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International Economics
Faculty: Prof. Sunitha Raju
Session 1: Introduction and International Trade Theory
Session Date: 06.07.13
MBA(PT)2012-15
International Economics/ Session: 1
Globalization - Meaning
Integration of national Economies into an international economy
Integration through trade investment, capital flows, technology and migration
MBA(PT)2012-15
International Economics/ Session: 1
Globalisation Trends
Promotion of Free Trade Elimination of tariffs subsidies Elimination of capital controls Reduction in transportation costs
Integration of production activities Wider choice of goods & services Creates competition for local firms & keeps costs
low Promotes specialisation Can lead to economic problem of unemployment
& deindustrialisation
MBA(PT)2012-15
International Economics/ Session: 1
Review of Trends in Global TradeReview of Trends in Global Trade
MBA(PT)2012-15
International Economics/ Session: 1
Trade to GDP Ratios
Source: UNCTAD Handbook of Statistics
MBA(PT)2012-15
International Economics/ Session: 1
Composition of Exports By Regions
Year 1980 1990 2000 2005 2009
World 2035542 3485651 6448493 10504579 12419054
Developing Economies 29.46 24.32 31.8 36.2 39.5
Transition Economies 4.19 3.4 2.3 3.4 3.8
Developed Economies 66.34 72.2 65.7 60.3 56.6
MBA(PT)2012-15
International Economics/ Session: 1
Total Merchandise Exports, 1995-2006
Reporter Name
Partner Name
1995 2000 2006
Value ($ billions)
Share in WLD to
WLD (%)
Value ($ billions)
Share in WLD to
WLD (%)
Value ($ billions)
Share in WLD to
WLD (%)
World World 5,037.5 100.0 6,316.1 100.0 11,565.8 100.0
Developing economies
World 1,417.4 28.1 2,061.7 32.6 4.110.8 35.5
Developing economies
Developing economies
570.2 11.3 786.6 12.5 1,824.2 15.8
Source: UNCTAD’s South-South Trade Information System
MBA(PT)2012-15
International Economics/ Session: 1
Composition of Exports of Developing Countries- Regional Groups
MBA(PT)2012-15
International Economics/ Session: 1
Export Structure by Product Group: World
All Food Items
Agriculture Raw Material
Ores & Metals
Fuels Manufacturing Goods
Total
1995 9.0 2.7 4.6 7.4 73.9 100
2005 6.5 1.6 4.7 13.8 70.5 100
2009 7.9 1.4 5.5 14.1 67.9 100
MBA(PT)2012-15
International Economics/ Session: 1
Export Structure of Commodities by Regions
Developed Economies Developing Economies Transition Economies
Item 1995 2005 2009 1995 2005 2009 1995 2005 2009
All Products 3385250 6849291 7373358 1536381 3269916 4602463 95802 260403 359190
All Food Items 67.3 68.2 62.0 28.9 27.3 33.0 4.4 4.5 4.6
Agriculture Raw Material
67.7 61.0 52.8 31.5 37.2 44.8 0.8 1.8 2.4
Ores & Metals 68.9 60.2 52.2 30 38.2 68.9 1.2 1.5 1.1
Fuels 68.7 66.6 58.0 28.9 31.6 30 2.7 1.8 2.1
Manufacturing Goods
67.4 65.8 60.4 31.1 28.2 8.5 1.5 2.6 3.1
MBA(PT)2012-15
International Economics/ Session: 1
Top 10 Economies in South-South Trade, 2003 (Percentage shares of total South-South Trade)
MBA(PT)2012-15
International Economics/ Session: 1
Applied Tariffs in Developed and Developing Countries by Selected Product Group,
1994 and 2005 (percent)
Pro
du
cts
and
Mar
ket
s
MBA(PT)2012-15
International Economics/ Session: 1
Trade and Investment Trends
Exports of Goods & Services 2010 2012 2015 2017
(i) World 18820.672
(100.0)
22847.769
(100.0)
26899.298
(100.0)
30552.711
(100.0)
(ii) Advanced Economies 11987.352
(63.692)
13870.86
(60.709)
16012.693
(59.528)
17852.059
(58.430)
(iii) Newly Industrialised Asia 1834.153
(9.745)
2185.931
(9.567)
2696.216
(10.023)
3145.178
(10.294)
(US $ billions)
MBA(PT)2012-15
International Economics/ Session: 1
World Trade Trends
a) Why do some countries trade more than others
b) Why is there a significant increase in the trade in manufactures compared to primary commodities
