International Trade and International Macroeconomics: Production Possibilities

International Trade and International Macroeconomics: 2 Units

Unit 22: International Trade Unit 23: Macroeconomics and the Open EconomyUnit 22 International Trade (Mankiw & Taylor, Ch 17)

Preview of Unit 22

1. In this last part we look at the international dimension. Unit 23 takes up international trade, i.e. the commercial flows of goods and services characterizing the trade balance between different countries.
2. The basic principle driving international trade is that of comparative advantages, which is based on the assessment of the social opportunity cost of specialization.
3. This principle leads to a positive view of free trade, which however can be qualified in some circumstances.
4. The welfare costs of protectionism can be assessed in terms of surplus losses and gains in competitive markets.

Introduction to International Trade

Consider a typical day: You have coffee in the morning (from beans grown in Kenya or Tea picked in Sri Lanka). After a shower, you get dressed (jumper made in Scotland, a shirt made in Bangladesh ... ). Meanwhile you switch on your radio (made in Japan) You drive to class in a car (made in Germany, with parts from half a dozen different countries). You open up your textbook published in Hampshire, from paper from trees grown in Finland and written by authors from America and England ....

International Trade Pervasiveness

... and so on. All this means that international trade is pervasive. Openness to international trade is usually measured by Exports+Imports X+M gdp Y

Notable Cases of Trade Openness

Some notable cases: Luxembourg (2017): 424% Germany (2017) 86.9% Hong Kong (2017): 375.1% USA (2016) 26.6% Italy (2016): 59.5% China (2017) 37.8%

Globalization Index Over Time

One way of measuring «globalization» is by noting that the world average of such an index has almost doubled in the last 50 years .... 60% World 50% 40% 30% 20% 10% 0% 1970 1980 1990 2000 2010 2019

Exports and GDP Growth Correlation

... and there appears to be a correlation between exports and growth of gdp per capita, though of course correlation is not causation. So the question is: what drives international trade? Introduction +8% Average annual change in merchandise exports as share of GDP Romania +6% South Korea France +4% Vietnam Japan China Burkina Faso Italy Austria Ireland India +2% Turkey United States Haiti Malaysia Liberia Democratic Republic of Congo Nigeria Brazil Saudi Arabia +0% Ethiopia Pakistan Indonesia Tanzania -2% Uganda Cuba -1% +0% +1% +2% +3% +4% +5% Average annual change in GDP per capita Albania

Production Possibilities Frontier(s)

Recall the production possibilities frontier, showing the combinations of output that the economy can possibly produce given the available factors of production and the available technology ... ... and recall how this can be used to define efficiency, opportunity costs and growth: in this example, moving the economy from point A to point C shows that the opportunity cost of 300,000 consumer goods is 50,000 capital goods. Growth would amount to an upward shift of the curve Quantity of capital goods (millions of units) Production is efficient at points on the curve e.g. points A and C. Production is inefficient inside the curve e.g. point B. Production at a point outside of the curve is not possible (e.g. point D) given the economy's current level of resources and technology. 1 · D C 0.75 0.7 A B Production possibilities frontier 0.3 0.8 1.7 2 3 Quantity of consumer goods (millions of units) FROM MANKIW AND TAYLOR, ECONOMICS 4TH EDITION 9781473725331 @ CENGAGE EMEA 2017

Different Production Possibility Frontiers

The general principle is that different countries would have different production possibility frontiers. Consider the following story: . Only two goods in an economy: potatoes and meat. . Only two people: a market gardener and a cattle farmer. And ask the obvious questions: What should each produce? Why should they trade?

Production Possibilities and Specialization

There are two possibilities: . The market gardener can only grow potatoes and the farmer can only raise beef cattle, or ... . ... the market gardener can raise cattle as well as grow potatoes, but we assume he is not as good at it; and the farmer can grow potatoes in addition to raising cattle, but her land is not well suited for it. . In other words, when both produce both commodities, each faces different opportunity costs.

Opportunity Costs in Production

In this example, whenever the gardener decides to produce one kg of meat, she is giving up the possibility of producing 4 kg of potatoes, while if the Time needed to make 1 kg of: Amount of meat or potatoes produced in 48 hours Meat Potatoes Meat Potatoes Gardener 6 hrs/kg 1.5 hrs/kg 8 kg 32 kg Farmer 2 hrs/kg 1 hr/kg 24 kg 48 kg FROM MANKIW AND TAYLOR, ECONOMICS 5TH EDITION 9781473768543 @ CENGAGE EMEA 2020 farmer does the same, he is giving up the possibility of producing 2 kg of potatoes. This means that the opportunity cost of producing meat is lower for the farmer. Similarly, the opportunity cost of producing potatoes is lower for the gardener. All this amounts to saying that the gardener and the farmer face different production possibility frontiers.

