International Trade Course Module PDF

UNIVERSITY OF LUSAKA FACULTY OF ECONOMICS, BUSINESS & MANAGEMENT UNDERGRADUATE PROGRAM INTERNATIONAL TRADE ECF330/BF310 COURSE MODULE  TABLE OF CONTENTS UNIT 1: INTERNATIONAL TRADE THEORY......................................................... 5 Mercant...

UNIVERSITY OF LUSAKA FACULTY OF ECONOMICS, BUSINESS & MANAGEMENT UNDERGRADUATE PROGRAM INTERNATIONAL TRADE ECF330/BF310 COURSE MODULE  TABLE OF CONTENTS UNIT 1: INTERNATIONAL TRADE THEORY......................................................... 5 Mercantilism....................................................................................................... 5 The Classical Theory of Trade........................................................................... 6 Why Nations Trade – The Principle of Absolute Advantage........................ 6 Why Nations Trade – The Concept OF Comparative Advantage.......... 7 Modern Trade Theory – The Generalized Theory of Comparative Advantage... 9 Production Possibility Schedules........................................................... 9 Trading Under Constant Cost Conditions............................................. 11 The Basis For Trade And The Direction Of Trade............................................ 12 Production Gains From Specialization.................................................. 12 Consumption Gains From Trade........................................................... 14 Distributing The Gains From Trade....................................................... 15 Equilibrium Terms Of Trade................................................................... 17 Terms-of-Trade Estimates...................................................................... 18 Trading Under Increasing Cost Conditions.......................................... 21 The Pure Theory Of International Trade- Demand And Supply........................ 26 Indifference Curves And Trade.............................................................. 26 Community Indifference Curves............................................................ 29 Restatement Of The Basis For Trade And The Gains From Trade.................. 30 The Offer Curve Of One Nation.............................................................. 32 The Offer Curve And Equilibrium Relative Commodity Prices With trade 35 The Terms Of Trade Of A Nation............................................................ 37 REVIEW QUESTION FOR UNIT 1........................................................................ 39 UNIT 2: THE HECKSCHER OHLIN THEORY..................................................... 42 Factor-Price Equalization................................................................................. 45 The Stolper–Samuelson Theorem.................................................................... 48 Empirical Evidence on the Heckscher-Ohlin Model-......................................... 49 The Leontief Paradox.............................................................................. 49 The Case of the Missing Trade.............................................................. 53 Patterns of Exports Between Developed and Developing Countries. 54 REVIEW QUESTIONS FOR UNIT 2...................................................................... 58 UNIT 3: EXTENSIONS TO THE HECKSCHER OHLIN THEORY........................ 59 Increasing Returns To Scale Or The Economies Of Scale Trade Theory........ 59 The Theory OF Overlapping Demand As A Basis For Trade........................... 61 Intra Industry Trade.......................................................................................... 62 The Product Life Cycle Theory Of Trade...................................................... 63 Dynamic Comparative Advantage: Industrial Policy Theory Of Trade.............. 64 Transportation Costs And Comparative Advantage................................... 64 REVIEW QUESTIONS FOR UNIT 3...................................................................... 65 UNIT FOUR: THE THEORY OF COMMERCIAL POLICY.................................... 66 Barriers To Free Trade- Tariffs......................................................................... 66 The Tariff Concept................................................................................... 66 Types Of Tariffs................................................................................................ 67 A specific tariff........................................................................................ 67 Ad valorem (of value) tariff..................................................................... 67 A Compound tariff................................................................................... 67 University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 2  The Relative Merits And Demerits Of Specific, AD Valorem, And Compound Tariffs............................................................................................................... 67 The Effective Rate Of Protection...................................................................... 69 Tariff Escalation................................................................................................ 73 Tariff Welfare Effects:....................................................................................... 74 Consumer And Producer Surplus.......................................................... 74 The General Equilibrium Analysis Of Tariffs..................................................... 76 Tariff Welfare Effects: Small-Nation Model........................................... 76 Tariff Welfare Effects: Large-Nation Model........................................... 81 UNIT 3 REVIEW QUESTIONS.............................................................................. 84 UNIT 5: NON TARIFF BARRIERS TO TRADE..................................................... 88 Import Quotas................................................................................................... 88 Quota - Trade And Welfare Effects........................................................ 89 Quotas Versus Tariffs....................................................................................... 91 Orderly Marketing Agreements......................................................................... 93 Tariff-Rate Quota:.................................................................................... 95 Domestic Content Requirements...................................................................... 96 Subsidies.......................................................................................................... 98 Domestic Subsidy................................................................................... 99 Export Subsidy...................................................................................... 101 Dumping......................................................................................................... 102 Sporadic dumping (distress dumping)................................................ 102 Predatory dumping............................................................................... 102 Persistent Dumping.............................................................................. 103 The Margin Of Dumping........................................................................ 103 REVIEW QUESTIONS FOR UNIT 5.................................................................... 104 UNIT 6: OTHER NON TARIFF BARRIERS AND ARGUMENTS FOR TRADE BARRIERS.......................................................................................................... 106 Government Procurement Policies................................................................. 106 Social Regulations.......................................................................................... 106 Arguments for Trade Restrictions.................................................................... 107 REVIEW QUESTIONS FOR UNIT 5.................................................................... 109 UNIT 7: Economic Integration........................................................................... 110 Regional Trading Arrangements..................................................................... 110 A Free-Trade Area................................................................................. 110 A Customs Union.................................................................................. 110 A Common Market................................................................................ 110 An Economic Union.............................................................................. 111 Reasons For Regionalism.............................................................................. 111 Effects Of A Regional Trading Arrangement.................................................. 112 Static Effects......................................................................................... 113 Dynamic Effects.................................................................................... 116 Constraints To Integration For LDC’s............................................................. 117 Regional and International Organisations...................................................... 118 The Southern African Development Community (SADC).................. 118 Aims of the SADC................................................................................. 118 SADC in practice................................................................................... 119 SADC’S Achievements......................................................................... 120 Challenges............................................................................................. 