c) Why is there a growing importance of developing countries in world trade
d) Why is there a significant increase in south-trade
e) What role do national trade policies have in defining the trade pattern
MBA(PT)2012-15
International Economics/ Session: 1
Framework for International Trade
MBA(PT)2012-15
International Economics/ Session: 1
Preview Questions
1. What is the basis for trade between countries?
2. How are gains from trade defined/ measured?
3. What determines the structure/pattern of trade flows?
MBA(PT)2012-15
International Economics/ Session: 1
Basis for Trade
1. Mercantilism
2. Standard Trade Model Absolute Advantage Comparative Advantage Heckscher-Ohlin Theorem
MBA(PT)2012-15
International Economics/ Session: 1
Absolute Advantage: Illustration
US will export wheat and import cloth from UK
UK will export cloth and import wheat
Absolute cost differences between countries lead to trade
US UK
Wheat (bushels/man-hour) 6 1
Cloth (Yards/man-hour) 4 5
MBA(PT)2012-15
International Economics/ Session: 1
Comparative Advantage: Illustration
US UK
Wheat (bushels/man-hour) 6 1
Cloth (Yards/man-hour) 4 2
US has absolute advantage in both wheat & cloth
UK has absolute disadvantage in both wheat & cloth
Can trade take place?
MBA(PT)2012-15
International Economics/ Session: 1
Principle of Comparative Advantage(Ricardo)
Comparison of relative advantage or disadvantage between countries
US has 6 to 1 advantage in wheat and 2 to 1 advantage in textiles (over UK)
UK has greater disadvantage in wheat than in cloth.
Wheat : 1 to 6
Cloth : 1 to 2
MBA(PT)2012-15
International Economics/ Session: 1
Comparative Advantage: Resource Cost
US
Domestically, 6W can be produced if 4C is given up (opportunity cost)
1C costs 1½ W and 1W costs W
UK
2C can be produced if 1W is given up 1C costs ½ W and 1W costs 2C
Therefore, cloth is relatively cheaper in UK and wheat in USA
3
2
MBA(PT)2012-15
International Economics/ Session: 1
Comparative Advantage: Gains from Trade 1
US (Cloth) Import of cloth takes place if 6W can be
exchanged for greater than 4Cif 1C is less than 1½ W
UK (Cloth) Export of cloth takes place if 2C can be
exchanged for greater than 1WIf 1C is greater than ½ W
Both US & UK gain if the price of cloth (in terms of wheat) is 1W
MBA(PT)2012-15
International Economics/ Session: 1
Comparative Advantage: Gains from Trade 2
Countries can gain from trade even when one of the countries has absolute disadvantage (cost) in both products
Relative Advantage / Disadvantage will define the implicit resource cost for production of goods
Relative prices determine the direction and volume of trade
MBA(PT)2012-15
International Economics/ Session: 1
Comparative Advantage: Gains from Trade 3
Benefits from trade can be assessed when compared to a situation without trade (Autarky)
In Autarky, resource allocation decision is based on production and consumption decisions of a country
Possible production trade-offs between goods X and Y given the available resources and technology (production possibility curve for a country)
Trade-offs between consumption of goods X and Y subject to consumer preferences (consumer indifference curve for a country)
MBA(PT)2012-15
International Economics/ Session: 1
Comparative Advantage and Trade: Production Possibility Schedule (PPS)
PPS shows various combinations of 2 goods that a country can produce when all inputs (land, labour capital & Entrepreneurship) are used most efficiently.
Under constant cost conditions, relative cost of producing one good in terms of other remains same
MRT = cloth
wheat
MBA(PT)2012-15
International Economics/ Session: 1
Production Possibility Frontier
Production Possibility Schedules for Wheat and Cloth in the United States and the United Kingdom
United States United Kingdom
Wheat Cloth Wheat Cloth
180 0 60 0
150 20 50 20
120 40 40 40
90 60 30 60
60 80 20 80
30 100 10 100
0 120 0 120
MBA(PT)2012-15
International Economics/ Session: 1
Consumption/Demand Issues
Consumer demand is underlined by tastes/ preferences or utility
How much of the goods produced will be consumed depends on consumer preferences
Consumer Indifference Curve
Slope of the Indifference Curve represents consumers’ trade off between two goods, i.e. Marginal Rate of Substitution
MBA(PT)2012-15
International Economics/ Session: 1
Slope = ∆ Y/∆ X = MRSA
UA
2
AU
A1
U0
YA
0 XA
Indifference Curves
MBA(PT)2012-15
International Economics/ Session: 1
Equilibrium in Autarky
Consumption utility maximized subject to the constraints of Production Possibility Frontier
Slope = -(bLX/bLY) = MRTB
Slope = MRSB
YB
YB
XB0 XB
UB B
2
UB1
UB0
LB/ bLY
MBA(PT)2012-15
International Economics/ Session: 1
120
80
60
40
20
100
30 60 90 120 150 180
•
••
••
•
•
A
Clo
th
120
80
60
40
20
100
20 60
•
••
••
•
Clo
th40
United States United Kingdom
Wheat Wheat
• •0 0
A′
•
Production Possibility Frontier: Equilibrium under Autarky
MBA(PT)2012-15
International Economics/ Session: 1
Equilibrium in Open Economy
120
70
60
90 110 180
•
••
•
E
Clo
th
United States United Kingdom
Wheat
•0
A
B
120
50
40
60 7040
•
••E′
Clo
thWheat
•0
B′
A′
MBA(PT)2012-15
International Economics/ Session: 1
Equilibrium-Relative Prices with Trade
With specialisation in production & trade, each nation can consume outside its production frontier.
