Lectures 7 & 8 AHEED Course “International Agricultural Trade and Policy”

Taught by Alex F. McCalla, Professor Emeritus, UC Davis.

March 31, 2010, University of Tirana, Albania

A Review of Neo-Classical Trade Theory & BoP

A Review of Neo-Classical Trade Theory & BoP

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• Classical Economists were mostly interested in trade problems

Why liberalized trade is beneficial• Adam Smith (1723-1790) studied exploitation of

increasing returns to scale• David Ricardo studied specialization according to

comparative advantage• Heckscher and Ohlin argued trade occurs because of

different factor endowments• Trade improves the efficiency of resource use by

shifting resources to most efficient use• Every country has a comparative advantage in

producing something; not a zero sum game• We will study 3 models: Ricardian, Heckscher-Ohlin-

Samuelson (HOS) and if time Jones fixed-factor.

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Overview of Trade TheoryOverview of Trade Theory

• Productive resources are unevenly distributed across the world

• e.g., BZ has 60 m. ha. of cropped land & another 100-170 m. ha. available for expansion; BZ is 2nd largest soy exporter & 3rd largest corn exporter.

• Much of BZ land was considered useless until tech change in 1970s.

• USA: 170 m. ha. cropped & 300 m. people• China: 140 m. ha. & 1,333 m.• India: 158 m. ha. & 1,170 m.• Japan: 5 m. ha. & 127 m. • Australia 45 m. ha & 21 m.

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Fundamental Basis for Food TradeFundamental Basis for Food Trade

Adam Smith : absolute advantageDavid Ricardo: corn laws; comparative advantagePaul Samuelson “Ricardian theory of c.a. is most

important proposition in economics ; is true & non-trivial”

Ricardian Assumptions1. 1 factor of production - labor2. 2 countries × 2 goods3. Constant Factor/Output ratios4. Factors immobile internationally5. Pure competition

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Ricardian ModelRicardian Model

David Ricardo(1772-1823)

Best Illustrated with an example

Unit Labor requirements

Cloth Wheat

Home (A) 90 hours per unit output

80 hours per

unit output

Foreign (B) 100 hours per unit output

120 hours per unit output

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Labor per unit output

aw =Lw/Qw

ac

a*c

Resource constraint Lc + Lw = L ; Lc* + Lw* = L*L, ac, & aw are exogenous; Lc, Lw, Qc & Qw are endogenous

Best Illustrated with an example

Unit Labor requirements

Cloth Wheat

Home (A) 90 hours per unit output

80 hours per

unit output

Foreign (B) 100 hours per unit output

120 hours per unit output

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Labor per unit output

aw =Lw/Qw

ac

a*c

Labor productivity aw = Lw/Qw, so productivity = 1/aw = output per unit labor

Country has Absolute Advantage if it can produce @ lower cost (i.e., higher productivity)

Country A has abs. adv. in cloth if ac < a*c , or if 1/ac > 1/a*c

• Opp. Cost is defined as value of next best opportunity, so if country

A decides to produce more wheat, opp. cost is loss of cloth production

• Labor constraint L = awQw + acQc

• Solve for Qc = L/ac – aw/ac(Qw)

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Opportunity costOpportunity cost

Lc

Qc

QW

PPF

Slope of PPF = opp. cost

-aw/ac

Slope gives cost of wheat productionin terms of cloth

R

Sx

1x represents amount of C that must be given up to produce 1 more unit of wheat; so x is opp. cost of producing wheat

Opp. Cost

Unit Labor requirements

Cloth Wheat

Home (A)

90 hours

per unit output

80 hours per unit output

Foreign (B)

100 hours

per unit output

120 hours per unit output

Opportunity Cost(In units of the other good)

Cloth Wheat

A: Home 90/80= 1.1 units wheat

80/90 = 0.9 units cloth

B: Foreign

100/120= 0.8 units

wheat

120/100 = 1.2 units

cloth

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Theory of c.a. compares ratios

Opportunity cost is Economic Cost

Gains from trade if Pc/Pw > ac/aw

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PricesPrices

Cost of cloth prodn.

