china center for economic research peking university international economics: trade theory and...
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China Center for Economic ResearchPeking University
International Economics:Trade Theory and Policy
Professor Wen Hai
Spring 2003
I. INTRODUCTION
1. Importance of International Economics
Why should we study international economics?
• Contribution of International Trade to the Nation’s Standard of Living
• Integration of the World Economy
• Problems in the World Economy
2.Structure of International Economics
• International Trade: Theory and Policy (Microeconomics of Open Economy)
• International Finance • (Macroeconomics of Open Economy)
3. Brief History of International Trade
• Brief History of the World Trade– International Trade in Ancient Times– World Trade after the 15th Century– The Emergence of Capitalism and Industrial
Revolution– International Trade after WWII
Brief History of Foreign Trade in China
• A Glorious Period in Ancient China
Isolations after the 16th Century
Open-door Policy under Foreign Warship
Foreign Trade since 1949
5. Basic Analytical Tools
• General Equilibrium Analysis
• Partial Equilibrium Analysis
General Equilibrium Analysis
• Supply-side: Production Possibility Frontier (PPF)
• PPF with Constant Costs• PPF with Increasing Costs
• PPF with Constant Costs
• PPF with Increasing Costs
Qw
Qw
Qc
Qc
Demand-side: Community Indifference Curves (CIC)
– Indifference Curves (review)– Community Indifference Curves
Qw
Qc
CIC1
CIC3
CIC2
Higher social welfare level
General Equilibrium in Isolation(PPF with constant costs)
• Qc
•
CIC0
PPF
QwQw0
Qc0A
Autarky EquilibriumD = S
General Equilibrium in Isolation(PPF with increasing costs)
• Qc
•
CIC0
PPF
QwQw0
Qc0A
Autarky EquilibriumS = D
Partial Equilibrium Analysis Commodity markets in an Open
Economy•
S
D
US ChinaPw/Pc Pw/PcPw/Pc
Qw Qw Qw
.8
1.5Sx
Dm
International Market
Equilibrium with Free Trade
S
D
US ChinaPw/Pc Pw/PcPw/Pc
Qw Qw Qw
Basis for Trade and Gain from Trade
• Basis: lower relative price export• Higher relative price import
• Gain from Trade: • In General Equilibrium Analysis: measured
by increase in social utility level
• In Partial Equilibrium Analysis: measured by consumer surplus , producer surplus, and net welfare change
II. TRADE THEORIES
Main Issues in Trade Theory
• Why do People Trade ?- Gain from Trade• Basis for Trade? - Pattern of
Trade• Effects of Trade? • Growth and Trade• Trade in Goods and Factor Movement
Framework of Trade TheoryMajor Model s Main
Contributors
Key Assumptions Basi s for Trade
Absolute
Advantages
Adam Smi th
Diff erences i n Absolute
Producti vi ty due to
Diff erent Technology
Classical Models
Comparati ve
Advantages
David
Ri cardo
Labor i s the only i nput Constant Marginal Cost Perfect Competi ti on i n both
Product and Factor Markets Constant Returns to Scale Demand i s gi ven
Diff erences i n Relati ve
Producti vi ty due to
Diff erent Technology
Factor
Endowment
E. Heckscher
B. Ohl in
Neoclassical Models
Specifi c
Factors
Paul
Samuelson
At l east two inputs Increasing Marginal Cost Perfect Competi ti on i n both
Product and Factor Markets Constant Returns to Scale
Diff erences i n Factor-
Endowment of Each Country
and Factor-Intensi ty of
Each Product
Economy of
Scale
Paul Krugman
Economy of Scale (Increasing
Returns to Scale)
Imperfect Competi ti on i n
Product Market
Diff erences i n
Production Scales
Modern Trade Models
Product
Cycle
Raymond
Vernon
Diff erent Stage of
Technology Development
and Factor Intensi ty
The Classical Trade Theories
1. Economic Thought in International Trade before Adam Smith
• Mercantilism: Older than Smith but still Alive Today
2. Adam Smith: Absolute Advantage
a. Basic Assumptions One input: Labor (L)
Two outputs: e.g. Wheat (QW) and Cloth (QC)
Two Countries: e.g. US and China
Different technologies: different productivity of labor
Labor supply is fixed. No international labor movement, but free to move within the country
Full employment, perfect competition,
and constant return to scale
transportation cost
alanced trade
b. Basis for TradeAbsolute advantage in Commodity Production
c. Determination of the Absolute AdvantageDifferences in technologies
d. Measurements of Absolute Advantage: Productivity or Cost of Production Unit of labor requirement (L) in each unit of output j: aLj= L/Qj -- Comparing aLc to a*Lc and aLw to a*Lw
A Numerical ExampleTable 2-1 Possible Output (L=L*=100)
Rice
(Qr)
Wheet
(Qw)
China 100 50
US 80 100
Table 2-2 Productivity (Qj/L)
Rice
Wheet
China 1.0 0.5
US 0.8 1.0
Table 2-3 Production Cost (aij)
Rice
Wheet
China 1.0 2.0
US 1.25 1.0
Limitation of the Smith ModelTable 2-4 Production Possibility
Rice
(Qr)
Wheet
(Qw)
China 100 50
US 150 100
e. Pattern of Production and Trade
A country should specialized in and export the product that it has absolute advantage, and import the product that it does not have absolute advantage in production.
