAL THEORIES OF INTERNATIONAL TRADE 2.1 The Mercantilists Trade Theory Mercantilism is economic nationalism which was advocated in the 16th century for the purpose of building a wealthy and powerful state. Adam Smith in his book “The Wealth of Nations” coined the term "mercantile system" to describe the system of political economy that sought to enrich the country by restraining imports and encouraging exports. In other words, the mercantilists maintained that the way for a nation to become rich and powerful was to export more than it imported. In any event, mercantilists advocated strict government control of all economic activity and preached economic nationalism because they believed that a nation could gain in trade only at the expense of other nations. Adam Smith led an eloquent and vigorous attack upon mercantilist theories of international trade in his book “Wealth of Nations” published in 1776. Smith argued that it was absurd to manufacture a commodity in a country at a great expense if a similar commodity could be supplied from foreign countries at a lower cost. He, thus, opposed the imposition of tariffs on the goods imported from other countries, and recommended that trade among different countries 3 should be free and be based on 'territorial division of labor'. He advocated, the doctrines of laissez-faire, or free markets, interpreted as economic welfare in a far wider sense of encompassing the entire population. 2.2 Theory of Absolute Advantage Adam smith (1723-1790) provided the basic building blocks for the construction of the classical theory of international trade. He enunciated the theory in terms of what is called Absolute Advantage model. Adam Smith viewed that for two nations to trade with each other voluntarily, both nations must gain. If one nation gained nothing or lost, it would simply refuse to trade. According to Adam Smith, trade between two nations is based on absolute advantage. When one nation is more efficient than (or has an absolute advantage over) another in the production of one commodity but is less efficient than (or has an absolute disadvantage with respect to) the other nation in producing a second commodity, then both nations through trade can gain by each specializing in the production of the commodity of its absolute advantage and exchanging part of its output with the other nation for the commodity of its absolute disadvantage. 2.2.1 Assumptions of the theory of absolute advantage a) Labor is the only factor of production and is homogenous, b) Labor was completely free to move within a single country, yet it was entirely immobile internationally. If labor were free to move between nations, then differences in wage rates and hence commodity prices could be equalized via labor migration, and there would be no need for international trade, c) Both countries can produce both commodities, d) No transportation costs were involved in trade e) There existed no other barriers, such as tariffs and quotas, to trade between countries. f) Constant returns to scale, 2.2.2 Illustration of absolute advantage Imagine a hypothetical world composed of only two countries, country A and country B. Both countries produce significant quantities of wheat and oil for domestic consumption, and there are absolutely no trade relations, factor movements, or other economic ties between them; i.e., each is taken to be operating in a state of isolation (autarky). Assume for the moment also that the 4 entire value of the two commodities is the amount of labor used in their production. Now suppose, further, that one man-hour of labor can produce the following quantities of wheat and oil in the two respective countries: Table 2.1: Absolute advantage Output of one Man-hour Country A Country B Commodity Wheat (Quintals) 5 10 Oil (barrels) 10 5 Table 2.1 and Figure 2.1 reveals that country A could produce 10 barrel of oil and no wheat, 5 quintal of wheat and no oil, or some combination of wheat and oil between these two extremes with one man hour of labor. The different combinations that country A could produce are represented by the line GG’ in the Figure 2.1 below. This is referred to as country A’s production possibility frontier. Fig 2.1 The Theory of Absolute Advantage Similarly, country B could produce 5 barrel of oil and no rice, 10 quintal of wheat and no oil, or some combination between these two extremes. The different combinations wheat and oil available to country B represented by the line KK’ in the figure, which is country B’s production possibility frontier. In this case, a quintal of wheat in country A has twice the value of a barrel of oil and a barrel of oil in country B has twice the value of a quintal of wheat. Apparently, country A has an absolute advantage in the production of oil (10 barrel is greater than 5 barrel), and country B has an absolute advantage in the production of wheat (10 quintal is greater than 5 quintal). 