Econ 355 1 The Pattern of Trade (who sells what to whom?) Differences in Technology determine the trade pattern-Ricardian Model Differences in Technology

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The Pattern of Trade (who sells what to The Pattern of Trade (who sells what to whom?)whom?)

Differences in Technology determine the trade Differences in Technology determine the trade pattern-Ricardian Modelpattern-Ricardian Model

Climate and resources determine the trade Climate and resources determine the trade pattern of several goods-Heckesher-Ohlin Modelpattern of several goods-Heckesher-Ohlin Model

Economies of ScaleEconomies of Scale

The The Ricardian modelRicardian model is based on is based on technological differences across countries.technological differences across countries.

These technological differences are reflected in These technological differences are reflected in differences in the productivity of labor.differences in the productivity of labor.

International Trade between International Trade between Countries (T-2)Countries (T-2)

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Lay Out followed for all the Trade Lay Out followed for all the Trade ModelsModels

ConceptsConcepts Story for a single countryStory for a single country

• Under Autarky (No Trade)Under Autarky (No Trade) Introducing Trade between two Introducing Trade between two

countriescountries• Pattern of TradePattern of Trade• Gains or Losses from trade?Gains or Losses from trade?• Comparative AnalysisComparative Analysis

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The Gains from TradeThe Gains from Trade• Many people are skeptical about importing Many people are skeptical about importing

goods that a country could produce for itself.goods that a country could produce for itself.• When countries sell goods to one another, When countries sell goods to one another,

countries do benefit.countries do benefit.• Trade and income distributionTrade and income distribution

International trade might hurt some groups within International trade might hurt some groups within nations.nations.

Trade and wages of high and low-skilled workers.Trade and wages of high and low-skilled workers.

International Trade International Trade

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On Valentine’s Day say the demand for roses is On Valentine’s Day say the demand for roses is about 10 million roses.about 10 million roses.

Growing roses in Canada in the winter is difficult.Growing roses in Canada in the winter is difficult.• Heated greenhouses should be used.Heated greenhouses should be used.• The costs for energy, capital, and labor are The costs for energy, capital, and labor are

substantial.substantial. Resources for the production of roses could be Resources for the production of roses could be

used to produce other goods, say computers.used to produce other goods, say computers.Opportunity CostOpportunity Cost

• The opportunity cost of roses in terms of The opportunity cost of roses in terms of computers is the number of computers that computers is the number of computers that could be produced with the same resources as could be produced with the same resources as a given number of roses.a given number of roses.

The Concept of The Concept of Comparative AdvantageComparative Advantage

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Comparative Advantage - A country has a comparative Comparative Advantage - A country has a comparative advantage in producing a good if the opportunity cost advantage in producing a good if the opportunity cost of producing that good in terms of other goods is lower of producing that good in terms of other goods is lower in that country than it is in other countries.in that country than it is in other countries.

Suppose that in the Canada 10 million roses can be Suppose that in the Canada 10 million roses can be produced with the same resources as 100,000 computers.produced with the same resources as 100,000 computers.

Suppose also that in Mexico 10 million roses can be Suppose also that in Mexico 10 million roses can be produced with the same resources as 30,000 computers.produced with the same resources as 30,000 computers.

This example assumes that Canada has advanced This example assumes that Canada has advanced technology / Mexican workers are less productive than technology / Mexican workers are less productive than Canada workers.Canada workers.


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If each country specializes in the If each country specializes in the production of the good with lower production of the good with lower opportunity costs, trade can be beneficial opportunity costs, trade can be beneficial for both countries.for both countries.• Roses have lower opportunity costs in Mexico.Roses have lower opportunity costs in Mexico.• Computers have lower opportunity costs in the Computers have lower opportunity costs in the

U.S.U.S.

The benefits from trade can be seen by The benefits from trade can be seen by considering the changes in production of considering the changes in production of roses and computers in both countries.roses and computers in both countries.


