II.  International Trade

A.  Foundations of Modern Trade Theory

1.  Historical development

a.  Mercantilists (1500 - 1800)

• Sought favorable trade balance (exports > imports)

- Gold and silver flows into country

- Money stimulates economy

- Advocated trade barriers (tariffs, quotas, regulations)

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• Problems

- Price-specie-flow doctrine (David Hume)

• Money (specie) flows into country => inflation => consumers turn to other countries (imports increase)

- Mercantilists' view is static

• View world's wealth as fixed

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b.  Absolute advantage

• Adam Smith - specialization and division of labor increases overall wealth

- Nations should specialize in the production of goods that could be produced cheaply

- Production costs differ among nations due to different productivities of factor inputs

- Natural advantages - climate, soil, mineral wealth

- Acquired advantages - special skills and techniques

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• Emphasizes supply side of market

• Cost of production is the chief consideration

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c.  Comparative advantage

• David Ricardo - nations can gain from specialization, even if they lack absolute advantage

Ex. -

Country	Product		Country	Product
Canada	Lumber		China	Textiles
Israel	Citrus fruit		Japan	Automobiles
Italy	Wine		South Korea	Steel, ships
Jamaica	Aluminum ore		Switzerland	Watches
Mexico	Tomatoes		United Kingdom	Financial services
Saudi Arabia	Oil		United States	Airplanes

• Look at relative cost differences and opportunity costs

• Assumptions

(1)  World consists of two nations and two goods

(2)  Labor, fully employed and homogeneous, is the only input (Labor Theory of Value)

(3)  Labor can move freely only within its nation

(4)  Technology level is fixed for both nations; all firms within a nation use common production methods

(5)  Costs are proportional to the amount of labor used, do not vary with level of production

(6)  Perfect competition in all markets, including identical products produced

(7)  Free trade between nations

(8)  Transportation costs are zero => customer doesn't care who produces products

(9)  Profit maximization and utility maximization are the goals of firms and consumers

(10) Trade is balanced => exports must pay for imports

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• Less efficient nation should specialize in and export good which is relatively less inefficient

• More efficient nation should specialize in and export good which is relatively more efficient

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2.  Production possibilities schedules

• Shows alternative combinations of two goods that could be produced by all factors in a country

• Maximum output possibilities of a nation given resource constraints, level of technology

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• Marginal rate of transformation (MRT) - amount of one product that must be given up to get the other product

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- Equals slope of the production possibilities schedule

- Measures opportunity cost

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3.  Trading under constant cost conditions

• Opportunity cost the same at all levels of production

- Factors of production are perfect substitutes

- All units of a factor are of equal quality

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a.  Basis and direction of trade

• Autarky - absence of trade

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b.  Production gains from specialization

• Complete specialization leads to higher productivity

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c.  Consumption gains from trade

• Trading possibilities line - shows alternative combinations that can be obtained by trade

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• Trade triangle - shows exports, imports, and terms of trade

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d.  Distributing gains from trade

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e.  Equilibrium terms of trade

• Theory of reciprocal demand (John Stuart Mill) - actual terms of trade determined by relative strength of each country's demand for the other country's product

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• Most relevant when both countries are equal in economic power

• Importance of being unimportant - one country dwarfs another in economic power

- Domestic exchange ratio of big country prevails because small country has little impact

- Most of gains from trade go to smaller country

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- Small country may not produce enough to meet big country's needs => big country produces both

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• Commodity terms of trade - measures relationship between import and export prices

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- Improvement in terms of trade => export prices rise relative to import prices

- Deterioration in terms of trade => export prices fall relative to import prices

Ex. - 2013 (2005 = 100)

Country	Export Price Index	Import Price Index	Terms of Trade
Australia	194	143	136
Argentina	166	153	108
Canada	132	125	106
Switzerland	148	142	104
United States	124	127	98
China	127	130	98
Brazil	156	184	85
Japan	108	145	74

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4.  Dynamic gains from trade

• More efficient use of resources

• Higher output and income

• More saving and investment

• Higher rate of economic growth

• Higher productivity

• Economies of large scale production, even in smaller countries

• Increased competition encourages innovation and cost efficiencies

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5.  Changing comparative advantage

• Differences in productivity growth may change comparative advantage

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6.  Trading under increasing-cost conditions

• Increasing opportunity costs - increasingly more of one product must be given up to produce more of the other product

• Inputs are imperfect substitutes for one another

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• Trade

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- Costs rise as more is produced => advantage is eventually eliminated

- Partial specialization - both countries likely to produce both goods

- Exit costs (antiquated plants, labor and input contracts, environmental cleanup requirements) may slow adjustment process

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7.  Multiple products and countries

a.  Multiple products

• Rank goods by comparative advantage

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• Dividing line depends on strength of demand for products

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b.  Multiple countries

• Multilateral trading relationships

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• Bilateral balance of trade not significant

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8.  Outsourcing

• Global supply chains use outsourcing - subcontracting work to another firm or purchasing components

a.  Advantages

• Reduced costs and increased competitiveness

• New exports - inputs and consumer products

• Repatriated earnings from overseas

• Job losses tend to be temporary

• Creation of new industries and jobs

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b.  Burdens

• Loss of jobs

- Overall level of jobs should be unchanged or increase, mix of jobs will change

• Downward pressure on wages

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c.  Reshoring

• Wage gap narrowing

• Cost of shipping goods by ocean freight increasing sharply - goods in transit for weeks

• Distance makes it difficult to customize goods to local markets

• Natural disasters, geopolitical shocks disrupt supply chains

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• Many firms now returning to the U.S.