M.A. FINAL ECONOMICS PAPER II INTERNATIONAL TRADE AND FINANCE WRITTEN BY SEHBA HUSSAIN EDITED BY PROF.SHAKOOR KHAN M.A. FINAL ECONOMICS PAPER II INTERNATIONAL TRADE AND FINANCE BLOCK 1 THEORY OF INTERNATIONAL TRADE, MEASUREMENT OF GAINS AND THEORY OF INTERVENTION 2 PAPER II INTERNATIONAL TRADE AND FINANCE BLOCK 1 THEORY OF INTERNATIONAL TRADE, MEASUREMENT OF GAINS AND THEORY OF INTERVENTION CONTENTS Page number Unit 1 Theory of International trade 5 Unit 2 Measurement of gains from trade 25 Unit 3 Free trade and theories of intervention 41 3 BLOCK 1 THEORY OF INTERNATIONAL TRADE, MEASUREMENT OF GAINS AND THEORY OF INTERVENTION The aim of this block is to present certain theories and approaches related to theory of international trade, measurement of gains and theory of intervention. First unit deals with explaining the varieties of theories of international trade. Second area of concern will be Ricardian model and theories of absolute advantage followed by Heckscher – Ohlin model. New trade theory and gravity model are explained in detailed manner. Regulation of international trade and empirical testing of theory of absolute cost were discussed in detail. Unit 2 discusses concepts related to gains from trade. Measurement and distribution of gains from trade and terms of trade will be explained in detail. Role of trade in accelerating growth of nation is discussed in last section along with suitable examples. The last unit that is unit 3 presents to you the basic and important concepts of free trade and theories of intervention. Features of free trade are discussed in continuation with the history of free trade. Economics of free trade and the basics of tariffs and trade barriers will be other areas of discussion. Welfare implications of trade barriers; impact of tariffs on prices and tariffs and their relevance in modern trade will be described in detailed manner. 4 UNIT 1 THEORY OF INTERNATIONAL TRADE Objectives After studying this unit you should be able to: Define the theories of International trade Understand the Ricardian model and concept of absolute and comparative advantage Know the Heckscher and Ohlin model of trade Explain new trade theory and gravity model of international trade Describe regulations of international trade Discuss the empirical testing of theory of absolute cost Structure 1.1 Introduction 1.2 Varieties of theories of international trade 1.3 Ricardian model and theories of absolute advantage 1.4 Heckscher – Ohlin model 1.5 New trade theory 1.6 Gravity model 1.7 Regulation of international trade 1.8 Empirical testing of theory of absolute cost 1.9 Summary 1.10 Further readings 1.1 INTRODUCTION International trade is exchange of capital, goods, and services across international borders or territories. It refers to exports of goods and services by a firm to a foreign-based buyer (importer) in most countries; it represents a significant share of gross domestic product (GDP). While international trade has been present throughout much of history (see Silk Road, Amber Road), it‘s economic, social, and political importance has been on the rise in recent centuries. Industrialization, advanced transportation, globalization, multinational corporations, and outsourcing are all having a major impact on the international trade system. Increasing international trade is crucial to the continuance of globalization. International trade is a major source of economic revenue for any nation that is considered a world power. Without international trade, nations would be limited to the goods and services produced within their own borders. 5 International trade is in principle not different from domestic trade as the motivation and the behavior of parties involved in a trade do not change fundamentally regardless of whether trade is across a border or not. The main difference is that international trade is typically more costly than domestic trade. The reason is that a border typically imposes additional costs such as tariffs, time costs due to border delays and costs associated with country differences such as language, the legal system or culture. Another difference between domestic and international trade is that factors of production such as capital and labor are typically more mobile within a country than across countries. Thus international trade is mostly restricted to trade in goods and services, and only to a lesser extent to trade in capital, labor or other factors of production. Then trade in goods and services can serve as a substitute for trade in factors of production. Instead of importing a factor of production, a country can import goods that make intensive use of the factor of production and are thus embodying the respective factor. An example is the import of labor-intensive goods by the United States from China. Instead of importing Chinese labor the United States is importing goods from China that were produced with Chinese labor. International trade is also a branch of