Pc/PW

Qc/QW

1.1

0.8

-

- D

A produces both

B produces both

No c

loth

pro

dn

No w

heat

pro

dn

Both countriesspecialize

Country A specializes in cloth if Pc/PW > ac/aw, & specializes in wheat if Pc/PW < ac/aw , & producesboth if Pc/PW = ac/aw

Why trade? Say Country A has 170 L; in autarky it produces 90 cloth & 80 wheat, or specializes & produces 2.1 wheat & trades 1.0 wheat for 1.0 cotton

1.0

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Comparing Productivities-1Comparing Productivities-1

•Another way to define c.a. is by comparing productivities; A’s c.a. is in the good in which it has the greatest productivity advantage.•Wages are based on productivity, so wages are higher in more productive country•Trade flows equalize prices between 2 countries•Differences in tech. initial differences in relative prices trade

Zero profit condition πw = PwQw – wLw = 0

so w = PwQw/Lw = Pw(Lw/aw) / Lw =Pw/aw

This means that if Pc/Pw = 1 w =1/80 units wheat in A & w* = 1/100 units cloth in B

Bottom Line- Most Likely Outcome -Complete Specialization. Something we do not Observe –Need More Complete Theory

Comparing Productivities-2Comparing Productivities-2

Cloth is cheaper in A if:

Wheat is cheaper in A if:

Cloth is cheaper in B if:

Wheat is cheaper in B if:

wac < w*a*c waw < w*a*w w*a*c < wac w*a*w < waw

or w/w*< a*c /ac or w/w*< a*w /aw or w*/w < ac /a*c or w*/w < aw /a*w

but 1/80÷1/100 > 100/90

& 1.25 < 120/80 & 1/100÷1/80 < 90/100 but 0.8 > 80/120

1.25 > 1.1 1.25 < 1.5 0.8 < 0.9 0.8 > 0.7

Conclude that A’s rel.productivity in wheat is > rel. wages

Conclude that B’s rel.productivity in cloth is > rel. wages

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Heckscher-Ohlin-Samuelson (HOS) Model • H-O-S model says basis of trade is differences in countries’ resources.• The H-O-S theory shows that comparative advantage is influenced by:

• Relative factor abundance (refers to countries)• Relative factor intensity (refers to goods)

• HOS theory emphasizes :– patterns of trade– impacts of factor growth on trade– factor price equalization– income distribution effects from trade

• HOS theory argues that international differences in factors of production create productive differences that explain why trade occurs.– Countries have relative abundance of factors of production.– Production processes use factors of production with

relative intensity.

• HOS theorem: Countries tend to export goods whose production is intensive in abundant factors & import goods that are intensive in its scarce factors of production (pattern of trade).

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HOS Assumptions:

• An economy produces two goods, e..g, cloth & food.

• The production of these goods requires two inputs that are in limited supply; labor (L) & land (T).

• Production of food is land-intensive & cloth is labor-intensive in both countries (i.e., identical prodn. functions).

• No factor intensity reversal, constant returns to scale, & both countries are incompletely specialized.

• Perfect competition in all markets.

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HOS Production Possibilities

Production possibilities are influenced by both land and labor (requirements):

aTF×QF + aTC×QC ≤ T

aLF×QF + aLC×QC ≤ L

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Total amount of land resources

Land required for each unit of food production

Total units of food production

Land required for each unit of cloth production

Total units of cloth production

Total amount of labor resources

Labor required for each unit of food production

Labor required for each unit of cloth production

aTC = acres of land used to produce one unit cloth & aLC = hours of labor used to produce one unit clothaTF = acres of land used to produce one unit food& aLF = hours of labor used to produce one unit foodL = total amount of labor & T = total amount of land

Concept of Factor Intensity

• Suppose that the domestic country has an abundant amount of labor (L) relative to the amount of land (T).– The domestic country is abundant in labor & the foreign country

is abundant in land: L/T > L*/ T*– Likewise, the domestic country is scarce in land & the foreign

country is scarce in labor.– However, the countries are assumed to have the same technology

& same consumer tastes.

• If we consider the total resources used in each industry & say that cloth production is labor intensive & food production is land intensive

if LC /TC > LF /TF. • Because the domestic country is abundant in labor, it will be

relatively efficient at producing cloth because cloth is labor intensive.

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Qc (Cloth)

QF (Food)

L/aLF

L/aLc

T/aTF

T/aTC

Land constraint slope = -aTC/aTF

Labor constraint slope = -aLC/aLF

Cloth is lab. intensive so labor const. is steeper than land const.aLC/aTC > aLF/aTF , or aLC/aLF > aTC/aTF

Labor constraint: aLFQF + aLCQC ≤ LSo QF ≤ L/aLF - (aLC/aLF )QC

Production Possibilities

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Qc (Cloth)

QF (Food)

L/aLF

L/aLc

T/aTF

T/aTC

Land constraint slope = -aTC/aTF

Labor constraint slope = -aLC/aLF

When land constraint is relaxed, prodn. possibilities expand in direction towards food production (Rybczynski theorem).

