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Models of International Trade

Models of International Trade.

MBA 6641, International Economics 1

Course Learning Outcomes for Unit III Upon completion of this unit, students should be able to:

2. Differentiate the different models of trade. 2.1 Explain the Heckscher-Ohlin theory of international trade.

 

Course/Unit Learning Outcomes

Learning Activity

2.1 Unit Lesson Chapter 4 Chapter 5

 

Required Unit Resources Chapter 4: Demand and Supply, Offer Curves, and the Terms of Trade Chapter 5: Factor Endowments and the Heckscher-Ohlin Theory

Unit Lesson

Introduction

In this unit, we will dig into some basic models of trade. To start, let’s take a look at trade through supply and demand. First, though, for the benefit of anybody without previous experience in economics, the following is a brief introduction to supply and demand.

Demand Demand is the relationship between the price of a good and how much of that good consumers want to buy. A demand curve is graphed with price on the vertical axis and quantity on the horizontal axis. As you might surmise, the more something costs, the less quantity consumers want to buy. So graphically, a demand curve is downward sloping such that high prices are associated with a low quantity and low prices are associated with a high quantity.

UNIT III STUDY GUIDE

Models of International Trade

 

 

 

MBA 6641, International Economics 2

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This downward slope, known as the law of demand, happens for two reasons. The substitution effect means that as the price of a good rises, other goods become relatively less expensive so consumers are drawn to those substitutes. Imagine going into a store, planning to buy a Coke, but you notice the price of Coke (and Coke only) has increased. Coke is now relatively more expensive than Dr. Pepper. Because of this change in relative prices, you will be more likely to substitute Dr. Pepper for Coke.

The income effect means that the price increase has left you with less purchasing power so you simply cannot buy as much of the good as before. Imagine a young child who gets an allowance and really likes baseball cards. Each week, when the child gets an allowance, he or she runs to the store and spends all of his or her money on baseball cards. Except this time, when he or she goes to the store, he or she finds that baseball cards are more expensive. The young child physically cannot buy as many baseball cards this week as he or she could last week, when the price was lower. Of course, this all works in reverse with a price increase.

Supply Supply is similar, except that it is from the perspective of the producer. The more a producer is paid, the more product he or she will want to produce and bring to market. Note the inclusion of bring to market in that sentence. Sometimes, suppliers might produce more of a good but withhold it from the market and wait for prices to rise. Therefore, it can be helpful to think of supply in terms of production, but it is not always accurate. To understand this, think of the old Willy Wonka movie and the geese that lay the golden eggs. A character remarks to Willy Wonka, upon learning about the geese, “But Easter’s over.” Willy Wonka, however, hushes the child and tells him he does not want the geese to know that because he is trying to get a jump on production for next year. That is, Willy Wonka is producing, but not yet bringing the good to market. A supply curve, unlike a demand curve, has an upward slope.

Demand curve for gasoline (Openstax College, 2013a)

 

 

 

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This is partly a function of producers wanting to produce more when they are getting paid more. It is also a reflection of the fact that sometimes producers have to get paid more in order to be able to produce more. Imagine a factory that is running at capacity but demand increases so leaders want to produce more. What do they have to do? They have to pay their workers overtime. When the cost of inputs rises, the price of the good has to follow suit or the firm will lose profits.

Equilibrium

Putting the demand curve and the supply curve on the same axes shows the equilibrium. Equilibrium is the intersection of supply and demand. At the equilibrium price, producers want to sell just as much as consumers want to buy. If price were, for some reason, away from the equilibrium price, then market forces would push the price towards the equilibrium. A price that is higher than equilibrium, for example, would have few buyers but producers would have produced (and brought to market) a lot of product. As they see their product go unsold, they will lower the price and cut back on their production (and/or what they bring to market). As the price is lowered, more consumers will be enticed to buy the product. If the price is lower than the equilibrium price, then the product will sell out quickly, leaving some buyers unable to obtain the product. Producers will see this, raise their price and produce more. Some consumers will turn away from the product as the price rises but those who still value sufficiency (i.e., are willing to pay the higher price) will be able to get the product.

Equilibrium Analysis with International Trade In autarky, the market is limited to domestic consumers and producers. When the economy is opened up to trade, however, the supply and demand from other countries matters. If the prevailing price on the world market for a good exceeds the price in the domestic market, then domestic producers will find it beneficial to sell on the world market. This means they will find it beneficial to bring more product to market and export what they do not sell domestically. Domestic consumers will no longer pay the price they were paying previously. They will have to pay the new, higher, world price. A producer would not, after all, want to sell at the old price when they could sell at the new, higher price.

