BA 187 – International Trade

1. BA 187 – International Trade Ricardo and Comparative Advantage: The Classical Model of Trade

2. Issues in International Trade • Initial attempt to understand two of the important issues in trade theory. • Gains from Trade • Pattern of Trade • Use insight of Adam Smith about different advantages in production across countries. • Focus on comparative, rather than absolute, advantage as source of pattern & gains from trade

3. Classical Model Assumptions • Fixed endowment of labor in each country. • Labor completely mobile within a country. • Labor completely immobile between countries. • Commodity value determined by labor content. • Technology fixed but differs across countries. • Prod’n costs constant, do not depend on quantity. • Full employment of labor, perfect competition. • No tariffs or transportation costs. • Two country, two commodity world.

4. Constant Cost Technology • Ricardo (1817) viewed mutual gains from trade possible based on comparative advantage. • Example above Portugal has absolute advantage in both goods, but trade still possible as England is relatively more productive in cloth than wine.

5. Absolute vs. Comparative Advantage • Absolute Advantage • A country has an absolute advantage in good X if one unit of labor produces more X than is produced by one unit of labor in the other country. • Comparative Advantage • A country has an comparative advantage in good X if its opportunity cost of X in terms of Y is less than in the other country • In previous example Portugal has an absolute advantage in both goods but a comparative advantage in wine.

6. Opportunity Costs and Advantage • Comparative advantage arises from differing opportunity costs across countries. • With total labor fixed, producing more of one good (Cloth) means producing less of other good (Wine). • Tradeoff is opportunity cost and differs between the two countries. • England • 1 more unit of cloth requires giving up 5/6 unit of wine. • Portugal • 1 more unit of cloth means giving up 4/3 units of wine. • England’s comparative advantage is producing cloth, while Portugal’s comparative advantage is in producing wine.

7. Ricardian Comparative Advantage • Assume each country has 120 units of labor. • Table shows all feasible combinations of cloth and wine for each country in autarky.

8. Gains from Trade • Now trade opens with terms of trade equal to 1W:1C • England specializes. Produces only cloth. • England exports cloth to Portugal in exchange for imports of wine. • At least as well off as in autarky. • Same results for Portugal. Mutual gains from trade.

9. Relative Wages • Assume unit of cloth & unit of wine sell for $12. • After trade: • English workers specialize in cloth, receive $1.20/hr ($12 for 10 hrs work) • Portuguese workers specialize in wine, receive $2.00/hr ($12 for 6 hours work) • Relative wage of English workers is 60% of that of Portuguese workers. • Note English workers are: • 50% as productive as Portuguese workers in wine and • 80% as productive as Portuguese workers in cloth • Relative wage lies between these two productivities.

10. BA 187 – International Trade Visualizing Comparative Advantage

11. Visualizing Comparative Advantage • Rather than rely on numerical examples can develop model visually to demonstrate results. • Technology: (Constant Costs) • aLX = # units of labor for 1 unit of X. (a*LXfor foreign) • aLY = # units of labor for 1 unit of Y. (a*LYfor foreign) • aLXqX + aLYqY = Ltotal(a*LXq*X + a*LYq*Y = L*total) • Tastes: • Each country possesses community indifference curves, UH for Home and UF for foreign. • Maximize utility subject to production constraints determined by technology and labor endowment.

12. L*/a*LY L/aLY aLX AF aLY UF AH UH L*/a*LX L/aLX Equilibrium in Autarky Y Y Home Foreign aLX/ aLY < a*LX /a*LY X X

13. Prices, Wages & Production • Prices, Wages, & Production • Let PX and PY be the price of each good. • Perfect competition implies wage to worker equals value of output produced, PX/aLX or PY/aLY • Labor mobility implies: • If PX/aLX > PY/aLY, or equivalently when PX/ PY > aLX /aLY then economy produces only X. • If PX/aLX < PY/aLY, or equivalently when PX/ PY < aLX /aLY then economy produces only Y. • In autarky, economy must produce both goods so relative prices of goods must equal their relative unit labor requirements, i.e. px = PX/ PY = aLX /aLY.

