lecture 3

Econ 102 --- The World Economy

Simon Fraser University

Summer 2015

Instructor: Yang Wang

Topic 3: Comparative Advantage and the Gains from Trade

Outline:

• Why countries trade? • Ricardian model • Absolute advantage/comparative advantage • The gains from trade

The World Economy 2

Why countries trade? • Differences in technology

– technology refers to the techniques used to turn input into output

• Differences in resource endowment • Differences in demand/preference • Existence of economies of scale in production

– economies of scale, aka increasing return to scale, refer to a production process in which production costs fall as the scale of production rises

• Existence of government policies

Above 5 reasons lead to: • Price difference: Example:

– suppose • two countries: country A & B • One good • Prices: PA > PB

• Transport cost between countries: c

– If prices differ by more than transport costs, that is, PA – PB > c • Buyers in country A (high-price country) will import • Sellers in country B (low-price country) will export • Anyone who buy a good in country b(low-price country), transport the good, and then sell it in country A (high-price

country) will make a profit.

– If PA – PB < c, no trade

• Difference in supply and demand – Imports enable a country to obtain goods that it cannot make itself or can make only at very high costs

The World Economy 3

What determines prices?

• Prices are determined by: – Productivity of labor (and other factors)

• Productivity: The amount of output obtained from a unit of input

• Labor productivity = (units of output) / (hours worked) If two loaves of bread can be produced in 1 hour, productivity = (2

loaves) / (1 hour)

– Price of labor: wage (w) – Exchange rate: E (prices of currencies)

• price of good = w * E / productivity For example, a worker in Canada can produce 3 goods in an hour, his wage is CAD15, and CAD 1 = USD 0.8, then the price of the good in USD =15*0.8/3=4

• Increasing productivity, reducing workers’ wage, or currency depreciation will lower the country’s price.

The World Economy 4

Ricardian Model:

• Assumptions:

– Two outputs

– Production uses labor only – Goods Markets are perfect competitive: Firms are price takers – Static world: Technology is constant (constant returns to scale)

and there are no learning effects “constant” here means labor productivity doesn’t vary with output – Labor is perfectly mobile between industries but perfectly

immobile across national borders. – Workers are fully employed – No transportation or trade costs.

The World Economy 5

• named after economist David Ricardo (1772-1823)

Ricardian Model:

The World Economy 6

• Absolute advantage: the advantage held by a country that produces more of a certain good per hour worked than another country.

• Gains from Trade : the improvement in national welfare.

The model • Two countries: US & Canada • Two goods: bread & shoes • Barter economy (no money, exchange article by article)

• US has absolute advantage in making bread. • Canada has absolute advantage in producing shoes.

US Canada

Labor endowment (# of workers) 10 10

Total output bread 100 50

shoes 50 100

Productivity (output per worker)

bread 10 5

shoes 5 10

Ricardian Model: • Autarky: no trade (countries can only consume the good they produce at home)

• Suppose that they both completely specialize (i.e., US produces only bread and Canada only shoes)

– Trade permits consumption to be higher, of both goods, in both countries!

– Both countries gain from trade.

The World Economy 7

US Canada

Labor allocation bread 4 6

shoes 6 4

Output = consumption bread 40 30

shoes 30 40

US Canada


shoes 0 10

output bread 100 0

shoes 0 100

Possible consumption with free trade (when trade price of bread = 1 pair of shoes)

bread 50 50

shoes 50 50

Ricardian Model:

The World Economy 8

• Question: What happens if a country does not have an absolute advantage in anything?

Now US has absolute advantage in both goods.

• Opportunity cost: the value of of the best alternative forgone Opportunity cost (relative price) of bread in the U.S. is 0.5 pairs of shoes. Opportunity cost (relative price) of bread in Canada is 2 pairs of shoes.

US Canada

Labor endowment (# of workers) 10 20

Total output bread 100 40

shoes 50 80

Productivity (output per worker)

Bread 10 2

shoes 5 4

bread

US

bread

Canada

5 pairs of shoes pairsP 0.5

10 loaves of bread loaves

4 pairs of shoes pairsP 2

2 loaves of bread loaves

Ricardian Model:

The World Economy 9

• Comparative advantage: the advantage held by a country that the opportunity costs of producing a good are lower than those of its trading partners.

