International Trade

1. International Trade Cheng Ming 程铭 School of Economics, Shanghai University

2. Chapter OneComparative Advantage--- The Ricardian Model • The Concept of Comparative Advantage Two basic reasons for International Trade • Countries can benefit from doing things they do well • Reaching economies of scale in production

3. David Ricardo, in his 1817 book “The Political Economy and Taxation” put forward the theory of Comparative Advantage • A company has a comparative advantage in producing a good if the opportunity cost in terms of other goods is lower. • Each country can benefit from the exporting the goods in which it has a comparative advantage.

4. 2. A One-factor Economy • In Ricardian model, international trade is SOLELY due to the differences in the productivity of labor • An Economy – Home Two Goods – Wine & Cheese One Factor – Unit labor requirement • We define: aLW –unit labor requirement in wine aLc – unit labor requirement in cheese L – total labor supply

5. Production Possibility Qw Slop: opportunity cost of cheese in terms of wine L/a LW aLC/aLW Qc L/a LC Production Possibility Frontier

6. Relative Prices and Supply • PPF illustrates the mixture of goods the economy can produce • The actual production mix is based on the relative prices (no profits in One-factor model) • If Pc/Pw > aLC/aLW, specialize in the production in cheese • If Pc/Pw = aLC/aLW, both goods will be produced • The economy will produce cheese if the relative price exceeds it opportunity cost

7. 3. Trade in a One-factor World We assume: Home country is less productive than Foreign in Wine, but more productive in Cheese Therefore: aLC/aLW < a*LC/a*LW Or, equivalently, that aLC/a*LC < aLW/ a*LW Therefore, Home country has comparative advantage in Cheese

8. Determining the Relative Price after Trade Relative price of Cheese a*LC/a*L Rs 1 2 aLC/aL R RD L/aL Q Relative Quantity of Cheese L/a*LW

9. Point 1, the intersection of demand curve R and RS curve, where the relative price of cheese is between the two countries’ pretrade prices. Each country will specialize in the production of the good in which it has a comparative advantage. • Point 2, the world relative price after trade is the same as the opportunity cost of cheese in terms of wine in Home, Home economy need not specialize, while Foreign does specialize in producing wine.

10. The Gains from Trade • The First Way -- to think of trade as an indirect method of production, i.e. Home can produce wine directly and trade with Foreign for cheese (produce indirectly) -- for an hour of labor, direct production 1/aLW wine, or 1/aLCcheese and be trade with wine -- if (1/aLC)(PC/PW) > 1/aLW, or PC/PW > aLC/aLW trade will be beneficial

11. Trade Expands Consumption Possibilities • The second way – how trade will affect the possibilities for consumption. Quantity of wine, Qw Quantity of wine, Qw T F P F P T Quantity of cheese, Qc Quantity of cheese, Qc (a) Home (b) Foreign

12. Relative Wages • Political discussion of international trade often focus on comparisons of wage rates in different countries. Unit Labor Requirements Cheese Wine Home aLC = 1hr per pound aLW = 2hr per gallon Foreign a*LC = 6 hr a*LW = 3hr

13. Since, aLC/aLW <a*LC/a*LW • So, Home will produce Cheese, Foreign produce Wine • Suppose a unit of cheese and wine both sell for $12, Home worker will earn $12 per hour, while Foreign worker will earn $4 • As long as the relative price of cheese to wine is 1, the wage of Home workers will be 3 times that of Foreign workers. • Home still has a comparative advantage in producing cheese since this wage rate lies between the ratios of the two countries productivities in the two countries.

14. 4. Misconceptions about Comparative Advantage • Productivity and Competitiveness Myth 1: Free trade is beneficial only if your country is strong enough to stand up to foreign competition. • The Pauper Labor Argument Myth 2: Foreign competition is unfair and hurts other countries when it is based on low wages. • Exploitation Myth 3: Trade exploits a country and makes it worse off if its workers receive much lower wages than workers in othernations.

