A2 macro presentation on some of the gains from trade, basics of international trade theory

1. The Economics of
International Trade
tutor2u
A2 Economics
Geoff Riley, 2013

2. Paul Krugman on Trade
• “If there were an
Economist’s Creed, it
would surely contain the
affirmations “I believe in
the Principle of
Comparative Advantage”
and “I believe in Free
Trade”.”
• Paul Krugman, Professor
of Economics at
MIT, Cambridge

3. Hidalgo and Economic Complexity
Ask yourself the question: If a good
cannot be produced in Japan
or Germany, where else can it be made?

4. Global Regions

5. What is Free Trade?
• Trade free from artificial barriers
• Trade reflects the impact of
specialisation and exchange
– Specialization: specialisation of scarce
resources
– Exchange: in part based on
comparative advantage in supplying
different goods and services

6. The concept of an open economy
• In an open economy, one nation
trades openly with other
– Trade in goods
– Trade in services
– Free flow of financial capital
– Free flow of labour resources
• An economy integrated with and
connected to the world economy

7. World Trade
Time period
1950-60
Volume of world trade
7.7
Real GDP (world)
4.5
1960-70 8.6 5.5
1970-80 5.3 4.1
1980-90 3.9 3.2
1990-00 6.5 2.3
2000-11 4.7 2.7
2001 -0.2 2.0
2002 3.4 2.3
2003 5.7 2.9
2004 9.7 4.0
2005 6.5 3.5
2006 8.6 4.0
2007 6.5 3.9
2008 2.3 1.3
2009 -12.1 -2.4
2010 14.0 3.8
2011 4.9 2.4
Volume of world merchandise exports and gross
domestic product, 1950-2011, annual % change

8. Exports of Goods and Services

9. Exports of Goods and Services

10. Potential Advantages from Trade
• (1) Increased competition for producers
– Increased market contestability
– Pressure on suppliers to keep prices down
– Improved allocative & productive efficiency
• Prices closer to their factor cost
• Pressure on unit costs to fall / scale economies
• (2) Better use of scarce resources
– Exploitation of comparative advantage
– Benefits from specialisation
– Trade can be an important source of economic
growth and development

11. Potential Advantages from Trade
• (3) Dynamic Efficiency Gains
– Trade speeds up the pace of technological
progress and innovation
– Transfer of ideas / technology spill-overs
– World Bank – “dynamic globalisers have
achieved the fastest growth over the last twenty
years”
– Greater choice for consumers

12. Potential Advantages of Trade
• (4) Economies of scale
– Increasing returns to scale from selling to larger
markets e.g. BRICs or the EU single market
– Falling LRAC / lower real prices
– Gains in producer & consumer surplus
• (5) A stimulant to growth / recovery
– Exports – an injection of AD into circular flow
– Boost to exports will have multiplier and
accelerator effects on national income
– Supply-side improvements from investment and
greater factor mobility between countries

13. Export Potential to BRICs & Beyond
Jim O’Neill
“By the end of the
decade, Britain’s trade
with the BRIC
countries of
Brazil, Russia, India
and China, will
account for 17pc of
total exports.”

14. Gains from External Trade
Reduction in
extreme poverty
Increased market
competition
Access to new
technologies
Inflows of
knowledge
Economies of
scale
Better use of
scarce resources

15. Comparative Advantage
• David Ricardo, one of the founding fathers
of classical economics
• Comparative advantage exists when
– Relative opportunity cost of production is lower
than in another country
– A country is relatively more productively efficient
than another
• Basic rule – specialise in the things that you
are relatively best at
• This opens up important gains from trade

16. Factor endowment model
• Developed by Heckscher and Ohlin
• Countries with a relative factor abundance
can specialise and trade
– Abundance of skilled labour → specialisation
→ export → exchange for goods and
services produced by countries with
abundance of unskilled labour
– Exports embody the abundant factor
– Imports embody the scarce factor
– Assumes a high degree of factor mobility

17. The Theory of
Comparative
Advantage
Analysis of the potential gains from
specialisation, trade and exchange between
regions and nations

18. Theory of Comparative Advantage
Half of each
country’s available
resources are
allocated to each
industry
Freezers
(000s per year)
Dishwashers
(000s per year)
Germany 1000 500
Italy 800 200
Total Output

