EC4333, Economics for Business, Lecture 3: Trade, Economic and Monetary Union

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The last two lectures (watch them here and here) looked at the history and structure of the EU up to the Lisbon Treaty. We also began talking about trade creation and trade destruction. The purpose of this lecture is first, to finish off the theory of trade, and look at some data regarding trade integration in the EU over time, and second, to begin talking about monetary union.

Click below for lecture notes, handouts, links, and slides. A podcast will be available after the lecture.

Trade Creation and Diversion

Trade creation arises when domestic production is replaced by cheaper imports from a partner country.

Trade diversion involves low-cost imports from suppliers in third countries being replaced by more expensive imports from a partner country. We’ll use the example of Oil to make the point about trade diversion.

It was generally assumed that integration would lead to a welfare gain because the positive effect of trade creation would exceed the possible negative effects of trade diversion. Viner (1950) considered the costs and benefits of forming a customs union only from the point of view of production, and assumed that products were always consumed in the same proportion. Lipsey (1957) pointed out that the customs union is also likely to have an effect on the consumption side. It is also ambiguous as to whether the terms ‘trade creation’ and ‘trade diversion’ refer to trade flows or welfare effects. Pelkmans and Gremmen (1983) have shown that changes in trade flows can be a misleading indicator of overall welfare changes, so caution is advised here.

We’ll go through a numerical example in class, and discuss the theories before moving on to integration and trade.

Integration and Trade

I have argued in lectures that the economics of EU integration are really a mixture of politics and economics, and can perhaps be summarized as the desire to spread ‘peace and prosperity’ though other aims have also always played a role. The idea of using integration to avoid further wars in Europe (‘peace’) emerged clearly in the process of constructing the European Community in the years after the Second World War. Prosperity is generally associated with the benefits to be obtained by removing barriers to trade, and by permitting freedom of movement of goods, services, labour and capital.

In order to explain how integration is expected to lead to prosperity, it is first necessary to indicate the main arguments in favour of free trade. After a review of the classical concepts of absolute and comparative advantage and the Heckscher-Ohlin-Samuelson framework, we will deal with protectionism, and, in particular, a description of the most commonly used obstacles to trade and an explanation of the reasons for their introduction.

Arguments for Free Trade

Many of our arguments in favour of free trade still owe much to the work of the classical economists Adam Smith and David Ricardo.1 These writers illustrated that trade between two countries could be mutually beneficial, thanks to the specialization of production.

Adam Smith discussed the principle of absolute advantage, arguing

what is prudent in the conduct of every private family can scarce be folly in that of a great kingdom. A family will not make at home what it costs less to buy from outside. A taylor [sic] will not make his own shoes, but will buy them from a shoemaker.

With two nations, if one country is more efficient in the production of one good, and less efficient in the production of the other, then each country should specialize in the production of the good where it has an absolute advantage. Part of the output of that country can be exchanged for the good for which it has an absolute disadvantage. In this way resources will be used in the most efficient way possible. For instance, according to this principle, in trade between the two countries Ireland should specialize in the export of Guinness, and Argentina in that of beef.

Comparative Advantage

In practice Smith’s concept of absolute advantage explains only a small share of international trade. From this point of view, the concept of comparative advantage developed by David Ricardo is much more useful. According to the principle of comparative advantage, even when one country is less efficient in the production of both goods there is a basis for mutually beneficial trade.
According to the principle of comparative advantage, even if one country has an absolute disadvantage in the production of both goods, it should specialize in the production and export of the good where its absolute disadvantage is smaller and import the product where its absolute disadvantage is greater. The country with an absolute advantage in the production in both goods should specialize in the production and export of the product where its absolute advantage is greater, and import the good for which its absolute advantage is smaller. T
Comparative advantage still remains an important element of the toolkit in explaining the advantages of free trade, so it useful to provide an example of how this principle works in practice. Ricardo based his approach on the labour theory of value, by which the price of a product is said to depend exclusively on the amount of labour used in its production. This theory requires:

• either that labour is the only factor used in making products, or that the ratio between labour and other factors such as land or capital is constant; and
• that labour is homogeneous and there are no differences in skills between people.

These are pretty restrictive assumptions, and have been eliminated in most later evolutions of the theory.

The Hecksher-Ohlin Theorem

What determines the comparative advantage of a country? Later developments in trade theory, like the Heckscher–Ohlin theorem, try to explain the pattern of comparative advantage between countries.

The HO theorem tries to answer the question: why does a country have a comparative advantage in the production of a particular good? According to this approach, trade can be explained by the pattern of endowments of countries with different factors of production.

For purposes of simplification, in textbooks the Heckscher–Ohlin theorem is usually presented using a highly simplified case of two countries, two products ( and ) and two factors (labour and capital).

A country has an abundance of a certain factor if the ratio of the total amount of one factor, say labour to capital, is higher than in the other country, and if the cost of labour relative to capital is less than in the other country.

If the production of one of the goods, say , requires more labour relative to capital than the other good, then product is said to be labour-intensive. According to the Heckscher–Ohlin theorem, a country will export the commodity whose production is intensive of the factor in which the country is relatively abundant.
For example, if Poland has an abundance of cheap labour, and the production of clothing is labour-intensive, Poland will tend to export clothing. In contrast, if Ireland has a factor abundance of capital (or skilled labour), and computers are intensive of capital (or skilled labour), Poland will specialize in textiles and import computers.

The Hecksher-Ohlin Samuelson Theorem

According to the Heckscher–Ohlin–Samuelson theorem, the liberalization of trade will bring about the equalisation of relative and absolute returns to the factors of production between countries or regions.

The Heckscher–Ohlin–Samuelson theorem is based on very strict assumptions such as perfect competition, no economies of scale, free trade, full employment of resources and the same technology in both countries, so take it with a pinch of salt.
Using the same example as above, if Poland, which has an abundance of labour, specializes in the production of clothing (which is intensive of labour) the demand for labour relative to capital will increase, and as a result so will the cost of labour,  (the wage rate) relative to the cost of capital , (the interest rate).

According to the theorem, in Ireland, which is assumed abundant in capital, the opposite will occur. With free trade Ireland will tend to specialize in products intensive of capital, so increasing the relative cost of capital . With the process of specialization in Ireland, labour-intensive production will decrease, releasing more labour relative to capital and pushing down the relative price of labour . With free trade (and under the restrictive assumptions of the model), the process will continue until the relative (and absolute) prices of labour and capital are the same in the two countries.
Returning to the model used above, as Country 1 (Poland) specializes in the production of (which is labour intensive) and reduces the production of (which is capital intensive), the demand for labour relative to capital will rise. This will cause the price of labour (, or wages) relative to that of capital (, or the interest rate) to rise. Country 1 is labour abundant, so initially the price of labour relative to capital was lower than in Country 2, but with trade the relative price for labour will rise in Country 1. The opposite will occur in Country 2. As Country 2 specializes in the production of the demand for capital relative to labour will rise and so too will relative to w. Trade will continue until the relative prices of the two factors are the same in the two countries.

Handout

Right click to download the handout.

Readings from the course outline

1. * Pelkmans, J. European Integration: Methods and Economic Analysis 1st ed., pgs. 83–104 and 133–155. 337.142 PEL.
2. El-Agraa, A.M., The European Union: Economics and Policies, 6th ed., pgs. 149–164, 337.142 AGR.
3. Lane, P. (2006) The Real Effects of EMU, Journal of Economic Perspectives.

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