|1. Surplus was the Reason for Trade|
|Reasons for Trade||
(i) Surplus was the main reason for the peoples of the ancient world to trade.
(ii) Before WWII, comparative advantage was the reason for trade.
(iii) Dissimilar factor endowments are the major reason for international trade (The theory applies to trade in the modern world during the postwar period. Production technologies of trading countries are the same.)
|Surplus||Those who settled down in river basins were successful in agriculture, and these surpluses were exported to neighboring regions in return for other goods. Surplus of a product simply means that its autarky price is lower in the exporting country than elsewhere. Beer was produced circa 3500 BC in Mesopotamia.|
Sumerians were the first beer drinkers. They knew how to make beer and they had the raw materials. Sumerians traded with the people in the mountains. They needed wheat and barley, and they traded timber, copper and flax for wheat. (Barter trade) Silver and grains were used in payment.
Even in modern times, the Communist bloc countries exported surpluses to other members and avoided trading with free market economies.
Babylonians produced 20 different varieties of beer (Samuel Adams: 60 varieties), drinking beer with straws. Babylonians exported beer to faraway countries, even to Egypt.
This Babylonian clay tablet is the first map of the world. Circles were used to denote city centers, and this method has been adopted by cartographers ever since. Babylonians were interested in geography because of their exports of beer and other agricultural surpluses.
Even before the silk road was built, Babylonia during the Kassite dynasty (1595-1157 BC) imported cobalt for coloring glasses from China (Donald McKenzie, Myths of Babylonia and Assyria, 1915). This Babylonia-China trade resulted in harmony of time counting. Both Babylonia and China (Shang dynasty) used the sexagesimal system. Spring and Autumn Annals used a sexagenary lunar calendar, dividing the day into 24 hours. This synchronicity may have been the result of trade between the two regions.
|2. The World Economy (1 AD - 1820s)|
As barbarians gathered in the river basins and began to form families and build cities, they found it necessary to regulate their own behavior. They adopted various codes regulating human behavior (Codex Hammurabi, Ten Commandments, etc.), including property rights. Civilizations began.
Fall of Icarus, by Pieter Bruegel (1558), illustrates the agricultural economy before the industrial revolution in the 1820s. Farming can be combined with animal husbandry.
|Adam Smith's Explanation for Trade|
|Adam Smith||Smith thought that countries export the commodities in which they have an absolute advantage and import those goods in which other countries have an absolute advantage. (wrong)|
| Adam Smith, a Scottish economist,
published a book "Wealth of Nations." (1776) In this book he emphasized
the importance of division of labor and specialization. He also ridiculed
the fear of free trade by comparing nations and households. He argued that
every household finds it worthwhile to produce only some of its needs, and
to buy other commodities from others with its products. Smith argued that
the same principle applies to nations.
|3. The World Economy (1820s - 2000)(before the 3rd Industrial Revolution)|
Many secrets were lost. ⇒ slowed the pace of industrial development.
Industrialization caused the migration of workers from the rural to the urban areas. Factories liberated women; they gained economic independence.
Max Libermann, Flax barn at Lauren, Kunsthalle Museum, Hamburg. Flax fiber is used to make linen, which was used as clothes, table cloth, towels, and to cover dead bodies in ancient times.
This painting illustrates the emerging manufacturing sector and the migration of workers to the urban areas.
GDP per capita of GB rose from $2100 in 1820 to $3600 in 1870. (growth rate = 1%)
Pont neuf (Auguste Renoir, 1872) depicting the city life during the period of industrial revolution. Washington National Gallery.
|Adam Smith's Idea|
|Absolute advantage||If countries have absolute advantages,
each country should specialize in the commodities in which it has absolute
advantages and export those products and import others in which it has absolute
example: President Woodraw Wilson.
|Question|| Smith assumed that each country
had enough absolute advantage over its trading partners so that if free
trade is allowed, each country would have a balance of trade.
What if a country had no absolute advantage? Wouldn't it become a slave
economy to capital rich countries?
|4. Theories against Free Trade after WWII|
Even earlier, Mahatma Gandhi led the salt march in 1930, breaking the salt law. It began with 80 Indians, but the number grew to 4000 when he reached the shore. That was the beginning of India's independence movement. He encouraged Indians to produce salt without paying taxes to the British government.