120 Future Outlook...................................................................................... 120 Common Market For Eastern And Southern Africa (COMESA)..................... 120 University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 3  Objectives OF COMESA....................................................................... 121 Achievements........................................................................................ 121 Challenges............................................................................................. 121 Future Outlook...................................................................................... 121 Organs of the Common Market............................................................ 122 Major International Trade Organisations......................................................... 123 The World Trade Organisation (WTO)........................................................... 123 Functions........................................................................................................ 123 Principles of the trading system...................................................................... 124 GATT/WTO rounds of negotiations..................................................... 126 Uruguay Round..................................................................................... 126 Doha Round (The Doha Agenda)......................................................... 127 REVIEW QUESTIONS FOR UNIT 7.................................................................... 128 UNIT 8 GROWTH AND INTERNATIONAL TRADE............................................ 130 Dynamic Factors in International Trade: Growth And Development............... 130 Growth In Factors........................................................................................... 130 Technical Progress...................................................................................... 132 1) K-Saving technical progress....................................................... 132 2) L–Saving Technical Progress..................................................... 132 3) Neutral technical progress............................................................ 133 Change In Factor Supplies And Technology And Trade........................... 134 Changes in Tastes and Trade...................................................................... 135 Dynamic Factors............................................................................................ 137 REVIEW QUESTIONS FOR UNIT 8.................................................................... 137 RECOMMENDED TEXTS................................................................................... 142 COURSE ASSESSMENT:.................................................................................. 142 University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 4 UNIT 1: INTERNATIONAL TRADE THEORY This Lesson introduces the student to classical and modern pure trade theory. At the end of this lesson a student should be able to explain the difference between the classical Adam Smith’s and Ricardian, reasoning of supply side assumed absolute and comparative advantages and the modern trade theory with production possibilities and restated theory of trade with community indifference curves (tastes and preferences) taken into analysis. Moreover the student should be able to understand the general reasoning of offer curve analysis in determining equilibrium terms of trade. It is advised that the lecture jumps to unit 8 immediately after completing unit 1 for continuity in the concepts. Mercantilism During the 1500-1800 periods Mercantilist writers were concerned with how a nation could regulate its domestic and international affairs so as to promote its own interests. The solution lay in a strong foreign trade sector. If a country could achieve a favorable Trade balance, it would realize net payment received from the rest of the world in form of gold and silver. Such revenues would contribute to increased spending and a rise in domestic output and employment. To promote a favourable trade balance, the Mercantilists advocated Govt. regulation with control of foreign trade being of paramount importance for ensuring the prosperity and security of the state. Tariffs, quotas and other commercial policies to minimize imports in order to protect a nation’s trade position. Mercantilists were criticized because 1. The assumption that a positive trade balance would exist was a short term one. The positive trade balance would eventually result in inflation in the home country making foreign products cheaper and the home University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 5  country would again have to import and in so doing eliminate the positive trade balance. The price–specie flow mechanism is a logical argument by David Hume against the Mercantilist (1700–1776) idea that a nation should strive for a positive balance of trade, or net exports because surplus stocks of gold (the money supply of those days) transformed into higher domestic price levels which would make imports cheaper thus resulting into a negative trade balance. 2. The Mercantilists static view of the world that the world’s wealth was fixed meaning that one nation’s gain from trade came at the expense of its trading partners. The Classical Theory of Trade Why Nations Trade – The Principle of Absolute Advantage The Mercantilists static view of the world’s being static was challenged by Adam Smith (1723-1790). who pointed out that the world’s wealth is not a fixed quantity. According To Adam Smith’s Absolute Advantage idea, cost differences govern the International movement of goods. He maintained that productivity of factors inputs represent the major determinants of production costs. Such productivities are either natural (climate, soil, and mineral wealth) or acquired advantages (special skills and techniques). Given these absolute advantages in the production of a good a nation would produce that good at a lower cost and thus become more competitive than its trading partner Assumptions Of Absolute Advantage i) Labour is the only is the factor of production and is homogeneous (The labour theory of value) ii) The cost or price of a good depends exclusively on the amount of labour required to produce it. iii) Two nations are producing two goods iv) International specialization of labour With the principle of Absolute advantage, international specialization and trade will be beneficial when one nation has an absolute advantage in one good and the other nation in another good. For both nations to benefit from trade, a University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 6 nation should import those goods in which it has an absolute disadvantage and export those goods in which it has an absolute advantage. Example 1.1 Country Wine Cloth A 5 20 B 15 10 If workers in country A can produce 5 Liters of wine or 20 meters of cloth in an hours time, while workers in country B can produce 15 liters of wine and 10 meters of cloth in an hours time, assuming equivalent wages in both countries, country B has an absolute advantage in cloth while country A has an absolute advantage in wine production Why Nations Trade – The Concept OF Comparative Advantage One shortcoming of the Absolute Advantage Principle by Smith is that it lacks explanation on what would happen if a nation is more efficient in the production of ALL the goods than its trading partner. David Ricardo (1772 – 1823) developed a principle to show that mutually beneficial trade can occur whether or not countries have an absolute advantage Ricardo theorized that the immediate basis for trade stemmed from the factor cost differences between nations which were underlain by their natural or acquired advantages. Unlike the absolute advantage principle which emphasized the importance of absolute cost differences, Ricardo’s principle emphasized comparative (Relative) cost differences. Ricardo‘s trade theory is thus known as THE PRINCIPLE OF COMPARATIVE ADVANTAGE. According to this principle even if a nation has an absolute advantage in the production of both goods, a basis for mutually beneficial trade still exists. The less efficient nation should specialize in and export that good in which it is relatively less efficient (where the Absolute disadvantage is least). The more efficient nation should specialize and export that good in which it is relatively more efficient. ASSUMPTIONS OF COMPARATIVE ADVANTAGE University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 7  1. Two nation producing two goods each using a single input or factor 2. In each country labour is the only input or factor with each nation having a fixed labour endowment , full labour employment and all labour being homogenous 3. Full and free labour mobility among industries within the nation but no labour mobility between nations 4. Fixed technology levels for both countries. Though the different nations may use different production techniques, all firms within each nation utilize a common production technique for each commodity. 5. Costs do not vary with the level of production and are proportional to the amount of labour used. 6. Perfectly competitive markets exist with free entry and exit from industry and the price of each product equals the product’s marginal cost of production. Firms and consumers are rational units i.e. firms make production decisions in an attempt to make profits whereas consumers maximize satisfaction through their consumption decisions 7. Free trade between nations with no Govt. barriers to trade. 