Economics 244 International Trade Notes PDF

Economics 244 International Trade Notes: 1. Introduction: A. Question: PERSISTENT INFLATION, COVID, GENERATIVE AI AND OBSTINATE WAR...

Economics 244 International Trade Notes: 1. Introduction: A. Question: PERSISTENT INFLATION, COVID, GENERATIVE AI AND OBSTINATE WAR: IS THIS THE END OF INTERNATIONAL TRADE? B. Solution: 1. why trade matters in the first place? 2. how it works Trade? 3. what it means for Africa’s development prospects? 4. for you and me, here in South Africa. C. Part 1: International Trade Theories o Explain the benefits of trade and how these benefits contribute to economic growth. o Have evolved over time to reflect changing economic conditions. Purpose of Theories o Provide explanations for observed economic phenomena. o Are abstractions from reality, as including every detail is impractical.  Assumptions o Simplify complex economic systems by setting assumptions within their theories. o Help create a framework for understanding trade dynamics. Evolution of Theories o Over time, trade theories may become less relevant due to changing circumstances or the emergence of new theories. o The evolution of international trade theories reflects the adaptation of economic thought to changing real-world conditions. D. Part 2: Part II: Trade Theories vs. Realities of Barriers to Trade o Economic theories often advocate for free trade as the optimal policy for maximizing economic welfare. o However, the real world is characterized by various barriers to trade, such as tariffs, quotas, and subsidies. Understanding Government Interventions in Trade o Governments intervene in trade for a variety of reasons, such as to protect domestic industries, raise revenue, or achieve other policy goals. o There are many different ways that governments can intervene in trade, including tariffs, quotas, subsidies, and technical barriers to trade. Reducing Trade Barriers and Capturing Gains o Trade barriers can reduce the benefits of trade by raising prices and reducing competition. o Reducing trade barriers can lead to lower prices, increased competition, and greater economic growth. o There are many different ways to reduce trade barriers, such as through trade agreements, unilateral reforms, and technical assistance.  E. Part 3: Part III: Reducing Trade Barriers through Two Approaches Multilateral Rules-Based System o The World Trade Organization (WTO) is an intergovernmental organization that regulates international trade. o The WTO sets rules for trade between its member countries and provides a forum for resolving trade disputes. o The WTO has been successful in reducing trade barriers, but it has also been criticized for being too slow to adapt to changing circumstances. Regional Integration o Countries can form regional trade agreements to reduce trade barriers between themselves. o Regional trade agreements can be more effective than multilateral agreements in reducing trade barriers, but they can also be more difficult to negotiate. Improving Well-Being through Economic Insights Economic theories and research can be used to understand the benefits of trade and the costs of trade barriers. This knowledge can be used to develop policies that reduce trade barriers and improve the well-being of people within countries. F. Part 5: Part IV: Opportunities for Africa The Fourth Industrial Revolution (FIR) is a period of rapid technological change that is transforming the way we live and work. Africa can harness the opportunities presented by the FIR by embracing new technologies, such as artificial intelligence, robotics, and blockchain. These technologies can be used to improve productivity, efficiency, and innovation. Africa can also benefit from the removal of trade barriers, which will allow African businesses to access new markets and compete on a global scale. By leveraging trade and technology, Africa can achieve economic growth and improve the well-being of its people. Leveraging Trade and Technology Africa can harness the opportunities presented by the FIR by: o Investing in education and skills development to prepare its workforce for the jobs of the future. o Creating an enabling environment for innovation and entrepreneurship. o Promoting regional integration to create larger markets for African businesses. Linking Trade, Economic Growth, and Well-Being There is a strong connection between enhanced trade, economic growth, and the improved well-being of people in Africa. When African countries trade more, they create jobs, boost incomes, and reduce poverty. Trade also helps to diversify the African economy and make it more resilient to shocks. The benefits of trade are not evenly distributed, however. Vulnerable groups such as youth and women are often left behind. It is important to ensure that the benefits of trade are shared more widely, particularly among the most marginalized groups. 2. Theory Of International trade timeline: International Trade o The exchange of capital, goods, and services across borders. o Has been a source of significant economic prosperity, though not evenly distributed worldwide. Economic Benefits of International Trade o Exploitation of comparative advantage: Nations specialize in producing goods where they have a comparative advantage, leading to mutual gains in trade.  o Gains from specialization: Specialization leads to increased production, economies of scale, and cost efficiencies. o Increased competition: Trade fosters competition, reducing world prices and promoting efficiency. o Breaking domestic monopolies: Trade disrupts domestic monopolies, encouraging innovation and consumer choice. o Diverse and high-quality goods: Trade expands access to a wider range of high-quality goods and services. o Employment: Trade is linked to production, creating employment opportunities. Mercantilism o Early economic philosophy that believed national wealth was measured by the accumulation of precious metals, primarily gold and silver. o Advocated for restrictive trade policies including: a. high tariffs on manufactured goods b. export subsidies to promote exports c. limiting wages d. exclusive trade with colonies e. maximizing the use of domestic resources f. government support for new industries through capital and tax benefits g. establishing monopolies over local and colonial markets. Adam Smith o Known as the father of economics. o Critiqued mercantilism in his work "The Wealth of Nations." o Argued against mercantilist practices and advocated for free trade, specialization, and the benefits of a competitive market economy. o Smith's ideas marked a shift in economic thought and laid the foundation for modern economic theory and policy.  3. Mercantilism: A. 1500-1700: o Mercantilism is the first theory of international trade: o Features of a mercantilist economy: 1. Imports of certain goods were prohibited through: A. Imposition of tariffs B. Imposition of other restrictions introduced by the government 2. The government prioritised export industries through the provision of subsidies. 3. Policies of nationalism were imposed. 