Comparative Advantage

1. Comparative Advantage International Trade – Session 1 Daniel TRAÇA

2. Globalization I: Increased trade in goods and services • International Trade involves mostly exchanges among high income countries. • Developing countries have increased their relevance, particularly East Asia, but are still a small part.

3. Trade in services and merchandise • Most of world trade is in goods (merchandise) – 82%. • Services trail behind, but are the fastest growing component. • Outsourcing is the latest trend

4. Globalization II: Foreign Investment - complex strategies of multinationals

5. Drivers of Modern Globalization • Lower transport and communication costs • Development of international institutions • The WTO • Regional Trade Agreements • Political decisions toward de-regulation and liberalization of trade and FDI regulations

6. Theory and practice of international trade and foreign investmentWHAT WE WILL LEARN… • Why do countries export certain goods and imports others? • What do countries and populations gain and loose from trade? • Why do multinationals exist and what are their effects? • Why do governments protect their industries and what are the costs and benefits? • What are the effects of different protectionist instruments? • How do the institutions that regulate global trade work? • What have been the economic and social consequences of the rise in trade and foreign investment with developing nations? • What has globalization brought to developing countries?

7. Theories of international trade Comparative advantage Gains from trade: static and dynamic Losers and winners Trade policy Policy Instruments The case for free-trade and exceptions Policies for Strategic sectors Political economy and the realist view The effects of modern globalization Trade and the developing countries Multinationals and FDI The effects in industrialized countries Institutions of global trade The W.T.O Regional agreements Organization of the course

8. Materials and examscourse website: www.danieltraca.com • Download class slides before class from website • Also available at GES • Practice exams and answer keys available at website. List of required sections available from website • Recommended textbook • “International Economics, 7th ed”by Krugman P. and Obstfeld M., Addison-Wesley • Available in French • Additional readings available at website

9. The theory of Comparative Advantage

10. Absolute Advantage • “It is the maxim of every prudent master of the family, never attempt to make at home what it will cost him more to make than buy … What is prudent in the conduct of every family can scarce be folly in that of a great kingdom If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them …” • Adam Smith 1776

11. Absolute Advantage Output per worker (productivity) Manufacturing (pieces) Food (bushels) NORTH 10 8 SOUTH 3 9

12. Gains from specialization • North specializes in Manufacturing and South in Food • There is more of both goods, if specialization follows absolute advantage

13. Comparative Advantage • "A country … enabled to manufacture commodities with much less labour that her neighbours may, in return for such commodities, import a fraction of the corn required for its consumption, even if … corn could be grown with much less labour than in the country from which it was imported." • David Ricardo

14. Comparative AdvantageNorth is MORE productive in both goods

15. 1 northerner (Food to Manuf) 10 Food  10 Manuf 2 southerners (Manuf to Food) 2 x 3 6 Manuf 2 x 9 18 Food Even so, there are gains from specialization Output • A country has Comparative Advantage in a given good if its relative productivity in that good is higher than in other goods • Specialization according to Comparative Advantage creates value, by increasing output. before after

16. How does the market work? • Does the decentralized international market achieve this pattern of specialization? How? • Who benefits and who looses from international trade in the free-market? • Among individuals within a country? • Among countries?

17. In Autarky... North Northern worker • They work in both sectors, and trade among them at the autarky relative price • The relative price • P=pManuf/pFood • In equilibrium, workers must be indifferent between the two sectors. • They must get the same wage Food South Manuf

18. The prices in autarky (closed economy) The relative price of Manuf (P) denotes how many bushels of Food for one piece of Manuf. Manuf (pieces) Food (bushels) P NORTH 10 10 10/10 = 1 SOUTH 3 9 9/3 = 3

19. Relative Supply (RSs) South PS= 3 Relative demand (RDW) It is the same in both countries if preferences are the same [Manuf/Agro]S [Manuf/Agro]N Relative prices, relative supply, relative demand P Relative Supply(RSN) North PN= 1 Manuf/Agro

20. The Northerners trade among them at the autarky price PN = 1 The Southerners trade among them at the autarky price PS= 3 In Autarky... Northern worker Southern worker South North Food Food Manuf Manuf

21. Wages and productivity • Are the wages the same in both sectors? Why? • If not, where are they higher? Why? • Are they the same in both countries? Why? • If not, where are they higher? Why?

22. Production Possibility Frontier 10 The choice of consumers …determines the allocation of labor MRS=MUFood/ MUManuf = 1/P =1 +1 -1 Equilibrium P=1, So that both goods are produced UN -1/PN = -1 10 The Production Possibility Frontier and Welfare North Manuf Slope = -ProdF / ProdM Northern Workers inManuf Northern Workers inAgro Agro

23. The beginnings of Trade… • Manuf is relatively cheaper in the North. • An enterprising Northerner takes 1 Manuf to the South and exchange it for 3 Foods. • Back in the North, she could sell 1 Foods for 1 Manuf with a net gain of 1 Food. • There are gains from exchange because prices are different: Trade occurs! • What happens to the relative price of Manuf in North? … • And in the South?

24. 2 . Prices adjust to new scarcity P rises in the North and falls in the South PS < 9/3 PN >10/10 Openness in the Short Run... North South Food Food 1 . Trade starts due to arbitrage Manuf Manuf

25. PS < 9/3 PN >10/10 3 . Factors (workers) respond to new prices and profitability -- specialization In the Long-Run, there is re-allocation North South Each country specializes completely in, and exports, the good in which it has comparative advantage Food Food Manuf Manuf There is one world price, which is between the initial prices 10/10 < PW <9/3

26. North and South produce only Manuf North produces Manuf only South produces both North and South specialize completely 1<PW <3 Relative Demand (RDW) World North and South produce only Food South produces Food only North produces both How to determine the world price? P Relative Supply (RSW) World 3 1 Manuf/Food

27. 1<PW <3 US(Food) 1<PW <3 The Gains from Trade according to Comparative Advantage South North Manuf Manuf 10 -1/PW UN(Manuf) -1/PN 3 PS =3 UN PN =1 -1/PW US -1/PS 10 Food 9 Food

28. Some unrealistic features of the model, so far… • What if there are transport costs? • What if there are more than two goods? • What if factors cannot adjust to other sectors? • What if there are more than one factor? • Why is there always complete specialization?

29. Transport Costs and Non-traded goods • If there are transport costs, the competitiveness edge of a country must more than make up for this transport cost. • Otherwise, the good will not be traded, even if it is cheaper to produce in one country. This good is called non-tradable. • In reality, economies spend large proportions of their income in these type of goods. • It can become tradable, if transport costs fall or the productivity advantages widen (globalization).

30. Global markets vs. local marketsTRADABLES and NON-TRADABLES • Tradable goods can travel across borders and have international markets that set prices. • Non-tradable goods have their prices set by supply and demand in local markets. • Often, the same good exists in different countries because it is produced locally. • With globalization, many goods and services have become tradable. Non-tradables Tradables Goods • Cement • Housing • McDonalds Hamburger • Textiles • Machinery • Almost all goods Services • Hairdressers • Government services • Auto-repair • Almost all services • Consulting • Banking • Telecom’s • Tourism

31. Summary • Comparative advantage: • Consumers react to price differences and buy from lower price foreign producers the goods in which their country does not have comparative advantage (gains from exchange). • Producers react to price differences and allocate resources to industries where relative productivity is higher, exporting those goods (gains from specialization). • Every country always has an industry in which it has Comparative Advantage and it is competitive in world markets for that industry.