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Hypothetical Changes in ProductionHypothetical Changes in Production

The Concept of Comparative Advantage

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The example in Table 2-1 illustrates the The example in Table 2-1 illustrates the principle of comparative advantage: principle of comparative advantage: • If each country exports the goods in which it has If each country exports the goods in which it has

comparative advantage (lower opportunity costs), comparative advantage (lower opportunity costs), then all countries can in principle gain from trade.then all countries can in principle gain from trade.

What determines comparative advantage? What determines comparative advantage? • Answering this question would help us Answering this question would help us

understand how country differences determine understand how country differences determine the pattern of trade (which goods a country the pattern of trade (which goods a country exports).exports).


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A One-Factor EconomyA One-Factor Economy Assume that we are dealing with an Assume that we are dealing with an

economy (which we call Home). In this economy (which we call Home). In this economy:economy:• Labor is the only factor of production.Labor is the only factor of production.• Only two goods (say wine and cheese) are Only two goods (say wine and cheese) are

produced.produced.• The supply of labor is fixed in each country.The supply of labor is fixed in each country.• The productivity of labor (Techonology) in each The productivity of labor (Techonology) in each

good is fixed.good is fixed.• Perfect competition prevails in all markets. Perfect competition prevails in all markets.

The economy’s total resources are defined The economy’s total resources are defined as as LL, the total labor supply (e.g. if , the total labor supply (e.g. if LL = 120, = 120, then this economy is endowed with 120 then this economy is endowed with 120 hours of labor or 120 workers).hours of labor or 120 workers).

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The constant labor productivity is The constant labor productivity is modeled with the specification of unit modeled with the specification of unit labor requirements:labor requirements:• The The unit labor requirementunit labor requirement is the is the

number of hours of labor required to number of hours of labor required to produce one unit of output.produce one unit of output.

Denote with Denote with aaLWLW the unit labor requirement for the unit labor requirement for wine (e.g. if wine (e.g. if aaLWLW = 2, then one needs 2 hours of = 2, then one needs 2 hours of labor to produce one gallon of wine).labor to produce one gallon of wine).

Denote with Denote with aaLCLC the unit labor requirement for the unit labor requirement for cheese (e.g. if cheese (e.g. if aaLCLC = 1, then one needs 1 hour of = 1, then one needs 1 hour of labor to produce a pound of cheese).labor to produce a pound of cheese).

A One-Factor EconomyA One-Factor Economy

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• The The production possibility frontierproduction possibility frontier (PPF) of (PPF) of an economy shows the maximum amount of a an economy shows the maximum amount of a good (say wine) that can be produced for any good (say wine) that can be produced for any given amount of another (say cheese), and vice given amount of another (say cheese), and vice versa.versa.

• The PPF of our economy is given by the following The PPF of our economy is given by the following equation:equation:

aaLCLCQQCC + + aaLWLWQQWW = = LL

LLCC + L + LWW = 120 = 120• From our previous example, we get:From our previous example, we get:

QQCC + 2 + 2QQWW = 120 = 120

A One-Factor EconomyA One-Factor Economy

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L/aLW

L/aLC

Figure 2-1Figure 2-1: Home’s Production Possibility Frontier: Home’s Production Possibility Frontier

A One-Factor Economy

Absolute value of slope equalsopportunity cost of cheese interms of wine

F

P

Home wine production, QW, in gallons

Home cheese production, QC, in pounds

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Denote with Denote with PPCC the dollar price of cheese; the dollar price of cheese; PPWW -dollar -dollar price of wine; price of wine; wwWW -dollar wage in the wine industry -dollar wage in the wine industry; ; wwCC -dollar wage in the cheese industry. -dollar wage in the cheese industry.

Then under perfect competition, the non-negative Then under perfect competition, the non-negative profit condition impliesprofit condition implies::

Value of marginal productivity of labour Value of marginal productivity of labour (vmpL)=wages, in a sector: VMPL=W(vmpL)=wages, in a sector: VMPL=W

Marginal Productivity-how much one person-hour Marginal Productivity-how much one person-hour can produce=1/ can produce=1/ aaLWLW

Value of marginal productivity=Price of wine * how Value of marginal productivity=Price of wine * how much one unit of labour (person-hour) can produce.much one unit of labour (person-hour) can produce.