economics, which, together with international finance, forms the larger branch of international economics. The first purpose of trade theory is to explain observed trade. That is, we would like to be able to start with information about the characteristics of trading countries, and from those characteristics deduce what they actually trade, and be right. That‘s why we have a variety of models that postulate different kinds of characteristics as the reasons for trade. Secondly, it would be nice to know about the effects of trade on the domestic economy. A third purpose is to evaluate different kinds of policy. Here it is good to remember that most trade theory is based on neoclassical microeconomics, which assumes a world of atomistic individual consumers and firms. The consumers pursue happiness (―maximizing utility‖) and the firms maximize profits, with the usual assumptions of perfect information, perfect competition, and so on. In this world choice is good, and restrictions on the choices of consumers or firms always reduce their abilities to optimize. This is essentially why this theory tends to favor freer trade. 1.2 VARIETIES OF THEORIES OF INTERNATIONAL TRADE Neoclassical theory has been successful because it is simple (though it may not always look simple when you‘re learning it). For example most neoclassical trade theories assume that the world only has two countries (which means that country A‘s exports must be country B‘s imports). They also usually assume only two commodities in international trade. If you try to ―generalize‖ by adding more countries or commodities, the math breaks down and you don‘t get clear results. 6 One of the most important, and limiting, assumptions in neoclassical trade theory is that firms produce under conditions of perfect competition. Any industry that is controlled by a small number of firms is not perfectly competitive. There is a whole area of economics, initially developed by Joan Robinson in the 1920's, that explores what happens under imperfect competition. We won‘t get into it in this course, but if there are significant ―economies of scale‖ (which means that per-unit costs are smaller for bigger firms), then you can get very different policy recommendations out of your model. Does this mean that the simple neoclassical models are useless? No. Their most important use is as a way to help you think through a set of issues. Neoclassical theory is especially good at pointing out the links between different markets. But you should be suspicious if you hear anyone saying that a theory ―shows‖ that one policy or another is the right one in the real world. The most famous neoclassical model is also the simplest — the model developed by the English political economist David Ricardo in the early 1800s. It‘s simple because Ricardo assumes that there is only one ―factor of production‖ (i.e. type of input) — labor. This model makes the point that trade should, in principle; benefit both parties even if one is more efficient. More sophisticated models were developed in the current century as economists learned more maths. The best-known is the Heckscher-Ohlin model, named after a couple of Swedish economists, which is often called Heckscher- Ohlin-Samuelson (HOS) because of the important contributions made by the U.S. economist Paul Samuelson. HOS includes two factors of production (e.g. labor and land), and it shows that particular factors of production may be hurt by trade, though it still agrees with Ricardo that there are overall gains from trade. There are many other varieties of trade theory, making different assumptions and getting different results. One kind that has gotten a lot of attention in recent years assumes increasing returns to scale, which means that large producers are more efficient than smaller producers. Ricardo, as noted above, assumed constant scale returns. Neoclassical theories like HOS assume decreasing returns and get generally similar results. If you allow increasing returns then bigger is better, and one nation may end up dominating an industry, but it's hard to say which nation will do so. In this case, the ability to intimidate and bluff may be important. So increasing returns undermines the ability of theory to explain or predict observed trade. Perhaps more seriously, scale economies may stack the deck against late-developers. 1.3 RICARDIAN MODEL AND THEORIES OF ABSOLUTE ADVANTAGE The Ricardian model focuses on comparative advantage and is perhaps the most important concept in international trade theory. In a Ricardian model, countries specialize in producing what they produce best. Unlike other models, the Ricardian framework predicts that countries will fully specialize instead of producing a broad array of goods. 7 Also, the Ricardian model does not directly consider factor endowments, such as the relative amounts of labor and capital within a country. The main merit of Ricardin model is that it assumes technology differences between countries.