15. 5.Comparative Advantage with many goods • With many goods, we label aLianda*Li as labor requirement for Home and Foreign, and rearranged as: aL1/a*L1< aL2/a*L2 < aL3/a*L3< …< aLN/a*LN • Let w and w* be the wage rate per hour in Home and Foreign, respectively • We know that it would produce cheaper in Home if waLi < w*a*Li, and it can be rearranged to yield a*Li/aLi > w/w*

16. Home and Foreign Unit Labor Requirements Relative Home Good Home Unit Labor Foreign Unit Labor Productivity Requirements(aLi) Requirements(a*Li) Advantage(a*Li/aLi) Apples 1 10 10 Bananas 5 40 8 Caviar 3 12 4 Dates 6 12 2 Enchiladas 12 9 0.75

17. 6. Adding Transport Cost and Nontraded Goods There are three reasons why specialization in the real international economy is not the extreme: • The existence of more than one factor • Countries sometimes protest industries from foreign competitions • It is costly to transport goods and services. i.e. because of the transport cost, there exists nontraded goods

18. Chapter Two Specific Factors and Income Distribution

19. 1.The Specific Factors Model • Although international trade is beneficial to both of the countries, it is, however, has strong effects on the distribution of income. While trade may benefit a nation as a whole, it often hurts significant groups within the country, at least in the short run. • We use the specific factors model to explain.

20. Assumption of the Model: -- an economy produce two goods: manufactures and food. -- three factors: labor(L), capital(K), and land(T) -- labor is the Mobil factor, while K and T are specific factors for manufactures and food, respectively -- so, QM = Q M(K,LM) QF = QF(T,LF) LM + LF = L

21. Production Possibilities Output, QM The Production Function for Manufactures The more labor input, the larger the output. Because of the diminishing returns, the successive input will has less output. Reflected by a flatter Curve. QM=QM(K,LM) Labor Input,LM

22. The Marginal Product of Labor Marginal product of labor, MPLM The marginal product of labor equal to the slop of the production function MPLM Labor Input,LM

23. The Production Possibility Frontier in the Specific Factors Model Output of food, QF, (increasing ) Economy’s Production Possibility Frontier(PPF) QF=QF(T,LF) 1’ QF L QM LF PP Labor input In food, LF (increasing ) Output of Manufactures, QM (increasing ) 1 LM L OM=QM(K,LM) Labor input In manufacturers, LM (increasing )

24. In the Specific Factors Model, the PPF is an convex line (reflecting diminishing returns to labor), while in the Ricardian Model, it is a straight line (reflecting constant returns) • The slop of the production possibility curve = - MPLF/MPLM • The slop represents the opportunity cost for manufactures in terms of food.

25. Price, Wages, and Labor Allocation • Each sector will hire labor to the point until to the point where the value produced by an additional person-hour equals to the cost of employing that hour. In manufacturing sector, for instance: • MPLM хPM = W, because of the diminishing returns, MPLM is a downward curve, giving the constant price of the manufactures. • We can also consider the above equation as the demand curve.

26. Since • MPLMхPM = MPLFхPF = w, therefore, • - MPLF/MPLM = - PM/PF • The result tells us that at the production point the production possibility frontier must be tangent to a line whose slop is minus the price of manufactures divided by that of food. QF Slop = -(PM/PF) QM

27. An equal proportional increase in the prices of manufactures and food Wage Rate, w 2 PFхMPLF 1 PFхMPLF PM Increase 10% PF Increase 10% w2 10% Wage increase 2 2 PMхMPLM w1 1 1 PMхMPLM Labor used In food,LF Labor used in Manufactures, LM

28. If both goods’ prices increase by 10%, the labor demand curves will both shift up by 10%. The allocation of labor between the sectors and the outputs of the two goods do not change. • So it generates a general principle: changes in the overall price level have no real effects, that is, do not change any physical quantities in the economy. Only changes in relative prices -- affect welfare or the allocation of resources.