8. Zero or negligible transports cost. Consumers will be indifferent between domestically produced and imported versions of a product if the domestic price of the two products is identical. 9. Trade is in balance (exports must pay for imports) thus ruling out flows of money between nations A Case Of Comparative Advantage When The Country Has Absolute Advantage In The Production Of Both Goods Country Wine Cloth A 40 40 B 20 10 Assume that in an hour’s time country A can produce up to 40 liters of wine or 40 meters of cloth while country B can produce 20 liters of wine or 10 meters of cloth. According to the principle of absolute advantage, there is no basis for mutually beneficial specialization and trade because the workers in country A are more efficient in the production of both goods University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 8 But the principle of Comparative Advantage recognizes that workers in country A are four time as efficient in the production of cloth but only two time as efficient in the production of wine. In other words, to produce 1 unit of cloth, country A has to forego 1 unit of Wine conversely to produce 1 unit of wine A 1 unit of cloth. Country B, on the other hand has to forego 2 units of wine in order produce 1 unit of cloth and to produce 1 unit of wine it has to forego of cloth. The OPPORTUNITY COST of producing cloth in country B is higher than that of producing cloth in country A , while the opportunity cost of producing wine in country A is higher than that of producing wine in country B. Thus, though country A has an Absolute Advantage in the cloth and wine production, it should specialize in the production of cloth where it has a lower opportunity cost (greater absolute advantage) while country B should specialize in the production of wine where it has a lower opportunity cost (smaller absolute Disadvantage) Each nation should specialize in and export that good in which it has a comparative advantage, Country A in cloth and country B in wine. The output gains from specialization will be distributed in the two nations through the process of trade. Both Nations will gain through trade. Modern Trade Theory – The Generalized Theory of Comparative Advantage Production Possibility Schedules Ricardo’s law of comparative advantage suggested that specialization and trade can lead to gains for both nations. His theory however depended on the restrictive assumption of the labour theory of value, in which labour is the only input. In practice labour is only one of the several factor inputs. Recognizing this shortcoming the modern trade theory provides a more generalized theory of comparative advantage. It explains the theory using University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 9  Production Possibility Schedule (Also called Transformation Schedule). This schedule shows various alternative combinations of the two goods that a nation can produce when ALL of its factor inputs (land, labour, capital and entrepreneurship) are used to their most efficient manner. It shows the maximum output possibilities of a nation. Fig 1.1(a) Country A tt Wheat Trading Possibilities 100 E line 80 60 C A 40 MRT = 0.5 20 F D B 20 40 60 80 100 120 140 160 Cars Country B Fig 1.1(b) 160 B’ 140 Wheat 120 100 D’ C’ A’ Trading Possibilities 80 line 60 40 MRT = 2.0 20 20 40 60 80 100 120 140 160 Cars University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 10 Figure 1.1 illustrates hypothetical production possibilities schedules for two countries A and B. By fully utilizing all available technology during a given time, country A could produce either 60 tons of wheat or 120 cars or certain combinations of the two products similarly country B could produce either 160 tons of wheat or 80 cars or a certain combination of the two products. So how does a production possibilities schedule illustrate the concept of comparative cost? The answer lies in the slope of the production possibilities schedule which is referred to as the Marginal Rate of Transformation (MRT). The MRT shows the amount of a product the nation must sacrifice to get one additional unit of the other product: MRT = This rate of sacrifice is sometimes called the OPPORTUNITY COST of a product. Because this formula also refers to the slope of the PPS the MRT equals the absolute value of the PPS’ slope. In figure 1.1 the MRT of wheat into cars gives the amount of wheat at endpoint on its PPS that must be sacrificed for each additional car produced. Concerning country A, the movement from the top endpoint on its PPS to the bottom endpoint shows that the relative cost of producing 120 additional cars is the sacrifice of 60 tons of wheat. This means that the relative cost of each car produced is 0.5 tons of wheat sacrificed (60/120 = 0.5) – that is the MRT is 0.5. Country B’s Trading Under Constant Cost Conditions So far illustrating the principle of comparative advantage has been done the assumption of Constant Opportunity Costs. Although the constant cost case may be of limited relevance to the real world it serves as a very useful academic tool for analyzing international trade. This analysis focuses on two questions: a) What is the basis and direction of trade? University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 11  b) What are the potential gains from trade for a single nation and for the world as a whole? Figure 1.1 shows PPS’s for country A and B as straight lines. This linearity indicates that the relative costs of the two products do not change as the economy shifts its production from all wheat to all cars or anywhere in between. For country A, the relative cost of a car is 0.5 tons of wheat as output expands or contracts. For country B the relative cost of a car is 2 tons of wheat as output expands or contracts. There are two reasons for constant costs: a) The factors of production are perfect substitute for each other. b) All units of a given factor of production are of the same quality So as a country transfers its resources from the production of wheat into the production of cars or vice versa, the country will not have to resort to resources that are less well suited for the production of the good. There the country must sacrifice exactly the same amount of wheat for each additional car produced regardless of how many cars it is already producing. The Basis For Trade And The Direction Of Trade Referring to Fig 1.1, assume that in autarky (the absence of trade) country A prefers to produce and consume at point ‘A’ on its PPS with 40 cars and 40 tons of wheat. Assume that country B also produces and consumes at point A’ with 40 cars and 80 tons of wheat. The slopes of the two countries PPS’s give the Relative Cost of producing an additional car is only 0.5 tons of wheat for country A but is 2 tons of wheat for country B. According to the principle of comparative advantage this situation provides the basis of mutually beneficial specialization and trade owing to the differences in the countries‘ relative costs. As for the direction of trade, we expect country A to specialize in and export cars and country B specializing in and exporting wheat. Production Gains From Specialization The law of comparative advantage asserts that with trade each country will find it favourable to specialize in the production of the good of its comparative University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 12 advantage and will trade part of this good for the good of its comparative disadvantage. In Fig 1.1 country A moves away from production point A to production point B totally specializing in cars. Country B totally specializes in wheat production moving away from point A’ to point B’. So taking advantage of specialization can result in Production Gains for both countries. Gains From Specialization And Trade Under Constant Opportunity Costs. Table 1.1 (a) Production gains From Trade: BEFORE AFTER NET GAIN (LOSS) SPECIALIZATION SPECIALIZATION CARS WHEAT CARS WHEAT CARS WHEAT Country A 40 40 120 0 80 -40 Country A 40 80 0 160 -40 80 THE WORLD 80 120 120 160 40 40 Prior to specialization, country A produces 40 cars and 40 tons of wheat. But with complete specialization, country A produces 120 cars and no wheat. As for country b, its production point after specialization is at 160 tons of wheat and no cars. Combining theses results, we find that both nations together have experienced a net production gain of 40 cars and 40 tons of wheat under conditions of complete specialization. Table 1(a) summarizes these production gains. Table 1.1 (b) Consumption Gains from trade. BEFORE AFTER University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON SPECIALIZATION SPECIALIZATION NET GAIN (LOSS) CARS WHEAT CARS WHEAT CARS Page 13 WHEAT Country A 40 40 60 60 20 20 Country A 40 80 60 100 20 20 The World 80 120 120 160 40 40 Consumption Gains From Trade In the absence of trade the consumption alternatives of country A and B are limited to points along their domestic PPS’s. with the exact consumption point for each nation will be determined by the tastes and preferences of each nation. But with specialization and trade , the two nations can achieve post trade consumption points Outside their domestic PPS’s ; that is , they can consume more wheat and cars than they could consume in the absence of trade. Thus trade can result in Consumption Gains for both countries. The set of post trade consumption points that a nation can achieve is determined by the rate at which its export product is traded for the other country’s export product. This rate is known as the TERMS OF TRADE. The terms of trade define the relative prices at which the two products are traded in