International trade - theory and challengesThe conventional economics view…PowerPoint PresentationSlide 4Overview of Trade TheoryTrade Theory-OverviewSlide 7Mercantilism: Mid-16th CenturyTheory of Absolute AdvantageAbsolute Advantage and the Gains From TradeSlide 11There may also be long-term benefits to free tradeSlide 13Comparative AdvantageSlide 15Comparative Advantage and the Gains From TradeSlide 17Slide 19How Comparative Advantage worksThe country less efficient in everything will be poor …Slide 22AssumptionsSlide 24Slide 25Slide 26Simple Ways to make the Comparative Advantage Model more realisticProduction Possibility Frontier Under Diminishing ReturnsBecause their theory showed big gains from trade, Smith & Ricardo advocated free tradeSlide 30Additional Simple Extensions of the Comparative Advantage ModelInfluence of Free Trade on PPFSlide 33Paradox: US exported labor-intensive goods when it had lots of capitalSlide 35When Intervention May HelpInfant industry protection is only good if it helps the industry become efficient‘New Trade Theory’ (developed 1970s & after)New Trade Theory-ApplicationsWhen Intervention May HelpSlide 41Development of the World Trading SystemSlide 43Slide 44Slide 45Slide 46Slide 47The World Trade OrganizationSlide 49Slide 50◦“Every individual seeks the most advantageous employment for his capital…. ◦“Study of his own advantage necessarily leads him to prefer that employment most advantageous to society” - Adam Smith, 1776The conventional economics The conventional economics view…view…Models from economics generally assume that if everyone pursues self-interest, things will work out for good◦May assume adherence to some straightforward ethical principlesFree Trade occurs when a government does not attempt to influence, through tariffs, quotas, or other means, ◦what citizens can buy from other countries or ◦produce and sell to other countriesThe Benefits of Trade allow countries to be richer by specializing in products they can produce most efficientlyThe history of government involvement in trade presents mixed evidence ◦There are lots of problems with trade There may be some ways that some governments can make things better by intervening (that is, by not practicing free trade)◦But government intervening in free trade is definitely dangerous Restrictions on trade havekept some countries very poorcontributed to huge depressionsTill the 16th century, philosophers didn’t theorize much about tradeThen mercantilists sought what we now call ‘development,’ teaching that a nation’s wealth depends on accumulated “treasure”◦Gold and silver are the currency of tradeMercantilists argued their countries should run a trade surplus ◦Maximize export through subsidies◦Minimize imports through tariffs and quotasFlaw: “zero-sum game”◦Mercantilists neglected to see the benefits of tradeAdam Smith argued (Wealth of Nations, 1776): Capability of one country to produce more of a product with the same amount of input can vary◦A country should produce only goods where it is most efficient, and trade for those goods where it is not efficientTrade between countries can, therefore, benefit both sides ◦Example: Portugal/wine vs. England/wool◦Ghana/cocoa vs.South Korea/riceAs people specialize and seek higher incomes, they may learn to do their specialties betterSuppose one country is more efficient than another in everything?There are still global gains to be made if a country specializes in products it produces relatively more efficiently than other productsDavid Ricardo (Principles of Political Economy, 1817):◦A country should import products for which it is relatively inefficient even if the country is more efficient in the product’s production than country from which it is buyingTrade is a positive-sum gameTheory of Comparative AdvantageCountries have comparative advantage in goods for which the opportunity cost of production is relatively low◦That is, those that can be produced by giving up relatively little in production of other goodsThis means your country has comparative advantage in the product or service where the ratio Resources required in your country . Resources required in the other countryis lowGhana has absolute advantage in both cocoa and rice, but its comparative advantage is in cocoa. Korea has comparative advantage in rice .CocoaGhana3.75 tonsKorea15 tons20 tonsLet Korea specialize in rice – Ghana expands cocoa production to replace all Korean cocoa production lost15 tonsThen Ghana can replace all Korean cocoa production and the countries have more of both goods.Rice 10 tons5 tonsBut it would be even poorer if it did not tradeThe country less efficient in The country less efficient in everything will be poor …everything will be poor …This is a very simple case, but the basic conclusions are generally valid and are used in setting international policy ◦We’re assuming no transportation costs◦We’re simplifying by not talking about currencies ◦We’re assuming constant returns to scale◦We’re assuming resources can move freely from production of one good to another ◦We’re not thinking about effects on income distributionUnder free trade, the country that is less efficient will have low wagesIt will be able to sell the products where it has comparative advantage without any special tariff or subsidy protection◦But it may need to work on infrastructure, institutions, and education for tradeChina, India both sell cheap manufactured goodsChina sells more because it has better transportation infrastructure and government that supports manufactured exportsImmobile resources:◦Resources do not always move easily from one economic activity to anotherSo some rice farms will persist in Ghana no matter what(Rice farmers will be losers as cheap rice comes from Korea)Diminishing returns:◦Diminishing returns to specialization suggests that after some point, the more units of a good the country produces, the greater the additional resources required to produce an additional itemThey believed that if people were left to trade on their own, they would naturally trade the goods in which their countries had comparative advantage◦“Every individual seeks the most advantageous employment for his capital…. ◦“Study of his own advantage necessarily leads him to prefer that