European Economics Issues Lecture 2 Why do we

European Economics Issues Lecture 2 Why do we trade? Some parts of this lecture are drawn from material in Chapter 23. 1 of Sloman (2009). For the remainder the primary source should be these notes. They are a simplified treatment of material covered in more detail in Markusen & Melvin, Theory of International Trade

Why Do We Trade? • • Why individuals and countries trade: Would we trade if everyone were identical? Yes? /No? /Maybe? One EXAMPLE Assume Same Production Capability, BUT Different Tastes Suppose that we could all produce equal numbers of apples and oranges BUT……. I only like Oranges and you only like Apples

Equilibrium before trade Oranges • Production set of both Economies 10 O 10 Apples

Equilibrium before trade • My Oranges Consumption • Production Set set of both Economies 10 O Apples

Equilibrium before trade • Production Oranges set of both Economies • Your Consumption Set O 10 Apples

20 Trade when production same + tastes differ Oranges I Sell Apples buy Oranges 10 U Sell Oranges buy Apples O 10 Apples 20

What is key assumption? • • • Same Production Pattern Equal Apples & Oranges But Different Tastes Same Production capability, Different Tastes If free to produce whatever we want (to match production and tastes) then no trade even if tastes differ • So need some restriction on production for trade: • In reality production capabilities are often not the same: – Some production fixed – Soil, natural resources, oil, minerals etc

Different Story • Same Tastes in each country, (both countries like Textiles and Computers) • But have different TECHNOLOGY • Suppose technology is such that Labour in Developed Country more productive than in Underdeveloped country

Pre-trade production and consumption possibilities Textiles (kilos m) a Less developed Country, population 500 Computers (Millions)

Pre-trade production and consumption possibilities Textiles (kilos m) a b Less developed country Computers (Millions)

Pre-trade production and consumption possibilities Textiles (kilos m) a Less developed country b c Workers can produce 1000 Kilos of textiles OR d 500 Computers e f • Or anything in Computers (Millions) between

Pre-trade production and consumption possibilities Textiles (kilos m) a Less developed country b c Workers can produce 1000 Kilos of textiles OR d 500 Computers e f • Or anything in Computers (Millions) between

Pre-trade production and consumption possibilities Textiles (kilos m) a Less developed country b c Workers can produce 1000 Kilos of textiles OR d 500 Computers e f Computers (Millions) So can produce in the ratio of 2 Textiles for 1 Computer

Pre-trade production and consumption possibilities Textiles (kilos m) a Less developed country b c So can produce in the ratio of 2 Textiles for 1 Computer d e f Computers (Millions) Or it takes 2 units of textiles to purchase 1 unit of computers

Pre-trade production and consumption possibilities Textiles (kilos m) a Less developed country b c d Formally we say…. the RELATIVE price of Computers in terms of Textiles e f Computers (Millions) (not money!!) is Pc/Pt=2/1

Pre-trade production and consumption possibilities Textiles (kilos m) a Less developed country b c d Or alternatively the RELATIVE price of Textiles in terms of Computers in the LDC is e f Computers (Millions) Pt/Pc=1/2

Developed Country can produce in the ratio of 2 Computers for 1 K of Textiles Or it takes 1 units of textiles to purchase 2 unit of computers Textiles (kilos m) Pre-trade production and consumption possibilities SO it takes 1/2 units of textiles to purchase 1 unit of computers Computers (Millions)

So the RELATIVE Price of a 1 computer in terms of textiles in the Developed Country is Pc/Pt=1/2 Textiles (kilos m) Pre-trade production and consumption possibilities Computers (Millions)

OR the RELATIVE Price of a 1 unit of texties computer in terms of computers in the Developed Country is Textiles (kilos m) Pre-trade production and consumption possibilities Pt/Pc=2/1 Computers (Millions)

Pre-trade production and consumption possibilities Less developed country b c d Slope 2/1 e f Computers (Millions) Textiles (kilos m) a Developed country g h Slope 1/2 i j k l Computers (Millions) m

Pre-trade production and consumption possibilities Developed countries relative pre-trade price = Pc /Pt=1/2 Less-Developed countries relative pretrade price = Pc /Pt= 2 Less developed country b c d Slope 2/1 e f Computers (Millions) Textiles (kilos m) a Developed country g h Slope 1/2 i j k l Computers (Millions) m

So C is relatively cheap in the Developed countries (it has a comparative advantage in Computers) And relatively expensive in the Less-Developed countries whereas Textiles are relatively cheaper. (The LDC is LESS BAD at Textiles and therefore Textiles are its comparative advantage) Less developed country b c d Slope 2/1 e f Computers (Millions) Textiles (kilos m) a Developed country g h Slope 1/2 i j k l Computers (Millions) m

Effect of trade on consumption possibilities Possibilities have clearly risen Slope 1/1 Textiles (kilos m) So can’t be worse off!! Computers (Millions) Less developed country Developed country

If there is no trade (the country is in Autarky) then the production possibility frontier in each case also represents the consumption possibilities. The bundle each consumes will depend on tastes but production and consumption will be the same. Less developed country b c d Slope 2/1 e f Computers (Millions) Textiles (kilos m) a Developed country g h Slope 1/2 i j k l Computers (Millions) m

If we now allow free trade between the two countries, the free trade price must lie between the two sets of AUTARKY prices Less developed country b c d Slope 2/1 e f Computers (Millions) Textiles (kilos m) a Developed country g h Slope 1/2 i j k l Computers (Millions) m

If we now allow free trade between the two countries, the free trade price must lie between the two sets of AUTARKY prices Less developed country b c d Slope 2/1 e f Computers (Millions) Textiles (kilos m) a Developed country g h Slope 1/2 i j k l Computers (Millions) m