In this case, US should export wheat and China should export rice.
3. Davis Ricardo: Comparative Advantage
a. Basic Assumptions
(the same as the Smith Model)
b. Basis for Trade
Comparative Advantage in Commodity Production
c. Determination of the Comparative Advantage
Differences in relative technologies
d. Measurements of Comparative Advantage:
-- Relative productivity
-- Relative production cost:
aLw /aLr vs. a*Lw /a*Lr
-- Opportunity cost:
Qr /Qw vs. Q*r /Q*w
-- Relative Price (exchange rate adjusted)
Pw /Pr vs. P*w /P*r
A Numerical ExampleTable 2-5 Relative Productivity
Rice (Qr/L)/(Qw/L)
Wheet (Qw/L)/(Qr/Qw)
China 2.0 0.5
US 0.8 1.25
Table 2-6 Relative Cost
Rice aLR/aLW
Wheet
aLW/aLR
China 0.5 2.0
US 1.25 0.8
Table 2-7 Relative Productivity(based on Table 2-4)
Rice
Wheet
China 2.0 0.5
US 1. 5 0.67
Limitation of the Smith ModelTable 2-4 Production Possibility
Rice
(Qr)
Wheet
(Qw)
China 100 50
US 150 100
e. Pattern of Production and Trade
A country should specialized in and export the product that it has comparative advantage, and import the product that it does not have comparative advantage in production.
In this case, US should export wheat and China should export rice.
f. Gain from Trade: General Equilibrium AnalysisEquilibrium Relative Prices and Comparative Advantage ( PPF with constant costs)
Pr/Pw < P*r/P*w
QrQ*r
Qw
Q*w
Pr/Pw
P*r/P*w
China US
General Equilibrium with Free Trade ( PPF with constant costs)
QrQ*r
Qw
Q*wPr/Pw
P*r/P*w
The Gains from Trade
QrQ*r
Qw
Q*w
Pr/Pw
P*r/P*w
CIC0
CIC1
China US
S0,D0
1.2 Comparative Advantage in the Hechscher-Ohlin Model
a. Basic Assumptionsa. • Two inputs (factors): Labor (L) and Land (T)• Two outputs: Cloth (Qc) and Food (QF)
• Production Functions: Qc = Qc (Tc, Lc), labor-intensive
QF = QF (TF, LF), land intensive
At any given factor price ratio w/r, TF /L F > Tc /Lc
• Two Countries, e.g. US and China Different proportion of factor endowment:
(T/L)US > (T/L)China;
US is a T-abundant country, China is a L-abundant country• Full Employment, Perfect Competition, and Constant return to
Scale
b: Basis for Trade • Comparative advantage
Different relative factor endowments (different proportion) different relative factor prices
different relative production costs different relative prices of products
Comparative advantage in producing and exporting the product that uses its abundant recourse intensively (lower relative cost)
c. Pattern of Production and TradeA country should produce more and export the product that uses its abundant recourse intensively, and import the product that uses its scarce recourse intensively. In this case, US should export wheat and China should export cloth.
2. Economies-of-Scale and Imperfect Competition Model
2.1. Modern Trade Facts
a. Rise of Intra-industrial TradeIntra-industrial Trade Index:
T = 1- (|X - M|/X + M)
b. Development of Trade among Developed Countries.
