1

Comparative AdvantageInternational Trade – Session 1

Daniel TRAÇA

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Globalization I: Increased trade in goods and services

Trade has grown faster than GDP

10

15

20

25

30

35

40

1980 1985 1990 1995

Tra

de

(% G

DP

)

World High income Low & middle income

…mostly for East Asia; it has fallen for Africa

0

15

30

45

E-Asia &Pac.

Lat. Am. &Carib.

Mid East, NAf

South Asia Sub-S.Africa

Exp

ort

s (%

GD

P)

1960 1970 1980 1990 1998

• International Trade involves mostly exchanges among high income

countries.

• Developing countries have increased their relevance, particularly

East Asia, but are still a small part.

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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

Share of goods and commercial services in total trade

(Percentages, based on balance of payments data)

Export Shares Import Shares  

GoodsCommercial

Services GoodsCommercial

Services

World 81.4 18.6 81.4 18.6

North America 77.2 22.8 85.9 14.1

Latin America 86.0 14.0 84.1 15.9

Western Europe 78.8 21.2 79.4 20.6

Africa 81.5 18.5 76.8 23.2

Egypt 42.5 57.8 68.2 31.8

Nigeria 93.8 6.2 71.1 28.9

Asia 85.7 14.3 81.3 18.7

India 71.4 28.6 73.4 26.6

Indonesia 92.8 7.2 72.3 27.7

Japan 87.1 12.9 74.8 25.2

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Globalization II: Foreign Investment - complex strategies of multinationals

Global FDI Flows 2000 1995 1990 1985 1980 1975 1970FDI in millions of dollars 1,270,764 331,068 202,297 56,583 54,725 25,850 12,542 FDI per capita (dollars) 210.3 58.8 41.4 12.8 13.6 9.8 5.3FDI as percentage of GDP 3.12 1.13 0.96 0.48 0.52 0.49 0.48FDI as percentage of exports 19.99 6.45 6.05 3.10 2.95 3.33 4.56

Gross foreign direct investment (% of GDP)

0

2

4

6

8

1976 1981 1986 1991 1996

World High income Low & middle income

Share of FDI flows, by group

0%

25%

50%

75%

100%

1980 1985 1990 1995

Low income

Middle income

High income

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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

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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?

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Organization of the course

• 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

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Materials and exams

course 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

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The theory of Comparative Advantage

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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

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Absolute Advantage

Output per worker (productivity)

93SOUTH

810NORTH

Food(bushels)

Manufacturing(pieces)

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Gains from specialization

Output

before after

1 northerner(FOOD to MANUF)

8 Food 10

Manuf

1 southerner(MANUF to FOOD)

3 Manuf 9 Food

• North specializes in Manufacturing and South in Food

• There is more of both goods, if specialization follows absolute advantage

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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

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Output per worker (Productivity)

Manuf(pieces)

Food(bushels)

NORTH 10 10

SOUTH 3 9

Comparative AdvantageNorth is MORE productive in both goods

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Even so, there are gains from specialization

2 x 918 Food

2 x 36

Manuf

2 southerners(Manuf to Food)

 10 Manuf

10 Food

1 northerner(Food to Manuf)

afterbefore

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.

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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?

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In Autarky...

Food

Manuf

North

Northern workerThey 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

Sou

th

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The prices in autarky (closed economy)

The relative price of Manuf (P) denotes how many bushels of Food for one piece of Manuf.

9

10

Food(bushels)

9/3 = 33SOUTH

10/10 = 110NORTH

PManuf

(pieces)

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Relative prices, relative supply, relative demand

1

Manuf/Agro

Relative demand (RDW)It is the same in both countries if preferences are the same

P

Relative Supply(RSN) North PN=

3Relative Supply (RSs)South PS=

[Manuf/Agro]S [Manuf/Agro]N

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In Autarky...

Food

Manuf

North

Northern worker Southern worker

The Northerners trade among them at the autarky price PN = 1

Food

Manuf

South

The Southerners trade among them at the autarky price PS= 3

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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?

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The Production Possibility Frontier and Welfare

NorthManuf

+1

-1

UN

10

10 Agro

The choice of consumers…determines the allocation of labor

MRS =MUFood/ MUManuf = 1/P =1

ProductionPossibility Frontier

-1/PN = -1

Equilibrium P=1, So that both goods are produced

Slope = -ProdF / ProdM

Northern Workers in Agro

No

rth

ern

Wo

rke

rs

in M

an

uf

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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?

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Openness in the Short Run...

Food Food

Manuf Manuf

1 . Trade starts due to arbitrage

2 . Prices adjust to new scarcity

P rises in the North and falls in the South

SouthNorthPS < 9/3PN >10/10

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In the Long-Run, there is re-allocation

Food Food

Manuf Manuf

North SouthEach country specializes

completely in, and exports, the good in which it has comparative advantage

There is one world price, which is between

the initial prices 10/10 < PW <9/3

PS < 9/3PN >10/10

3 . Factors (workers) respond to new prices and profitability -- specialization

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How to determine the world price?

1

3

Manuf/Food

Relative Supply (RSW)World

South produces Food onlyNorth produces both

North produces Manuf onlySouth produces both

Nor

th a

nd S

outh

spe

cial

ize

com

plet

ely

Nor

th a

nd S

outh

pro

duce

on

ly M

anuf

North and South

produce only Food

Relative Demand (RDW)World

1<PW <3

P

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The Gains from Trade according to Comparative Advantage

North South

10

10 Food

Manuf

Food

Manuf

9

3

UN

US

P N =1

P S =3

US(Food)

UN(Manuf)

1<P W <3

1<P W <3

-1/PN

-1/PS

-1/PW

-1/PW

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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?

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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).

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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.

• Consulting• Banking• Telecom’s• Tourism

• Hairdressers• Government services• Auto-repair• Almost all services

Services

• Textiles• Machinery• Almost all goods

• Cement• Housing• McDonalds Hamburger

Goods

TradablesNon-

tradables

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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.