ECONOMICS 3150B Lecture 10 October 25, 2005

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ECONOMICS 3150BLecture 10October 25, 2005
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Basis for Trade

• Differences in relative prices
• P1/P2A ? P1/P2B
• Countries differ
• Resources
• Culture, tastes
• Demographics
• Incentives/motivation
• Differences in availabilities of products (goods,
  services)
• Companies create competitive advantages

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Optimization Solution 2

• Optimal level of production of two products Y1,
  Y2
• Maximize value of output
• Max P1Y1 P2Y2
• S.t. PPF
• PPF and income lines
• Max utility
• Max U(Y1, Y2)
• S.t. PPF
• Solution GE model with perfect competition ? P1,
  P2, C1, C2, Y1, Y2

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Basis for Trade

• Different relative prices
• Different technologies different p.f.,
  different states of technology
• Different relative quantities of factors of
  production
• Different tastes different utility functions
• Absence of perfect competition monopolistic
  markets
• Different products
• Different factors of production
• Absence of perfect competition
• Low trade costs
• Transportation costs
• Trade barriers
• Other hedging, insurance, etc.

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Basis for Trade

• Bottom Line firms produce goods
• Firms need info on products (characteristics,
  p.f.) technology
• Agents need info on relative and absolute prices
  and access to distribution channels in foreign
  countries
• Value chain production of final product entails
  various intermediate stages examples gasoline
  at retail PCs autos
• Trade in intermediate products

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Changes in Relative Prices

• Equilibrium P2/P1 will change if
• Change in shape of PPF
• Change in relative availabilities of X1, X2
• Change in production functions
• Change in state of technology
• Changes in tastes

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Comparative Advantage Models

• 1. Single Factor, Ricardian Model
• Assumptions
• One factor of production X1
• Two goods Y1, Y2
• Constant returns to scale ??Y F(?X1)
• PF Yi ?i1 X1 ?i1 units of product i per
  unit of factor of production 1
• Resulting PPF
• Y1/ ?i1 Y2/ ?21 ? 0X1
• Opportunity cost of Y1 in terms of Y2 ?21/ ?11
• No adjustment problems since sole factor of
  production can move costlessly and
  instantaneously between products

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Single Factor Ricardian Model

• Utility maximization ? optimal production and
  consumption point, P1, P2
• Slope of straight line PFF
• P2/P1
• ?11/ ?21
• Relationship between relative prices and
  opportunity costs

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Single Factor Ricardian Model

• Two countries, two products, one factor of
  production
• Conditions for pre-trade relative prices to
  differ i.e. P1/P2A ? P1/P2B
• Different production functions ?i1(A) ? ?i1(B)
• Different tastes will not produce different
  relative prices
• Comparative advantage
• Country has comparative advantage in product with
  lower relative opportunity cost
• Country A has comparative advantage in product 1
  if
• ?21/ ?11 A lt ?21/ ?11B
• P1/P2A lt P1/P2B

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Single Factor Ricardian Model

• Trade between A and B will equalize relative
  prices ? P1/P2A P1/P2B
• Equilibrium relative prices post-trade between
  original pre-trade ratios
• If A is large country and B a small country,
  equilibrium relative prices post-trade closer to
  pre-trade ratio in A
• Specialization small country, not necessarily
  for large country
• Terms of trade price of exported product
  relative to price of imported product
• For country P1/P2

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Single Factor Ricardian Model

• Gains from trade
• Consumption, production pre-trade and
  post-trade
• Exports, imports
• Higher level of utility, higher level of real
  income/GDP
• Equilibrium in currency market will result in
  current account balance 0
• Total value of exports total value of imports
• D/S of countrys currency depend upon current
  account transactions only
• For Country A P1AEX(Y1) P2BIM(Y2)E
• With no trade costs P1A P1BE and P2A P2BE

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Single Factor Ricardian Model

• Example Canada-US
• Assumptions
• X1 labour measured in person-hours
• W(C) C 10/hr
• W(US) US 10/hr
• E 1.00

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Canada-US Example

• US has absolute advantage in both products
• ?11 (US) gt ?11 (C) and ?21 (US) gt ?21 (C)
• However ?11 / ?21 C gt ?11 / ?21 US
• Relative prices pre-trade
• P1/P2C lt P1/P2US
• P2/P1C gt P2/P1US
• Canada has comparative advantage in Y1, US in Y2
• At E 1 P1CE gt P1US and P2CE gt P2US
• E will have to decrease (depreciation) in order
  for trade to occur
• Limits for new equilibrium E 0.33 ? 0.83
• Relationship to productivity
• Canada exports Y1, imports Y2

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Canada-US Example

• Assume equilibrium E 0.65
• P1CE US 1.30 lt P1US US 1.67 and P2CE US
  6.50 gt P2US US 3.33
• P1C ? and P1US ?
• P2C ? and P2US ?
• Post-trade P1/P2C P1/P2US
• Wage rates do not change in each countrys
  currency, but Canadian wage rate declines in US
• Pre-trade _at_ E1, Canadian wage rate US 10/hr
• Post-trade _at_ E0.65, Canadian wage rate US
  6.50/hr
• Trade occurs even with lower Canadian wage rate ?
  offset by higher productivity of US labour
• Trade costs keep relative and absolute prices
  from equalizing
• Create a wedge large enough, no trade takes
  place (non-traded goods)

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Canada-US Example

• Conclusions
• Extreme degree of specialization
• No impact on distribution of income within each
  country no losers (full employment, one factor
  of production)
• Gains from trade
• No explanation of differences in production
  functions and relative and absolute
  productivities