5 To see the benefit from an international trade, it is better to begin from autarky. As table 2.2 shows the combination of both goods produced and consumed by each country before trade. Table 2.2: Pre trade production and consumption Commodity Country A Country B World Wheat (Quintals) 5 10 15 Oil (barrels) 10 5 15 When both countries produce wheat and oil for domestic consumption, and absolutely no trade relations exist between two countries, the world production would be 15 quintals of wheat and 15 barrels of oil. If the two countries opened their economy, the direction that trade would take can be immediately determined. Therefore, country A would export oil to country B, in return for which country B would export wheat to country A. In this case there is a scope for complete specialization in production in both countries. The effect of opening trade between the two countries is shown in the following table. The table below reveals that before trade both countries produce only 15 units each of the two commodities by applying one labor-unit on each commodity. If A were to specialize in producing in oil production and use both units of labor on it, its total production will be 20 units of oil. Similarly, if B were to specialize in the production of wheat alone, its total production will be 20 units of wheat. The combined gain to both countries from trade will be 5 units of oil and 5 unit of wheat for country A and B, respectively. Table 2.2: production after specialization and gain from trade Production Production Gain from trade before trade After trade Commodity Country Country Country Country Country Country A B A B A B Wheat (Quintals) 5 10 - 20 -5 +10 Oil (barrels) 10 5 20 - +10 -5 As a result of trade, the total production of the two countries went up. This means that both countries become richer or have become better off in terms of production, after trade as compared to before trade, without making any country worse off. 6  2.2.3 Criticism on theory of absolute advantage Smith has been criticized for his vagueness and lack of clarity. Accordingly, Smith assumes without argument that international trade requires an exporting country to have superiority with a given amount of capital and labor to produce a larger output than any rival. But this basis of trade is not realistic because there are many underdeveloped countries which do not possess absolute advantage in the production of any commodity, and yet they have trade relations with other countries. Thus, Smith's analysis is weak and unrealistic. 2.3 Theory of Comparative Advantage Like Adam Smith, David Ricardo emphasized the supply side of the market. The immediate basis for trade stemmed from cost differences between nations, which were underlined by their natural and acquired advantages. Unlike Adam Smith, who emphasized the importance of absolute cost differences among nations, David Ricardo emphasized comparative cost differences. Comparative Advantage is a situation in which one country specialize in producing the goods it produces most efficiently and buys the products it produces less efficiently from other countries, even if it could produce the goods more efficiently itself. 2.3.1 Assumptions of the theory of comparative advantage  The world consists of two nations, each using a single input to produce two commodities.  In each nation, labor is the only input. Each nation has a fixed endowment of labor, which is fully employed and homogeneous.  Labor is completely free to move within a single country among industries, yet is entirely immobile internationally.  Nations may use different technologies, but all firms within each nation utilize a common production method or technology for each commodity.  Costs do not vary with in the level of production and are proportional to the amount of labor used.  There are similar test between countries.  Perfect competition prevails in all markets. Because it is assumes that no single producer or consumer is large enough to influence the market, all are price takers. Product quality does not vary among nations, implying that all units of each product are identical. There is free entry to and exit from an industry, and the price of each product equals the products of marginal costs of production.  Free trade occurs between nations (i.e.; no government barriers to trade exist).  Transaction costs are zero. Consumers will thus be indifferent between domestically produced and imported versions of a product if the domestic prices of the two products 7  are identical.  Firms make production decisions in an attempt to maximize profits, where as consumers maximize satisfaction through their consumption decisions.  Trade is balanced; exports must pay for imports, thus ruling out flows of money between nations. 2.3.2 Illustration of comparative advantage In his example Ricardo imagined two countries, England and Portugal, producing two goods, cloth and wine, using labor as the sole input in production. Instead of assuming, as Adam Smith did, that England is more productive in producing one good and Portugal is more productive in the other; Ricardo assumed that Portugal was more productive in both goods. Based on Smith's intuition, then, it would seem that trade could not be advantageous, at least for England. Ricardo showed that the specialization good in each country should be that good in which the country had a comparative advantage in production. In order to identify a country's comparative advantage, it requires a comparison of production costs across countries. However, one does not compare the monetary costs or even the resource costs (labor needed