the market place. Under constant cost conditions, the slope of the PPS defines the domestic rate of transformation (Domestic Terms of trade), which represents the relative prices at which the two commodities can be exchanged at home. For a country to consume at some point Outside its PPS, it must be able to exchange its export good internationally at terms of trade more favourable than the domestic terms of trade. Assuming countries A and B achieve a terms of trade ratio that permits both trading partners to consume at some point outside their respective PPS (Fig 1.1). Suppose the terms of trade agreed on are a 1:1 ratio, whereby one car is exchange for 1 ton of wheat. Based on these conditions let line ‘tt’ represent the international terms of trade for both countries. This line is referred to as the Trading Possibilities line (drawn with a slope having an absolute value of 1) University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 14 Suppose now that country A decides to export, say, 60 cars to country B. Starting at post specialization production point B in the fig 1.1 country A will move along its trading Possibilities Line until point C is reached. At point C, 60 cars will have been exchanged for 60 tons of wheat at the 1:1 terms of trade ratio. Point C will then represent country A’s post trade consumption point. Compared with point ‘A’, point ‘A’ results in a consumption gain for the country A of 20 cars and 20 tons of wheat. The triangle BCD showing country A’s exports (along the horizontal axis), imports (along the vertical axis) and terms of trade (the slope) is referred to as the Trade Triangle. So how does this trade triangle provide favourable results for country B? Starting at post specialization production point B’ in Fig 1.1, country b would move along its Trading Possibilities Line until it reached until it reached point C’. Clearly this is a more favourable consumption gain of 20 cars and 20 tons of wheat. Country B’s trade triangle is denoted by B’C’D’. Note that in our two country model , the trade triangles of country A and b are Identical; one country’s exports equal the other country’s imports, which are exchange at the at the equilibrium terms of trade.. Table 1.1 (b) summarizes the consumption gains from trade for each country and the worlds as a whole. One implication of the foregoing trading example is that country A produced only cars whereas B produced only wheat – that is, complete specialization occurs. As country A increases and country B decreases the production of cars, both countries unit productions remain constant. Because the relative costs never become equal , country A does not lose its comparative advantage and neither does country B. Country A produces only cars and similarly as country B produces more wheat and country A reduces its production of wheat both countries’ production costs remain the same. Distributing The Gains From Trade The trading example has assumed that the terms of trade agreed to by the Country A and Country B will result in both trading partners' benefiting from trade. But where will these terms of trade actually lie? A shortcoming of University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 15 Ricardo's principle of comparative advantage was its inability to determine the actual terms of trade. The best description that Ricardo could provide was only the outer limits within which the terms of trade would fall. This is because the Ricardian theory relied solely on domestic cost ratios (supply conditions) in explaining trade patterns; it ignored the role of demand. To visualize Ricardo's analysis of the terms of trade, recall our trading example of Figure 1.1 It was assumed that for the Country A the relative cost of producing an additional car was 0.5 Tons of wheat, whereas for Country B the relative cost of producing an additional car was 2 Tons of wheat. Thus, the Country A had a comparative advantage in cars, whereas Country B had a comparative advantage in wheat. Figure 1.2 illustrates these domestic cost conditions for the two countries. For each country, however, the domestic cost ratio, given by the negatively sloped production possibilities schedule, has been translated into a positively sloped cost-ratio line. According to Ricardo, the domestic cost ratios set the outer limits for the equilibrium terms of trade. If the Country A is to export cars, it should not accept any terms of trade less than a ratio of 0.5 cars to 1 ton of wheat, indicated by its domestic cost-ratio line. Otherwise,the COUNTRY A’S. post trade consumption point would lie inside its production possibilities schedule. The Country A would clearly be better by the domestic price line. The region of mutually beneficial trade is thus bounded by the cost ratios of the two countries Fig 1.2 University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 16  Country B Ratio 2:1 Improving Country A Terms Of trade Improving Country B Terms Of trade Country A Ratio 0.5:1 Cars Equilibrium Terms Of Trade Ricardo did not explain how the actual terms of trade would be determined in international trade. This gap was filled by classical economist, John Stuart Mill (1806-1873). by bringing into the picture the intensity of the trading partners' demands, Mill could determine the actual terms of trade for Figure 1.2. Mill's theory is known as the theory of reciprocal demand which asserts that within the outer limits of the terms of trade, the actual terms of trade is determined by the relative strength of each country's demand for the other country's product. Simply put, production costs determine the outer limits to the terms of trade, while reciprocal demand determines what the actual terms of trade will be within these limits. Referring to Figure 1.2, if Country B’s consumers are more eager for Country A’s. cars than Country A’s citizens are for Country B’s wheat, the terms of trade would end up close to the Country B’s cost ratio of 2:1. Thus, the terms of trade would improve for the Country A. However, if Country A’s citizens are more eager for Country B’s wheat than Country B’s consumers are for Country A’s. cars, the terms of trade would fall close to the Country A’s. cost ratio of 0.5:1, and the terms of trade would improve for Country B’s. The reciprocal-demand theory best applies when both nations are of equal economic size, so that the demand of each nation has a noticeable effect on University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 17 market price. If two nations are of unequal economic size, however, it is possible that the relative demand strength of the smaller nation will be dwarfed by that of the larger nation. In this case, the domestic exchange ratio of the larger nation will prevail. Assuming the absence of monopoly elements working in the markets, the small nation can export as much of the commodity as it desires, enjoying large gains from trade. The supply-side analysis of Ricardo describes the outer limits within which the equilibrium terms of trade must fall. The domestic cost ratios set the outer limits for the equilibrium terms of trade. Mutually beneficial trade for both nations occurs if the equilibrium terms of trade lie between the two nations' domestic cost ratios. According to the theory of reciprocal demand, the actual exchange ratio at which trade occurs depends on the trading partners' interacting demands. The example just given implies the following generalization: If two nations of approximately the same size and with similar taste patterns participate in international trade, the gains from trade will be shared about equally between them. However, if one nation is significantly larger than the other, the larger nation attains fewer gains from trade while the smaller nation attains most of the gains from trade. This situation is characterized as the importance of being unimportant. What's more, when nations are very dissimilar in size, there is a strong possibility that the larger nation will continue to produce its comparative disadvantage good because the smaller nation is unable to supply all of the world's demand for this product. Terms-of-Trade Estimates As we have seen, the terms of trade affect a country's gains from trade. How are the terms of trade actually measured? The commodity terms of trade (also referred to as the barter terms of trade) are a frequently used measure of the international exchange ratio. It measures the relationship between the prices a nation gets for its exports and the prices it pays for its imports. This is calculated by dividing a nation's export price index by its import price index, multiplied by 100 to express the terms of trade in percentages: University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 18 Terms of Trade = X 100 Deriving The Export And Import Indices A base year is chosen, at which the average price of exports is assigned an index of 100 as is the average price of imports Suppose in the year 2010, the base year, the average price of a basket of Zambia’s exports was K450, 000 while the average price of a basket of imports was K500, Each of these prices would be assigned an index of 100and the terms would be (100/100) = 1. In fact 100 multiply by this ratio when the terms of trade are calculated. So the terms of trade for the year 2010 are 100. Now suppose in the year 2011, the average price of exports rose by 10% to K 495,000, while the average price of imports rose by 6%. The index of exports would have risen to 100 X 1.1 = 110, and the index for imports would rise to 100X 1.06 = 106. The terms of trade for 2011 would then be = X 100 = 104 The rise in the terms of trade reflects the fact that export prices