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Chapter 3 Objectives of the Chapter Chapter Three looks at trade in a hypothetical world of two countries and two commodities. This simple trade model is based on barter, where countries exchange only goods without any money being used. The price of each good is, therefore, what each unit of the good is worth in units of the other good. Countries trade because their prices would differ if something prevented international trade. In this chapter we focus on production side differences between countries as a source of price differentials. Each country has a comparative advantage in producing some good for which it has more resources or higher productivity than other countries. To understand this chapter you should be able to:
Outline:
Overview This chapter extends the analysis of international trade to consider trade in a multiple-product economy. An economy composed of two products is useful to bring out insights about international trade. This general equilibrium approach explicitly shows the effects of resource reallocations between industries. The chapter shows how our understanding of trade, especially of why countries trade, has evolved over time. The story begins with Adam Smith and absolute advantage. (A box on mercantilism summarizes the view that Smith opposed and shows how mercantilist thinking continues today.) The analysis focuses on the resource cost (labor hours) of producing each of two products (wheat and cloth) in two countries (the United States and the rest of the world). Smith examined the case of absolute advantage in which the labor hours to produce one product are lower in one country and the labor hours to produce the other product are lower in the other country. The resource costs (or labor hour input-output coefficients) indicate the relative prices of the products in each country with no trade. The difference in prices with no trade sets up the opportunity for arbitrage, with each good being exported from the initially low-price country and imported by the initially high-price country. The shift to a free trade equilibrium results in an equilibrium international price. Without information on demand, we cannot say exactly what this price will be, but we do know that it is between the two no-trade price ratios. Smith's approach does not indicate what would happen if the same country had absolute advantage in both products. Ricardo took up this case and demonstrated the principle of comparative advantage-a country will trade in the pattern that maximizes its advantage (or minimizes its disadvantage). With the exception that one country has an absolute advantage in both products, the example to demonstrate Ricardo's insight is very similar to the example used to illustrate Smith's insight. The chapter uses the Ricardian example to introduce a key analytical device-the production possibility curve, which shows all combinations of outputs of different goods that an economy can produce with full employment of resources and maximum productivity. The resource costs of producing each product in the country and the total amount of labor hours available in the country are used to graph the country's production possibility curve, a straight line whose slope equals the (negative of the) extra (or marginal) cost of additional cloth. The straight line indicates that the marginal or opportunity cost of each good in each country is constant, following Ricardo's assumptions. The slope of this line also indicates the relative price of cloth (the good on the x-axis) with no trade. If free trade results in an equilibrium international price ratio that is strictly between the two no-trade price ratios (because both countries are "large countries"), then each country specializes completely in producing only the good in which it has the comparative advantage. Each trades at the equilibrium international price ratio (along a trade line or price line) to reach its consumption point. Both countries gain from trade. Each is able to consume more of both goods than it consumed with no trade. The assumption of constant marginal cost and the implication that countries will completely specialize in producing only one (or a few) product(s) are unrealistic. In the modern theory of international trade, we use the assumption of increasing marginal costs-as one industry expands at the expense of others, increasing amounts of other goods must be given up to obtain each extra unit of the expanding output. Increasing marginal cost results in a bowed-out production possibility curve. This is linked to upward-sloping supply curves for each product. Increasing marginal costs arise because some resources are better suited to producing one good rather than the other (including differences in factor input proportions between the two products-Appendix B shows this explicitly). The market price ratio determines which production point will actually be chosen. Production will be driven to levels at which the marginal (or opportunity) cost of producing another unit just equals the price at which the output can be sold. On the graph this is a tangency between the production possibility curve and the price line whose slope reflects the market price ratio. The second key analytical tool that we need is a way to picture demand for two products at the same time. For individuals this can be done using indifference curves and income or budget lines. The chapter reviews (or summarizes) the basics of indifference curves (levels of well-being or happiness or utility, bowed shape, infinite number of which only a few are usually pictured). It then indicates that we are going to use community indifference curves, even though there are serious questions about them. At the least, they are reasonable for depicting national demand patterns for two goods simultaneously. Under certain assumptions they also provide information on national well-being or welfare, but this use is more debatable. Putting the production possibility curve together with the community indifference curves results in a picture of an entire (two-product) economy. The chapter shows the equilibrium with no trade (a tangency of a community indifference curve with the production possibility curve). It then shows two countries whose no-trade price ratios differ. When trade is opened between the two countries, an equilibrium international price ratio is established that clears the international markets for the two goods. Production in each country shifts to the tangency with the new price line (whose slope shows the equilibrium international price), and each country trades along the price line to a consumption point determined by a tangency between the price line and a community indifference curve. The right-angle triangle between the production point and the consumption point is a trade triangle showing export and import quantities for each country. (The chapter also indicates how the graph can be used to derive a demand curve for cloth, so that the analysis is shown to be consistent with the supply-demand analysis from the previous chapter.) The graph can be used to show that each country gains from trade. Trade allows each country to consume beyond its ability to produce (shown by the production possibility curve). Trade allows each country to reach a higher community indifference curve. How much the country gains from trade depends on the country's terms of trade-the price of its exports relative to the price of its imports. The graph also shows the effects on the production and consumption quantities for each good in each country. The chapter ends by returning to the key question addressed in the chapter-what determines the pattern of trade. While demand differences might explain some trade, most analysis focuses on production-side differences. If demand is neutral, then the trade pattern is determined by production-side differences that cause no-trade price ratios to differ. In our graph, these differences skew one country's production possibility curve toward producing wheat and the other country's toward producing cloth. The skewness itself could arise for two reasons. First, production technologies or resource productivities may differ between countries. This explanation is the one used in the Ricardian approach, and we will return to it in Chapter 5. But, for the remainder of this chapter and the next chapter, we ignore technology or resource productivity differences, and instead focus on the second reason-differences in resource availability and resource use. The skewness of production possibility curves can arise because resource availability differs between countries and the use of these factors in producing differs between products. These differences in factor endowments and factor proportions lead to the Heckscher-Ohlin theory of trade patterns-countries export the products that use their abundant factors intensively (and import the products that use their scarce factors intensively). With no trade the relatively abundant production factors will be relatively cheap, so that the product that uses these factors relatively intensively will have a low no-trade price. As trade is opened, this product is exported.