1.4 Equilibrium Relative Prices and Comparative Advantage ( PPF with increasing costs)
Pw/Pc < P*w/P*c
QaQ*a
Qc
Q*c
Pw/Pc
P*w/P*c
1.5 General Equilibrium with Free Trade ( PPF with increasing costs)
QwQ*w
Qc
Q*c
Pw/Pc
P*w/P*c
1.6 The Gains from Trade( PPF with increasing costs)
QwQ*w
Qc
Q*c
Pw/Pc
P*w/P*c
• Changes in an export market
S
D
Qw
Pw/Pc Effects of Free Trade
Price:Production:Consumption:Welfare Changes:
P.S. +(a +b)C.S. - anet: + b
a b
P0
P1
• Changes in an import market
S
D
Qw
Pw/Pc Effects of Free Trade
Price: Production: Consumption: Welfare Changes:
P.S. - cC.S. + (c + d)net: + d
c dP1
P0
A
B
C
S
Gain from Exchange and from Specialization
CIC0
CIC0’
CIC1
A: autarkyB: consumption throughExchange of existing productsC: consumption after specialization and free tradeS: production after specialization and free trade
Gain from exchange: CIC0 CIC0’Gain from specialization:CIC0’ CIC1
Production: A S;Consumption A C
1.7 Trade based on Differences in Tastes
Qw
Qc
2.4 The Terms of Trade
TOT = Px / Pm
Px/PmTOT= Px/Pm S
DQx
Qx
Qm
2.2. Economies-of-Scale Model
a. Economies of Scale: external and internal External Economies of Scale
External economies of scale occur when the average cost (AC) of output depends on the size of the industry, but not necessarily on the size of any one firm. An industry where economies of scale are purely external will typically consist of many small firms and be perfectly competitive.
Internal Economies of ScaleInternal economies of scale occur when the average cost of output depends on the size of an individual firm, but not necessarily on that of the industry. Internal economies of scale give a cost advantage over small and lead to an imperfectly competitive market structure.
b. Monopolistic-Competitive Firm with Internal Economies-of-Scale
• Equilibrium of a Monopolistic Competitive Firm in a Closed Economy
Q
P, C ($)
Dhome
MR0
AC
MC
Q0
P0
• Equilibrium of a Monopolistic Competitive Firm in an Open Economy (with Trade in Short Run, Case 1: P )
Q
P, C ($)
Dhome
MR0
AC
MC
Q0
P0
Dtotal
MR1Q1
P1
AC1
• Equilibrium of a Monopolistic Competitive Firm in an Open Economy (with Trade in Short Run, Case 2: P )
Q
P, C ($)
Dhome
MR0
AC
MC
Q0
P0
Dtotal
MR1Q1
P1AC1
• Equilibrium of a Monopolistic Competitive Firm in an Open Economy (with Trade in Long Run)
Q
P, C ($)
Dhome
MR0
AC
MC
Q0
Dtotal
MR2Q2
P2 = AC2
P0 = AC0
3.2 Economy-of-Scale & Intra-Industrial TradeUS US
Q car
Q car
Japan Japan Q truck
Q truck
AC AC
AC AC
30
15
3. Dynamic Comparative Advantage: the Product-Cycle Model
3.1 Change in Pattern of Trade (Dynamic Pattern)
Export
Import
US
Japan
China
Color TV
3.2 The Product Cycle Theory: Change in Factor Intensity
Technological cycle of a new product:• Stage 1: Innovation
(High technology; cost of research: R&D intensive product)
• Stage 2: Tech. Diffuses(Technology becomes less important - standardized, cost of capital and skilled labor: capital and skilled-labor intensive product)
• Stage 3: Tech. Stagnates(Technology embodied in purchasable equipment, cost of less skilled labor: labor intensive product)
3.3 Dynamic Changes in Comparative Advantage
• Stage 1: R&D intensive product
R&D and scientists abundant country such as the US has comparative advantage
• Stage 2: Capital and skilled-labor intensive product
Capital and Skilled labor abundant countries such as Japan and Germany have comparative advantage
• Stage 3: Labor intensive productLabor abundant countries such as China have comparative advantage
C. EFFECTS OF TRADE ON INCOME
Effect of Trade on Income in the H-O Model1. Effects of Trade on Factor Prices in Each Country 1.1 Short-Run (no factors are mobile among sectors)
Return to factors: W = P x MPL,
R = P x MPT
In the short run, returns to factor are determined by changes in Product Price. No changes in marginal productivity of factor
Price of export product increases, both factors in the export sector gainPrice of import-competing product decreases, both factors in the import-competing loss
1.2 Long-Run (all factors are able to move among sectors)
The Stolper-Samuelson (S-S) TheoremFree trade raises the return to the factor used intensively in the rising-price sector (export sector) and lowers the return to factor used intensively in the falling-price (import competing sector)
Magnification Effect
Changes in returns to factors are greater than the changes in product prices
2. Effects of Trade on Factor Prices in Both Countries
The Factor Price Equalization Theorem
Under the assumptions of H-O model, free trade will
equalize not only commodity prices but also factor prices.