have risen more than import prices. An increase in the terms of trade is called an improvement in the terms of trade One reason for wanting an increase in the terms of trade is that a given quantity of exports will now pay for more imports. In the example above the foreign currency earned by exporting one basket of exports in the year 2010 (K450, 000 worth) would buy = 0.9 or 90% of a basket of imports. When the terms of trade improved in 2011 so that the average price of exports was K495,000 while that of imports was K 530,000 ( 500000 X 1.06), one basket of exports would earn enough foreign currency to pay for - 0.9339 or 93.34% of a basket of imports. This means that, all things remaining equal, fewer exports are required to pay for imports An improvement in a nation's terms of trade requires that the prices of its exports rise relative to the prices of its imports over the given time period. A smaller quantity of export goods sold abroad is required to obtain a given quantity of imports. Conversely, a deterioration in a nation's terms of trade is University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 19 due to a rise in its import prices relative to its export prices over a time period. The purchase of a given quantity of imports would require the sacrifice of a greater quantity of exports. Dynamic Gains from Trade The previous analysis of the gains from international trade stressed specialization and reallocation of existing resources. However, these gains can be outweighed by the effect of trade on the country's growth rate and thus on the volume of additional resources made available to, or utilized by, the trading country. Such benefits are known as the dynamic gains from international trade, as opposed to the static effects of reallocating a fixed quantity of resources. (Carbaugh Robert J, 2005 P.62) This can result due to following factors: Over time, increased income from trade tends to result in more saving and, thus, more investment in equipment and manufacturing plants. This additional investment generally results in a higher rate of economic growth. Moreover, opening an economy to trade may lead to imported investment goods, such as machinery, which fosters higher productivity and economic growth. In a roundabout manner, the gains from international trade grow larger over time. Empirical evidence has shown that countries that are more open to international trade tend to grow faster than closed economies.' Free trade also increases the possibility that a firm importing a capital good will be able to locate a supplier who will provide a good that more nearly meets its specifications. The better the match, the larger is the increase in the firm's productivity, which promotes economic growth. Economies of large-scale production represent another dynamic gain from trade. International trade allows small and moderately sized countries to establish and operate many plants of efficient size, which would be impossible if production were limited to the domestic market. University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 20  Simply put, besides providing static gains rising from the reallocation of existing productive resources, trade might also generate dynamic gains by stimulating economic growth. Proponents of free trade note the many success stories of growth "through trade. However, the effect of trade on growth is not the same for all countries. In general, the gains tend to be less for a large country such as the United States than for a small country such as Zambia Trading Under Increasing Cost Conditions In the real world, a good's opportunity costs may increase as more of it is produced. Based on studies of many industries (ibid P 64) economists think the opportunity costs of production increase with output rather than remain constant for most goods. The principle of comparative advantage must be illustrated in a modified form. Increasing opportunity costs give rise to a production possibilities schedule that appears concave, or bowed outward from the diagram's origin. In Figure 1.3, with movement along the production possibilities schedule from A to B, the opportunity cost of producing cars becomes larger and larger in terms of wheat sacrificed. Increasing costs mean that the MRT of wheat into cars rises as more cars are produced. Remember that the MRT is measured by the absolute slope of the production possibilities schedule at a given point. With movement from production point A to production point B, the respective tangent lines become steeper-their slopes increase in absolute value. The MRT of wheat into cars rises, indicating that each additional car produced requires the sacrifice of increasing amounts of wheat. 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 car production rises and wheat production falls in Figure 4, inputs that are less and less adaptable to cars are introduced into that line of production. To produce more cars requires more and more of such resources and thus an increasingly greater sacrifice of wheat. For a particular product, such as cars, increasing cost can be explained by the principle of diminishing marginal productivity. The addition of successive units of University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 21 labor (variable input) to capital (fixed input) beyond some point results in decreases in the marginal production of cars that is attributable to each additional unit of labor. Unit production costs thus rise as more cars are produced. Under increasing costs, the slope of the concave production possibilities schedule varies as a nation locates at different points on the schedule. Because the MRT equals the production possibilities schedule's slope, it will also be different for each point on the schedule Fig 1.3 Slope: 1 car = 1ton Wheat Slope: 1 car = 4tons Wheat Cars Fig 4 In addition to considering the supply factors underlying the production possibilities schedule's slope, we must also take into account the demand University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 22  factors (tastes and preferences), for they will determine the point along the production possibilities schedule at which a country chooses to consume. Fig 1.5 a) Country A b) Country B fB (1car = 3Wheat fA (1car = 0.33Wheat tt (1car = 1Wheat tt (1car = 1Wheat Cars Cars Figure 1.5 shows the production possibilities schedules of the Country A and Country B under conditions of increasing costs. In Figure 5(a), assume that in the absence of trade the Country A is located at point A along its production possibilities schedule; it produces and consumes 5 cars and 18 Tons of wheat. In Figure 1.5(b), assume that in the absence of trade Country B is located at point A' along its production possibilities schedule, producing and consuming 17 cars and 6 Tons of wheat. For the Country A, the relative cost of wheat into cars is indicated by the slope of line tA tangent to the production possibilities schedule at point A (1 car = 0.33Tonnes of wheat). In like manner, Country B's relative cost of wheat into cars is denoted by the slope of line tB (1 car = 3 Tons of wheat).Because line tA Country A’s is flatter than line tB, cars are relatively cheaper in the Country A and wheat is relatively cheaper in Country B. According to the law of comparative advantage, the Country A will export cars and Country B will export wheat. As the Country A specializes in car production, it moves downward along its production possibilities schedule from point A toward point B. The relative cost University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 23 of cars (in terms of wheat) rises, as implied by the increase in the (absolute) slope of the production possibilities schedule. At the same time, Country B specializes in wheat. As Country B moves upward along its production possibilities schedule from point A' toward point B', the relative cost of cars (in terms of wheat) decreases, as evidenced by the decrease in the (absolute) slope of its production possibilities schedule. The process of specialization continues in both nations until a) The relative cost of cars is identical in both nations and b) Country A’s exports of cars precisely equal Country B's imports of cars, and conversely for wheat. If this situation occurs when the domestic rates of transformation (domestic terms of trade) of both nations converge at the rate given by line tt, Country A produces at point B, while Country B produces at point B'. Line tt becomes the international terms-of-trade line for the Country A and Country B; it coincides with each nation's domestic terms of trade. The international terms of trade are favorable to both nations because tt is steeper than tA Country A’s.and flatter than tB. What are the production gains from specialization for the Country A and Country B? Comparing the amount of cars and wheat produced by the two nations at their points prior to specialization with the amount produced at their post specialization production points; we see that there are gains of 3 cars and 3 Tons of wheat. The production gains from specialization are shown in Table 1.3(a). University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 24  TABLE 1.3 Cars Cars Cars Country A Country B The World Cars Cars Cars Country A Country B The World What are the consumption gains from trade for the two nations? With trade, the Country A can choose a consumption point along international terms-of-trade line tt. Assume that the Country A prefers to consume the same number of cars as it did in the absence of trade. It will export 7 cars for 7 Tons of wheat, achieving a post trade consumption point at C. The Country A’s. consumption