Prior to 1991, on the whole, India was a closed economy, and the average tariff exceeded 200%. Since the economic reform in 1991, India's economy improved maintly due to increased trade.
This theory was proposed by Raul Prebisch in the 1950s. He claimed that developing countries become exploited and do not benefit from trade. Keep out imported goods until the infant industries become competitive.
He proposed that poor countries adopt import substitution policy. LDCs usually export primary products, and the transition to manufacturing was difficult in LDCs.
Socrates (470-399BC): Know thyself
WWII would not have happened had the Allies followed "love thy neighbors policy." Germany had to sign the Versaille Treaty to pay 132 billion gold marks ($33 billion, but actual payment by 1932 was only about 1/6, $5 billion)" (The financial cost to the Allies (excluding Russia, and excluding human cost) was about $1 trillion in 1945."
To survive in the Modern world: Invest in R&D or learn from your neighbors (export promotion)
The Latin American countries that adopted the import substitution policy (1950s-1980s) grew at a slower rate (2%) than those Asian countries that adopted export promotion policy (3.5%) during the postwar period.
Import substitution is a move toward autarky.
|World Economy after 2020 (Ricardian world again)|
Rich countries invest in R&D.
Only High income economies (per capita GDP > $12,000) invest in R&D.
Imitation is costly, and requires highly educated labor force.
Technological gaps between high-income countries and developing countries may not be reduced in the future.
Some trade (roughly half of global trade is determined by factor content as in the Heckscher-Ohlin model.) The rest is explained by the Ricardian model based on technological differences.
|5. Assumptions of The Ricardian Trade Model: 2 × 2 × 1|
|Ricardo wrote Principles of Political Economy and Taxation in 1817. Most countries in Europe then were agricultural economies with some maufacturing. The Ricardo's model is useful in explaining trade patterns with different technologies (until 1980s). Karl Marx wrote Das Kapital in 1867.|
The HO model is applicable to countries that have similar technologies but factor endowments are dissimilar. (since 1980s)
|Input-output coefficients|| aij = the amount of input i
required to produce 1 unit of good j
= variable, and responsive to changes in factor prices in the Heckscher-Ohlin trade model.
yi = the amount of good i produced in industry i
aL1 = L1/y1
aK2 = K2/y2
Production Possibility Frontier
| A PPF shows various maximum output combinations
the economy can possibly produce from given technology and resources, including
capital (K) and labor (L) inputs. Only one of these points will ultimately
be chosen. Labor Demand in Sector 1
L1 = aL1y1
For instance, assume that industry 1 produces automobiles. If it requires 2 auto workers (per year) to produce one automobile (aL1 = 2) and 10 million automobiles (y1 = 10 million) are produced per year, the total number of auto workers required is
L1 = 2 × 10 million = 20 million.
L2 = aL2y2
L1 + L2 = L (Aggregate demand for labor = aggregate labor supply)
aL1y1 + aL2y2 = L (Production Possibility Frontier)
|6. Absolute vs. Comparative Advantage|
|Absolute Advantage||If aL1 < aL1*,
then the HC is said to have an AA in industry 1.
HC = Home country, FC = Foreign country
|Different productivities due to weather and other conditions||
Ricardo: Labor productivities differ between countries
|Comparative Advantage||If aL1/aL2 < aL1*/aL2*,
then the HC is said to have a CA in industry 1
[The autarky (relative) price of good 1 in HC is less than that in FC].
|Note that aL1/aL2 = (p1/p2)A
is the relative price of good 1 in autarky.
Remark: A country may have AAs in both commodities, but it cannot have CAs in both commodities.
Similarly, a country may have AAs in many commodities, but it cannot have CAs in all commodities.
|World outputs under two scenarios|
More outputs can be produced under free trade. Yet we need to prove that each country will be better off under free trade.
The gap between autarky and free trade points above measures the gains from trade.
How the gains are distributed between the two countries depends on the exchange rate.
When trade is balanced, both countries benefit from trade.