29. A change in relative prices Wage Rate,w 1 PFхMPLF 7% upward Shift in labor demand 2 W1 w2 2 Wage rate Rises by Less than 7% PMхMPLM 1 1 PMхMPLM Labor used in Manufactures, LM Labor used In food, LF Amount of labor shifted from food to manufactures

30. Two important facts about the results of the shift of the labor in the above diagram • First, although the wage rate rises, it rises by less than the increase in the price of manufactures. • Second, when only PM rises, in contrast to the case of a simultaneous rise in PM and PF, labor shifts from the food sector to the manufacturing sector and the output of manufactures rises while that of food falls. (This is why w dose not rise as much as PM: because manufacturing employment rises, the marginal product of labor in that sector falls.

31. Relative prices and the distribution of Income • Let’s discuss the the results of the shifts of labor for the incomes of three groups: • 1) Workers – their wage rate has risen, but less than in the proportion to the rise in PM. Thus, their real wage in terms of manufactures (w/PM) falls, while (w/PF) rises. • So, the warfare of workers are uncertain, depending upon their preferences of consumption.

32. 2) Owners of capital, are definitely better off. The real wage rate in terms of manufactures has fallen, so that the profits of capital owners in terms of what whey produce rises. • 3) Owners of land are definitely worse off. The lose for two reason: --- the real wage in terms of food rises, squeezing their income, and --- the rise in manufactures prices reduces the purchasing power of any given income.

33. 2. International Trade in the Specific Factors Model • We know that an increase in the supply of manufactures (or land) would increase manufactures (food) output and reduce the food (manufactures) output. • Now we suppose that American has a larger supply of land than Japan; while Japan has a larger supply of capital than American.

34. We also suppose that under any PM/PF, the demand of two countries is the same, i.e. trade is occurred only because of the difference of the relative supply • Therefore, the relative price of manufactures is determined by the world relative supply RSworld and world relative demand Rdword.

35. Relative price Of manufactures, PM/PF RSA RSworld RSj (PM/PF)A (PM/PF)world (PM/PF)j RDworld Relative quantity Of manufactures, QM/QF

36. Trade pattern and Budget constraint • In a closed economy, output equals to consumption, so DM = QM, DF = QF • Although trade makes it possible for a country to consume the different mix of manufactures and food, the value of consumption must be equal to the value of production, so PM хDM + PF хDF = PM хQM + PF хQF, or DF – QF = (PM/PF) х(QM – DM)

37. The budget constraint for a trading economy Consumption of food, DF Output of food, QF Point 1 represents the economy’s Production. The economy’s con- sumption must lie along a line that Passes through point 1 and has a Slope equal to minus the relative Price of manufacturers. Budget constraint (slope = - PM/PF) 1 1 QF Production Possibility frontier 1 QM Consumption of Manufacturers,DM Output of Manufacturers, QM

38. 3. Income distribution and the gains from trade • After trade, it leads to a convergence of relative prices. • Trade benefits the factor that is specific to the export sector of each country but hurts the factor specific to the import-competing sectors, with ambiguous effects on mobile factors. • Do the gains outweight the losses? Through the diagram in the next page, we find that trade potentially benefits a country since it expends the economy’s choices of consumption.

39. Trade expands the economy’s consumption possibilities Consumption of food, DF Output of food, QF Before trade, economy’s pro- duction and consumption were at Point 2 on its production possibilities frontier (PP). After trade, The economy can consume at any point on its budet constraint in the colored region consists of feasible posttrade consumption choices with consumption of both goods higher than at the pretrade point 2. 2 Budget constraint (slope = - PM/PF) 1 QF 1 PP Consumption of Manufacturers, DM Output of Manufacturers, QM 1 QM

40. 4. The political economy of trade: a preliminary review • Optimal trade policy In spite of the real importance of income distribution, most economists remain strongly in favor of more or less free trade, reasons are: a. Income distribution effects are not specific to international trade. b. It is always better to allow trade and compensate those whose who are hurt by it than to prohibit the trade.