gains from trade are 3 Tons of wheat, as shown in Figure 1.5(a) and also in Table 1.3(b). The Country A’s trade triangle, showing its exports, imports, and terms of trade, is denoted by triangle BCD. In like manner, Country B can choose to consume at some point along international terms-of-trade line tt. Assuming that Country B holds constant its consumption of wheat, it will export 7 Tons of wheat for 7 cars and wind up at post trade consumption point C'. Its consumption gain of 3 cars is also shown in Table 1.3(b). Country B's trade triangle is depicted in Figure 1.5(b) by triangle B'C'D'. Note that Country B's trade triangle is identical to that of the Country A. In this lecture, we have discussed the autarky points and post trade consumption points for the Country A and Country B by assuming "given" tastes and preferences (demand conditions) of the consumers in both countries. University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 25 The Pure Theory Of International Trade- Demand And Supply Indifference Curves And Trade Indifference curves are introduced to show the role of each country's tastes and preferences in determining the autarky points and how gains from trade are distributed. The role of tastes and preferences can be illustrated graphically by a consumer's indifference curve. An indifference curve depicts the various combinations of two commodities that are equally preferred in the eyes of the consumer-that is, yield the same level of satisfaction (utility). The term indifference curve stems from the idea that the consumer is indifferent among the many possible commodity combinations that provide identical amounts of satisfaction.. Fig 1.6 : Indifference Map Wheat A 6 U3 B U2 3 U1 Cars 1 2 Figure 1.6 illustrates a consumer's indifference map, which consists of a set of indifference curves. Referring to indifference curve I, a consumer is just as happy consuming, say, 6 tons of wheat and 1 car at point A as consuming 3 tons of wheat and 2 cars at point B. All combination points along an indifference curve are equally desirable because they yield the same level of satisfaction. Besides this fundamental characteristic, indifference curves have several other features: Indifference curves pass through every point in the figure; Indifference curves slope downward to the right; Indifference curves are bowed in (convex) to the diagram's origin; University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 26  Indifference curves never intersect each other; Indifference curves lying farther from the origin (higher curves) represent greater levels of satisfaction Having developed an indifference curve for one individual, can it be assumed that the preferences of all consumers in the entire nation could be added up and summarized by a community indifference curve? Strictly speaking, the answer is no, because it is impossible to make interpersonal comparisons of satisfaction. For example, person A may prefer a lot of coffee and little sugar, whereas person B prefers the opposite. The dissimilar nature of individuals' indifference curves results in their being non comparable. Despite these theoretical problems, a community indifference curve can be used as a pedagogical device that depicts the role of consumer preferences in international trade. Using indifference curves, let us now develop a trade example to restate the basis for trade and the gains-from-trade issues. Figure 7 depicts the trading position of Country A. Country University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 27  Fig 1.7 Country FA Car A in the absence of trade will maximize satisfaction if it can reach the highest attainable indifference curve, given the production constraint of its production possibilities schedule. This will occur when Country A’s production possibilities schedule is just tangent to indifference curve I, at point A. At this point, Country A’s relative price ratio is denoted by line fA, which equals the absolute slope of the production possibilities curve at that point. Suppose that Country A has a comparative advantage vis-a-vis Country B in the production of cars. Country A will find it advantageous to specialize in car production until the two countries' relative prices of cars equalize. Suppose this occurs at production point B, where Country A’s price rises to Country B's price, depicted by line tt. Also suppose that tt becomes the international terms-of-trade line. Starting at production point B, Country A will export cars and import wheat, trading along line tt. The immediate problem Country A faces is to determine the level of trade that will maximize its satisfaction. Suppose that Country A exchanges 6 cars for 50 tons of wheat at terms of trade tt. This would shift Country A from production point B to post trade consumption point D. But Country A would be no better off with trade than it was in the absence of trade. University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 28 This is because in both cases the consumption points are located along indifference curve I. Trade volume of 6 cars and 50 tons of wheat thus represents the minimum acceptable volume of trade for Country A. Any smaller volume would force Country A to locate on a lower indifference curve. Suppose instead that Country A trades 22 cars for 183 tons of wheat. Country A would move from production point B to post trade consumption point E. With trade, Country A would again locate on indifference curve I, resulting in no gains from trade. From Country A’s viewpoint, trade volume of 22 cars and 183 tons of wheat therefore represents the maximum acceptable volume of trade. Any greater volume would find Country A moving to a lower indifference curve. Trading along terms-of-trade line tt, Country A can achieve maximum satisfaction if it exports 15 cars and imports 125 tons of wheat. Country A’s post trade consumption location would be at point C along indifference curve II, the highest attainable level of satisfaction. Comparing point A and point C reveals that with trade Country A consumes more wheat, but fewer cars, than it does in the absence of trade. Yet point C is clearly a preferable consumption location. This is because under indifference- curve analysis, the gains from trade are measured in terms of total satisfaction rather than in terms of number of goods consumed. Community Indifference Curves So far only supply side conditions have been dealt with in each nation with no regard to the demand side. The model can be expanded to explicitly include the tastes and preferences or demand side of each nation. These are introduced with the analysis of the Community Indifference curves which shows various combinations of two commodities which yield equal satisfaction to the community or nation. Higher curves in the X,Y plane refer to more satisfaction and lower ones to less.. They are negatively sloped and convex to the origin and in order to be useful, they must not cross due to transitivity assumptions of rational choice. The absolute slope of a community indifference curve at any point gives the marginal rate of substitution (MRS) or the amount of a commodity which the nation must give up to obtain one additional unit of the University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 29 other commodity which the nation must give up to obtain one additional unit of the other commodity and still remain on the same indifference curve. Restatement Of The Basis For Trade And The Gains From Trade In the absence of trade, a nation is in equilibrium when it reaches the highest indifference curve possible with its production possibilities curve. This occurs where a community indifference curve is tangent the nation’s production possibilities curve. The common slope of the two curves at the point of tangency point gives the internal equilibrium relative commodity price in isolation in each nation. When this pretrade relative commodity price differs in the two nations, there is a basis for mutually beneficial trade between them. Specialization in production and trade will then take place. Figure 1.8 gives the three indifference curves from the indifference map of country A. In terms of satisfaction; N = A < J < E for country A. For country B, R’ = A’ < J’ < E’. A movement from point N (20 Cars and 70 Wheat) to a point A (40 cars and 60Wheat) in country A, MRScw = - = - =. At point A, MRScw = absolute slope of the curve I for country A = =. For country b, a movement from A’ (89 cars for 50 Wheat) to R’ (90 cars and 30 wheat gives an average MRScw = - = 2. At a point A’, MRScw = 4. So as we move down a community indifference curve, its absolute slope or the MRScw diminishes. Fig 1.8 Community Indifference curves for Country A and B University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 30  Country A Country B W W 100 100 80 80 III E’ I 60 60 40 40 III 20 I II 20 20 40 60 80 100 C 20 40 60 80 100 C consumes, at point A in isolation. At point A, MRTcw = MRScw = PA = = Internal Equilibrium in isolation. On the other hand country B is in equilibrium at point A’ in isolation where MRTcw = MRScw = PA’ = 4 = Internal Equilibrium. Since in isolation differs in the two nations, there is a basis for mutually advantageous trade. If is stabilized PB with trade, country A wiil go from point A to point B in production by exchanging 60C for 60W with country B reaching point E in consumption on its indifference curve III. both nations gain 20 cars and 20 wheat from trade. In this case the pre trade University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 31 differences in in the two two nations is based on a difference in their production conditions reinforced