14. QF L*/a*LY L/aLY CF CH AF U’F U’H UF AH UH QH L*/a*LX L/aLX Potential Gains from Trade Y Y Home Foreign X X

15. Foreign Exports Home Imports Home Exports Foreign Imports Equilibrium and Trade Equilibrium occurs at relative price that makes the two triangles equal Y Y Home Foreign QF L*/a*LY L/aLY CF AF CH U’F U’H UF AH UH QH X L/aLX L*/a*LX X

16. Determining Terms of Trade • How can we determine exactly what the relative price will be in equilibrium with trade? • Terms of trade for a country: • Ratio of the price of its export commodity to the price of its import commodity. • In our example, terms of trade for Home are PX/PY, and PY/PX for Foreign. • Number of analytical tools to determine the equilibrium relative price ratio with trade. • K&O focus on Relative Demand and Supply analysis.

17. Relative Demand and Supply • Relative analysis focuses on ratio of prices PX/PY & ratio of total quantities (qX+ q*X)/(qY+ q*Y). • Relative Demand: • Rise in PX/PY makes X more expensive relative to Y. • Substitution away from X towards Y, leads to downward-sloping Relative Demand Curve, RD. • Relative Supply: • If PX/PY < aLX /aLY : no Good X produced. • If PX/PY = aLX /aLY : Home produces X as demanded. • If a*LX /a*LY > PX/PY > aLX /aLY : Home specializes in X. • If PX/PY > a*LX /a*LY : Both Home & Foreign produce X.

18. a*LX/a*LY RS 1 RD aLX/aLY 2 RD’ (L/aLX)/(L*/aLY) Relative Demand and Supply Relative Price of X PX/PY Relative Quantity of X (qX+ q*X)/(qY + q*Y)

19. BA 187 – International Trade Summary of Results from the Classical Model of Trade

20. Results of Trade • Mutual Gains from Trade • Trade enlarges the range of consumption choices for each nation over autarky. • Absolute vs. Comparative Advantage • Gains arise from specializing in producing goods in which have a comparative (not absolute) advantage. • Trade & Specialization • Expect trade to lead nation to specialize in prod’n. • Relative Wages • What matters for trade is relative wage versus relative labor productivities.

21. Shortcomings of Ricardo Model • Classical approach has serious shortcoming, in that it assumes rather than explains comparative advantage. • Classical model does not explain why labor productivities differ between nations. It is these differences which are the source of comparative advantage. • Ignores how relative resource endowments change as countries grow (constant costs assumption). • Benefits of trade come from more efficient use of domestic resources through specialization. • Specialization can have negative aspects if it results in a lopsided pattern of growth within a developing country. • May produce an export enclave rather than a well-balanced economy.

22. Statements to Address • Productivity & Competitiveness “Free trade is beneficial only if your country is strong enough to stand up to foreign competition.” • Pauper Labor “Foreign competition is unfair and hurts other countries when it is based on low wages.” • Exploitation “Trade exploits a country and makes it worse off if its workers receive much lower wages than workers in other countries.” • Specialization “There cannot be distinct roles within Mercosur, with one country producing primary products while another is industrialized” Fernando de la Rita, Presidential Candidate Argentina

23. BA 187 – International Trade Appendix: Small Country vs. Large Country Gains from Trade

24. Does Trade Exploit Small Nations? • Examine effects of opening trade between a large economy and a small economy. (Think NAFTA) • Is it true that the large nation will use its economic clout to exploit the small nation? • Next slide examines this case. • SC = Small Country, LC = Large Country • Begin with both nation’s in autarky, ASC and ALC. • Open trade, change relative prices to find equilibrium (equal trade triangles) between the countries. • Equilibrium with trade (Consumption, Production) given by (CSC, QSC) and (CLC, QLC) • Surprising results for Small vs. Large Country.

