05 Trade

Trade¶

We can live without trade, but the standard of living will be lower

Trade happens only when it is cheaper to import than to produce it yourself

we have already covered all this in principle of economics trade point

When we trade, the total availability of goods and services increases, ie the post-trade PPC exceeds the pre-trade PPC

Before trade, the production and consumption points will be the same After trade, the consumption point exceeds the production point

Bases for Trade¶

shows what a country should import/export

these minimize the opportunity costs

Absolute Advantage Theory¶

A country must specialize in which it has absolute advantage, ie when it can

• produce more at the same cost as others
• produce same at a lower cost than others

Comparative Advantage Theory¶

Also called as Ricardian Model

Countries should specialize in goods in which they have a higher relative advantage; ie goods where they have a lower opportunity cost relative to the trading partner

seems very obvious considering marginal net benefit for investment, and opportunity cost

1. Calculate OC of all commodities in both countries \(= \frac{\text{commodity production you lose out on}}{\text{what you chose to produce}}\)
2. Compare OC of each commodity b/w the countries
3. The country with the lower OC for every commodity will produce that commodity

Factors of comparative advantage¶

endowment factors ie the relative abundance/scarcity/productivity of labor and capital

1. comp advantage in labor

   • lower labor costs

   • higher labor productivity

2. comp advantage in capital goods

   • more available capital (infrastructure, machinery)
   • higher capital productivity

Exchange rate¶

Absolute exchange rate¶

is the ratio of nominal value of 2 currencies

Real exchange rate¶

also called as terms of trade

Rate at which one commodity is exchanged for another

is the ratio of the goods/services you can buy with 2 currencies

Pegging¶

the absolute exchange rate is fixed against another currency

isn’t natural it is due to govt intervention

for eg, in UAE Dirham, the Central Bank of UAE

• buys dollars when the value of dollars reduces
  • in order to create a fake shortage
  • and hence increase value
• sells dollars when the value of dollars decreases

Empirical Tests of the Ricardian Model¶

cost \(\propto \frac{1}{\text{productivity}}\)

eg: AC ka efficiency

US vs UK productivity¶

Relative exports of 2 countries \(\propto\) Relative output/productivity

US vs Japanese costs¶

Relative exports of 2 countries \(\propto \frac{1}{\text{Relative labor cost}}\)

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