EC 340

Lecture 1 - Why Do Nations Trade?

administrative stuff
importance of trade to the U.S. economy
impact of globalization on the U.S. economy
why does trade occur?
comparative advantage and trade
an international example
increasing opportunity costs and trade
Heckscher-Olin Theory
trade with demand and supply
measuring the gains from trade
different tastes as a basis for trade

Administrative Stuff

You should carefully read the syllabus at your leisure. I want to hit only the highlights:

Importance of Trade to the U.S. Economy

How important are exports (American goods purchased by foreigners) and imports (foreign products purchased by Americans) to the U.S. economy? Many goods and services are nontradeable, e.g. most buildings and most personal and governmental services. So, what proportion of the nation's output that is potentially exportable is, in fact, exported?

In 1994, U.S. exports of goods were equal to 24% of the domestic output of goods. This is up from 8% in 1960 and 16% in 1980.

What change has occurred in the relation of goods imported to goods consumed?

In 1994, imports accounted for 28% of total goods consumed compared to just 7% in 1960.

Impact of Globalization on U.S. Economy

Why Does Trade Occur?

In some ways the Japanese are our competitors in the world economy since American and Japanese firms do produce many of the same goods. Ford and Toyota compete for the same customers in the automobile market. Compaq and Toshiba compete for the same customers in the personal computer market.

But, trade between the United States and Japan is not like a sports contest, where one side wins and the other side loses. In fact, trade between countries can make each country better off.

Think about how trade affects your family. When a member of your family looks for a job, she competes against members of other families who are looking for jobs. Families also compete against each other when they are shopping because each family wants to buy the best goods at the lowest price. So, each family is competing with all the other families in the economy.

But, your family would not be better off isolating itself from all other families. If it did, your family would need to grow all of its own food, make its own clothes, and build its own house and car. Your family gains from its ability to trade with others. Trade allows each person to specialize in the activities he or she does best. By trading with others, people can buy a greater variety of goods and services at a lower cost than if they tried to produce each good by themselves.

Countries also benefit from the ability to trade with one another. Trade allows countries to specialize in what they do best and to enjoy a greater variety of goods and services. The Japanese are as much our partners in the world economy as they are our competitors.

Comparative Advantage and Trade

Michael Jordan can probably mow his lawn faster than anyone else. But just because he can mow his lawn fast, does this mean he should? Let's say Jordan can mow his lawn in 2 hours while Debbie, the girl next door, can mow Jordan's lawn in 4 hours. Because he can mow the lawn in less time, Michael Jordan has an absolute advantage in mowing lawns.

However, is mowing his lawn the best use of Jordan's time? Suppose that in the same 2 hours it takes him to mow his lawn, he could film a Nike commercial and earn $10,000. Jordan's opporunity cost (the value of his next best alternative) of mowing the lawn is $10,000.

In contrast, Debbie's next best alternative is to wrap meat at Wegman's where she earns $8 an hour. So, in the 4 hours it would take her to mow Jordan's lawn, she could have earned $32. Debbie's opportunity cost of mowing his lawn is $32.

Jordan has an absolute advantage in mowing lawns because he can do the work in less time. But, Debbie has a comparative advantage in mowing lawns because she has the lower opportunity cost. A person or a country has a comparative advantage when they can produce a good at a lower opportunity cost compared to someone else.

The gains from trade are enormous. Rather than mowing his lawn, Jordan should make the commercial and hire Debbie to mow the lawn. As long as he pays her more than $32 and less than $10,000, both of them are better off.

Countries can benefit from specialization and trade with one another in the same way individuals can. The gains from trade do not disappear at national borders.

An International Example

production possibilities under autarky

          Ghana                        Peru

    wheat        cloth          wheat         cloth
  (bushels)     (bolts)       (bushels)      (bolts)

    150            0             240            0
    120           15             180           20
     90           30             120           40
     60           45              60           60
     30           60              30           70
      0           75               0           80

Because the same amount of resources can produce more in Peru than in Ghana, Peru can make either a bushel of wheat or a bolt of cloth with fewer resources than Ghana. So, Peru has an absolute advantage in both products.

Ghana can get 15 more bolts of cloth by decreasing wheat production by 30 bushels. So, the price of 30 bushels of wheat in Ghana is 15 bolts of cloth. So, 1 bushel of wheat costs 1/2 bolt of cloth or 1 bolt of cloth costs 2 bushels of wheat.

In Peru, 1 bushel of wheat costs 1/3 bolt of cloth or 1 bolt of cloth costs 3 bushels of wheat.

Ghana can buy its wheat for only 1/3 bolt of cloth in Peru. Peru can buy one bolt of cloth in Ghana for just 2 bushels of wheat. So, there are gains from trade. These gains and the direction of trade are determined by comparative advantage.