4. Wealth was measured in gold and silver: A. In the national treasury B. In private accumulation C. Use or export of precious metals was prohibited 5. Promotion of one-way trade with colonies 6. Promotion of the importation of precious metals from a trading partner. o Three assumptions of mercantilism: 1) There is a finite amount of wealth in the world. 2) A nation should have a positive Balance of Trade by exporting more than its imports. 3) A nation can only grow rich at the expense of other nations 4) This is thus a reflection of trade being a zero-sum game o The view of trade as a zero-sum game: Mercantilism ▪ An economic philosophy that believed national wealth was measured by the accumulation of precious metals, primarily gold and silver. Problems with Mercantilism ▪ Led to the adoption of complex government trade restrictions. ▪ Resulted in higher prices and hindered the growth and freedom of businesses. ▪ Sparked conflicts between trading parties and their colonies due to its focus on accumulating precious metals and imposing trade regulations. Decline of Mercantilism ▪ Attributed to the rise of the laissez-faire doctrine of free-market economics. ▪ Laissez-faire economics advocated for minimal government interference in economic activities and promoted the principles of free trade and competition. Adam Smith ▪ Author of the influential work "The Wealth of Nations." ▪ Coined the term "mercantile system" to describe the prevailing economic philosophy.  ▪ Challenged the mercantilist system and emphasized the benefits of specialization, free trade, and self-interest. ▪ Laid the foundation for modern economic thought and policies. 4. Absolute Advantage: Adam Smith o Scottish economist and philosopher. o Author of the influential work "The Wealth of Nations." o Challenged the mercantilist idea that national wealth was reflected in a country's holdings of precious metals. o Argued that national wealth was reflected in a nation's productive capacity. o Believed that growth in productive capacity was fostered best in an environment where individuals are free to pursue their self-interest. o Advocated laissez-faire, or minimal government interference in economic activities. o Believed that division of labour and specialization led to gains in productivity. o Applied the principles of division of labour and specialization to international trade, arguing that countries would specialize in and export goods in which they have an absolute advantage. Mercantilism o An economic philosophy that believed national wealth was measured by the accumulation of precious metals, primarily gold and silver. Laissez-faire o An economic doctrine that advocates for minimal government interference in economic activities. o Believes that the free market is the best way to allocate resources and promote economic growth.  Absolute Advantage o A country has an absolute advantage in the production of a good if it can produce that good more efficiently than any other country. Comparative Advantage o A country has a comparative advantage in the production of a good if it can produce that good at a lower opportunity cost than any other country. Absolute advantage theory: - This is whereby a particular country has the capability to produce more of a commodity at a lower cost than its competitors could. - This is achieved through low-cost production. - Efficiency leads to lower costs is linked to the division of labour and specialization. The assumptions of the theory 1. A two-country and two-community model is applied. 2. Labour is the only factor of production thus only input or production cost taken into account 3. Labour is homogenous and mobile within a country but immobile between countries. 4. Free Trade – no restrictions on imports or exports. 5. Perfect competition. 6. The labour theory of value holds 7. No transport costs  The economic principle of absolute advantage: 1. Principle of Absolute Advantage A country has an absolute advantage in the production of a good if it can produce that good more efficiently than any other country. This means that the country can produce the good with fewer resources or in less time than any other country. Specialization: A country should specialize in producing goods and services in which it has an absolute advantage. This specialization leads to mutually beneficial trade for all participating countries, creating a positive-sum game. Positive-sum game: A situation in which all parties involved benefit from the interaction. Free trade: The free movement of goods and services between countries without government interference. Protectionist measures: Government policies that restrict trade, such as tariffs and quotas. 2. Shift in Perspective The mercantilist view of trade: Trade is a zero-sum game, meaning that one country's gain is another country's loss. Adam Smith's view of trade: Trade is a positive-sum game, meaning that all countries involved can benefit from trade. This shift in perspective led to the concept of free trade and the reduction of government-imposed protectionist measures.  3. Impact on Modern Trade Theory and Policy The principle of absolute advantage has had a profound influence on modern trade theory and policy. It is the foundation of the theory of comparative advantage, which is a more sophisticated model of trade. The principle of absolute advantage is also used to justify free trade policies. Free trade policies are those that allow goods and services to move freely between countries without government interference.  5. David Ricardo’s Comparative Advantage Theory: Ricardian Theory of Trade: B. 1800’s: Comparative Advantage Theory Developed by David Ricardo in the 19th century. Builds on the ideas of Adam Smith but introduces the notion that trade can be mutually beneficial even when one country does not have an absolute advantage in the production of any particular good. Absolute Advantage vs. Comparative Advantage Absolute advantage: A country has an absolute advantage in the production of a good if it can produce that good more efficiently than any other country. Comparative advantage: A country has a comparative advantage in the production of a good if it can produce that good at a lower opportunity cost (or relative cost) than another country. Mutually Beneficial Trade Even if one country is less efficient in the production of all goods compared to another country, they can still benefit from trade. This is because each country can specialize in producing the goods for which they have a comparative advantage, and then trade with each other. By doing so, they can obtain goods more efficiently than if they tried to produce everything themselves. Specialization Comparative advantage leads to specialization. Each country should specialize in the production of the goods in which it has a comparative advantage. Specialization increases overall production efficiency and leads to more goods being available for trade. Technology and Relative Costs Ricardo's theory suggests that differences in technology and relative costs are the driving factors behind comparative advantage. These differences create opportunities for countries to specialize in the production of goods where they are relatively more efficient. Benefits of Trade The primary benefits of trade according to Ricardo's theory include: o Increased efficiency o Expanded production o A higher standard of living for both trading partners By specializing in what they do best and trading for other goods, countries can enjoy a wider range of products and services. Impact of the Theory Ricardo's Comparative Advantage Theory revolutionized the way economists think about international trade. It showed that even if one country is less efficient than another in the absolute sense, they can still benefit from trade by specializing in what they are relatively better at producing.  