Extensions and Tests of Classical Model

1
Extensions and Tests of Classical Model

• The classical trade model (Ricardos presentation
  of comparative advantage principle) is very
  simple
• Extensions in this chapter
• keep the straight line ppf - still simplistic
• add transportation costs
• increase the number of goods or countries

2
Introduce price into the model

• Once price is introduced, the condition for
  exporting a good is
• export if the world price is higher than the
  price at home in autarky
• need wage and exchange rate

3
Example

• In table with prices, we see that with trade,
  England will export cloth because it is less
  costly to make and import wine from Portugal
• Portugal would export wine for the same reason

4
Example

• We need to compare the English and Portuguese
  prices
• Exchange rate number of units of one currency
  needed to purchase a second currency
• Example The Canadian U.S. exchange rate is
  about 1.485
• For trade to occur, the Portuguese/British
  exchange rate must lie within a specific range.
• With only two countries and two goods, these
  limits will always hold

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Example

• In this example, assume exchange rate is 1 1
  esc.
• English cloth purchased in Portugal costs 1 esc.
• Portuguese produced cloth costs 1.2 esc
• Portuguese buy cloth from England
• Portuguese wine sold in England costs 2.4
• English wine costs 3
• English buy wine from Portugal
• Wine is more expensive than cloth
• The terms of trade for England are PC /PW 1/2.4

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Exchange rate limits

• How high could the English currency reach with
  England exporting to Portugal? Export condition

• Import condition

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Example

• In example England exports cloth
• 1hr x 1/hr x 1 esc/ lt 2 hrs x 0.6 esc/hr
• England doesnt export wine
• 3 hrs x 1/hr x 1esc/ gt 4 hrs 0.6 esc/hr

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Example

• Limit exchange rate for England to export cloth
  would be
• 1hr x 1/hr x ? esc/ 2 hrs x 0.6 esc/hr
• ? is 1.2
• Limit exchange rate for Portugal to export wine
  is
• 3 hrs x 1/hr x ? 4 hrs x 0.6 esc/hr
• ? is 2.4/3 0.8

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Wage limits

• If the exchange rate is set, then comparative
  advantage tells us the limits on relative wages
  between two countries In example England
  exports cloth
• (1hr / 2) hrs x 1 esc/ lt W (Port)/hr /
  W(Eng) /hr
• Limit for wine
• (3 hrs / 4 hrs) x 1esc/ gt W (Port)/hr / W(Eng)
  /hr
• Wage limits are 0.5 ltWP/WE lt 0.75

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You do find exchange limits
11
More than 2 goods
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Array of goods

• For a lot of goods, we can examine the conditions
  under which a country exports some of the goods
  and imports others
• In general a country exports goods which it can
  produce more cheaply than its competitors - for
  which its domestic price in autarky would be
  lower than the world price
• A country imports goods whose price at home in
  autarky is higher than the price of the good if
  it were imported from another country

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Many goods

• Let z represent and ordering of the goods, with
  z1 as the good with the highest
• Let A(z) a2(z)/a1(z)
• We can draw a graph showing the relationship
  between wages and A(z)
• W1e/W2A(z)
• As in the previous table, A(z) separates the
  goods imported by country 1 from the goods
  imported by country 2 for any relative wage

14
Many goods

• Now to find the equilibrium in the world market,
  we need to look at the distribution of world
  income
• is the fraction of world income spent on
  country 1s goods
• is the fraction of world income spent on
  country 2s goods.
• must add to one

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Many Goods

• Assuming tastes are identical, the income spent
  by country 1 on imports from country 2 is theta 2
  x country 1s income denoted in country 2
  currency
• Income spent by country 2 on imports from country
  1 is

16

• With balanced trade, the amount spent on imports
  must be equal across countries
• Or
• Or

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Many goods

• If z increases, this means the share of world
  income spent on country 1 goods increases, due to
  an increase in world demand. An increase in
  demand for country 1 good leads to a relative
  increase in W1 or e. This relationship produces
  the upward sloping line C

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Example

• W1 3, W2 2, e 1, ?1 0.6 L1 12,000 L2
  8,000
• Assume productivity in country 1 increases. This
  means A(z) shifts up (or right). For any good z,
  coutry 1 would can now increase the wage of its
  workers, recall W1e/W2A(z) a2(z)/a1(z).
• Interpret A(z) as shifting right. This would
  mean that at the original relative wages, with
  the increase in productivity the cost of
  production in country 1 would lead that country
  to be more competitive in a wider range of goods
  that before

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• For the sake of the example, let W14 after the
  increase in productivity.
• On the income side, an increase in A(z) leads to
  a movement to the right along the line C. This
  means that country 1 now receives a larger share
  of world income than before. ?1(z) increases
• We can calculate the increase based on the
  relationship between spending and income. With
  W1e/W22, ?10.75
• So, country 1 has both a higher share of world
  income and higher share of world trade. Does
  this mean country 2 is poorer? ...

