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:

• Two hourly exams over the semester and a cumulative final. The first exam is
February 16.

• There are weekly problem sets. I want to remind that that you should work on
these on your own. Collaborative effort is an act of academic dishonesty which
will result in a 0 for the course. If you miss class, the assignments are posted on
my web page.

• There will be a group project and presentation. You should form up into groups of
3 or 4 over the next few weeks. I'm going to assign topics at the beginning of
February.

• Each class will end with a "minute paper". This consists of short responses to two
questions. Basically, "What did you learn tonight?" and "What didn't I explain
well?"

• Attendance: you don't have to come to class, but we do only meet once a week
(13 times after tonight; 10 if you don't count the nights of the exams and
presentations) and you can't do a minute paper if you are not here.

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

• foreign economic conditions impact on the U.S. economy

• U.S. more dependent on foreign suppliers

• more competition in domestic markets: price of imported products falls,

benefiting consumers but hurting U.S. producers of the goods

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
assumptions:

• 2 countries with the same population and capital stocks (Ghana and Peru)

• 2 products: wheat and cloth

• perfect competition

• full employment of resources

• ignore demand side

 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.

• deriving the trade line

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.
g
a
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
different goods use factors of production in different ratios
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

implications:
U.S. should export wheat and import cloth
 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

X is preferred to Y
Y is preferred to X
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.