This theory has had a profound impact on trade policy and continues to be a fundamental concept in the field of economics. The assumptions of the model: 1. A two-country or two-commodity model is applied. 2. Labour is the only favour of production. 3. Labour is homogenous. 4. Labour is mobile within a country but immobile between countries. 5. Technology does not change – no innovation. 6. Full employment in both countries before and after the trade. 7. Perfect competition prevails in all markets. 8. Constant returns to scale. 9. Free trade – no restrictions on imports or exports. 10. No transport costs. Opportunity costs: Opportunity Cost o The value of the next best alternative that must be sacrificed when a decision is made to allocate resources to a particular activity or choice. o It is the foregone benefit or utility from not choosing the next best alternative. o In the context of international trade, opportunity cost is the cost of producing one good in terms of the amount of another good that must be forgone. Comparative Advantage o A country has a comparative advantage in the production of a good if it can produce that good at a lower opportunity cost than another country. o This means that the country can produce the good with fewer resources or in less time than the other country.  Wine and Cloth Example o Ricardo illustrated his theory with an example involving the production of wine and cloth in England and Portugal. o He showed that even if England was more productive in both wine and cloth production, they should still specialize in the one in which they had a lower opportunity cost. o In this case, England had a lower opportunity cost of producing cloth, so they should specialize in cloth production and export it to Portugal. o Portugal, on the other hand, had a lower opportunity cost of producing wine, so they should specialize in wine production and import cloth from England. Efficient Resource Allocation o Opportunity cost helps guide efficient resource allocation. o When countries or individuals make choices based on comparative advantage and opportunity cost, they allocate their resources (such as labour and capital) to activities where they can achieve the greatest benefit, leading to higher overall productivity and economic welfare. Dynamic Nature o Opportunity cost is not static; it can change over time due to shifts in technology, resources, or preferences. o As such, countries may need to periodically reassess their comparative advantage and adjust their specialization and trade patterns accordingly. Basis for Trade Decisions o In the context of international trade, opportunity cost serves as the basis for trade decisions. o Countries export goods for which they have a lower opportunity cost and import goods for which their trading partners have a lower opportunity cost. o This specialization and trade allow both countries to enjoy a higher standard of living.  Modern Economic Thinking o While Ricardo's theory was based on the labour theory of value, modern economics has evolved to incorporate other factors of production and subjective preferences. o However, the fundamental concept of opportunity cost remains a cornerstone of economic decision-making.  1. Production Possibility Frontier: Is a graph that shows all the different combinations of the output of two commodities. This can be produced using the total amount of available factors of production and technology. It shows the maximum possible production level of another given the existing levels of production and state of technology. The PPF captures the concept of: a. Scarcity b. Choice c. Trade-offs The shape: Dependent on the cost structure Increasing cost: - Concave - Outward from origin Decreasing cost: - Convex - Inward from origin - One constant cost – Straight line The slope: Indicates the opportunity cost Trade-off of producing one commodity in terms of the other commodity. Comparing Opportunity Costs – Determination of comparative advantage. Efficiency: Means that it is impossible to produce more of a good without reducing the production of another good. A. Inefficiency: If an economy is only producing computers and shoes = The production of computers trades off to produce more shoes. B. Efficiency: The economy can choose between combinations on the PPF = This is dependent on society’s preference between Computers or shoes  Production Possibility Frontier (PPF) o A graphical representation of a country's production capabilities. o Shows the maximum combination of two goods that a country can produce with its limited resources. o Can shift outwards or inwards due to changes in inputs, technology, or external factors. Shift Outwards of the PPF o Occurs when a country experiences: ▪ An increase in available inputs such as labour or capital. ▪ Technological progress that allows for more output with the same level of inputs. o Indicates that a country can produce more of one or both goods without having to reduce the production of either. Shift Inwards of the PPF o Occurs when a country faces: ▪ A decrease in the labour force. ▪ Depletion of raw materials. ▪ Natural disasters that damage physical capital. o Means that the country's ability to produce goods and services is reduced, resulting in a decrease in output.  Autarky and the PPF o A state of isolation without trade. o In autarky, a country consumes only what it produces. o The PPF in autarky represents the maximum combination of goods a country can produce and consume on its own. Trade and the Global PPF o Trade allows countries to consume outside their individual PPFs. o The global PPF is created by combining the PPFs of multiple countries. o When countries specialize in producing goods according to their comparative advantage and engage in free trade, the total quantity of each good produced and consumed is greater than the sum of autarkic production. o This demonstrates that free trade increases the absolute quantity of goods available for consumption compared to a situation of isolation (autarky). Gains from Trade and Opportunity Cost o Opportunity cost, as represented by the PPF, plays a crucial role in explaining the gains from trade. o When countries specialize based on comparative advantage, they can produce more of both goods by trading with each other, as the opportunity cost of producing the traded goods domestically is higher. Community Indifference Curve (CIC) o A graphical representation of the combinations of goods that a country can consume and be equally satisfied with. o The CIC shifts outwards when the country's consumption possibilities increase. o The intersection of the CIC and PPF illustrates the allocation of resources and consumption possibilities for a country.  