Supply curve for gasoline (Openstax College, 2013b)

Equilibrium (SilverStar, 2006)

 

 

 

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If the prevailing price on the world market is lower than the domestic price, then consumers will find buying foreign-made products more advantageous. Domestic producers will only be able to sell their products at that lower price, meaning the amount of the product they are willing to bring to market will decrease. Consumers will import the product from other countries.

As you might imagine, different groups (consumers or producers) prefer different scenarios.

Terms of Trade An important metric for examining trade is the terms of trade. Terms of trade is the ratio of export prices to import prices, and it gives an indication of the relative value of what countries trade (Salvatore, 2020). Terms of trade are calculated using price indices, which are composite numbers that measure prices across a variety of goods. Price indices are typically calculated on a 100 scale and measured over time (a price index less than 100 shows a decrease from the base measure, a price index greater than 100 shows an increase from the base measure) (Salvatore, 2020). A terms of trade greater than 100 indicates the value of export goods exceeds the value of import goods (this is just based on price and is not indicative of a trade surplus or deficit). See Table 4.2 in your textbook for a real-world application of this concept.

Heckscher-Ohlin Theory The Heckscher-Ohlin (H-O) theory of trade makes two major predictions. The H-O theory views trade as arising from factors of production. According to the H-O theory, countries will produce and export those goods that are made with abundant factors of production in a country (Salvatore, 2020). Therefore, if a country has vast amounts of oil, then that country will produce oil and export it to other countries. If a country has farmland particularly well suited to growing wheat, that country will produce and export wheat. Countries will import goods that are made with factors of production not particularly abundant in that region. Alaska, for example, would be expected to import pineapple.

The graph on the left illustrates exports while the graph on the right illustrates imports. The blue triangles are graphical representations of the extra benefits received from international trade as producers are able to sell more at a higher price (left graph) or consumers are able to buy more at a lower price (right graph). (Moledina, n.d.)

 

 

 

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A second important part of the H-O theory is that returns to factors of production will equalize across nations (Salvatore, 2020). This is similar to the concept of convergence. The logic behind it is quite straightforward. Assume a worker with a particular skill gets paid a high income in one country but not in another. Workers with that skill will migrate to the country that pays the higher wage. As they do, the supply of such workers will increase, and the wage will decrease. Similarly, in the country that did not pay as high of a wage, departing workers will decrease supply, causing wages to rise. This process will continue until wages are equal and there is no reason for workers to migrate from one country to another. There are important assumptions to making the H-O theory work. They are covered more extensively in the textbook readings, but some important ones are highlighted here. First, factors of production can move freely across countries. This is called factor mobility. Without factor mobility, the equalizing forces described for the returns to inputs just described could not happen. Another important assumption is that the people in both countries like the same products equally. If not, there might not be a need to produce a good produced with an abundant factor. For example, Alaskans may not like pineapple so the places that produce pineapple may not find a sufficient trading partner for all the pineapple they could produce. An important note is that while international trade might equalize returns to inputs across nations, it does not necessarily equalize returns to inputs across inputs. That is, trade could lead to some inputs seeing strong returns (those factors that are not particularly abundant), while more abundant factors see a decrease in returns. For example, this effect is seen with skilled versus unskilled labor. The H-O model makes a lot of logical sense, but the empirical findings are not particularly strong. One such finding that does not support the theory is the Leontief paradox, which you will explore in more depth as we move through the unit.

References Moledina, A. & Lumen Learning (n.d.). Free trade of sugar [Image]. https://courses.lumenlearning.com/suny-

microeconomics/chapter/reading-demand-and-supply-analysis-of-international-trade/ Openstax College. (2013a). Economics demand curve [Image].

https://commons.wikimedia.org/wiki/File:Economics_demand_curve.jpg Openstax College. (2013b). Economics supply curve [Image].

https://commons.wikimedia.org/wiki/File:Economics_supply_curve.jpg Salvatore, D. (2020). International economics (13th ed.). Wiley.

https://online.vitalsource.com/#/books/9781119554950 SilverStar. (2006, November 28). Supply demand equilibrium [Image].

https://commons.wikimedia.org/wiki/File:Supply-demand-equilibrium.svg

Models of International Trade

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