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Series of lectures from Brian Butler, given during fall 2008 session at Thunderbird Global MBA, Miami campus:This lecture 05: continue learning the basics of trade economics, starting with absolute advantage, comparative advantage, and looking at the economics of free trade
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Brian David ButlerMiami Campus FacilitatorInternational Economics & Trade (Prof. Grosse)
Email: [email protected]: 305-396-6116
Connect:•Facebook•Linkedin•GloboTrends blog
Session #5
Why study trade?
• Class outline
Today Future classTrade theory trade barriersWhy trade? Economics of tariffsComparative advantage
Compare this class vs. finance class?
Perspectives:
Whats the difference:
1. How economist sees trade?2. How marketing sees trade?
- Goals / objectives
For initial discussion…
1. “free trade is mutually beneficial for both countries” i.e. both countries are better off
2. “the freer the trade, the more both countries benefit”
– Agree? disagree? Limitations?– what are the benefits of free trade?– Negatives?
benefits?
1. Greater diversity of products 2. Economies of scale (from specialization)
– bigger market, drives costs down)– Greater efficiency in large plants (autos, example)– Advantage to specialize in fewer products, and trade– Don’t need factory in each country…less cost…
3. Competition = innovation– Kills off lazy & stupid
4. Avoid inefficient costs of protectionism– Tariffs, quotas, export subsidies, etc…
why controversial?
1. Local industry harmed?– Unfair competition /imperfect competition– Dumping– State enterprise vs. private enterprise
2. Unfair Income distribution– Convergence of relative prices…leads to effects on
relative earnings of land & labor…leads to …– Trade tend to make low skilled workers in the US worse
off, while making high-skilled workers better off.
why controversial?
– Special interests• Pain is localized, benefit is generalized• Motivation of few vs. many• Protect income of certain interest groups
– Political process• Buy votes with protectionism
History:
– Adam Smith (1776) – Absolute cost advantage Theory
– England absolute = Machinery– France absolute = Wine– Should each specialize + Trade …obvious!
Trade: Absolute Advantage:
History:
– David Ricardo (1817) – Relative cost advantage
But, this time… Portugal is Absolute in BOTH
– Trade …not obvious!
Trade: Comparative Advantage:
Portugal has 120/80 = 1.5x advantage in winePortugal has 100/90 = 1.1x advantage in cloth
….so, they have a comparative better advantage in wine
Trade recommendation: specialize + trade for cloth
Comparative Advantage cont’d:
Gains from Trade
• Gains from free trade – depend on• “Specialization”
– More production if you specialize, and everyone can be better off
• Insight:– “Trade between two countries can benefit
BOTH countries if each country exports the goods in which it has a comparative advantage”
– If you learn one economic principle in this class, it should be this one!
Trade: Comparative Advantage:
example:
1. The numbers in the table refer to the number of airplanes, and millions of bushels with complete specialization.
2. Which country has:• Absolute advantage?• Comparative advantage?
Airplanes applesFrance 18 241USA 12 198
example:
Comparative: =18/12 = 241/198= 1.5 =
1.22
• Absolute advantage? France in both• Comparative? France has comparative
advantage in Airplanes, USA in apples
Airplanes applesFrance 18 241USA 12 198
• What exchange rates will produce 2way trade, assuming these prices:
Airplanes applesFrance* price € 100m €7.47USA* price $90 m $5.4
Note: if you are given Airplane prices, you should be able to derive apple prices!
Airplanes applesFrance* price € 100m €7.47USA* price $90 m $5.4
USD / Euro = $90 / 100 =7.47/5.45
Trade range= US$ 0.90 < x < US$0.73• If USD weaken to $1 / euro…it would limit
French airplane exports to USA. • If USD strengthens to $0.5 /euro…it would limit
US exports of apples
Comp. Adv. Assumptions
• Products are identical– Quality / characteristics
• Frictionless trade (negligible transport, etc.)• No gov’t interference
– Tariff– Subsidy– Etc..
• Assume prices relate to costs…. – (marketing guys will disagree!!!)
Barriers to gains?
• Limitations on comparative advantage:– Trade barriers (tariffs, quotas, etc)– Limits on labor mobility, – Limits on ability to shift production from one
industry to other…
Comparative Advantage Example:
Appliances Bananas USA 200* 100Honduras 60 80
*Max # units per year:
Note: US absolute better at both
Comparative Advantage Example:
A B USA 200 100Honduras 60 80
Relative: 200/60 100/80 advantage USA: = 3.33x = 1.25x
333% more efficient
Note: USA has BIGGER advantage in appliances
Question:
• Will both countries really be better off if each specializes in “comparative advantage” and if they engage in free trade?
• If so, by how much?
With no trade:
Production if both countries specialize + tradeA B
USA 200 0Honduras 0 80 total = 200 + 80 = 280
Production / consumption with NO tradeA B
USA 120 40Honduras 40 30 total = 160 + 70 = 230
How much SHOULD they trade?
• Need to trade enough to meet minimum consumption desires of both countries.
• All extra = surplus• So, if the US makes 200 (A), and Honduras
wants 40, then 40 = min export…can keep 160…which is more than could be kept without trade
• Benefit from trade! (more goods overall)
What exchange rates make trade possible
• Assume:– Price appliance US = $10– Price appliances Hon = L200
• Banana– What does price in US have to be? 200 / 100
ratio….so 200 appliances have same value as 100 bananas
– Price bananas US = $20 (must be able to calculate!)
– Price bananas Hon = 60/80… 200 *60 / 80 = L150
What FX rates give trade?
Appliances bananasUSA $10 $20Honduras L200 L150
Lempira/ USD = L20 / 1 =L7.5/1
Trade range= L 20/1 < x < L7.5/1• If HON weaken to L100 / dollar…it would limit US appliance exports
to HON. • If HON strengthens to L5 /dollar…it would limit HON bananas
exports to USA
• If FX = L20/1… which country has advantage?
Comparative vs. Absolute?
Heckscher-Ohlin Theory: -Takes what Ricardo did-But adds….factor product proportions
-Land, resources, minerals, etc…
Trade: definitions
• Import tariff: taxes levied on imports…raises the price of imported goods inside country vs price outside
• Export subsidy: payments given to domestic producers who sell abroad…incentive to export…effect is to raise prices at home
• Terms of trade: relative prices of a country's exports to imports
Trade: Comparative Advantage:
– “undeniably true yet not obvious to intelligent people” Samuelson
– Opportunity costs= trade off• Ex: opportunity cost of roses in terms of computers• Ex: 10 million roses (resources to grow) = 100,000
computers• So, opportunity cost of 10 mm roses = 100k computers• But, other country might have different ratio…
– 10 mm roses = just 30 k computers– So, other country should grow roses!– Each specialize, Import + increase world production!