by a difference in their demand preferences Fig 1.9 Production Possibilities Curves and Indifference Curves for Country A and B Country B W 160 W Country A 140 140 B’ 120 II 120 II 100 100 I E 80 80 E’ A 60 60 A’ PA= 40 40 PB’= 1 20 20 B PB= 1 PA’= 4 I 20 40 60 80 100 120 140 20 40 60 80 100 120 140 Cars Cars The Offer Curve Of One Nation In order to determine the relative commodity price at which trade actually takes place, we introduce the offer curve of each nation. The offer curve of a nation shows how much of its import commodity the nation requires in exchange for various quantities of its export commodity. The offer curve of a nation is derived from the nation’s production possibilities curve, its indifference map and the various hypothetical relative commodity prices at which trade could take place. In panel A of Fig 1.10 , country A starts at equilibrium point A as in fig 1.9.If trade takes place at PB = = 1, then country A will move to point B in production trading 60 cars for 60 wheat with country B and reach point E in consumption. This give point E in Panel B of figure 1.10. At = Pc = country University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 32 A will move from point A to point G in production , exchange 40 cars for 20 wheat with country B and reach point J on its indifference curve II. This gives point J in Panel B. This gives point J in Panel B. If points J and E are joined with the origin and other points similarly obtained, an offer curve is generated for country A shown in Panel B. This shows how much wheat imports country A requires to be willing to export various quantities of its cloth. PA, PC and PB in Panel B of figure 1.10 refer to the same as PA, PC and PB in Panel A, since they refer to the to the same Absolute Slope University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 33  FIG 10 : THE OFFER CURVE OF COUNTRY A W Country A W Panel B A Panel A E PB = 1 60 50 110 40 100 30 90 PC = J 20 E 80 10 PA = 70 J H F 10 20 30 40 50 60 60 A 50 H G 40 PA = 30 F 20 B PC = 10 PB = 1 10 20 30 40 50 60 70 80 90 100 110 120 130 C The Offer Curve Of Country B The offer curve of the other trade partner is obtained from its production possibilities curve, its indifference map and the various relative commodity prices at which trade can take place in a completely analogous way. In Panel A of fig 11 country B starts at its pre trade equilibrium point A’. If trade takes place at PB’ = = 1, country B moves to B’ in production trading 60 wheat for 60 cars with country A reaching point E’. This gives point E’ in panel B of figure 11. At = PA’, country B would move away from A’ to point G’ in University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 34 production exchanging 40 wheat for 20 cars with country A reaching point J’ on its indifference curve II. This gives point J’ of country B shown in Panel B. This shows how much cloth imports country B requires to export various quantities of wheat. In order to induce country B to export more wheat, must fall. But for a sufficiently small volume of trade country B would trade at PA’. The Offer Curve And Equilibrium Relative Commodity Prices With trade The point where the offer curves of the two nations intersect give the equilibrium relative commodity price with trade. At any other relative commodity price, the desired quantities of imports and exports of each commodity are not equal. This results in a pressure on the relative commodity price to move to its equilibrium level University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 35  FIG 1.11 THE OFFER CURVE OF COUNTRY B Panel B PA’ = 4 PC’ = 2 W Panel A W PB’= 1 160 60 F’ 150 E’ 140 50 H’ J’ 130 40 B’ 120 30 110 20 100 10 G’ 90 10 20 30 40 50 60 80 C E’ 70 F’ 60 H’ J’ 50 A’ PB’= 1 40 30 20 10 P C’ = 2 PA’ = 4 10 20 30 40 50 60 70 80 90 100 110 120 130 C The offer curves of country A and B in fig 1.12 are those of fig 1.10 and 1.11. The two offer curves intersect at point E, giving equilibrium = PB = 1. At PB, country A offers 60 cars for 60 wheat which is point E on country A’s offer curve and country B offers exactly 60 wheat for 60 cars which is point E’ on country B’s offer curve. Thus trade is in equilibrium at PB. At any price ratio other than , trade is not in equilibrium.. University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 36  For example at PC, the 40 cars of exports supplied by country A (point J) falls short of the car imports demanded by country B ( which’s given by the extended PC where the extended PC line crosses the extended country B’s offer curve). This excess demand tends to drive up. As this occurs, the car exports supplied by country A rise and the car imports demanded by country B fall, until they are equalized at PB. The pressure on PC to rise to PB could also be explained in terms of wheat and arises at any point other than ≠ PB. By determining the equilibrium PB = 1, the simple trade model is complete. FIG 1.12: THE OFFER CURVE AND THE EQUILIBRIUM RELATIVE COMMODITY PRICE WITH TRADE W PC > PW A PC = PW PB PC’ F’ E 60 B E’ 50 H’ J’ PC 40 PC < PW 30 20 J 10 H F 10 20 30 40 50 60 70 80 90 100 110 120 C The Terms Of Trade Of A Nation In a two commodity two nations model, the ratio of the price of an nation’s export good to the price of its import good or at equilibrium, is called the nation’s terms of trade. Since in a two nation model, the imports of one nation University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 37 are the exports of its trade partner, the terms of trade of the partner are the inverse or the reciprocal of the terms of trade of the other nation. Thus the terms of trade of country A are the inverse or the reciprocal of the terms of trade of the other nation. Thus, the terms of trade of country A in Fig 12 are given by = PB = 1, while the terms of trade of country B equal or the inverse of which is also equal to 1 in this case. When more than two commodities are traded in the terms of trade are given by the ration of the index of export to import prices and are usually expressed in percentages. Terms-of-Trade Estimates Terms of trade affect a country's gains from trade. It is important to know how they are actually measured. The commodity terms of trade (also referred to as the barter terms of trade) is a frequently used measure of the international exchange ratio. It measures the relationship between the prices a nation gets for its exports and the prices it pays for its imports. This is calculated by dividing a nation's export price index by its import price index, multiplied by 100 to express the terms of trade in percentages: Terms of Trade = X 100 Deriving The Export And Import Indices A base year is chosen, at which the average price of exports is assigned an index of 100 as is the average price of imports Suppose in in the year 2010, the base year, the average price of a basket of Zambia’s exports was K450,000 while the average price of a basket of imports was K500,. Each of thses prices would be assigned an index of 100and the terms would be (100/100) = 1. In fact 100 multiply by this ratio when the terms of trade are calculated. So the terms of trade for the year 2010 are 100. Now suppose in the year 2011, the average price of exports rose by 10% to K 495,000, while the average price of imports rose by 6%. The index of exports University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 38 would have risen to 100 X 1.1 = 110, and the index for imports would rise to 100X 1.06 = 106. The terms of trade for 2011 would then be = X 100 = 104 The rise in the terms of trade reflects the fact that export prices have risen more than import prices. An increase in the terms of trade is called an improvement in the terms of trade One reason for wanting an increase in the terms of trade is that a given quantity of exports will now pay for more imports. In the example above the foreign currency earned by exporting one basket of exports in the year 2010 (K450,000 worth ) would buy = 0.9 or 90% of a basket of imports. When the terms of trade improved in 2011 so that the average price of exports was K495,000 while that of imports was K 530,000 ( 500000 X 1.06), one basket of exports would earn enough foreign currency to pay for = 0.9339 or 93.34% of a basket of imports. This means that, all things remaining equal, fewer exports are required to pay for imports REVIEW QUESTION FOR UNIT 1 1). Autarky means that a) a country’s consumption possibilities are the same as its production possibilities b) equilibrium has been reached with the maximum gains from specialization and trade c) equilibrium has been reached with the maximum amount of international trade d) the nation has such a high standard of living that there are technically no poor people 2). The terms of trade are a) the length of time two individuals or countries have been trading b) the countries’ production possibilities curve c) the autarky equilibrium d) the exchange rates of two goods 3) A nation’s consumption possibilities frontier is a) always the same as its production possibilities frontier University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 39  b) never the same as its production possibilities frontier c) the same as its production possibilities frontier only if there is advantageous trade d) the same as its production possibilities frontier only if there is no international trade 4). The gains from trade are due primarily to the fact that a) the wealth of large, industrialized nations can be spread throughout the world b) total world output increases when each country specializes c) countries can boost their economies by increasing exports 5). The source of gains from trade is