basic trade theory - Basic trade theory needed for policy...

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1 Basic trade theory needed for policy analysis November 5, 2007
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2 Objectives of this set of lectures Provide an overview of reasons for trade. Explain “opportunity cost” Explain comparative advantage and absolute advantage Discuss three sources of comparative advantage: differences in (i) technology, (ii) factor endowments, and (iii) institutions. Introduce “Theory of the second best”. Introduce the “Principle of Targeting”
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3 Why do countries trade? Because they are different: i) Different relative labor productivity across sectors. ii) Different relative endowments of inputs (e.g., capital, labor, natural resources) iii) Different institutions (e.g. property rights) and different laws (e.g. environmental protection)
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4 A caveat Similarities across countries can also promote trade. Volume of trade amongst “similar” countries is greater than volume amongst “very different” countries. “Intra-industry trade” (e.g. importing and exporting autos) takes advantage of specialization and decreasing average costs. Similar countries may also benefit from being part of a network of production.
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5 Nevertheless…. “Differences” rather than “similarities” are probably a more fundamental reason for trade, and are certainly more important for North-South trade. Differences are the basis for comparative advantage. A country’s comparative advantage depends on its “opportunity costs”
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6 What are opportunity costs? The opportunity cost of any action is the value of the best alternative to that action: it is what you give up in order to perform the action. Ricardo-like example: Table shows amount of labor needed in each country to produce food or cloth Labor needed for one unit of Food Labor needed for one unit of Cloth US 1 1 Canada 3 6
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7 Absolute vs. Comparative Advantage (CA) In example in previous slide, US has absolute advantage in both sectors US opportunity cost of one unit of food is one unit of cloth Canada’s opportunity cost of one unit of food is ½ unit of cloth. Canada has lower opportunity cost (compared to US) in production of food, Therefore Canada has comparative advantage in production of food. US has lower opportunity cost = comparative advantage in production of cloth Comparative advantage results from difference, across countries, in relative productivity between sectors. Pattern of trade driven by CA, not by absolute advantage. See online lecture notes “Ricardian Model” for more details
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8 Compare two examples Labor needed for one unit of Food Labor needed for one unit of Cloth US 1 1 Canada 3 6 Labor needed for one unit of Food Labor needed for one unit of Cloth US 1 1 Canada 6 6 Example on the right : opportunity cost of food is the same in both countries. Neither country has a CA in production of either commodity. These countries do not benefit from trade. This is a “knife-edge” example, since a perturbation of any of the four parameters eliminates the equality (across countries) of relative labor requirements in the two sectors.
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This note was uploaded on 08/01/2008 for the course ECON 131 taught by Professor Karp during the Fall '07 term at University of California, Berkeley.

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basic trade theory - Basic trade theory needed for policy...

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