41. c. Those who stand to lose from increased trade are typically better organized than those who stand to gain. This imbalance creates a bias in the political process that requires a counterweight • Income distribution and trade politics in most of the countries, including the U.S.A., those who want trade limited are more effective politically than those who want it extended. Typically, those who gain from trade in any particular product are a much less concentrated, informed, and organized group than those who lose.

42. Chapter Three: Resources and Trade – The Heckscher-Ohlin Model 1. A model of Two-factor Economy • The economy produce two goods – cloth and food • Two factors – labor and land • aTC = acres of land used to produce one unit of cloth • aLC = hours of labor used to produce one unit of cloth • aTF = acres of land used to produce one unit of food • aLF = hours of labor used to produce one unit of food • L and T = supply of labor and land

43. Input Possibilities in food production Unit land input aTF, in acres Input combinations that produce oneunit of food A farmer can Produce a unit of Food with less land If he or she uses more Labor,and vice versa. II Unit land input aLF,in hours

44. What he or she will actually use? • It depends on the relative cost of land and labor -- factor prices: w/r (wage rate per hour of labor/ cost of one unit of land) • It is represented by the Figure as the curve FF. • There is a corresponding relationship between w/r and the land-labor ratio in cloth production. As showed by the curve CC. • Curve CC lies to the left of FF, indicating production of food uses a higher ratio of land to labor than the production of cloth.

45. Factor prices and input choices Wage-rental ratio, w/r CC FF 在每个部门，生产中所使用的土地与劳动的比例取决于劳动与土地的相对价格，即w/r。图中的FF曲线表示在粮食生产中的土地-劳动比的选择，CC曲线则表示在棉布生产中的土地-劳动比率。对于任何一个给定的工资-租金比，粮食生产会使用较高的土地-劳动比率。在这种情况下，我们称粮食生产为土地密集型(land intensive)，棉布生产为劳动密集型(labor intensive). Land-labor Ratio, T/L

46. Factor prices and goods prices Relative price of Cloth, PC/PF SS 由于棉布生产是劳动密集型的,粮食生产是土地密集型的,要素相对价格w/r与商品相对价格PC/PF存在着一 一对应的关系. 劳动的相对成本越高,劳动密集型产品的相对价格就越高. 图中的SS曲线显示了这种关系. Wage-rental ratio, w/r

47. 从商品价格到要素投入的选择From Goods Prices to Input Choices CC Relative Price of cloth PC/PF FF 2 w/r 1 w/r Land- Labor Ratio T/L 1 1 2 2 1 2 PC/PF PC/PF TC/LC TC/LC TF/LF TF/LF Increasing Increasing 给定棉布的相对价格,工资与地租 的比例一定等于(w/r)1. 对应于这一工资—地租比例,棉布和粮食生产中的土地与劳动比例分别是(TC/LC)1和(TF/LF)1. 如果棉布的相对价格上升到(PC/PF)2, 工资—地租比就一定会上升到(w/r)2,从而造成两个部门生产中使用的土地– 劳动比例提高.

48. The allocation of resources Increasing Labor used in food production OF Increasing Land used in food production Land used in clothproduction Increasing C 1 F OC Labor used in cloth production Increasing

49. What will be happen, if the economy resources change, say, by increasing the offer of land. • We notice that an increase the economy’s supply of land will lead to a fall in the output of the labor intensive good, with the rise of the output of the land intensive good. • That is, there is a biased expansion of production possibilities.

50. Resources and Production Possibilities Output of food,QF 资源供给的变动对生产可能性的偏向性效应是理解资源差异如何导致国际贸易的关键. 土地供给的增加使一国的生产可能性向偏向于粮食生产的方向扩张,而劳动的增加使生产可能性向偏于棉布生产的方向扩张. 因此, 土地对劳动的相对供给比较高的国家在生产粮食生产上具有相对优势.一般说来,一个国家生产本国相对充裕资源密集型的产品具有比较优势. Slope= -PC/PF 2 2 QF Slope= -PC/PF TT2 1 1 QF TT1 1 2 Output of cloth, QC QC QC -- known as the “Rybcznski effect” (罗布津斯基效应)