Key Terms Absolute advantage: A nation has an absolute advantage in a commodity it produces more efficiently (with higher productivity) than the rest of the world. Barter trade: A method of exchanging goods and services directly for other goods and services without using a separate unit of account or medium of exchange. Basis for trade: The mechanism that explains differences in (relative) prices in different countries, which in turn gives rise to trade between countries. Community indifference curves: An illustration of the different combinations of commodity quantities that would bring the whole community (here, the nation) the same level of satisfaction. Comparative advantage: A nation has a comparative advantage in the production of those goods which (compared to other goods and countries in the world) it produces less inefficiently than other commodities. A country will have a comparative advantage in one or more commodities , whether or not it has absolute advantages. Factor abundance and scarcity: A country is relatively abundant (scarce) in some factor if the ratio of the amount of that factor to other factors in that country is higher (lower) than in the rest of the world. Factor intensity: A product is intensive in some factor if the cost of that factor is a greater share of the product's value than it is of the value of other products. Heckscher Ohlin (H O) theory: A country will export that good which intensively uses the country's abundant (cheap) factor, and import the good which intensively uses its scarce (expensive) factor. Mercantilism: A school of thought which was dominant in Europe (roughly in the 16`h century through the I 8d' century). Mercantilism advocates trade restrictions through restriction of imports and expansion of exports so as to accumulate gold and foreign exchange. Terms of trade: The ratio of the price of a country's exports to the price of its imports. Warm up Questions True or False? Explain. 1. T / F A country can have a comparative advantage in a good even if it is at an absolute disadvantage in producing that same good. 2. T / F David Ricardo was the husband in "I Love Lucy." 3. T / F Under the H O theory, a country is considered "land abundant" if it has more acres of land than another country. 4. T / F Under increasing costs, countries will not necessarily specialize completely in one good. 5. T / F The Heckscher Ohlin theory assumes each country has the same tastes for goods. Multiple Choice 1. The economist credited with the first systematic expression of the principle of comparative advantage was:
A. Bertil Ohlin 2. The Heckscher Ohlin theorem indicates that:
3. If with one hour of labor nation A can produce either 3x or 3y, while nation B can produce either 1x or 1y with an hour of labor, and if labor is the only input, then:
A. Nation A has an absolute advantage in
both goods. 4. For Heckscher Ohlin, the most important cause of the difference in relative commodity prices is the difference between countries in:
A. Factor endowments. 5. In the absence of trade, the consumption points available to a nation:
A. Are above the production possibilities
curve. Problems 1. Consider the following hypothetical data on labor requirements in Leinster and Saxony, the only two countries in "the world":
2. Let's try an application of the Heckscher Ohlin model to the countries of Leinster and Saxony. Assume the only two factors of production are labor and land. a. If Leinster has 8 million acres of land and 2 million laborers while Saxony has 2 million acres of land and 400,000 laborers, which country is "labor abundant?" . Which is "land abundant?" Explain. b. If labor accounts for 80 percent of the total cost of producing telephones but only 20 percent of the total cost of producing bread, which country is more likely to export telephones? Bread? Why? 3. Consider two countries that have exactly the same increasing cost production possibilities curves. Show how a difference in the tastes of the two countries can then determine the pattern of trade between the countries. 4. Assume that Chile has 600 units of labor and Brazil has 1000 units of labor. Both countries produce cloth and wheat. In Chile, the labor requirement for a yard of cloth is 3 units, while for a bushel of wheat requires 2 units. In Brazil, the labor requirement for a yard of cloth is 5 units, while a bushel of wheat requires 2 units. In both countries there are constant costs of production. a. Draw the production possibilities curves for each country and calculate the pre-trade price of wheat in each country. b. When these two countries engage in free trade, which country would export cloth? Why? Is it possible for the cloth exporting country to charge 5 bushels/yard for its cloth? c. Suppose that the labor endowment in Chile increases to 1200 units. how could this affect the pattern of trade? d. Suppose instead that the unit labor requirement in Brazil's cloth industry drops to two. What will happen to the pattern of trade? 5. Using the logic of comparative advantage, explain why it makes sense for parents to require even the youngest children of a family to do household chores. Discussion Topics 1. Can a country do anything to change its relative factor abundances? 2. Are there reasons for a country to want relative abundance in one factor rather than another?
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