•

•A

BThe opportunity cost of producing cloth:

–is low when the economy produces a low amount of cloth and a high amount of food

–is high when the economy produces a high amount of cloth and a low amount of food

Production Possibilities

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How do the outputs of the two goods change when the economy’s resources change?– Rybczynski Theorem:

• If a factor of production (T or L) increases, then the supply of the good that uses this factor intensively increases and the supply of the other good decreases for any given commodity prices.

– The reverse is also true. • The biased effect of increases (decreases) in resources on

production possibilities is the key to understanding how differences in resources give rise to international trade.

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Production Possibilities

With more than one factor of production, the PPF (opp. cost in production) is no longer a straight line. Why?

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Output offood, QF

Output ofcloth, QC

PP

Slope = -PC/PFQF

QC

• With substitution of inputs, then the PPF becomes curved.

– For example, many laborers could work on a small plot of land or a few laborers could work on a large plot of land to produce the same amount of output.

– Unit factor requirements are not constant at every quantity of cloth & food produced.

HOS-Consumers

Demand Side –Individual preferences shown by indifference curves Uo, U2 and U3.Consumer maximizes utility by choosing combinations of A & B where her budget line AB is tangent to highest indifference curve –point EIf all consumers have identical preferences, community indifference curves have same properties- societal welfare is max when price ratio line is tangent to highest social indifference curve

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HOS ProductionAB –all possible combinations of food and cloth given country’s labor and capital endowments;CD relative price of cloth faced by producers.P competitive equilibrium where pc/pf = mrt of food into cloth.XF quantity of food produced;

XC quantity of cloth produced

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HOS Autarky

With no trade consumers and producers are in equilibrium when both the PPC and MRS are tangent to the price line.This occurs at point AWhere (CF =XF) = (CC = XC)

i.e. is when both are tangent to the price line PA.Production of each good equals consumption of each good.Now let there be trade

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HOS –With Trade2 country world and that in equilibrium- world equilibrium price is p*Given p* the optimum production in our country is at P where p* is tangent to the PPF at point A-Country produces XC of cloth & X F of food. Given p* consumer can reach a higher indifference where p* is tangent to uF at point CCountry consumes CC of cloth and CF of foodThe country exports Cc-Xc of cloth and imports CF-XF of foodCBP is trade triangle –gains from trade. Country is better off i.e. is on a higher utility curve Uf>UA

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Trade in the HOS Model

• An economy will be relatively efficient at producing goods that are intensive in the factors of production in which the country is relatively well endowed.

• Since cloth is a labor intensive good, the domestic country’s PPF will allow a higher ratio of cloth to food relative to the foreign county’s PPF.

• At each relative price, the domestic country will produce a higher ratio of cloth to food than the foreign country.– The domestic country will have a higher relative supply

of cloth than the foreign country.

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HOS- Factor Intensity, Factor prices &Product Prices

One good produced- one unit can be produced using varying combos of K & L : Q – Q is a unit isoquant;Least cost combo where ratio of factor prices = slope of QQ.If initially isocost line (input price ratio) equals AB, point E is such a point.Cost minimizing K/L ratio is slope of ray OE.Suppose wage/rental rate rises which implies steeper isocost line CD Cost minimizing point now F and K/L ratio is slope of ray OF which has increased.

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Factor Prices & Goods PricesAn increase in the relative price of food, PF /PC , will:

– raise profits in food sector relative to that of labor, r/w and attracts new firms to food sector

– Given that food is more capital intensive ,the increased demand for capital will be greater than that released from cloth sector.

– Result excess demand for capital and excess supply of labor which bids up return to capital and lowers return to labor.

– raise the real income of capital owners and lower the real income of labor in both sectors.

– Stolper-Samuelson Theorem:• If the relative price of a good increases, holding factor

supplies constant, then the nominal and real return (in terms of both goods) to the factor used intensively in the production of that good increases, while the nominal and real return (in terms of both goods) to the other factor decreases.

– The reverse is also true.

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What says is that relative product prices uniquely determine factor prices.

Given that free trade will equate relative commodity prices across countries, it follows factor prices will be equalized across countries that have same technology even though factors are assumed be immobile internationally. Leads to:

Factor Price Equalization Theorem• International trade leads to complete equalization in

the relative and absolute returns to homogeneous factors across countries.

• It implies that international trade is a substitute for the international mobility of factors.

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Trade in the HOS Model

• An economy will be relatively efficient at producing goods that are intensive in the factors of production in which the country is relatively well endowed.

• Since cloth is a labor intensive good, the domestic country’s PPF will allow a higher ratio of cloth to food relative to the foreign county’s PPF.

