Sunday, 2 October 2011

Economics note: International trade I numerical analysis on international trading

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International trade
1)       International trade is the exchange of goods and services across territories/boundaries.
2)       Free trade is the international trade that is not hindered by any restriction imposed by the government.
Absolute vs comparative advantages
Assumption:
1)       Only two countries [economies], A and B exist.
2)       Only two goods exist, say X and Y.
3)       The resource is homogeneous, i.e., the MC of production is constant.
4)       Trade involve zero transport and transaction cost.
Case: A produce 8X or 6Y while B produces 7X or 4Y with 1 unit of resources.
Absolute advantage: One country has higher productivity per unit of resources than another country. For the above case, A has an absolute advantage over B on both good X and Y.
Comparative advantage: One country forgone less goods to produce another good than another country. For the above case, opportunity cost (OC) of producing X for A is 6/8Y while that for B is 4/7Y. Since B has a lower OC, it has comparative advantage over A on X.
Note that a country can obtain absolute advantage for both goods but not comparative advantage. When A has the comparative advantage for X, then B has the comparative advantage for Y.
The principle of comparative advantage states that when two countries specialize in producing the good in which the country has a comparative advantage on it, the total world output increases.
Terms of trade (world price Pw) is the exchange ratio of goods between the two countries.
Gain of trade per unit of X for importer = OC of producing 1X - Pw (in terms of Y)
Gain of trade per unit of X for exporter = Pw – OC of producing X.
When deficit occur to one of the country no trade would occur. Therefore the term of trade (TOT) is fixed to OC of importer > TOT > OC of exporter. In the above case, the TOT is between X = 6/8Y and X=4/7Y.
Total gain of trade = OC of producing X for importer – OC of producing X for exporter.
When transaction cost occur, trade still exist when total gain of trade ≥ transaction cost, otherwise at least one of the country lost from the trade. When two countries share the transaction cost, the range of TOT is given by:
OC of producing X for importer – part of the transaction cost > TOT > OC of producing X for exporter + the rest of the transaction cost.
For the above case, assume the transaction cost is 0.2Y while A and B share the transaction cost equally, TOT is given by (6/8-0.1)Y > TOT > (4/7+0.1)Y, which lies between 0.671Y and 0.675Y.

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