19. Theory of Comparative Advantage
Half of each
country’s available
resources are
allocated to each
industry
Freezers
(000s per year)
Dishwashers
(000s per year)
Germany 1000 500
Italy 800 200
Total Output 1800 700

20. Assuming Constant Returns – The
Effects of Partial Specialisation
Gain in total output
after specialisation
Freezers
(000s per year)
Dishwashers
(000s per year)
Germany 400 (-600) 800 (+300)
Italy 800 200
Total Output

21. Assuming Constant Returns – The
Effects of Partial Specialisation
Gain in total output
after specialisation
Freezers
(000s per year)
Dishwashers
(000s per year)
Germany 400 (-600) 800 (+300)
Italy 1600 (+800) 0 (-200)
Total Output

22. Assuming Constant Returns – The
Effects of Partial Specialisation
Gain in total output
after specialisation
Freezers
(000s per year)
Dishwashers
(000s per year)
Germany 400 (-600) 800 (+300)
Italy 1600 (+800) 0 (-200)
Total Output 2000 (+200) 800 (+100)

23. Assuming Constant Returns – The
Effects of Partial Specialisation
Gain in total output
after specialisation
Freezers
(000s per year)
Dishwashers
(000s per year)
Germany 400 (-600) 800 (+300)
Italy 1600 (+800) 0 (-200)
Total Output 2000 (+200) 800 (+100)

24. Beneficial Terms of Trade
• A beneficial terms of trade is an agreed rate
of exchange of one product for another than
leaves both countries better off from trade
• Consider the domestic terms of trade for each
country
– Without trade, Germany gets 2 extra freezers for
every dishwasher that is gives up
– Without trade, Italy has to give up 4 freezers for
every extra dishwasher it produces
• Is there a mutually beneficial terms of trade?

25. Trade increases amount available
in each country
Final output in
after trade
Freezers
(000s per year)
Dishwashers
(000s per year)
Germany 1150
(+750 .. import)
550
(-250 ..export)
Italy 850
(-750 .. export)
250
(+250 .. import)
Total Output 2000
At start: (1800)
800
At start: (700)

26. Assumptions underlying theory
Constant
returns to scale
Mobility of
factor inputs
No externalities
Trade finance
available
Barriers to
trade are small

27. Assumptions underlying theory
Constant
returns to scale
Mobility of
factor inputs
No externalities
Trade finance
available
Barriers to
trade are small
Krugman –
New Trade
Theory
“In
reality, world
trade is
dominated by
rich countries
trading
similar goods
with each
other”

28. Assumptions underlying theory
Constant
returns to scale
Mobility of
factor inputs
No externalities
Trade finance
available
Barriers to
trade are small
Krugman –
New Trade
Theory
“In
reality, world
trade is
dominated by
rich countries
trading
similar goods
with each
other”
Standard theory
ignores extra
benefits from
(i) Consumer
choice
(ii) Economies
of scale
(iii) Positive
trade
externalities
(iv) Other
dynamic
effects of
trade

29. Supply and Demand Analysis
Price
Output (Q)
Domestic Demand
Domestic Supply
World Price

30. Supply and Demand Analysis
Price
Output (Q)
Domestic Demand
Domestic Supply
P1
Q1
World Price
QdQs
Pw

31. Comparative Advantage
Unit labour costs Exchange rate Innovation
Economies of scale Sustainability Human capital

32. The Importance of Human Capital =
More Value Added from Exports
Technology spill-overs Universities Science Parks
Precision Engineering Capital Projects Creative Industries

33. Economic complexity and trade
Two countries that have
high levels of economic complexity, but
still low levels of per capita income are
China and Thailand
Ask yourself the question, if you cannot
produce it in China or Thailand, where
else can you produce it?

34. Export Patterns: Rwanda

35. Export Patterns: Malawi

36. Export Patterns: United Kingdom

37. Shifts in Advantage for the UK
• Long term decline in comparative advantage
in many areas of manufacturing industry
– Lower cost producers in SE Asia and E.Europe
– Productivity gap with other leading economies
– Strong ex. rate has damaged competitiveness
• The UK still has trade surpluses in chemicals
and high knowledge manufacturing
• Main comparative advantage lies with
business and financial services