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• No. Country 2s real income measured in terms of
  the goods it can buy from country 1 is
• W2L2/(a1(z)W1e)
• If a1 falls, this is measured by the vertical
  increase in A(z). The increase in wage for
  country 1 is W1e/W2, which is smaller than the
  increase in A(z).
• Therefore the purchasing power of country 2
  increases. In a nutshell, they can now buy more
  goods from country 1 than before with their
  earnings.

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You do

• What happens if the population grows in country
  1?
• What happens if country 2 experiences an increase
  in productivity?

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ReviewAA and CA

• Which country has an absolute advantage in the
  production of good 1? good 2?
• Which country has a relative advantage in the
  production of good 1? good 2?

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Transportation Costs

• Transportation costs have two effects
• 1) The relative price of goods in two countries
  need not be exactly equal with trade. The ratio
  in country 1 and country 2 will differ by the
  amount of the transportation cost
• 2) Some goods will become non-traded. If
  transportation costs are too high, the good will
  only be sold in the home market.

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Transportation Costs

• In the example below, the cost of transportation,
  in terms of hours, is added to the number of
  hours required to produce a unit of output, FOR
  exporters.
• This is because the higher price must be paid by
  the importer. If the difference between the cost
  of production in the two countries is not high
  enough to cover the transportation costs, the
  good will NOT be traded. (you do, tr2)

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Example 1

• Good 1 costs 7 hrs in A, 2 hrs in B and 3 hrs if
  produced in B and transported to A
• Good 2 costs 3 hrs in A, 2 hrs in B and 2.5 if
  produced in A and transported to B
• With transportation costs A will export good 2
  and import good 1
• (21)/7lt2/4 (1) lt2/(30.5) or 3/7 lt 2/4 lt 2/3.5
• In money terms ((21)X4)lt(7X2) and ((30.5)X2)lt
  (2X4)

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Example

• (202)/15lt3/2lt 6/ (21) you do

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Example T Costs in

• Good 1 costs 8 (A currency) in country A in
  autarky, 11 (A currency) if produced in A and
  transported to B
• Good 1 costs 15 (A currency) in country B in
  autarky, 18 (A currency) if produced in B and
  transported to A

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Good 2

• Good 2 costs 4 (A curr) if produced consumed
  in A and 4.50 (A curr) if produced in A and
  consumed in B
• Good 2 costs 5 (A curr) if produced consumed
  in B and 5.50 (A curr ) if produced in B and
  consumed in A

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Multiple Countries

• For more than two countries, there will be a
  clear exporter and a clear importer for each
  good.
• In the following table, Sweden and France
  represent two extremes for comparative advantage,
  Germany is in the mid-range
• Sweden definitely imports fish, France
  definitely imports cutlery

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Multiple Countries

• Recall The Ricardian (or classical) model does
  NOT include demand considerations
• Now If the world price fell between
  
• Germany would export fish and import cutlery
• If world price fell between
• Germany would export cutlery and import fish

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Testing the Classical Model

• Two types of tests
• 1. McDougal (1951), Stern (1962) and Balassa
  (1963) - tested U.S. and U.K. data
• - hypothesis - in industries where U.S. had
  higher labour productivity, U.S should be a net
  exporter (similar for U.K.)
• - hypothesis confirmed
• 2. Golub - looked at data by industry, found
  other countries unit labour costs clustered
  around U.S. unit labour costs (more productive
  higher wage)
• - also found where unit labour costs higher,
  country is a net importer.

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Chapter 5

• No graphs on computer yet
• - individual indifference curves - NEVER cross
• community indifference curves
• distribution of income important - each curve
  drawn for a particular income distribution
• can cross when change in prices change the income
  distribution
• Budget constraint - consumer equilibrium