International Trade and Comparative Advantage Assignment

International Trade and Comparative Advantage Assignment Words: 2524

Economics 364: International Trade Assistant Professor Peter M. Morrow University of Toronto peter. [email protected] ca Economics 364 (International Trade) Fall 2011 1 Welcome! ??? This class will deal with issues of international trade. ??? What determines the ? ow of goods and services across borders? What are the implications of these ? ows for domestic and foreign economic conditions? ??? How have the forces that determine these ? ows changed over time? Economics 364 (International Trade) Fall 2011 2 Administration: Books ??? We will use International Economics: Theory and Policy by Paul R. Krugman, Marc J.

Melitz, and Maurice Obstfeld. ??? http : //krugman. blogs. nytimes. com/ (Paul Krugman, Princeton) ??? http : //economistsview. typepad. com/ (Mark Thoma, University of Oregon) ??? http : //worthwhile. typepad. com/ (Nick Rowe, Carleton University) Economics 364 (International Trade) Fall 2011 3 Administration: Grading ??? Grade Composition ??? Problem Sets 10% ??? Midterm Exam: 40% (October 24th) ??? End of Term Exam: 50% Final exam period (to be announced) Economics 364 (International Trade) Fall 2011 4 Administration: Grading ??? Grade Scale ??? ??? ??? ??? ??? : : : : : “A”: 80 ? 100 “B”: 70 ? 79. 9 “C”: 60 ? 69. 9 “D”: 50 ? 9. 9 “F”: 0 ? 49. 9 ??? This distribution roughly follows the Academic Handbook for instructors that was issued in September 2010. ??? The exams will “aim” for an median of approximately 70. ??? At the end of the term, if the median score is less than 70, all scores will be adjusted up so that the median is 70. Economics 364 (International Trade) Fall 2011 5 Administration: Of? ce Hours ??? My of? ce hours are 10am-11am Tuesdays and Wednesdays. Appointments outside of normal of? ce hours can be made in extreme circumstances. ??? My email is peter. [email protected] ca ??? Feel free to contact me via email. I generally check my email several times a day and will respond within 24 hours during the week or 48 hours on the weekend. ??? However, if your email questions cannot be answered in a couple of sentences or less, there is a strong chance I will ask you to come to my (or the TA’s) of? ce hours. ??? See the syllabus for more details. Economics 364 (International Trade) Fall 2011 6 Administration: TA and Website ??? Your Teaching Assistants are Leandro Freylejer and Michelle Liu. ??? leandro. [email protected] ca and mengxiao. [email protected] ca ??? I will be using the Blackboard teaching support website.

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It will contain the supplemental questions, readings, and announcements. ??? Let’s get to it…. Economics 364 (International Trade) Fall 2011 7 Tackling Big Questions ??? Developing models to answer questions that involve the actions of billions of workers and trillions of dollars worth of international transactions. Economics 364 (International Trade) Fall 2011 8 Tackling Big Questions ??? Developing models to answer questions that involve the actions of billions of workers and trillions of dollars worth of international transactions. ??? We will obviously abstract from many important details. ??? Question: Do these omissions change our predictions?

Economics 364 (International Trade) Fall 2011 9 Solow (1953) ??? “All theory depends on assumptions that are not quite true. That is what makes it theory. The art of successful theorizing is to make the inevitable simplifying assumptions in such a way that the ? nal results are not very sensitive. A ‘crucial’ assumption is one on which the conclusions do depend sensitively, and it is important that critical assumptions be reasonably realistic. When the results of a theory seem to ? ow speci? cally from a special crucial assumption, then if the assumption is dubious, the results are suspect. “

