Basics of International Trade.ppt
- 2. TWO BASIC QUESTIONS IN INTERNATIONAL TRADE: 1) WHAT DETERMINES INTERNATIONAL TRADE? 2) WHY COUNTRIES WOULD GAIN FROM TRADE?
- 3. Historical Development of Trade Theory Mercantilism – positive trade balance Absolute advantage (Adam Smith) – Countries benefit from exporting what they make cheaper than anyone else Comparative advantage (David Ricardo) – Nations can gain from specialization, even if they lack an absolute advantage Foundations of trade theory
- 4. Absolute Cost Advantage Theory (Adam Smith) Assumptions: 1) Labour Theory of Value 2) Free Trade Country 1 Unit of A 1 Unit of B I 10 20 II 20 10 Labour Cost of Production (in Hours) The Difference on absolute cost of producing the commodities between the two countries in isolation will serve a useful basis for opening up of mutually gainful international trade between two countries.
- 5. David Ricardo Theory of Comparative Cost Advantage Basis of International Trade is the comparative cost differences between two countries. According to this theory, Adam Smith’s Absolute Cost Advantage Theory is not quite unambiguous proposition. Cases may arise where any one country may enjoy absolute advantage over other country in both the goods. Under such circumstances still trade may occur given that there exists comparative cost difference.
- 6. Example Labour Cost (in Hours) for 1 unit of production Country Wine Cloth Portugal 80 90 England 120 100 Portugal has absolute advantage in both cloth and wine over England. According to Ricardo trade is still worthwhile due to comparative cost difference. In Portugal, 1 unit of wine= 8/9 units of cloth, where as it is 12/10 in England. So, opportunity cost of production of 1 unit of wine in Portugal is 8/9 units of cloth but in England it is 12/10. So, Portugal enjoys comparative cost advantage in production of wine.
- 7. Country Wine Cloth Portugal 80 90 England 120 100 Reference Table Country Wine Cloth Portugal 8/9 9/8 England 12/10 10/12 Opportunity Cost* for *The opportunity cost for good X is the amount of other goods which have to be given up in order to produce one additional unit of good X. Thus Portugal has lower opportunity cost of the two countries in producing wine while England has lower opportunity cost in producing cloth. So, Portugal has a comparative advantage in production of wine and England has an advantage in production of cloth.
- 8. So, in this case Comparative cost serve as an useful basis for opening up of a gainful international trade between Countries. Each country seeks here to specialise in production and export of the commodity in which it has comparative advantage and wants to import the other commodity from its trading partner.
- 9. Live Example Suppose, India 1US$= Rs. 50 Tanzania 1US$= Tnz Shilling 1000 (Rates are assumed for simplification of calculation) Water Beer Pw/Pb India Rs. 10 Rs. 30 1/3 Tanzania Ts. 500 Ts. 700 5/7 In terms of absolute cost, both water and beer are cheaper in India Suppose both the countries decide for a price ratio of ½, then India will gain in selling water and Tanzania in Beer. Explanation: Domestically in India a person has to sell 3 bottles of water to get a bottle of beer but if he buys from Tanzania, he requires to exchange only 2 bottles of water to get 1 bottle of beer. On the other hand in Tanzania when a person sells a bottle of beer he/she gets slightly more than a bottle of water, but if the beer bottle is sold internationally to India, the gain is more as the person will get full 2 bottles of water in return.
- 10. Transformation schedules or Production Possibility Generalizes theory to include all factors, not just labor Shows combinations of products that can be made if all factors are used efficiently Slope, or marginal rate of transformation, shows the opportunity cost of making more of one good (how much of one good must be given up to make more of another) Comparative advantage
- 11. The opportunity cost version of Comparative cost: The concept of Production Possibility Curve (PPC) Wheat Cloth The concept of Opp. Cost can be described through PPC. This shows alternative combination of any two products that can be produced efficiently with given resources and technology. In virtue of full employment and efficient use of resources, it is true that PPC will be downward slopping. But it may either a straight line or concave or convex curve to the origin. . Slope of PPC measures marginal opp. Cost of producing one commodity in terms of others
- 12. Wheat Cloth Under condition of constant cost in production PPC becomes a straight line. Again if law of increasing cost is operating then PPC will be concave. This is so because factors of production may not be adaptable completely to the two alternative use. In case of decreasing cost condition in production, PPC will be convex to the origin
- 13. Marginal Rate of Transformation 0 10 20 30 40 50 60 70 0 20 40 60 80 100 120 140 Autos A B C Slope = MRT = 0.5 Wheat
- 14. Wheat Cloth PPC and Price Line Under constant cost condition PPC coincides with the price line* But this is not so in case of varying cost condition because in this case cost alone does not determine the prices. We have to consider the demand conditions also. Given the internal demand condition we need to draw a separate price line whose slope will represent the ratio of exchange between goods. *The slope of the Price line denotes the relative price ratio of two products.
- 15. Indifference curves Final pattern of trade depends not just on supply, but also on demand - which is determined by individual tastes Tastes can be shown graphically with indifference curves, which show the various combinations of two goods that give a consumer the same total level of satisfaction Bringing demand into the model
- 16. A consumer’s indifference map 0 1 2 3 4 5 6 7 0 1 2 3 4 5 6 7 8 9 Autos Bringing demand into the model A B C D E I II III Wheat
- 17. Indifference curves (cont’d) “Higher” indifference curves (those farther from the origin) represent greater levels of satisfaction Individual preferences cannot really be added up into a “community indifference curve” but it is useful to imagine that they can for the purposes of trade theory Bringing demand into the model
- 18. Indifference curves (cont’d) Indifference curves have a negative slope – Keeping satisfaction constant means giving up some of one good for more of another Indifference curves are convex – As the consumer gets more of one good, she is less willing to give up what is left of the other – The rate of substituting one good for another is shown by the slope of the curve, the marginal rate of substitution Bringing demand into the model
- 19. Equilibrium Black Line: Price Ratio Red Curve: PPC Green Curves: Community Indifference curve (CIC), denotes preference pattern of the community Equilibrium A Community’s demand pattern is described by its CICs. Production of the goods by PPC. Price ratio by the price line. Y X Equilibrium occurs at R which we call the point of autarky or equilibrium in absence of international trade. At this point. PPC becomes tangent to the highest achievable CIC (and also price line). R