Graphical Illustration of the Gains from Trade Closed Economy (No Trade): o A closed economy is one that does not engage in international trade. o The Production Possibility Frontier (PPF) shows the maximum combination of two goods that a country can produce with its limited resources. o The Indifference Curve (IC) represents the nation's preferences for combinations of clothing and food. o The point of domestic equilibrium (E) is where the PPF and the IC are tangent to each other. This means the resources are allocated efficiently within the closed economy. Comparative Advantage and Opportunity Cost: o Comparative advantage is the ability of a country to produce a good at a lower opportunity cost than another country. o Opportunity cost is the value of one product in terms of another. o In a closed economy, a country is producing at a point of self-sufficiency, meaning it is producing all the goods it consumes. Effects of Opening to Trade: o When a country opens to trade, it can specialize in the production of goods in which it has a comparative advantage. o This allows the country to produce more of these goods and export them to other countries. o In return, the country can import goods that it does not produce as efficiently. o This specialization and trade allow the country to consume more goods than it could produce on its own. Gains from Trade: o The gains from trade are the additional consumption possibilities that a country can achieve by opening to trade. o These gains can be illustrated graphically by the movement from the point of domestic equilibrium (E) to a new point of consumption (G) that is outside the PPF.  o This movement to point G represents the additional consumption possibilities that the country can achieve by specializing in the production of goods in which it has a comparative advantage and trading with other countries. Conclusion: o The gains from trade are realized because countries can specialize in producing what they are relatively better at (comparative advantage) and trade for other goods. o This specialization and exchange allow countries to move beyond their domestic production possibilities and attain a higher standard of living. Before Trade:  Key Concepts Related to Autarky Limited Economic Growth: In autarky, a country's economic growth is limited by its own resources and technology. It cannot easily expand its consumption possibilities beyond its Production Possibility Frontier (PPF). Unattainability of Points Beyond the PPF: Points beyond the PPF are unattainable in autarky. The PPF represents the maximum combination of two goods that a country can produce with its available resources. Any point beyond this frontier cannot be reached without external trade. Consumption Equals Production in Autarky: In autarky, a country's consumption is equal to its production. This means that a country relies solely on its internal resources to meet its consumption needs. Efficiency at the Point of Tangency: The most efficient point in autarky occurs where there is a tangency between several key elements: o The PPF, representing the trade-off between the two goods a country can produce. o The price line or price ratio, which represents the relative price of the two goods. o The highest possible country indifference curves (ICi), representing the levels of satisfaction or utility derived from consuming various combinations of goods. Indifference Curves and Utility: o An indifference curve is a graphical representation showing various combinations of two goods that provide a consumer with equal satisfaction or utility. o Higher indifference curves indicate greater levels of utility or satisfaction. Therefore, consumers prefer combinations of goods that lie on higher indifference curves. o Utility refers to the total satisfaction received from consuming goods or services. In this context, consumers aim to maximize their utility by selecting points on the highest possible indifference curve given their budget constraint.  After Trade: How International Trade Allows a Country to Determine its Comparative Advantage, Specialize in Production, and Achieve Gains from Trade Determining Comparative Advantage: o A country's comparative advantage is the product in which it can produce at a lower opportunity cost than another country. o This can be determined by comparing the slopes of the two lines, the PPF and the ITOT. o The country with the steeper line has the lower opportunity cost and therefore has the comparative advantage in the production of that product. Specialization and Comparative Advantage: o Once a country has determined its comparative advantage, it can specialize in the production of that product. o This is represented by the movement of the production point from A to B on the PPF.  o The country produces more of the product with its comparative advantage and less of the product with its comparative disadvantage. International Terms of Trade (ITOT): o The ITOT is the price at which a country can export its goods in exchange for imports. o It is represented by the slope of the ITOT line. o Favourable ITOTs allow a country to specialize in its comparative advantage and export more of its products. Shift in Production and Consumption: o When a country specializes in its comparative advantage, it shifts production to a point lower down on its PPF. o This is represented by the movement of the production point from A to B on the PPF. o The country can then export the product with its comparative advantage and import the product with its comparative disadvantage. Export and Import: o The country exports the product with its comparative advantage and imports the product with its comparative disadvantage. o The difference between the quantity produced and the quantity exported is the quantity consumed domestically. o The difference between the quantity imported and the quantity consumed domestically is the quantity exported. Consumption Increases: o After trade, the country can consume more of both products. o This is because the country can specialize in its comparative advantage and import the product with its comparative disadvantage. o The consumption point moves from C to D on the indifference curve. Gains from Trade: o The gains from trade are the increase in consumption that a country experiences after it specializes in its comparative advantage and engages in international trade.  