Global Trade:4 Global Trade: Lessons Lessons Topics Lesson 1 The World Economy and Global Trade: An Overview and Stylized Facts on Global Trade Lesson 2 Lesson 3 Lesson 4 Lesson 5 Lesson 6 Theories of International Trade-I: The Ricardian Model: Labor Productivity and Comparative Advantage: Theories of International Trade-II: The Heckscher-Ohlin Model: Factor Endowments and Comparative Advantage Theories of International Trade-III: The Standard Trade Model and Gains from Trade Combination of Labor Productivity and Factor Endowments Policy Instruments of International Trade: Tariffs, Export Subsidies, Import Quotas, Export Restraints Policy Issues of International Trade: 1) Free Trade vs. Protectionism 2) Liberalization in Developing Countries 3) The Role of the World Trade Organization Texts Main Text: Required: 1. International Economics: Theory & Policy, Krugman, P.R., and Obstfeld, M., 8th Edition, Pearson-Addison-Wesley. Recommended: 1. International Economics, Husted, S., and Melvin, M., 8th Edition, AddisonWesley. 2. International Economics, Gerber, J., 5th Edition, Addison-Wesley. 3. World Trade and Payments: An Introduction, Caves, R.E., Frankel, J.A., and Jones, R.W., 10th Edition, Pearson-Addison-Wesley. 4. The World Economy: International Trade, Yarbrough, B.V., and Yarbrough, R.M., 7th Edition, Thomson-South-Western. 5. Principles of Microeconomics, Only Chapter 3: Interdependence and the Gains from Trade, Mankiw, N.G., 5th Ed., South-Western Cengage Learning. Lesson 4 Lesson 4: Global trade theory-II: The Standard Trade Model Procedure: The PowerPoint Presentation Duration: 60 minutes Overview This lesson combines the ideas of the Ricardian trade model and the Heckscher-Ohlin model of comparative advantage, and derives the Standard trade model. This part describes the relevant concepts and tools: relative supply and demand, world price, and terms of trade. Lesson 4 (cont.) Outline List of Class needs: the text, a computer, and a notebook. Pre-class reading and preparation: Chapter 5 of the text. Activities and timing: Go over the entire presentation in 60 minutes and think about the main findings of the lesson. Practice the diagrams in the lesson and find their uses. Identification of Learning Objectives: Objective #4 from Section I Identification of the Global Workforce Skills for the lesson: Skill point #3 in Section II Lesson 4 (cont.) Lesson notes and suggestions for Instructors: Read the relevant chapters in the recommended texts and look for online data for the latest figures of global trade. Acknowledgment: The Course Developer took help of different sources as referred while preparing the study materials. When a considerable number of diagrams have been developed to enhance interest in the subject, many diagrams come from the required text for the convenience of the students. The standard trade model The standard trade model combines ideas from the Ricardian model and the Heckscher-Ohlin model. 1. Differences in labor services, labor skills, physical capital, land, and technology between countries cause productive differences, leading to gains from trade. 2. A country’s production possibility frontier (PPF) determines its relative supply function. 3. National relative supply functions determine world a relative supply function, which along with world relative demand determines an equilibrium under international trade. The standard trade model (cont.) Recall that when the economy maximizes its production possibilities, the value of output V lies on the PPF. V = PCQC + PF QF describes the value of output in a two good model, ◦ and when this value is constant the equation’s line is called and isovalue line. ◦ The slope of the isovalue line equals – (PC /PF), and if relative prices change the slope changes. Economy’s output We saw in the previous lesson how the economy’s output is determined by relative prices. An economy whose PPF is TT will produce at Q, which is on the highest possible isovalue line. Changes in prices & relative supply The isovalue line becomes steeper when the relative price of cloth rises from (PC /PF )1 to (PC /PF )2 (shown by the rotation from VV1 to VV2). As a result, the economy produces more cloth and less food and the equilibrium output shifts from Q1 to Q2. Production & consumption Production choices are determined by the economy’s PPF and the prices of output. This gives the supply side. Question: What determines consumption choices, which will give the demand side? Answer: Consumer preferences and prices determine consumption choices. Production & consumption (cont.) Consumer preferences are represented by indifference curves. An indifference curve (IC) shows different combinations of goods that make consumers equally satisfied (indifferent). Each consumer has his or her own preferences, but we pretend that we can represent the preferences of an average consumer that represents all consumers. Note: Principles of Microeconomics, as recommended in the Text page, has an elaborate discussion on the IC. Production & Consumption in the Standard Model The economy produces at point Q, where PPF is tangent to the highest possible isovalue line. It consumes at point D, where that isovalue line is tangent to the highest possible indifference curve. Trade in the Standard Model In the previous slide we saw that the economy produces at point Q and consumes at point D. The economy produces more cloth than it consumes and therefore exports cloth; correspondingly, it consumes more food than it produces and there imports food. Welfare & the Terms of Trade (TOT) The terms of trade (TOT) refers to the price of exports relative to the price of imports. When a country exports cloth and the relative price of cloth increases, the terms of trade increase or improve. Because a higher price for exports means that the country can afford to buy more imports, an increase in the terms of trade increases a country’s welfare. Determining Relative Prices To determine the price of cloth relative to the price food in our model, we again use relative supply and relative demand. Relative supply considers world supply of cloth relative to that of food at each relative price. Relative demand considers world demand of cloth relative to that of food at each relative price. In a two country model, world quantities are the sum of quantities from the domestic and foreign countries. World Relative Supply & Demand The higher PC/PF is, the larger the world supply of cloth relative to food (RS) and the lower the world demand for cloth relative to food (RD). Equilibrium relative price (here, (PC/PF)1) is determined by the intersection of the world relative supply and demand curves. Summary points The Standard Trade Model: Combination of the ideas in the Ricardian model and the Heckscher-Ohlin model Production and consumption Determining exports and imports Relative prices and changes in production and consumption Relative Supply and demand Activity/Homework 1. Which model do you like the most to explain global trade and why? 2. If relative demand for cloth goes up, what happens to the relative price of cloth in the world? Answer by using the diagram of world relative demand and supply. Activity/Homework 1. If both relative demand for and relative supply of cloth go up, what happens to the relative price of cloth in the world? Answer by using the diagram of world relative demand and supply.