The relative prices that balances trade (i.e. export of 1 country = import by another country)
MBA(PT)2012-15
International Economics/ Session: 1
Exports
Imports
E*
S
DE
A
B
P3
P2
P1
SX
International Trade in Commodity X
Nation 1’s Market for Commodity X
Nation 2’s Market for Commodity X
SX
A’
E’B’
A’’
DX
P3
B*
A*
XXO O O
.
..
.
. .
.
.
.
.
The Equilibrium-Relative Commodity Price
Panel A Panel B Panel C
Dx
Y
XP
P
Y
XP
PY
XP
P
MBA(PT)2012-15
International Economics/ Session: 1
Trading under Constant Costs
Basis for Trade Slopes of the production possibilities schedules give
the relative cost of one product in terms of other Differences in relative costs provide the basis for
mutually favourable trade
Production gains from Specialisation
A country will specialise in the production of the good in which it has comparative advantage
A country will trade part of this production for the good in which it has comparative disadvantage
(a)
(b)
Contd..
MBA(PT)2012-15
International Economics/ Session: 1 Consumption gains from Trade
Consumption alternatives limited by the domestic production possibilities schedules
The exact consumption will be determined by the tastes & preferences
Specialization & free trade care achieve post-trade consumption outside domestic production possibilities schedules trade results in consumption gains for both countries
Terms of Trade Domestic terms of trade represents the relative prices at which
goods are exchanged at home A country will exports/import goods internationally if the terms
of trade are more favourable than domestic terms of trade
(d)
(c)
Trading under Constant Costs
MBA(PT)2012-15
International Economics/ Session: 1
Production Possibility Schedule under Increasing Costs
(i) Increasing opportunity costs mean that more of one commodity is to be given up (to release resources) for additional production of another commodity
(ii) Increasing costs result when inputs are not perfect substitutes
MBA(PT)2012-15
International Economics/ Session: 1
0 0
Nation 1 Nation 2
Production Frontiers of Nation 1 and Nation 2 with Increasing Costs
10 30 50 70 90 110
130
∆X
-∆Y
A
B
X
Y
20
40
60
80
100
120
140
∆Y
-∆X
A’
B’
Y
Slope of the PPS (or MRT) varies at different points on the schedule
MBA(PT)2012-15
International Economics/ Session: 1
0 0
Nation 1 Nation 2
10 30 50 70 90 110
130
A
B
X
Y
20
40
60
80
100
120
140
A’
B’
Y
20
40
6070
80
.
I
4
1AP
140
20 40 60 80
.
.
I’
85
PA’=4
Trade Under Increasing Cost
MBA(PT)2012-15
International Economics/ Session: 1
0 0
Nation 1 Nation 2
10 30 50 70 90 110
130
A
B
X
Y
20
40
60
80
100
120
140
A’
B’
Y
20
40
6070
80
.
I
20 40 60 80
.
.
I’
100
... III
E
150
PB=1C
100
120
III
E’C’
PB’=1
Trade Equilibrium Under Increasing Costs
MBA(PT)2012-15
International Economics/ Session: 1
Trading under Increasing Costs
Supply factors and Demand factors together determine the point at which a country chooses to consume along the PPS.
In Autarky, a country is in equilibrium which the PPS is tangent to the highest indifference curve
This tangency determines the equilibrium relative prices of commodities in each country.
MBA(PT)2012-15
International Economics/ Session: 1
Determining Relative Prices
(i) Terms of Trade (Net barter terms of trade) Ratio of price of export commodity to the price of
import commodity Assume 2 countries :
– Home → Exports Food
→ terms of trade
– Foreign → exports manufactures
→ terms of trade
M
F
P
P
F
M
P
P
MBA(PT)2012-15
International Economics/ Session: 1
Sources of Comparative Advantage
a) Factor Endowments
b) Technology
c) Consumer Tastes (Demand Issues)