If we now allow free trade between the two countries, the free trade price must lie between the two sets of AUTARKY prices Less developed country b c d Slope 2/1 e f Computers (Millions) Textiles (kilos m) a Developed country g h Slope 1/2 i j k l Computers (Millions) m

Textiles (kilos m) Effect of trade on consumption possibilities Computers (Millions) Less developed country Developed country

Effect of trade on consumption possibilities Possibilities have clearly risen Slope 1/1 Textiles (kilos m) So can’t be worse off!! Computers (Millions) Less developed country Developed country

Effect of trade on consumption possibilities Textiles (kilos m) 600 Exports Imports 600 x Computers (Millions) Less developed country Textiles (kilos m) • Imports 600 y Exports Computers (Millions) 600 Developed country

• Developed Country is better at producing both Textiles AND Computers – It has an absolute advantage in both – Initially c = 1600 t = 400 – But it has a comparative advantage in producing computers – Specialise in producing 2400 computers – Exports 600 c, Imports 600 t: c = 1800 t = 600 – Less Developed Country initially t = 200, c = 400, – If it now produces textiles = 1000 – Exports 600 t, Imports 600 c: t = 400 c= 600, – DC gains 200 c and 200 t, LDC gains 200 c and 200 t

THE ADVANTAGES OF TRADE • 1. Production (& technology) the same but fixed - tastes different = TRADE • 2. Production, technology the same, but can produce any combination you want = No Trade • 3. Technology Different, tastes same - Trade – absolute advantage & comparative advantage • 4. NEXT: Technology the same, tastes the same but endowment of resources (e. g Capital & Labour or skilled labour) different.

Equilibrium before trade Textiles Suppose Computers need mostly capital and textiles need mostly labour, and suppose Developed country has mostly capital and the less developed country has mostly labour O Computers

Equilibrium before trade Textiles Suppose initially each country put exactly half their workers in to producing computers and textiles DC LDC O Computers

Textiles Labour abundant LDC If capital and labour were used in the same ratio in both industries then if I want to produce more T or more C then move in a straight line either way along the production frontier O Computers

Labour abundant LDC Textiles But if Textiles are more labour intensive then can produce more, LDC And if computers are capital intensive cannot produce as much So Production frontier looks like… O Computers

Labour abundant LDC Alternative explanation: Textiles As we move down from the spot, to produce more computers we are allocating more capital & workers LDC but since capital is relatively scarce, capital per worker is lower, so not getting much extra production. O Computers

Labour abundant LDC Textiles AND…. LDC As we move UP from the spot, to produce more textiles, we are allocating more workers and capital but workers per machine is rising, so can produce more. O Computers

Capital abundant Developed Country For DC Textiles are more labour intensive so LESS produce……. DC LDC O Computers

Capital abundant Developed Country Textiles And since Computers are more capital intensive can MORE produce……. DC LDC So Production frontier looks like… O Computers

Trade Textiles Assume initially that each country produces & consumes at the dots DC LDC O Computers

Textiles Note in LDC Computers will be RELATIVELY expensive, e. g, Pc /Pt = 2/1 while in DC they will be relatively cheap e. g. Pc /Pt =1/2 DC LDC O Computers

Textiles Now suppose we allow free trade……. And have a common price that lies in between DC LDC O Computers

Now suppose we allow free trade……. And have a common price that lies in between Textiles LDC EXPORT IMPORT LDC DC IMPORTS DC DC EXPORT O Computers

Trade when have different factor endowments • Even if technology and tastes are the same, different factor endowments means different production possibilities. • Again this creates possible comparative advantages and hence benefits from trade. • In the example, both countries gain by producing more of the good in which they have the abundant factor and engaging in trade. • This was probably believed to be the dominant source of gains from trade in the original EU.

Comparative Advantage or Why might prices differ – Summary 1 -5? • 1. Different tastes – (same Technology & Factors) • 2. Different technology or physical capabilities – (Patented R&D, Land/Minerals) • 3. Differences in Factor Endowments – Labour/Capital/Skilled labour • 4. Differences in Taxes – e. g. Corporation tax, alcohol, cigs, petrol • 5. (Differences in) competition – (Monopoly pushes prices up) • 6. One Special case: Can trade even if we are identical – Increasing Returns to Scale

Returns to Scale • Constant returns to scale – Double the factory, double the workforce, double the machinery ---- Get double the production • Increasing returns to scale – Double the factory, double the workforce, double the machinery ---- Get MORE THAN DOUBLE the production • Why might this happen – Internal Economies – More efficient work practice and specialisation of workers – Bigger buying power for materials or better distribution networks – External Economies – Government invests in training or infrastructure

Aeroplanes Identical technology, endowments and tastes BUT increasing returns to scale. O Computers

Identical technology, endowments and tastes BUT increasing returns to scale. Aeroplanes Initially both Germany and UK produce Aeroplanes and computers Now suppose UK specialises in Aeroplanes and gains increasing returns to scale Germany & UK O Computers

Identical technology, endowments and tastes BUT increasing returns to scale. Aeroplanes Similarly, Germany specialises in Computers Germany & UK and gains increasing returns to scale Overall EU(? ) Production Frontier no moves out O Computers

Identical technology, endowments and tastes BUT increasing returns to scale. Now Germany exports Computers and imports Aeroplanes U K E x p o r t s UK IMPORTS Germany & UK I M P O R T S While the UK exports Aeroplanes and imports Computers O Computers German Exports

Identical technology, endowments and tastes BUT increasing returns to scale. Aeroplanes U K E x p o r t s UK IMPORTS Germany & UK I M P O R T S So Even when identical specialisation and Trade allows welfare gains O Computers German Exports