o These gains come from the ability to produce more of the product with the country's comparative advantage and import the product with its comparative disadvantage. o The gains from trade are represented by the area of the shaded triangle between the indifference curves C and D. Sure, here is a more detailed explanation of the variables y1, y2, y3, IC1, IC2, x1, x2, and x3: y1, y2, y3: These are the quantities of good y produced and consumed before, during, and after trade. IC1, IC2: These are the indifference curves, which represent the different combinations of goods that a country can consume and be equally satisfied with. x1, x2, x3: These are the quantities of good x produced and consumed before, during, and after trade.  the country produces more of good y and less of good x after trade. - This is because the country has a comparative advantage in producing good y. - The country also imports good x and exports good y. This allows the country to consume more of both goods. The gains from trade are represented by the area of the shaded triangle between the indifference curves IC1 and IC2. - This area represents the additional consumption that the country can achieve after trade. 6. Heckscher-Ohlin factor endowment theory: 1990’s: Assumptions of the model: 1. Two country and two commodity model applies. 2. Two factors of production a. Capital (K) b. Labour (L) 3. Perfect competition prevails in all markets. 4. Free trade – no restrictions on imports or exports. 5. Constant returns to scale. 6. Countries have identical production technologies 7. Consumer tastes are the same across countries 8. Preferences for commodities do not vary with a country’s income level.  Propositions: Heckscher-Ohlin Model Factor Endowments and Comparative Advantage o Countries have different factor endowments (relative availability of factors of production). o Countries with more abundant labour will specialize in labour-intensive goods. o Countries with more abundant capital will specialize in capital-intensive goods. Technology and Factor Intensity o Products can be produced using different combinations of factors of production. o The capital-to-labour ratio (K/L) determines whether a production process is labour-intensive or capital-intensive. Trade Strategy Based on Factor Endowments o A country's trade strategy should be based on its factor endowments. o Labour-abundant countries should export labour-intensive goods and import capital-intensive goods. o Capital-abundant countries should export capital-intensive goods and import labour-intensive goods. Relative Factor Prices o Factor prices (wages and return on capital) will differ between countries based on their factor endowments. o Labour will be relatively cheap in labour-abundant countries. o Capital will be relatively cheap in capital-abundant countries. Trade and Factor Price Equalization o International trade can lead to factor price equalization over time. o Trade can result in the adjustment of factor prices, as countries trade goods based on factor endowments and factor intensities.  Theorem: Heckscher-Ohlin Theorem Predicting Trade Patterns o A capital-abundant country will tend to export capital-intensive goods, while a labour-abundant country will tend to export labour-intensive goods. o This is because countries will specialize in the production of goods that make the most efficient use of their abundant factors of production. Inter-Industry Trade o The trade pattern explained by the Heckscher-Ohlin (H-O) theory is one of inter-industry trade, meaning trade occurs between different industries or sectors. o Developed countries, which are rich in capital, are expected to export manufactured goods. o Developing countries, which have abundant labour and natural resources, are expected to export primary goods like agricultural and mining products. Winners and Losers in Free Trade o In a free trade scenario based on the H-O model, there are winners and losers. o Winners: ▪ Owners of the relatively abundant factor (e.g., capital in capital- abundant countries) will see an increase in real income as they benefit from exports. o Losers: ▪ Owners of the relatively scarce factor (e.g., labour in capital-abundant countries) may see a decrease in real income due to import competition. Pro-Free Trade vs. Anti-Free Trade o Pro-free trade: ▪ Owners of relatively abundant resources often support free trade policies because they benefit from increased exports and economic gains.  o Anti-free trade: ▪ Owners of relatively scarce resources may be inclined to oppose free trade because they face more competition and potential income reduction. Overall Positive-Sum Game: o Despite the winners and losers, international trade is generally considered a positive-sum game. This means that the overall benefits, in terms of increased efficiency and wealth creation, outweigh the costs. Addressing the Losers: o A critical question in international trade policy is how to address the concerns of those who may lose out due to trade liberalization. o Policymakers often implement measures such as retraining programs, social safety nets, and policies to promote job mobility to help workers affected by trade-related job displacement. 7. Introduction of New Trade Theories: Trade Theories and Intra-Industry Trade Classical Trade Theories o Mercantilism: Accumulation of wealth through a positive trade balance (exporting more than importing). o Absolute Advantage (Adam Smith): Countries should specialize in producing goods they are most efficient at producing. o Comparative Advantage (David Ricardo): Even if one country is less efficient in producing all goods, they should still specialize in what they are relatively more efficient at producing. o Heckscher-Ohlin Model: Differences in factor endowments (land, labour, capital) between countries explain trade patterns. New Trade Theories o Product Differentiation (Paul Krugman): Intra-industry trade can occur when firms produce slightly differentiated products within the same industry. o New Trade Theory (Paul Krugman): Economies of scale and network effects can lead to intra-industry trade.  o Gravity Model: Explains trade patterns based on factors like the size of economies, geographical proximity, and cultural ties. Intra-industry Trade o Exchange of similar products within the same industry. o Cannot be explained by classical trade theories. o Can be explained by new trade theories. Implications o New trade theories offer a more nuanced understanding of trade patterns in the modern global economy. o They relax some of the assumptions of classical theories. o They offer valuable insights into the intricacies of international trade. Linder's Overlapping Demand Theory Key idea: Trade between countries is driven by the similarity of their demand patterns. Assumption: Consumers in different countries have similar preferences for certain goods and services. Implications: o Countries with similar demand patterns will tend to trade more with each other. o Countries with different demand patterns will tend to trade less with each other. o Trade can help to promote economic growth by increasing the variety of goods and services available to consumers. Economies of Scale (Krugman) Key idea: Economies of scale occur when the average cost of production falls as the quantity produced increases. Assumption: Firms can produce goods at a lower cost when they produce a larger quantity. Implications: o Firms may choose to produce goods in a single location where they can achieve economies of scale.  