Economics 364 (International Trade) Fall 2011 10 Marshall (quoted in Sills and Merton 1991, p. 151) ??? “(1) Use mathematics as a shorthand language, rather than as an engine of inquiry. (2) Keep to them till you have done. (3) Translate into English. (4) Then illustrate by examples that are important in real life. (5) Burn the mathematics. (6) If you can’t succeed in 4, burn 3. ” Economics 364 (International Trade) Fall 2011 11 Two Cheers for Formalism ??? Models are especially useful in international trade. ??? Logical consistency. ??? Suprising (testable) implications. ??? See Krugman’s “Two Cheers for Formalism. Economics 364 (International Trade) Fall 2011 12 Outline for Today 1. “Stylized Facts” for Canada, China, Mexico and the United States: ??? Trade over time, ??? by commodity, ??? and by partner country. 2. Chinese imports into Canada and the U. S. 3. Outline of semester. 4. Introduce the Ricardian Model. Economics 364 (International Trade) Fall 2011 13 Trade Over Time Economics 364 (International Trade) Fall 2011 14 Trade Over Time Economics 364 (International Trade) Fall 2011 15 Trade Over Time ??? Trade as a proportion of GDP has growth dramatically since 1970 and especially since 1980. This is true for both developing and developed countries. ??? What is driving this? Economics 364 (International Trade) Fall 2011 16 Exports by Commodities (%) (1980) Type of Goods Cars and Airplanes Chemicals Food Textiles Canada 13. 8 3. 0 10. 2 0. 3 China 0. 3 2. 7 14. 5 9. 3 Mexico 1. 5 2. 2 9. 6 1. 5 United States 11. 6 4. 0 13. 2 0. 6 Source: Robert Feenstra, “World Trade Flows” Economics 364 (International Trade) Fall 2011 17 Exports by Commodities (%) (1980) Type of Goods Cars and Airplanes Chemicals Food Textiles Canada 13. 8 3. 0 10. 2 0. 3 China 0. 3 2. 7 14. 5 9. 3 Mexico 1. 5 2. 2 9. 1. 5 United States 11. 6 4. 0 13. 2 0. 6 Source: Robert Feenstra, “World Trade Flows” Economics 364 (International Trade) Fall 2011 18 Exports by Commodities (%) (1980) ??? Developed countries produce relatively more cars, airplanes, and chemicals. ??? Developing countries produce relatively more textiles and food. ??? There seems to be some specialization. ??? One must look at both industries and countries. ??? Look at the differences in the differences. Economics 364 (International Trade) Fall 2011 19 Exports by Commodities (%) (1990) Type of Goods Cars and Airplanes Chemicals Food Textiles Canada 23. 2. 2 6. 8 0. 2 China 0. 9 2. 0 7. 7 18. 8 Mexico 11. 0 2. 5 6. 9 1. 8 United States 15. 2 3. 7 8. 1 0. 6 Source: Robert Feenstra, “World Trade Flows” Economics 364 (International Trade) Fall 2011 20 Exports by Commodities (%) (2000) Type of Goods Cars and Airplanes Chemicals Food Textiles Canada 23. 6 1. 5 5. 5 0. 7 China 1. 6 1. 5 3. 5 13. 6 Mexico 18. 8 1. 0 3. 5 5. 6 United States 12. 4 3. 4 4. 7 0. 6 Source: Robert Feenstra, “World Trade Flows” Economics 364 (International Trade) Fall 2011 21 Economics 364 (International Trade) Fall 2011 22 Economics 364 (International Trade) Fall 2011 23

Trade by Partners: Canada Export Share (1970) United States United Kingdom Japan (West) Germany Italy % 65. 3% 9. 4% 5. 5% 2. 9% 1. 3% Export Share (1995) United States Japan Germany United Kingdom China % 75. 0% 5. 5% 1. 9% 1. 9% 1. 4% Source: Robert Feenstra, “World Trade Flows” Economics 364 (International Trade) Fall 2011 24 Trade by Partners: China Export Share (1970) Hong Kong Japan Singapore (West) Germany Malaysia % 28. 0% 15. 2% 7. 6% 4. 6% 4. 5% Export Share (1995) Hong Kong United States Japan Germany South Korea % 30. 0% 20. 9% 15. 5% 4. 8% 3. 2% Source: Robert Feenstra, “World Trade Flows”

Economics 364 (International Trade) Fall 2011 25 Trade by Partners: United States Export Share (1970) Canada Japan West Germany United Kingdom France % 20. 6% 12. 1% 6. 6% 6. 0% 4. 1%. Export Share (1995) Canada Japan Mexico United Kingdom Germany % 17. 5% 12. 0% 8. 5% 5. 1% 5. 0% Source: Robert Feenstra, “World Trade Flows” Economics 364 (International Trade) Fall 2011 26 Major Points 1. Countries tend to trade the most with countries that are big and/or close. ??? This is commonly referred to as the “gravity model. ” ??? Bodies tend to exhibit larger a gravitational pull, the larger and closer they are. 2.