per unit of output) of production. Instead one must compare the opportunity costs of producing goods across countries. This is illustrated in terms of Ricardo’s well known example of trade between England and Portugal as shown in Table 2.3. Table 2.3: Ricardo’s comparative cost Country Wine Cloth England 120 100 Portugal 80 90 The table shows that the production of a unit of wine in England requires 120 men for a year while a unit of cloth requires 100 men for the same period. On the other hand, the production of the same quantities of wine and cloth in Portugal requires 80 and 90 men respectively. Thus, England uses more labor than Portugal in producing both wine and cloth. In other words, the Portuguese labor is more efficient than the English labor in producing both the products. So Portugal possesses an absolute advantage in both wine and cloth. However, Portugal would benefit more by producing wine and exporting it to England because it possesses greater comparative advantage in it. This is because the cost of production of wine (80/120 men) is less than the cost of production of cloth (90/100 men). 8  Fig 2.2 Theory of Comparative Advantage On the other hand, it is in England’s interest to specialize in the production of cloth in which it has the least comparative disadvantage. This is because the cost of cloth production in England in less (100/90 men) as compared with wine (120/80 men). Thus, trade is beneficial for both the countries. The comparative advantage position of both is illustrated in Fig. 2.2 in terms of production possibility curves. PL is the production possibility curve of Portugal, and EG that of England. Portugal enjoys an absolute advantage in the production of both wine and cloth over England. It produces OL of wine and OP of cloth, as against OG of wine and OE of cloth produced by England. But the slope of ER (parallel to PL) reveals that Portugal has a greater comparative advantage in the production of wine because if it gives up the resources required to produce OE of cloth, it can produce OR of wine which is greater than OG of wine of England. On the other hand, England had the least comparative disadvantage in the production of OE of cloth. Thus, Portugal will export OR of wine to England in exchange for OE of cloth from her. 2.3.3 Gains from Trade and Their Distribution The opportunity for gain can be seen immediately by comparing the real exchange ratios that will prevail in each country in the absence of international trade. In Portugal, in isolation 1 unit of cloth will exchange for 1.13 barrels of wine Table 2.4 Exchange rate before trade England Portugal Wine 120 : 100 Cloth (1 : 1.2) Wine 80 : 90 Cloth (1 : 0.89) Cloth 100 : 120 Wine (1 : 0.83) Cloth 90 : 80 Wine (1 : 1.13) Suppose now, as Ricardo did, that both countries are offered the chance to trade at the barter 9 exchange ratio 1 cloth for 1 wine. Portugal will find such trade an attractive way to acquire cloth. Instead of giving up 1.13 barrels of wine to obtain 1 cloth, it need give up only 1 barrel of wine. It saves 0.13 barrel of wine on each unit of cloth acquired. Consequently, Portugal will specialize in wine production, and obtain its cloth from England through trade. Similarly, England will benefit because for one cloth it can obtain a barrel of wine, instead of only 0.89 of a barrel as in direct production. It will specialize in cloth, obtaining wine from Portugal through trade at less cost than it can be produced at home. Thus Ricardo showed that both countries gain, even though Portugal enjoys an absolute advantage in both commodities. The gains from trade and their distribution are also shown in Figure 2.3 where the line C1W2 depicts the domestic exchange ratio 1 unit of cloth = 0.83 unit of wine of England, and the line WI C2 that of Portugal at the domestic exchange ratio 1 unit of wine = 0.89 unit of cloth. The line C1 W1 shows the exchange rate of trade of 1 unit of cloth = 1 unit of wine between the two countries. At this exchange rate, England gains W2W1 (0.17 unit) of wine, while Portugal gains C2C1 (0.11 unit) of cloth. Fig 2.3. Theory of comparative advantage At this point, you may ask, “How did Ricardo know that the barter terms of trade between Portugal and England would be 1C: 1W?” The answer is that he did not know precisely what that rate would be. All he knew was that the international exchange ratio had to lie somewhere in be- tween the two domestic ratios, that is, Portugal 1C : 1.13W England 1C : 0.83W Any ratio between these two limits will permit both countries to gain from trade. Ricardo chose the ratio 1C: 1W because it was a convenient one to use in making his point. He did not discuss the forces that would determine the exact ratio that would exist in the market. He simply said that 10 the two countries would gain from trade so long as England concentrated on the production of cloth and Portugal on the production of wine. Ricardo did not give a name to the principle, but it has long been known as the law of comparative costs. 2.3.4 Criticisms on the comparative cost advantage theory  The most severe criticism of the comparative advantage doctrine is that it is based on the labor theory of value. Under the labor theory of value, the value or price of a commodity depends exclusively on the amount of labor time going into the production of the commodity. Since neither of these assumptions is true, the labor theory of value must be rejected.  