o This can lead to trade between countries, as firms export goods from the location where they are produced to other countries. o Trade can help to promote economic growth by increasing competition and lowering prices. The Technology Gap and Product Lifecycle Theories (Posner & Vernon) Key idea: The pattern of trade between countries can be explained by the different stages of the product lifecycle. Assumption: The product lifecycle is the process by which a new product is introduced to the market, becomes established, and eventually declines. Implications: o Countries that are at the leading edge of technology are more likely to export new products. o As products mature, they become less expensive to produce and other countries may begin to export them. o Countries that are at the trailing edge of technology are more likely to import products. o Trade can help to promote economic growth by transferring technology from leading-edge countries to trailing-edge countries. 8. Linder’s Overlapping Demand Theory: 1996: Linder's Overlapping Demand Theory Focuses on demand: Linder's theory focuses on the demand side of international trade, rather than the supply side. Applies to manufactured goods: Linder's theory is specifically applicable to manufactured goods, which are differentiated in terms of quality, brand, or variety. Starts with domestic demand: Linder's theory posits that manufactured goods are initially produced to satisfy domestic demand. Exports to neighbouring countries: After fulfilling domestic demand, countries may export these manufactured goods to neighbouring countries.  Income levels and demand similarities: Linder's theory predicts that countries with similar income levels will have overlapping demand patterns and therefore engage in more trade with each other. The Linder hypothesis: The Linder hypothesis states that countries will export and import goods that match the preferences of their consumers. Assumptions of the theory: 1. Potential trade of a country is confined to goods that have domestic demand. 2. Two trading countries are engaged in the trade of goods for which demand exists within their domestic markets. 3. The domestic demand for goods is determined by the level of per capita income. 4. Similar levels of income influence the potential trade between the two countries. 5. Similar tastes and preferences in the trading partners. Linder's Overlapping Demand Theory Applicability: o Primarily applicable to trade in differentiated manufactured goods. o H-O theory still applies to trade in primary products. Domestic Demand as a Starting Point: o Goods are initially produced to meet domestic demand. o Countries consider exporting these products after domestic demand is met. Income Levels and Product Quality: o High-income countries are more likely to produce and consume high-quality products. o Low-income countries are expected to produce lower-quality goods.  Preference Similarities Hypothesis: o International trade will occur between countries with similar income levels because their consumers will have overlapping preferences for similar types of manufactured goods. Gains from Trade: o Gains from trade arise not only from lower costs but also from meeting consumer demands for specific quality, brands, or varieties of products. Trade Between Different Income Levels: o Income disparities can exist within countries, leading to overlapping demand for different quality levels of products. 9. Paul Krugman: Economies of Scale: 1979: Paul Krugman's Contribution to International Trade Theory Departure from Ricardian Assumptions: o The Ricardian framework for comparative advantage was based on strict assumptions like perfect competition, constant returns to scale, and homogeneous labour. o These assumptions became less applicable in the modern economy, where perfect competition was rare, and increasing returns to scale played a significant role in many industries. Introduction of Intra-Industry Trade: o Modern economists recognized the need to develop models that could explain intra-industry trade, where countries engage in the exchange of similar products within the same industry. Krugman's Breakthrough: o Paul Krugman's seminal paper titled "Increasing Returns, Monopolistic Competition, and International Trade" introduced a formal model that provided a simple explanation for trade in the absence of the classical bases for comparative advantage.  Internal Economies of Scale: o Krugman's model emphasizes the role of internal economies of scale in driving trade. o This occurs when a firm's average cost per unit of output decreases as total output increases. o One of the simplest reasons for this phenomenon is high fixed costs, where producing more output allows firms to spread these fixed costs over a larger production volume. Identical Preferences, Technology, and Factor Endowments: o Krugman's model suggests that trade and gains from trade will occur between countries with identical preferences, technology, and factor endowments. o In this context, trade becomes a way to extend markets and exploit economies of scale. Explaining Intra-Industry Trade: o Krugman's model helps explain observed patterns of intra-industry trade, where countries with similar characteristics trade with each other. o This type of trade is characterized by the exchange of goods that are differentiated by quality, brand, or variety within the same industry. Assumptions of the model: 1. All individuals in the economy have the same utility function – same tastes. 2. Countries have identical technology and factor endowments. 3. Labour is the only factor of production. 4. Full employment. 5. The elasticity of demand rises as the price of a good increases. 6. There exist internal economies of scale – firm can reduce average cost by expanding production.  7. Monopolistic competition: Imperfect competition: Monopolistically competitive markets are imperfectly competitive because firms have some market power. This means that they can influence the price of their products to some extent. Fewer firms: There will be fewer firms in monopolistically competitive markets than in perfectly competitive markets. This is because firms have some market power, so they can charge a price above marginal cost. More output: Each firm in a monopolistically competitive market will produce more output than a firm in a perfectly competitive market. This is because firms have some market power, so they can sell more output without having to lower their price. Product differentiation: Firms in monopolistically competitive markets will differentiate their products from each other. This can be done in terms of quality, features, branding, or other factors. Entry and exit: New firms can enter a monopolistically competitive market if they believe they can make a profit. However, profits will eventually be driven down to zero by competition. Economies of scale, imperfect competition and international trade: Krugman's Model of International Trade Economies of scale: Economies of scale occur when the average cost of production falls as the quantity produced increases. Monopolistic competition: Monopolistic competition is a market structure where there are many firms selling similar but differentiated products. Acquired comparative advantage: Acquired comparative advantage refers to the ability of a country to produce a good more efficiently than another country because of economies of scale.  