Brian David ButlerMiami Campus FacilitatorInternational Economics & Trade (Prof. Grosse)

Email: bdbutler@global.t-bird.eduhome: 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!