All labors will earn the same wage rate and all units of
capital (or land) will earn the same profit (or rental returns)
in both countries regardless of the factor supplies or the demand patterns in the two countries.
Effect of Trade in the Specific Factor Model
1. Basic Assumption of the Model Three inputs (factors):
Mobile factor: Labor (L)
Specific Factors: Capital (K) and Land (T)
Two outputs: Manufacture (QM)
Food (QF)
Production Functions: QM = f (K, LM)
QF = f (T, LF)
Full Employment: LM+ LF = L
Perfect Competition and Constant return to Scale
2. Production possibility Frontier in the Specific Factors Model
2.1 The Production Function
Lm
QmQm(K, Lm)
2.2 The Marginal Product of Labor
Lm
MPLm
2.3 Production Possibility Frontier
Qm
Qf
PPF
Lf
Lm
3. The Allocation of Labor and
Determination of Wage
3.1 Allocation of Labor
Pf MPLfPmMPLm
Lf Lm
W W
W*
3.2 Effects of Price Changes
• An Equal Proportional Change in Prices
P’f MPLf
PmMPLm
Lf Lm
W W
W*
Pf MPLf
W*’
P’mMPLm
• An Equal Proportional Change in Prices
No changes in labor allocation
no changes in output
Nominal Wage (W)
Profit (RK)
Rent (RT)
In real term, not affected
• A Change in Relative Price (say Pf 10%)
P’f MPLf
PmMPLm
Lf Lm
W W
W*
Pf MPLf
W*’
• A Change in Relative Price (say Pf 10%)
LM and LF QM and QF
W (< 10%), RT (> 10%), RK
In real term, T gainsK losesL is ambiguous (depending on using what price to
measure)
3.3 Effects of International Trade
• Trade and Relative PricesBefore trade: (PF/PM)A < (PF/PM) J
After trade: (PF/PM)A = (PF/PM) world = (PF/PM) J
Relative Price of Export • Income Distribution (same effect of relative price
change)Specific factor in export sector gains
Specific factor in import sector loses
Ambiguous effects on mobile factor
3.4 Effects of Economic Growth
• A Change in Capital Stock
Pf MP’Lf
PmMPLm
Lf Lm
W W
W*
Pf MPLf
W*’
• K
the same effects as PM on Labor
allocation, production, and nominal returns to factors.
However, the returns to labor in real terms increase since there is no price change
• A Change in Labor Supply
L , labor and output in both sectors ,
L loses, both K and T gain
PmMPLm
Lf Lm
W W
W*
Pf MPLf
W*’
D. GROWTH AND TRADE
Growth and Trade in the H-O Model
1. Definition of Growth and Types of Growth
1.1 Increases in factor endowments and Factor-saving technological progress
1.2 Biased economic growth:
Export Expanding (EE) Growth
vs. Import Replacing (IR) Growth
2. Effects of Growth in a Small Country2.1 IR Growth
Qw
Qc
S1
D2
D1
S2
TOT
2.2 EE Growth
Qw
Qc
S1
D2
D1
S2
TOT
The Rybczynski Theorem
The Rybczynski Theorem postulates that at constant commodity prices, an increase in the endowment of one factor will increase by a greeter proportion the output of the commodity intensive in that factor and will reduce the output of the other commodity.
3. Effects of Growth in a Large Country3.1 IR Growth
Qw
Qc
S1
D2
D1
S2
TOT
3.2 EE Growth
Qw
Qc
S1
D2
D1
S2
TOT
3.3 A Special Case in the EE Growth
- Immiserizing Growth
Qw
Qc
S1
D2D1
S2
TOT