Trade costs have fallen leading to distance being less of an impediment. This is commonly referred to as the “death of distance” and is just as (if not more) important as the increase in trade agreements. 3. However, the gravity model is of limited use. Economics 364 (International Trade) Fall 2011 27 Limitations of the Gravity Model ??? Nothing about what goods a country produces. ??? Nothing about factor prices (wages). ??? No statement on if or when trade is “good” or “bad”. ??? We need to develop a framework that can answer these questions… Economics 364 (International Trade) Fall 2011 28 The “Rise” of China Canada and the United States have seen imports from China boom over the past 10 years. ??? Change is dramatic and might have implications for production and wages. Economics 364 (International Trade) Fall 2011 29 Economics 364 (International Trade) Fall 2011 30 Economics 364 (International Trade) Fall 2011 31 Outline of Course ??? Models of Comparative Advantage 1. The Ricardian model ??? One factor of production. ??? Specialization driven by differences in productivity. ??? Only winners. 2. The Heckscher-Ohlin model (two factors of production) ??? Two factors of production. ??? Specialization driven by differences in factor abundance. Winners and losers due to trade. ??? Winners win by more than losers lose. Economics 364 (International Trade) Fall 2011 32 ??? Trade and Wages ??? The changing structure of inequality. ??? The impact of trade ? ows on wages and prices in developing and developed countries. ??? Causality is dif? cult to pin down. ??? Outsourcing/Offshoring ??? Why do ? rms outsource or “offshore” their production process? ??? How has outsourcing/offshoring changed recently? ??? Imperfect Competition ??? Specialization driven by increasing returns to scale. ??? Gains from “variety. ” Economics 364 (International Trade) Fall 2011 33 Openness and Growth ??? Does increased “openness” lead to higher living standards? ??? Very unclear. ??? Trade Policy and Political Economy. ??? How do those helped and hurt by trade advance their interests? ??? Is protectionism good? ??? Firm and International Trade ??? Not all ? rms export. ??? How does this heterogeneity affect trade and results of trade liberalization? Economics 364 (International Trade) Fall 2011 34 Sidebar: Winners and Losers ??? Trade is a very contentious issue. Economics 364 (International Trade) Fall 2011 35 Sidebar: Winners and Losers Economics 364 (International Trade) Fall 2011 36 Sidebar: Winners and Losers “In the face of all the strong and various arguments in favor of integrating, the question has long been why the world has not made more progress in promoting integration? The traditional, very important reason why such progress is resisted comes down to basic political economy. The losers know who they are and organize, and winners do not know who they are and cannot and do not organize. ” (Summers, JEP, 1999) Economics 364 (International Trade) Fall 2011 37 Comparative Advantage: The Ricardian Model ??? Why do countries specialize in different commodities/goods? ??? Is trade a good thing? Economics 364 (International Trade) Fall 2011 8 Comparative Advantage: The Ricardian Model ??? Why do countries specialize in different commodities/goods? ??? Is trade a good thing? ??? Trade unlinks consumption from production. ??? Gains come from the consumption side. ??? You can consume things that you do not produce. Economics 364 (International Trade) Fall 2011 39 The Ricardian Model: De? nitions ??? Unit Labor Requirement: the amount of labor required to increase output by one unit. ??? aj is the amount of labor needed to produce one unit of good j. With one factor (labor), 1/aj is the marginal product of labor. ??? Arithmetically, if Y = F (L), then the unit labor requirement is MPL Economics 364 (International Trade) Fall 2011 = 1 ?Y ? L = ?L ? Y 40 The Ricardian Model: Motivating Example ??? Suppose that Canada and China each have 100 workers and technology manifested by the following unit labor requirements: Unit Labor Requirements Country Canada China Textiles 10 5 Computers 5 10 Economics 364 (International Trade) Fall 2011 41 The Ricardian Model: Motivating Example ??? Suppose that each country divides its labor force in half so that there are 50 workers in each sector… Output Country Canada China Textiles 5 10 Computers 10 5 World Economics 364 (International Trade) Fall 2011 15 15 42 Examine two other possibilities. 1. Canada specializes in computers and China in textiles. 2. Canada specializes in textiles and China in computers. Canada: C, China: T Country C T Canada China World 20 0 20 0 20 20 Canada: T, China: C C T 0 10 10 10 0 10 43 Economics 364 (International Trade) Fall 2011 ??? If countries specialize in the “right” sector, world output can increase. ??? But how do we know what the “right” sector is? Economics 364 (International Trade) Fall 2011 44 The Ricardian Model: De? nitions ??? Constant Returns to Scale: If one increases all inputs by some proportion, output increases by the same proportion. ??? ??? ??? y=ouput and l= labor. y = f (l) is CRS if y = f (? l) = ? f (l) where ? ; 0. y = l is a CRS production function. y = l0. 4, y = l1. 1, and y = l+5 are all not CRS production functions. ??? Homothetic: The form of utility function does not depend on income. ??? Autarky : When economies are “closed” and do not trade at all. Economics 364 (International Trade) Fall 2011 45 The Ricardian Model: Assumptions ??? Two countries, two goods, one factor (labor), ??? Labor is immobile across countries but mobile across sectors within a country, ??? Constant returns to cale (CRS) production, ??? Identical and homothetic preferences, ??? Perfect Competition (all agents are price takers). Economics 364 (International Trade) Fall 2011 46 The Ricardian Model: Opportunity Costs ??? Opportunity costs formalize the tradeoffs implicit in the unit labor requirements. ??? Recall that an opportunity cost is the cost associated with forgoing one’s next best option. Unit Labor Requirements Country Canada China Textiles 10 5 Computers 5 10 Economics 364 (International Trade) Fall 2011 47 ??? A Canadian worker can either produce 1/10 of a textile or 1/5 of a computer. Consequently, the opportunity cost of producing a computer in Canada is the 0. 5 of a textile that is forgone. Economics 364 (International Trade) Fall 2011 48 ??? A Canadian worker can either produce 1/10 of a textile or 1/5 of a computer. ??? Consequently, the opportunity cost of producing a computer in Canada is the 0. 5 of a textile that is forgone. ??? A Chinese worker can either produce 1/5 of a textile or 1/10 of a computer. ??? Consequently, the opportunity cost of producing a computer in China is the 2 textiles that are forgone. Economics 364 (International Trade) Fall 2011 49 A Canadian worker can either produce 1/10 of a textile or 1/5 of a computer. ??? Consequently, the opportunity cost of producing a computer in Canada is the 0. 5 of a textile that is forgone ??? A Chinese worker can either produce 1/5 of a textile or 1/10 of a computer. ??? Consequently, the opportunity cost of producing a computer in China is the 2 textiles that are forgone. ??? Because the opportunity cost of producing an computer is lower in Canada than China, Canada has a comparative advantage in computers and China possesses a comparative advantage in textiles. Economics 364 (International Trade) Fall 2011 50 An absolute advantage is when a country has a lower unit labor requirement than another country for a given good. ??? Absolute advantage involves comparing unit labor requirements for a given good across countries. Comparative advantage involves comparing unit labor requirements across countries and goods. ??? Comparative advantage is a “difference-in-difference” statement, absolute advantage only refers to differences. ??? Do not confuse the two. Economics 364 (International Trade) Fall 2011 51 ??? With the same two goods, C(omputers) and T(extiles), Canada will possess a comparative advantage in computers if and only if: aCan.