Export specialization: Export specialization refers to the tendency of countries to export the goods they produce more of. Factor endowments: Factor endowments refer to the natural resources, labour, and capital available in a country. Intra-industry trade: Intra-industry trade refers to the exchange of similar products within the same industry. Key Points Economies of scale can lead to trade even between countries with identical characteristics. This is because economies of scale allow firms to produce goods more efficiently, which can lead to lower prices and a greater variety of products. Countries tend to export the goods they produce more of, which is often due to economies of scale. The type of trade between two countries also depends on factors like differences in factor endowments. Krugman's model helps explain trade patterns that traditional comparative advantage models could not account for. Real-World Examples Automobile manufacturing: The automobile industry is an example of an industry where economies of scale are important. Large automobile manufacturers like Toyota, General Motors, and Volkswagen can produce cars more efficiently than small manufacturers because they can spread fixed costs over a larger number of vehicles. Technology manufacturing: The technology industry is another example of an industry where economies of scale are important. Companies like Apple and Samsung can produce smartphones more efficiently than smaller manufacturers because they can mass-produce them. Airlines: Airlines can also benefit from economies of scale. Airlines with larger fleets of aircraft can spread fixed costs (e.g., aircraft purchase and maintenance) over more flights and passengers, resulting in cost savings.  10. Technological Gap Model of International Trade: Krugman's Perspective on International Trade and Competition in Monopolistically Competitive Markets Identical Countries: Two countries have identical tastes, technologies, and factors of endowment. Traditional Theories vs. Krugman: Traditional theories suggest that countries with identical characteristics would have no reason to trade with each other. Market Size and Free Trade: Free trade between identical countries can lead to: o Economies of scale: Firms can produce more efficiently as they expand their production due to the larger market. o Product diversity: Consumers have access to a wider range of goods produced by different firms. o Acquired comparative advantage: Countries can still benefit from trade by leveraging economies of scale and product diversity, even if they do not have traditional comparative advantages. Export Specialization: Under conditions of internal economies of scale, countries are likely to specialize in producing and exporting the goods they are already producing more of domestically. Barriers to Trade: Barriers to trade can limit specialization because they increase the costs of exporting. Models that explain international trade based on technological changes: 1. Technological Gap or Imitation Gap Model 2. Product Cycle Model 1961: 1. Technological Gap or Imitation Gap Model: Technological Gap Theory Premise: Even if countries have similar factor endowments and preferences, a technological change can give rise to trade.  Mechanism: o A firm introduces a new product in its domestic market. o If the product is successful, the firm tries to introduce it in the foreign market. o The new product gives the firm a temporary monopoly position in world trade. o Patents and copyrights protect this monopoly position. o The exporting country enjoys a comparative advantage over the rest of the world until the foreign producers imitate the new product or learn new processes of production. o The lag between the introduction of the new product and the introduction of the substitutes by the foreign market creates the technology gap. Implications: The technological gap theory suggests that countries can benefit from trade by being the first to introduce new products or technologies. The theory also suggests that countries can protect their comparative advantage by investing in research and development. The theory can be used to explain why some countries are more successful at exporting certain products than others. Limitations: The technological gap theory is based on a number of assumptions, such as the availability of perfect information and the absence of government intervention. The theory does not take into account the role of other factors, such as economies of scale and transportation costs, in determining trade patterns. The theory has been criticized for being too simplistic and for not being able to explain all the observed patterns of trade.  Real-World Examples: The United States has a long history of technological innovation, and this has been a major factor in its economic success. For example, the United States was the first country to develop the personal computer, the Internet, and the smartphone. Other countries that have been successful in technological innovation include Japan, Germany, and South Korea. Criticisms: The technological gap model has been criticized for being too simplistic. It does not take into account other factors that can affect trade, such as the cost of labour and the availability of natural resources. The model also assumes that all countries have the same ability to innovate, which is not always the case.. Assumptions of the model: 1. There are two countries, A and B. 2. The factor endowments are similar in the two countries. 3. Both Countries have similar demand structures. 4. The cost of production in the two countries are similar before trade. 5. Countries have different production technologies. Posner split the Technological gap into three categories: 1. Demand lag – taken by the domestic consumers to acquire a taste for the new product. 2. Foreign reaction lag – time taken for the foreign firm to imitate and produce the new product. 3. Domestic reaction lag – time required by the domestic producers to keep innovating and introducing new varieties to maintain the upper-hand in both domestic and foreign markets.  