25. LC production point with trade QLC LC Exports SC Imports SC consumption point with trade U’SC QSC LC Imports SC Exports Large/Small Country Y Small Country = SC Large Country = LC LC consumption point in autarchy & trade CLC CSC ULC ASC X

26. Summary of Small vs. Large Country • Small Economy • Receives maximum gains available by opening trade. • As a price-taker, it trades at the relative prices set by the large economy. • Completely specializes in good for which it has the comparative advantage. • Large Economy • Receives no gains from trade with small nation. • No change in its production constraint. • Produces both goods after trade, though more of good in which it has comparative advantage.

27. BA 187 – International Trade Extensions to the Classical Model of Trade

28. Adding Money to Ricardo • So far have dealt with trade in terms of barter of one good for another. • How to move to monetary economy? Domestic value of good found as PX = W•aLX • Link economies through exchange rate. e = # units of foreign currency per unit domestic currency • Put price of good in common terms (foreign currency) • Domestic Country: PX = aLX •W•e • Foreign Country: P*X = a*LX •W* • Trade occurs based on differences in money prices

29. Example of Money & Ricardo • Assume Exchange Rate of 1 escudo:£1 • Cheaper to buy cloth in England, buy wine in Portugal. • Consistent with relative labor efficiency ( ½ < ¾ ) • Terms of trade for England PCloth/PWine = 1/2.4 • If trade not balanced, then specie flows to country with trade surplus. Raises prices & wages, offsets trade.

30. The Export Condition • Monetized version of Classical trade model. • Country exports any product it can produce most inexpensively, given wage rate & exchange rate. • Export Condition • Cost conditions necessary for country to export a good. PX = aLX W e<a*LX W* = P*X ora*LX/ aLX >We/W* • In a monetized world, ability to export depends not only on relative labor efficiency but also on relative wage rates and the exchange rate. • Establishes limits on wage rates and/or exchange rate for trade to take place between countries.

31. Wage and Exchange Rate Limits • Trade in a two-good, two country world requires each country produce one good more cheaply. This imposes limits on wage rates & exchange rates for trade to occur. • Wage Rate Limits(assumes e = £1:1escudo) • In previous example, England loses export market in cloth if English wage rises to £1.2/hr or higher. • England gains export market in wine if it wage falls to £0.8/hr or lower. • Exchange Rate Limits(assumes wages fixed) • Similar logic dictates that at if EXR rise to 1.2 esc/£1 or higher England loses export market in cloth. • England gains export market in wine if it EXR falls to 0.8esc./ £ 1 or lower.

32. Trade in Multi-Commodity World • Pattern of trade in multi-commodity world depends on relative labor requirements versus ratio of relative wages. • Also can see effects of change in exchange rate or relative wages on the pattern of trade. • Finally trade flows equalized by changes in relative wage rates due to flows of gold or exchange rate changes.

33. Effects of Change in Relative Wages • Increase in Home wage rate, decrease in Foreign wage rate, or rise in exchange rate (home currency more valuable) • Makes home country goods more expensive, reduces the number of goods exported by the home country. • Again any imbalance in trade flows will be equalized by changes in relative wage rates due to flows of gold or exchange rate changes.

34. RS RD = Relative Derived Demand for labor RS = Relative Supply of labor, L/L* Cloth a*LC/aLC Wine (We/W*)eq Bread Cheese Tools RD Determining the Relative Wage Relative Wage , We/W* Relative Quantity of Labor L/L*

35. Evidence on Comparative Advantage • MacDougall (1951) • Looked at ratio of labor productivity US vs. UK plotted against export volume ratio, US vs. UK. • Found that higher relative productivity for US vs. UK associated with higher export volume for US vs. UK in that industry. • In addition found that relative productivity above relative wage associated with higher export volume. • Similar results obtained by Balassa(1963) and Stern (1962)