• In this model,

• US has comparative advantage in making bread.

• Canada has comparative advantage in producing shoes.

bread bread shoes shoes

US Canada US CanadaP < P and P > P

Ricardian Model: • Autarky: no trade

• With trade, US produces only bread and Canada only shoes

• Answer: Even if a country does not have any goods with an absolute advantage, it can still benefit from trade.

The World Economy 10

US Canada


shoes 6 8

Output = consumption bread 40 24

shoes 30 32

US Canada


shoes 0 20

output bread 100 0

shoes 0 80

Possible consumption with free trade (when trade price of bread = 1 pair of shoes)

bread 60 40

shoes 40 40

Ricardian Model:


• This is a very simply model.

• It does generalize to:

• Many goods

• Many countries

• Many other assumptions can also be relaxed

• What’s omitted in this model?

– Money (wage, exchange rate, output price)

• Even if a low productivity country does not have an absolute advantage in anything, it can still compete in world market, because of its low wage and/or low value of its currencies

• High wage/high value of currency country can still compete in world market, because of its high productivity.

Absolute/comparative advantage: • Absolute advantage is having a higher labor productivity than the other

country. • comparative advantage focuses on differences in ability to produce goods.

A country has comparative advantage in a good if its relative cost of producing the good is lower than the other country’s. – note: this comparison should be done in autarky.

• For the purposes of trade, what matters most is a NOT country’s absolute advantage, but rather its comparative advantage.

• Let Ecg denote the productivity (output per unit of input) in good g in country c

• Then, country 1 has an absolute advantage in producing good 1 if E11 > E21 • country 1 has a comparative advantage in producing good 1 if

• The equilibrium trade price of good 1 is within the range (E12 /E11, E22 /E21) • For any price out of the range, no trade will take place.


12 22

11 21

< E E

E E

Absolute/comparative advantage: • Example

• Given data on labor productivities (outputs per unit worker), Country A

has absolute advantage in both goods since 800 > 400 and 10 > 6

• Country A has comparative advantage in apple since

• Country B has comparative advantage in phone since

• The range of the equilibrium trade price of apple: (0.0125, 0.015)

• The range of the equilibrium trade price of phone: (66.67, 80) The World Economy 13

Output per unit labor country

A B

good apple 800 400

phone 10 6

400 800 i.e., 66.67 < 80

6 10

10 6< i.e., 0.0125 < 0.015

800 400

Absolute/comparative advantage:

• Even if a country has no absolute advantage in anything, comparative advantage can help promote development. – Case study: South Korea

• Comparative advantage v.s. competitive advantage – Comparative advantage = competitive advantage when the prices of

both inputs and outputs are an accurate indication of their relative scarcity

– Comparative advantage ≠ competitive advantage when the markets fail to correctly value the price of inputs and outputs.

undervaluation/overvaluation result from

• Inherent difficulties in measuring its true value/cost of production

• government policies, such as subsidies or protection

– the interest of business enterprises ≠ the interests of nation (profit) (efficient resource allocation)


Gains from Trade • Sources of grains from trade:

– Gains analogous to how individuals gain from trade

– sources of gain which are not in this model

• Differences in tastes

• Economies of scale

– Other social benefits: reduced child mortality, increased education, and …

• There are losers from trade.

Economic restructuring: Changes in the economy that may require some industries to grow and others to shrink or disappear

– In our Ricardian model, trade opening in the U.S. moved labor from shoes to bread production (assumption: labor is perfectly mobile between industries)

– But in real world, labor is NOT perfectly mobile between industries in the short run. Restructuring made some industries disappear, and hurt some individuals benefits.

– If trade results in net gain (in an increase of the consumption bundle), a country as a whole will be better off by trading. Restructuring improves overall economic welfare.

• In general, gains from trade outweigh the losses (especially from comparative Advantage).


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