• ((PPWW / / aaWW ) )


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• Then under perfect competition, the non-negative profit Then under perfect competition, the non-negative profit condition implies:condition implies:

If If PPWW / / aaWW < < wwWW, then there is no production of , then there is no production of QQWW.. If If PPWW / / aaWW = = wwWW, then there is production of , then there is production of QQWW..

If If PPCC / / aaCC < < wwCC, then there is no production of , then there is no production of QQCC..

If If PPCC / / aaCC = = wwCC, then there is production of , then there is production of QQCC..

• The above relations imply that if the relative price of cheese The above relations imply that if the relative price of cheese

((PPCC / / PPWW ) exceeds its opportunity cost ( ) exceeds its opportunity cost (aaLCLC / / aaLWLW), then the ), then the

economy will specialize in the production of cheese.economy will specialize in the production of cheese.

• In the absence of trade, both goods are produced, and In the absence of trade, both goods are produced, and

therefore therefore PPCC / / PPWW = = aaLCLC / /aaLWLW..


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In the absence of trade, both goods are In the absence of trade, both goods are produced, and therefore produced, and therefore PPCC / / PPWW = = aaLCLC / /aaLWLW..

Diagram: showing the PPF, the opportunity Diagram: showing the PPF, the opportunity cost, the price.cost, the price.

The above relations imply that if the relative The above relations imply that if the relative

price of cheese (price of cheese (PPCC / / PPWW ) exceeds its ) exceeds its

opportunity cost (opportunity cost (aaLCLC / / aaLWLW), then the economy ), then the economy

will specialize in the production of cheese.will specialize in the production of cheese.


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Ricardian Model: Trade in a One-Ricardian Model: Trade in a One-Factor WorldFactor World

• Assumptions of the model about the Assumptions of the model about the world:world:

There are two countriesThere are two countries Labor is not mobile across the two countries.Labor is not mobile across the two countries. Perfect competition prevails in all markets.Perfect competition prevails in all markets. All variables with an asterisk refer to the All variables with an asterisk refer to the

Foreign country.Foreign country.

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The following table describes the technology of the two counties:

Table 2-2: Unit Labor Requirements

TRADE in a One-Factor WorldTRADE in a One-Factor World

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• A country has an absolute advantage in A country has an absolute advantage in a production of a good if it has a lower a production of a good if it has a lower unit labor requirement than the foreign unit labor requirement than the foreign country in this good.country in this good.

aaLCLC < < aa**LCLC and and aaLWLW < < aa**

LWLW

• Home is more productive in the production of Home is more productive in the production of both goods than Foreign.both goods than Foreign.

• Absolute Advantage in both goodsAbsolute Advantage in both goods

• Even if Home has an absolute advantage in Even if Home has an absolute advantage in both goods, both goods, beneficial trade is possible in beneficial trade is possible in this casethis case..

• The pattern of trade will be determined by The pattern of trade will be determined by the concept of the concept of comparative advantagecomparative advantage..

Trade in a One-Factor WorldTrade in a One-Factor World

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Comparative AdvantageComparative Advantage• aaLCLC / /aaLWLW < < aa**

LCLC / /aa**LWLW (2-2)(2-2)

This implies that the opportunity cost of cheese in This implies that the opportunity cost of cheese in terms of wine is lower in Home than it is in Foreign.terms of wine is lower in Home than it is in Foreign.

In other words, in the absence of trade, the relative In other words, in the absence of trade, the relative price of cheese at Home is lower than the relative price of cheese at Home is lower than the relative price of cheese at Foreign.price of cheese at Foreign.

Home has a comparative advantage in Home has a comparative advantage in cheese and will export it to Foreign in cheese and will export it to Foreign in exchange for wine, wine is cheaper in the exchange for wine, wine is cheaper in the foreign country.foreign country.