Self-Sufficiency and Consumption Possibilities

Self-Sufficiency would imply that the production possibilities frontier is also the consumption possibilities frontier. In this example the farmer might choose point B on her own PPF, Meat (kilograms) Meat (kilograms) 24 If there is no trade, the farmer chooses this production and consumption. B 12 8 A 4 0 24 48 0 16 32 Potatoes (kilograms) Potatoes (kilograms) If there is no trade, the gardener chooses this production and consumption. FROM MANKIW AND TAYLOR, ECONOMICS 5TH EDITION 9781473768543 @ CENGAGE EMEA 2020 while the gardener might choose a point like A on his own PPF. Notice that in this simple case the PPFs are linear.

Specialization and Trade Benefits

Consider now the case where the gardener and the farmer decide to specialize and trade: the former goes only for potatoes and the latter goes for meat. If they do so, each can move outside his own production possibility frontier: i.e., both would be better off if they Gardener Farmer specialized in Meat Potatoes Meat producing what they Without trade: are more suited to Production and consumption 4 kg 16 kg 12 kg produce, and then With trade: 18 kg Production 0 kg Gives 5 kg Trade Consumption 13 kg 32 kg Gives 15 kg 17 kg trade with each Gets 5 kg 5 kg other. The relative price is here 1/3: 5 Gains from trade: Increase in consumption +1 kg +1 kg +1 kg kg of meat against 15 kg of potatoes. FROM MANKIW AND TAYLOR, ECONOMICS 5TH EDITION 9781473768543 @ CENGAGE EMEA 2020 Potatoes 24 kg 12 kg Gets 15 kg 27 kg +3 kg

Gains from Trade and Opportunity Costs

The gains from trade show up in each trader being able to consume a combination of products which would be impossible under self sufficiency. This is driven by the different opportunity costs faced by each trader. (a) The gardener's production and consumption (b) The farmer's production and consumption Meat (kilograms) Meat (kilograms) 24 Farmer's production with trade 18 Farmer's consumption with trade 13 B* 8 Gardener's production and consumption without trade B 12 Farmer's production and consumption without trade 5 4 A: Gardener's production with trade 0 32 Potatoes (kilograms) 0 12 24 27 48 16 -17 Potatoes (kilograms) FROM MANKIW AND TAYLOR, ECONOMICS 5TH EDITION 9781473768543 @ CENGAGE EMEA 2020 Gardener's consumption with trade A*

Comparative Advantages Principle

If we think of the farmer and the gardener as two different countries identified by their different production possibility frontiers, we can see this story as an example of the principle of comparative advantages ... ... according to which each country should specialize in producing (and selling abroad) the commodity whose opportunity cost is lower, while importing that whose opportunity cost is higher. Comparative advantages should not be confused with absolute advantages, which is what most people think of when discussing international trade.

Absolute Advantages Assessment

Assessment of absolute advantages is based on comparing producers according to their productivity: the producer requiring a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good. In our example, the farmer needs only 1 hour to produce a kilogram of potatoes, whereas the gardener needs 1.5 hours; and the farmer needs only 2 hours to produce a kilogram of meat, whereas the gardener needs 6 hours, so that ... the farmer has an absolute advantage in both potatoes and meat, as is shown by her PPF being above that of the gardener.

Comparative Advantages Assessment

By contrast, assessment of comparative advantages is based on comparing producers according to their opportunity costs, so that ... ... the farmer has a comparative advantage in producing meat and the gardener has a comparative advantage in producing potatoes, as is shown by their PPFs having different slopes

Opportunity Costs and Comparative Advantage

The farmer's opportunity cost of a kilo of potatoes is 1/2 of a kilo of meat, whereas the gardener's opportunity cost of a kilo of potatoes is 1/4 a kilo of meat. Opportunity cost of: 1 kilogram of meat 1 kilogram of potatoes Gardener The farmer's opportunity cost of a kilo of meat is only 2 kilos of potatoes, while the gardener's opportunity cost of a kilo of meat is 4 kilos of potatoes .... 4kg of potatoes 0.25kg of meat Farmer 2 kg of potatoes 0.5kg of meat ... so, the farmer has a comparative advantage in the production of meat, but the gardener has a comparative advantage in the production of potatoes. FROM MANKIW AND TAYLOR, ECONOMICS 5TH EDITION 9781473768543 @ CENGAGE EMEA 2020

Basis for Specialized Production and Trade

Comparative advantage and differences in opportunity costs are the basis for specialized production and trade: this holds generally, as whenever potential trading parties have differences in opportunity costs, they can each benefit from trade. The idea is that trade can benefit everyone in a society because it allows people to specialize in activities in which they have a comparative advantage. By taking into account differences in opportunity costs at the level of different countries, the principle of comparative advantages provides a rationale for explaining the benefits of international trade. The principle of comparative advantages as the driver of international trade was first outlined precisely by David Ricardo (1817: Principles of Political Economy and Taxation), who famously discussed an example based on England and Portugal producing cloth and wine.