C aCan. T < aChn. C aChn. T ??? China will possess a comparative advantage in computers if and only if: aCan. C Can. aT > aChn. C aChn. T ??? There is no comparative advantage if: aCan. C Can. aT Economics 364 (International Trade) Fall 2011 = aChn. C aChn. T 52 ??? Is this con? rmed in the earlier data? Unit Labor Requirements Country Canada China Textiles 10 5 Computers 5 10 ??? We asserted that Canada has a comparative advantage in computers and China has a comparative advantage in textiles. Economics 364 (International Trade) Fall 2011 53 ??? Is this con? rmed in the earlier data? aCan. C aCan. T 5 10 1 2 ? < aChn. C aChn. T 10 5 < 2). ??? the South is unhappy because they have to give up more textiles per computer than they would with no trade. ??? the North happy because they can obtain more textiles per computer with trade than they would in autarky. ??? ? the South is better off producing its own computer and the relative price cannot be more than 2 textiles per computer. ??? Consequently, the the relative price of textiles per computer will be between 0. 5 and 2. Economics 364 (International Trade) Fall 2011 67 ??? Can 1 (textile per of computer) be an equilibrium the relative price? ??? the North produces computers.

The one textile per computer it can obtain through trade is better than the 1/2 of a textile it could get if it produced its own textiles. ??? the South produces textiles. The one computer per textile it can obtain through trade is better than the 1/2 of a computer it could get if it produced its own computers. ??? For yourself: verify that 0. 75 and 1. 5 are also both possible equilibrium relative prices. Economics 364 (International Trade) Fall 2011 68 ??? More generally, an equilibrium relative price must satisfy the following restriction where the North has a comparative advantage in good x and the South has a comparative advantage in good y. N orth x aN orth y ? px py ? aSouth x aSouth y ??? This only pins down a possible range of equilibrium goods prices. To narrow this range, we will introduce demand. Economics 364 (International Trade) Fall 2011 69 The Gains from Trade Conjecture: Suppose that the North has a comparative advantage in good x: ??? If aN x aN y = px py < aS x aS y then the North neither gains nor loses from trade and the South gains. aN x aN y aS x aS y < = then the North gains from trade and the South ??? If neither gains nor loses. px py Economics 364 (International Trade) Fall 2011 70

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