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Labour Labour UnitsUnits

Unit L RUnit L R CheeseCheese WineWine

HomeHome 120120 aaLCLC =1 =1

aaLW LW =2=2

Max-120Max-120 Max-60Max-60

ForeignForeign 360360 a*a*LCLC =6 =6

a*a*LW LW =3=3

Max-60Max-60 Max-120Max-120

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F*

P*

L*/a*LW

L*/a*LC

Foreign wine production, Q*

W, in gallons

Foreign cheese production, Q*

C , in pounds

+1

Figure 2-2: Foreign’s Production Possibility Frontier


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• Determining the Relative Price After Determining the Relative Price After TradeTrade

What determines the relative price What determines the relative price (e.g., (e.g., PPCC / / PPWW) after trade? ) after trade? • To answer this question we have to define the To answer this question we have to define the

relative supply and relative demand for cheese in relative supply and relative demand for cheese in the world as a whole.the world as a whole.

• The The relative supplyrelative supply of cheese equals the total of cheese equals the total quantity of cheese supplied by both countries at quantity of cheese supplied by both countries at each given relative price divided by the total each given relative price divided by the total quantity of wine supplied, (quantity of wine supplied, (QQCC + + QQ**

CC )/()/(QQWW + + QQ**WW).).

• The The relative demandrelative demand of cheese in the world is a of cheese in the world is a similar concept.similar concept.


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2RDPrice after trade

1

aLC/aLW=1/2

a*LC/a*

LW

=2

RS

Figure 2-3Figure 2-3: World Relative Supply and Demand: World Relative Supply and Demand

Trade in a One-Factor World

Relative priceof cheese, PC/PW

Relative quantityof cheese, QC + Q*

C

QW + Q*W

L/aLC

L*/a*LW

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The Gains from TradeThe Gains from Trade• If countries specialize according to If countries specialize according to

their comparative advantage, they all their comparative advantage, they all gain from this specialization and trade.gain from this specialization and trade.

• We will demonstrate these gains from We will demonstrate these gains from trade in two ways.trade in two ways.

• First, we can think of trade as a new First, we can think of trade as a new way of producing goods and services way of producing goods and services (that is, a new technology).(that is, a new technology).


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Second expansion of consumption possibilitySecond expansion of consumption possibility• The consumption possibility frontier states the The consumption possibility frontier states the

maximum amount of consumption of a good a maximum amount of consumption of a good a country can obtain for any given amount of the country can obtain for any given amount of the other commodity.other commodity.

• No trade, the consumption possibility curve = No trade, the consumption possibility curve = production possibility curve.production possibility curve.

• Trade enlarges the consumption possibility for Trade enlarges the consumption possibility for each of the two countries.each of the two countries.

The previous numerical example implies that:The previous numerical example implies that: aaLCLC / / a aLWLW = 1/2 < = 1/2 < aa**

LCLC / / a a**LWLW = 2 = 2

• In world equilibrium, the relative price of cheese In world equilibrium, the relative price of cheese must lie between these values. Assume that must lie between these values. Assume that PPcc//PPWW = 1 gallon of wine per pound of cheese. = 1 gallon of wine per pound of cheese.


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2RDPrice after trade

1

aLC/aLW=1/2

a*LC/a*

LW

=2

RS

Figure 2-3Figure 2-3: World Relative Supply and Demand: World Relative Supply and Demand


Relative priceof cheese, PC/PW

Relative quantityof cheese, QC + Q*

C

QW + Q*W

L/aLC

L*/a*LW

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Figure 2-4Figure 2-4: Trade Expands Consumption Possibilities: Trade Expands Consumption Possibilities

T

F

P

T*P*

F*

(a) Home (b) Foreign

Quantityof wine, QW

Quantityof cheese, QC

Quantityof wine, Q*

W

Quantityof cheese, Q*

C

T*

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Figure 2-4Figure 2-4: Trade Expands Consumption Possibilities: Trade Expands Consumption Possibilities

T

F

P

T*P*

F*

(a) Home (b) Foreign

Quantityof wine, QW

Quantityof cheese, QC

Quantityof wine, Q*

W

Quantityof cheese, Q*

C

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• Home can use one hour of labor to Home can use one hour of labor to produce 1/produce 1/aaLWLW = 1/2 gallon of wine if it = 1/2 gallon of wine if it does not trade.does not trade.