Ghana has the comparative advantage in cloth production since its opportunity costs are smaller. Peru has the comparative advantage in wheat production. (Suppose there are 2 countries, A and B, and 2 goods, X and Y. If country A has a comparative advantage in good X, country B must have the comparative advantage in good Y.)

Ghana should specialize in cloth production and Peru in wheat production and then they trade. World production is 240 bushels of wheat and 75 bolts of cloth. No other combination will give so high a total world output.

Increasing Opportunity Costs and Trade

The Ghana/Peru example assumes constant costs which should result in total specialization. The world fails to show total specialization. This would result if there were increasing opportunity costs so that the PPC is concave.

concave PPC and trade gains
In the absence of trade, each country consumes at their point A. Slope of tangent line gives the cost ratio. As long as the slopes are different there is an incentive to trade.

gains from trade
Each country produces where the world price ratio line is tangent to its PPC (point B). At point B, the world price equals the domestic opportunity cost. Then, they trade to end up consuming at point C. The consumption point depends on preferences, but we'll bring those in later.

Heckscher-Olin Theory

International trade occurs because of differences in opportunity costs, that is, from different shaped PPC's. International differences in the shape of PPC's result from
  1. different goods use factors of production in different ratios
  2. nations differ in their relative factor endowments
The Heckscher-Olin Theory argues that factor proportions explain a nation's trade patterns.

Countries export the products that use their abundant factors intensively and import the products that use their scarce factors intensively.

A country is labor abundant if it has a higher ratio of labor to other factors of production than does the rest of the world.

A product is labor intensive if labor costs are a greater share of its value than they are of the value of other products.

Suppose 2 bushels of wheat = 1 bolt of cloth in the U.S. and 1 bushel of wheat = 1 bolt of cloth in the rest of the world. Wheat is relatively cheap in the U.S. H-O presumes that factor proportions account for comparative cost differentials.

So, the U.S. has relatively more of the factors that wheat uses intensively and relatively less of the factors that cloth uses intensively than does the rest of the world. Suppose land is the factor wheat uses intensively and labor is the factor cloth us es intensively. In other words, the U.S. must be land abundant.

U.S. land supply   R.O.W. land supply
---------------- > ------------------
U.S. labor supply  R.O.W. labor supply

  1. U.S. should export wheat and import cloth
  2. land should be relatively cheap in the U.S. and labor should receive a relatively higher wage in the U.S. than elsewhere
H-O theory explains general trade patterns relatively well, but recent trends indicate that the industrial countries are becoming more similar in their factor endowments. So, the H-O theory may become less relevant.

Trade with Demand and Supply

Consider a consumer with a given money income, all of which she spends on only two goods: pizza and beer. The combinations of pizza and beer are called bundles.
e.g. X = (2 slices of pizza, 3 bottles of beer)
     Y = (3 slices of pizza, 1 bottle of beer)

Assume that the consumer can tell us whether
  1. X is preferred to Y
  2. Y is preferred to X
  3. she is indifferent between X and Y
Suppose she is indifferent between X and Y. Connecting the points gives an indifference curve. An indifference curve shows all combinations of pizza and beer that the consumer is indifferent among.indifference curve
This is an indifference map:
indifference map
There is an infinite number of indifference curves. Consumers want to be on the highest possible indifference curve.

Community indifference curves purport to show the preferences of the entire nation.

Of all the points at which the country can produce, point E gives the highest utility. The line drawn through point E gives the equilibrium price ratio which brings producers and consumers into equilibrium.without trade

with trade
The country produces at point A and consumes at point B. So, they end up on a higher indifference curve.

Measuring the Gains from Trade

The demand curve measures the value an individual places on each unit of the good. The height of the demand curve shows the amount she is willing to pay for that unit of the good.

consumers surplus
The consumer pays less than she would be willing to for the good. Consumers surplus is the difference between what a consumer is willing to pay and the market price of the good. Consumer surplus is the area below the demand curve above the market price.

Producer surplus is the difference between the price firms would have been willing to accept and the price they actually receive. Graphically, producer surplus is the area above the supply curve below the market price.

producer surplus
The sum of consumer surplus and producer surplus is called net national welfare. When net national welfare increases, society is better off.

Different Tastes as a Basis for Trade

Assume identical PPC's but different tastes. There are gains from trade even in this case.

Allowing more products and more countries makes the analysis more difficult but doesn't alter the basic gains from trade.

David A. Latzko
318 COB
Department of Business and Economics
Wilkes University
Wilkes-Barre, PA 18766
phone: (717) 408-4718
fax: (717) 408-4917