• At each relative price, the domestic country will produce a higher ratio of cloth to food than the foreign country.– The domestic country will have a higher relative supply

of cloth than the foreign country.

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Trade in the HOS Model

• The H-O model predicts a convergence of relative prices with trade. Because relative prices are equalized & given the direct relationship between relative prices & factor prices, factor prices are also equalized.

• Trade increases the demand for goods produced by abundant factors,

indirectly increasing the demand for the abundant factors themselves, raising the factor prices of the abundant factors across countries.

• With trade, the relative price of cloth will rise in the domestic country & fall in the foreign country. – In the domestic country, the rise in the relative price of cloth leads to a rise

in the relative production of cloth & a fall in relative consumption of cloth; the domestic country becomes an exporter of cloth & an importer of food.

– The decline in the relative price of cloth in the foreign country leads it to become an importer of cloth & an exporter of food.

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Income Distribution in HOS Model• Because an economy can afford to consume more with

trade, the country as a whole is made better off.• But some do not gain from trade, unless the model

accounts for a redistribution of income.• Trade changes relative prices of goods, which have effects

on the relative earnings of labor & land.– A rise in the price of cloth raises the purchasing power of domestic

laborers, but lowers the purchasing power of domestic land owners.

• The model predicts that with trade owners of abundant factors gain, but owners of scarce factors lose.

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Empirical Evidence on the HOS Model

• Because factor prices are not equalized across countries, the predicted volume of trade is much smaller than actually occurs.– A result of “missing trade” discovered by Daniel Trefler (‘95).

• The reason for this “missing trade” appears to be the assumption of identical technology among countries.– Technology affects the productivity of labor & therefore the value of labor

services.– A country with high technology & a high value of labor services would not

necessarily import a lot from a country with low technology & a low value of labor services.

• Tests on North-South Trade: North-South trade in manufactures seems to fit the H-O theory much better than the overall pattern of international trade.

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Summary• The H-O model, in which two goods are produced using two

factors of production, emphasizes the role of resources in trade.• A rise in the relative price of the labor-intensive good will shift

the distribution of income in favor of labor:– The real wage of labor will rise in terms of both goods, while

the real income of landowners will fall in terms of both goods.• The owners of a country’s abundant factors gain from trade, but

the owners of scarce factors lose.• In reality, complete factor price equalization is not observed

because of wide differences in resources, barriers to trade, & international differences in technology.

• Empirical evidence is mixed on the H-O model.– Most economists do not believe that differences in resources

alone can explain the pattern of world trade or world factor prices.

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The Financial Side of Trade• So far we have been dealing with “real” trade theory

where we have looked at why countries would gain from trading but not how.

• Unless in barter economy, need a medium of exchange - money or currency.

• Given that countries have their own money/currency the needs to be a market where you can exchange one currency for another.

• Called Foreign Exchange(Fx) Markets• So will briefly look at why Fx transactions are NB,• And will say a word about the Balance of Payments

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Foreign Exchange Trading• For every international transaction involving real goods there is an equal

and opposite monetary transaction.

• Italy buys wheat from Canada and Canada wants payment in $CAN so Italy sells Euros to buy $ in the Fx markets.

• so export of wheat has caused an import of $CAN;

• In Fx market supply of Euros has gone up putting downward pressure on price of Euros; and the demand for $CAN puts upward pressure P of $CAN.

• The ratio of prices of any two currencies is the exchange rate -$/Eur,Yen/Peso, Yuan/Rupee.

• Given differences to timing of real & monetary transaction, there have developed futures markets for currencies as well as goods which allow traders to hedge against changes in Ex Rates.

• Critical because if a country devalues its currency it exports are cheaper for the ROW and the imports it buys abroad are more expensive.

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A Country’s Balance of Payments (BoP)- Accounts Always Balance

Credits• Current/Merchandise

Account-– exports of goods;– Investment income;– Sales of services.

Capital Account-

borrowing from abroad-exporting IOU’s

Debits• Current Account-

– Imports of goods;– Payments to foreign

markets –interest, repatriated earnings;

– Travel abroad

Capital Account-Lending to foreigners

public and private.

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BoP cont.

• So when hear that US has a huge trade deficit it means its current account is in deficit -it is importing more goods and services than it is exporting.

• In principle this should put downward pressure on the price of $US;

• But if others -e.g. the Chinese- are buying US bonds, this is an export of IOU’s and is counted as a credit bringing the BOP into balance.

• Wont go further here- basic point is that you keep in mind that every international transaction involves 2 markets.

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