• Since the world price of wine is Since the world price of wine is PPWW / / PPCC = 1 = 1 pound of cheese per gallon. The country pound of cheese per gallon. The country can trade at this pricecan trade at this price

• Alternatively, it can use one hour of labor Alternatively, it can use one hour of labor to produce 1/to produce 1/aaLCLC = 1 pound of cheese, sell = 1 pound of cheese, sell this amount to Foreign, and obtain 1 this amount to Foreign, and obtain 1 gallon of wine.gallon of wine.


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Relative WagesRelative Wages• Because there are technological Because there are technological

differences between the two countries, differences between the two countries, trade in goods does not make the wages trade in goods does not make the wages equal across the two countries.equal across the two countries.

• A country with absolute advantage in A country with absolute advantage in both goods will enjoy a higher wage both goods will enjoy a higher wage after trade.after trade.


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Productivity and CompetitivenessProductivity and Competitiveness• Myth 1: Free trade is beneficial only if a country Myth 1: Free trade is beneficial only if a country

is strong enough to withstand foreign is strong enough to withstand foreign competition.competition.

This argument fails to recognize that trade is based This argument fails to recognize that trade is based on comparative not absolute advantage.on comparative not absolute advantage.

The Pauper Labor ArgumentThe Pauper Labor Argument• Myth 2: Foreign competition is unfair and hurts Myth 2: Foreign competition is unfair and hurts

other countries when it is based on low wages.other countries when it is based on low wages. Again in our example Foreign has lower wages but Again in our example Foreign has lower wages but

still benefits from trade.still benefits from trade.

Misconceptions AboutMisconceptions About Comparative Advantage Comparative Advantage

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Adding Transport CostsAdding Transport Costs and Nontraded Goods and Nontraded Goods

There are three main reasons why There are three main reasons why specialization in the real international specialization in the real international economy is not extreme:economy is not extreme:

• The existence of more than one factor of The existence of more than one factor of production.production.

• Countries sometimes protect industries from Countries sometimes protect industries from foreign competition.foreign competition.

• It is costly to transport goods and services.It is costly to transport goods and services. The result of introducing transport costs The result of introducing transport costs

makes some goodsmakes some goods nontraded nontraded.. In some cases transportation is virtually In some cases transportation is virtually

impossible.impossible.• ExampleExample: Services such as haircuts and auto : Services such as haircuts and auto

repair cannot be traded internationally.repair cannot be traded internationally.

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Empirical EvidenceEmpirical Evidence on the Ricardian Model on the Ricardian Model

Figure 2-6: Productivity and ExportsA comparative study shows that U.S. exports in industries in which the

U.S had higher relative labour productivity. Dot-Industry

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SummarySummary We examined the Ricardian model, the We examined the Ricardian model, the

simplest model that shows how differences simplest model that shows how differences between countries give rise to trade and between countries give rise to trade and gains from trade.gains from trade.

In this model, labor is the only factor of In this model, labor is the only factor of production and countries differ only in the production and countries differ only in the productivity of labor in different industries.productivity of labor in different industries.

In the Ricardian model, a country will export In the Ricardian model, a country will export that commodity in which it has comparative that commodity in which it has comparative (as opposed to absolute) labor productivity (as opposed to absolute) labor productivity advantage.advantage.

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Extending the one-factor, two-good Extending the one-factor, two-good model to a world of many model to a world of many commodities makes it possible to commodities makes it possible to illustrate that transportation costs illustrate that transportation costs can give rise to the existence of can give rise to the existence of nontraded goods.nontraded goods.

SummarySummary

Documents

Econ 355 1 The Pattern of Trade (who sells what to whom?) Differences in Technology determine the trade pattern-Ricardian Model Differences in Technology