Basic trade theory needed for policy analysisObjectives of this set of lecturesWhy do countries trade?A caveatNevertheless….What are opportunity costs?Absolute vs. Comparative Advantage (CA)Compare two examplesFactor endowments: Another source of CA Heckscher-Ohlin-Samuelson (HOS) modelA third source of comparative advantageWhat does it mean to say that the “country” gains from trade?Who are the winners and who are the losers (from trade liberalization) within a country?How do we measure welfare gains? (One possibility)Welfare gains from trade: comparison of Ricardian and H-O-S modelsWhen do “countries” gain from trade?What determines whether country gains or loses from trade in third case?A slightly more realistic exampleDoes trade improve welfare in both countries?Theory of the second best (TSB)More on TSBThe Principle of TargetingSummary1Basic trade theory needed for policy analysisNovember 5, 20072Objectives of this set of lectures•Provide an overview of reasons for trade.•Explain “opportunity cost”•Explain comparative advantage and absolute advantage•Discuss three sources of comparative advantage: differences in (i) technology, (ii) factor endowments, and (iii) institutions.•Introduce “Theory of the second best”.•Introduce the “Principle of Targeting”3Why do countries trade?•Because they are different:i) Different relative labor productivity across sectors.ii) Different relative endowments of inputs (e.g., capital, labor, natural resources)iii) Different institutions (e.g. property rights) and different laws (e.g. environmental protection)4A caveat•Similarities across countries can also promote trade.•Volume of trade amongst “similar” countries is greater than volume amongst “very different” countries.•“Intra-industry trade” (e.g. importing and exporting autos) takes advantage of specialization and decreasing average costs.•Similar countries may also benefit from being part of a network of production.5Nevertheless….•“Differences” rather than “similarities” are probably a more fundamental reason for trade, and are certainly more important for North-South trade.•Differences are the basis for comparative advantage.•A country’s comparative advantage depends on its “opportunity costs”6What are opportunity costs?•The opportunity cost of any action is the value of the best alternative to that action: it is what you give up in order to perform the action.•Ricardo-like example: Table shows amount of labor needed in each country to produce food or clothLabor needed for one unit of FoodLabor needed for one unit of ClothUS 1 1Canada3 67Absolute vs. Comparative Advantage (CA)•In example in previous slide, US has absolute advantage in both sectors•US opportunity cost of one unit of food is one unit of cloth•Canada’s opportunity cost of one unit of food is ½ unit of cloth.•Canada has lower opportunity cost (compared to US) in production of food, Therefore Canada has comparative advantage in production of food.•US has lower opportunity cost = comparative advantage in production of cloth•Comparative advantage results from difference, across countries, in relative productivity between sectors.•Pattern of trade driven by CA, not by absolute advantage.•See online lecture notes “Ricardian Model” for more details8Compare two examplesLabor needed for one unit of FoodLabor needed for one unit of ClothUS 1 1Canada3 6Labor needed for one unit of FoodLabor needed for one unit of ClothUS 1 1Canada6 6•Example on the right: opportunity cost of food is the same in both countries. Neither country has a CA in production of either commodity. These countries do not benefit from trade. This is a “knife-edge” example, since a perturbation of any of the four parameters eliminates the equality (across countries) of relative labor requirements in the two sectors.9Factor endowments: Another source of CA Heckscher-Ohlin-Samuelson (HOS) model•Stick with two-country two-commodity example. Food and cloth production both require capital and labor (K,L). The countries have the same technologies, but different aggregate capital/labor ratios.•Suppose the K/L ratio higher in cloth sector than in the food sector: cloth is more “capital intensive” than food. •Suppose that US aggregate capital/labor ratio is higher than Canada’s: the US is relatively well endowed in capital and Canada is relatively well endowed in labor.•Under additional technical assumptions this difference in relative factor endowments implies that US has lower opportunity cost in cloth production. US therefore has comparative advantage in cloth production. Canada has CA in food.•In general, a country has the comparative advantage in the commodity that uses relatively intensively the factor in which the country is relatively abundant.10A third source of comparative advantage•Suppose that two countries are identical with respect to relative endowments and technology.•Only difference is that one country has weak environmental laws.•If food production is “relatively environment-intensive”, country with weak laws has an (apparent) CA in food production.11What does it mean to say that the “country” gains from trade?•It can only means that the citizens (or inhabitants), possibly including those living in the future, gain. But in general some people gain and some lose from any policy change.•We say that the “country” gains if trade liberalization increases “efficiency”, by which we mean that the gain for winners is great enough to compensate the loss for losers, leaving both groups better off.•Many people think that this criterion is not useful, because in practice the losers are seldom compensated (although policies such as Trade Adjustment Act(s) are an attempt to do just that).12Who are the winners and who are the losers (from trade liberalization) within a country?•Remember the partial equilibrium story – where we have producers, consumers and tax payers. This model is useful because it shows that there are winners and losers from a policy change, but the model is unsatisfactory because many people are in all three groups.•An alternative model recognizes that people rent their “factors of production”, i.e. their land, labor and capital, and get utility from consumption.•With this approach, we ask how a policy reform (such as trade liberalization) affects owners of different factors
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