a) tariffs b) self-sufficiency c) autarky equilibrium d) comparative advantage 6). Mutually beneficial trade cannot occur a) when each country has its own comparative advantage b) if one country has absolute advantages in the production of every good c) when the opportunity costs of producing each good are equal for both trading partners d) if total world production equals total world consumption 7).To maximize worldwide gains from trade, the country which should produce a good is the country that a) has the lowest opportunity cost of producing that good b) can produce that good using the fewest resources c) will produce that good using the most expensive resources 8). Comparative advantage a) exists only when one producer can make the product using fewer resources than any other producer b) leads to the most efficient allocation of resources and the greatest combined output c) eliminates specialization, so that each country produces all of its own needs independently University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 40  9) Country A can produce 8 units of food per day or 12 units of clothing per day. Country B can produce 5 units of food per day or 10 units of clothing per day. Which of the following is true? a) mutually beneficial trade is not possible b) to maximize world production, Country A should produce only food, Country B should produce only clothing, and they should trade c) both countries should produce both goods and they should trade 10). Which of the following is not an economic reason for international specialization? a) some countries have educated, trained workers, which other countries have unskilled workers b) tastes and preferences tend to be different in different countries c) the world price of a good is determined by the world supply and demand for the product 11). When the world price of an internationally traded product is greater than a country’s domestic equilibrium price a) the domestic price will prevail, and the world price is irrelevant b) the country’s import line is horizontal c) the country’s exports of the product will increase 12). The world price is in equilibrium when a) half of the individual countries’ domestic prices are higher and half of the individual countries’ domestic prices are lower b) the desired level of total world exports of the good equal the desired level of total world imports of the good c) each countries’ exports of this good equal its import of this good 13) Assume we have a two nation (A and B) and a two good (X and Y) world. A and B both have linear production possibility frontiers. For A: Y = 10 - 4X and for B: Y = 10 - 3X. Assume both have identical tastes. a) Graph both countries' production possibility curves (put X on the horizontal axis). University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 41  b) Show the autarky production and consumption points (assume both X and Y are consumed). What is the rule to maximize social welfare? c) Now assume we have free trade between A and B. The World Terms Of Trade will be somewhere between what numerical values? Graphically show for A and B the after trade consumption and production points. What is the rule to maximize social welfare? What is the rule to maximize the value of production? Show the amount of export and import for A and B. d) Graphically derive the offer curve for A in problem.. UNIT 2: THE HECKSCHER OHLIN THEORY This lessons introduces the student to extensions to the traditional principle of comparative advantages and some of the empirical tests of the factor endowment theory and the results thereof. The student should be able to understand and appreciate the findings, their explanations and limitations. The student should be able to explain the factor prices and their pre trade and post trade positions and their limitations to equalization in the real world. David Ricardo did not explain the basis or the sources of the comparative advantages and the differences. Ricardo essentially assumed the existence of comparative advantage in his theoretical model. Moreover, Ricardo's assumption of a single factor of production (labor) ruled out an explanation of how trade affects the distribution of income within a nation and why certain groups favor free trade, whereas other groups oppose it. The Swedish economists Eli Heckscher and Bertil Ohlin (ibid P.63) formulated a theory addressing two questions left largely unexplained by Ricardo: i) What determines comparative advantage? University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 42  ii) What effect does international trade have on the earnings of various factors of production (distribution of income) in trading nations? Because Heckscher and Ohlin maintained that factor endowments underlie a nation's comparative advantage, their theory became known as the factor- endowment theory. It is also known as the Heckscher-Ohlin theory' (H-O theorem), The factor-endowment theory states that comparative advantage is explained exclusively by differences in relative national supply conditions. In particular, the theory highlights the role of nations' resource endowments as the key determinant of comparative advantage. The Heckscher-Ohlin theory focuses on the difference in relative factor endowments and factor prices between nations as the most important determinants of trade. The H.O theorem postulates that each nation will export the commodity intensive in its relatively abundant and cheap factor and import the commodity intensive in its relatively scarce and expensive factor. The factor price equalization theorem, which is a corollary of the H-O theorem postulates that trade will lead to the elimination or reduction in the pretrade difference in relative and absolute factor prices between nations. The factor-endowment theory relies on several simplifying assumptions: a) Nations have the same tastes and preferences (demand conditions); b) They use factor inputs that are of uniform quality; and c) Production is conducted under perfect competition in both nations d) The production function of the two countries have constant returns to scale e) There is free factor movement within the countries but not between countries f) There is minimal or no transportation costs and no barriers to trade. g) Countries use the same technology. According to the factor-endowment theory, relative price levels differ among nations because (1) the nations have different relative endowments of factor inputs and (2) different commodities require that the factor inputs be used with differing intensities in their production. University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 43 For example, refer to Table 1, which illustrates hypothetical resource endowments in Country A and Country B. TABLE 2.1 Factor Abundance In Country A and B Country A Country B Country A’s capital labor ratio equals 0.5 (100 machines/200 workers = 0.5). In Country B, the Capital labor ratio is 0.02 (20 machines/1,000 workers = 0.02). Since Country A’s capital labor ratio exceeds Country B's capital labor ratio, we call Country A the capital-abundant country and Country B the capital scarce country. On the other side of the coin, Country B is called the labor-abundant country and Country A the labor-scarce country. Relative abundance of a resource suggests that its relative cost is less than in countries where it is relatively scarce. This means that before the two countries trade, capital would be less expensive in Country A and labor would be less expensive in Country B. Therefore, Country A will have a lower opportunity cost in the production of goods, say, aircraft, that are produced using more capital and less labor. Country B's opportunity cost will be lower in goods that are produced using more labor and less capital, say, textiles. The relative abundance of a resource determines the comparative advantage in the following way. When a resource is relatively abundant its relative cost is lower than that of the other country where the it is relatively scarce. This means that before the two countries trade, labour is relatively cheap in country B. Therefore Country A has a lower relative price in aircraft, which are produced using more capital and less labour. Country B’s relative price is lower in textiles which are produced using more labour and less capital. The effect of resource endowment on comparative advantage is summarized as follows: Difference s Difference s Difference s Difference s In relative In relative In relative In Resource Resource Product Comparative endowments price prices Advantage University of Lusaka, ECF330/BF310 International Trade Course Module - Prepared by Chibwe JDB B.A M.A ECON Page 44  Factor-Price Equalization We have learnt that free trade tends to equalize commodity prices among trading partners. Can the same be said for factor prices?' A nation with trade finds output expanding in its comparative- advantage industry, which uses a lot of the cheap, abundant factor. As a result of the rise in demand for the abundant factor, its price increases. At the same time, the expensive, scarce factor is being released from the comparative-disadvantage industry; producers will not be induced to employ this factor unless its price falls. Because this process occurs at the same time in both nations, each nation experiences a rise in the price of the abundant factor and a fall in the price of the scarce factor. Trade therefore leads toward an equalization of the relative factor prices in the two trading partners. The Factor-Price Equalization theory postulates that trade will lead to the elimination or reduction of pre-trade difference in the relative and absolute factor prices be