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 P_w) is the exchange ratio of goods between the two countries.

Gain of trade per unit of X for importer = OC of producing 1X - P_w (in terms of Y)

Gain of trade per unit of X for exporter = P_w – 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.