Trade theory Flashcards
Explain the gravity model and its factors of trade
The gravity model asseses effects of trade agreements (reduction of formalities and tariffs) and shows that political factors (war) have a higher impact on trade than innovations
- distance between markets influence transportation costs as well as contact and communication
- cultural affinity: cultural ties –> economic ties
- geography: ocean harbours and a lack of mountain barriers make trade easier
- multinational corporations: corporations spread across different nations import and export many goods between their divisions
- borders: involves time- and money consuming formalities
What factors does the gravity model assume are important for trade?
Only size and distance are important for trade in its basic form
estimates that a 1% increase in distance will lead to a 1% decrease in trade volume
What is the Ricardian model?
A model that examines differences in productivity of labour due to differences in technology between countries and how it leads to trade
Explain the components of the one-factor ricardian model.
- labour is the only factor of production
- labour productivity varies between countries but is constant
- supply of labor is constant
- two goods: wine and cheese
- competition allows workers to be paid a competitive wage equal to the value of what they provide
- two countries: home and foreign
What is the key take away from the ricardian model?
even if a country is the most efficient producer of all goods, it can still benefit from trade
What are weaknesses of the ricardian model?
- Only one factor of production
- In real world almost no country produces only the goods in which they have a comparative advantage
- Opportunity costs between goods are unlikely to be constant, but rather should be increasing
- Most significantly, the model does not explain the source of comparative advantage: why can some countries produce more cheaply?
What is the specific factors model and what is its components?
the model allows trade to affect income distribution.
assumptions of the model:
- two goods, cloth and food
- three factors of production: labor (L), capital (K) and land (T)
- perfect competition prevails: price = cost
- cloth produced using L and K
- food produced using L and T
- labor is mobile
- land and capital are specific factors used in the production of one good
function for cloth is concave and labor employed in cloh and food must equal the total supply of labor
How is wage equilibrium determined in the specific factors model?
demand curve for cloth: MPL(c) * P(c) = w
demand curve for food: MPL(f) * P(f) = w
wage equilibrium is found where the two intersect
What is the Heckscher-Ohlin model and what are the components?
In addition to labor productivity, trade occurs due to differences in resources across countries .
The Heckscher-Ohlin (HO) theory proposes that countries export what they can most efficiently and plentifully produce, while proportionately importing the resources they need
Two-factor HO model:
- two countries: home and foreign
- two goods: cloth and food
- two factors of production: labor and capital
- the mix of L an K varies across goods
- The supply of L and K is constant and varies across countries
- both L and K can move in the long run
What are the key take aways from the Heckscher-Ohlin model?
- predicts that owners of relatively abundant factors will gain from trade and owners of scarce factors will lose.
- changes in distribution of income occurs through changes in output prices.
- wages of unskilled workers should increase in unskilled labor abundant countries relative to wages of skilled labor
What are external and internal economies of scale according to the Heckscher-Ohlin theory?
external: occur when the cost per unit of output depends on the size of the industry
internal: occur when the cost per unit of the output depends on the size of the firm
what are dynamic increasing returns to scale:
when average cost falls as cumulative output over time rises
production depends on the accumulation of knowledge and experience –> learning curve
what are benefits of free trade?
- producers and consumers allocate resources most efficiently when governments do not distort market prices through trade policy
- allows firms/industries to take advantage of economies of scale
- provides competition and opportunity for innovation
- avoids the loss of resources through rent seeking
what is rent seeking?
When companies use funds on quota rights instead of innovation
What is a terms of trade gain?
ratio of price of imports to price of exports