4. Posner – referred to the combination of innovation and imitation lag = Dynamism. ▪ A dynamic country is one which innovates at a greater rate and imitates the foreign innovations at a greater speed. ▪ A prosperous country is one that has a greater degree of dynamism than the other ▪ Absence of dynamism – erosion of markets and trade deficits. Salvatore – Shortcomings of the model: 1. Does not explain the size of the gap 2. Does not explain the reason for its emergence 3. Does not explain how it is eliminated over time 11. Raymond Vernon – Product Life Cycle Theory: 1966: o Every product has its life span o Every product goes through various stages – introduction till declination o Innovating Countries that initially produced and exported end up being the importing country of the same product or a differentiated variety of that product. Assumptions of the model: 1. The producer in capital-rich countries initially introduce new products. 2. The innovating firms have some real or monopolistic advantage. 3. The need or opportunities of the domestic market stimulate the innovation of a new product. 4. The innovating firm has little information about the conditions existing in foreign markets.  5. The domestic environment in the advanced countries which initially make the innovation is different from in other advanced countries. 6. The market is competitive and rival producers can enter the market, which prompts the turning out of the product for export. o Argument: the factor requirement of a product varies over the lifetime for there to be a cycle in its production. o Risks: a. Induced by relatively rich firms. b. Can be reduced – adaptability on the production side c. This reduction requires – skilled labour and easy access to consumer insights Vernon's Product Life Cycle Theory Assumptions: o New products are first produced in advanced countries. o Other countries can enter the market when the product and manufacturing processes are standardized. o The pioneering country is overtaken by other countries in the production of these goods. Phases: o Introduction: The product is first introduced to the market. It is likely to be expensive and have a limited market. o Growth: The product becomes more popular and the market expands. Prices start to fall. o Maturity: The product reaches its peak of popularity. Prices are stable and competition is high. o Decline: The product starts to lose popularity and the market shrinks. Prices may fall further.  Implications: The theory suggests that countries can gain a competitive advantage by being the first to produce new products. The theory also suggests that countries can lose their competitive advantage as products mature and other countries enter the market. The theory can be used to explain the changing patterns of trade over time. Real-World Examples: The United States was the first country to produce many of the world's most popular products, such as the personal computer, the Internet, and the smartphone. However, other countries have since caught up and are now major producers of these products. For example, China is now the world's largest producer of smartphones. Criticisms: The product life cycle theory has been criticized for being too simplistic. It does not take into account other factors that can affect the production and trade of goods, such as the cost of labour and the availability of natural resources. The theory also assumes that all countries have the same ability to innovate, which is not always the case.  Introduction stage: The product is first introduced in the domestic market of the innovating country. The innovating country is typically an advanced country with a high income, capital, and skilled labour force. The innovating country has a comparative advantage in the production of the new product due to its ability to do research and development (R&D) and to manufacture the product at a high quality and low cost. The product is initially sold at a high price because the innovating country has a monopoly in the market. Demand for the product is low in the introduction stage because the product is new and consumers are not familiar with it. Implications: The introduction stage is a risky stage for the innovating company because it is investing a lot of money in R&D and manufacturing, but it is not yet making a profit. The innovating company needs to carefully manage its costs and price the product so that it can recoup its investment and make a profit in the future. The innovating company also needs to build brand awareness and educate consumers about the benefits of the new product. Growth Stage: The product is introduced in foreign markets. Demand for the product grows rapidly in foreign markets as consumers become more familiar with it. Foreign producers start to manufacture the product or its close substitutes. The innovating country's share of the market starts to decline, but it still supplies a significant amount of the product. The price of the product starts to decline as competition intensifies.  Implications: The growth stage is a profitable stage for the innovating company because demand for the product is high and prices are still relatively high. The innovating company needs to invest in production capacity to meet the growing demand for the product. The innovating company also needs to invest in marketing and advertising to maintain its brand awareness and market share. Maturity stage: The product becomes standardized and competition intensifies. Foreign producers have a competitive advantage over innovating country producers due to lower labour costs and economies of scale. The price of the product continues to decline. Profits start to fall for innovating country producers. The innovating country producers may start to lose market share to foreign producers. Implications: The maturity stage is a less profitable stage for the innovating company because demand for the product is no longer growing and prices are declining. The innovating company needs to focus on reducing costs in order to maintain its profitability. The innovating company may also need to differentiate its product from the competition in order to maintain its market share. Here are some additional points about the maturity stage of the product life cycle: The innovating company may start to outsource production to foreign countries in order to reduce costs. The innovating company may also start to focus on new product development in order to stay ahead of the competition. The innovating company may also start to focus on marketing and branding in order to maintain its brand awareness and market share.  Decline Stage: The product is replaced by newer, more innovative products. Demand for the product falls. Prices continue to decline. Profits become negative for innovating country producers. Innovating country producers may stop producing the product altogether. Implications: The decline stage is a loss-making stage for the innovating company. The innovating company may need to exit the market or find a new way to compete. The innovating company may also need to focus on new product development in order to stay ahead of the competition. Here are some additional points about the decline stage of the product life cycle: The innovating company may start to focus on marketing and branding in order to maintain its brand awareness and market share. The innovating company may also start to focus on recycling and disposal of the product in order to reduce its environmental impact.