Labor is also not used in the same fixed proportion in the production of all commodities.  Ricardo ignores transport costs in determining comparative advantage in trade. This is highly unrealistic because transport costs play an important role in determining the pattern of world trade.  The assumption that factors of production are perfectly mobile internally and wholly immobile internationally. This is not realistic because even within a country factors do not move freely from one industry to another or from one region to another.  The Ricardian model is related to trade between two countries on the basis of two commodities.  Another serious weakness of the doctrine is that it assumes perfect and free world trade. But, in reality, world trade is not free.  The theory of comparative advantage is based on the assumption of full employment. This assumption also makes the theory static and unrealistic.  The theory neglects the role of technological innovations in international trade.  The Ricardian theory is one-sided because it considers only the supply side of international trade and neglects the demand side.  Complete specialization will be impossible on the basis of comparative advantage in producing commodities entering into international trade.  The classical conclusion of complete specialization between two countries can hold ground only... by assuming trade between two countries of approximately equal economic performance.  The theory simply explains how two countries gain from international trade. But it fails to show how the gains, from trade are distributed between countries. 2.4 Comparative Advantage and Opportunity Costs Opportunity Costs and The production possibility curve By rejecting the labor theory of value, we must also reject Ricardo’s explanation of comparative advantage, but not the law of comparative advantage itself. The law of comparative advantage can be explained on the basis of the opportunity cost theory. 11 According to the opportunity cost theory, the cost of a commodity is the amount of a second commodity that must be given up to release just enough resources to produce one additional unit of the first commodity. Consequently, the nation with the lower opportunity cost in the production of a commodity has a comparative advantage in that commodity (and a comparative disadvantage in the second commodity). For example, based on Table 2.4, if in the absence of trade the Portugal must give up 0.89 unit of cloth to release just enough resources to produce one additional unit of wine domestically, then the opportunity cost of wine is 0.89 unit of cloth (i.e., 1W = 0.89C in the Portugal). If lW = 1.2C in England, then the opportunity cost of wine (in terms of the amount of cloth that must be given up) is lower in the Portugal than in England. Therefore, it can be said that Portugal would have a comparative (cost) advantage over England in wine production. In a two-nation, two commodity world, England would then have a comparative advantage in cloth. 2.4.1 Incomplete Specialization There is one basic difference between trade model under increasing and the constant opportunity costs case. Under constant costs, both nations specialize completely in production of the commodity of their comparative advantage. However, under increasing opportunity costs, there is incomplete specialization in production in both nations. The reason for this is that as country I specializes in the production of X, it incurs increasing opportunity costs in producing X. Similarly, as country II produces more Y, it incurs increasing opportunity costs in Y (which means declining opportunity costs of X). Thus, as each nation specializes in production of the commodity of its comparative advantage, relative commodity prices move toward each other until they are identical in both nations. This occurs before either nation has completely specialized in production. 2.4.2 The Gains from Exchange and Specialization A country’s gains from trade can be broken down into two components: the gains from exchange and the gains from specialization. Suppose that, for whatever reason, country I could not specialize in the production of X with the opening of trade but continued to produce at point A. Starting from point A, country I could export 20X in exchange for 20Y at the prevailing world relative price of Pw = 1, and end up consuming at point T on indifference curve II. Even though country I consumes less of X and more of Y at point T in relation to point A, it is better off than it was in autarky because T is on higher indifference curve II. The movement from point A to point T in consumption measures the gains from exchange. 12 Figure 2.4. Gains from Exchange and Specialization If subsequently country I also specialized in the production of X and produced at point B, it could then exchange 60X for 60Y with the rest of the world and consume at point E on indifference curve III. The movement from T, to E in consumption measures the gains from specialization in production. Note that country I is not in equilibrium in production at point A with trade because PA