BA 187 International Trade

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BA 187 International Trade

• Ricardo and Comparative Advantage The Classical
  Model of Trade

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Issues in International Trade

• Initial attempt to understand two of the
  important issues in trade theory.
  
• Gains from Trade
• Pattern of Trade
• Use insight of Adam Smith about different
  advantages in production across countries.
  
• Focus on comparative, rather than absolute,
  advantage as source of pattern gains from trade

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Classical Model Assumptions

• Fixed endowment of labor in each country.
• Labor completely mobile within a country.
• Labor completely immobile between countries.
• Commodity value determined by labor content.
• Technology fixed but differs across countries.
• Prodn costs constant, do not depend on
  quantity.
  
• Full employment of labor, perfect competition.
• No tariffs or transportation costs.
• Two country, two commodity world.

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Constant Cost Technology

• Ricardo (1817) viewed mutual gains from trade
  possible based on comparative advantage.
  
• Example above Portugal has absolute advantage in
  both goods, but trade still possible as England
  is relatively more productive in cloth than wine.

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Absolute vs. Comparative Advantage

• Absolute Advantage
• A country has an absolute advantage in good X if
  one unit of labor produces more X than is
  produced by one unit of labor in the other
  country.
• Comparative Advantage
• A country has an comparative advantage in good X
  if its opportunity cost of X in terms of Y is
  less than in the other country
  
• In previous example Portugal has an absolute
  advantage in both goods but a comparative
  advantage in wine.

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Opportunity Costs and Advantage

• Comparative advantage arises from differing
  opportunity costs across countries.
  
• With total labor fixed, producing more of one
  good (Cloth) means producing less of other good
  (Wine).
  
• Tradeoff is opportunity cost and differs between
  the two countries.
  
• England
• 1 more unit of cloth requires giving up 5/6 unit
  of wine.
  
• Portugal
• 1 more unit of cloth means giving up 4/3 units of
  wine.
  
• Englands comparative advantage is producing
  cloth, while Portugals comparative advantage is
  in producing wine.

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Ricardian Comparative Advantage

• Assume each country has 120 units of labor.
• Table shows all feasible combinations of cloth
  and wine for each country in autarky.

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Gains from Trade

• Now trade opens with terms of trade equal to
  1W1C
  
• England specializes. Produces only cloth.
• England exports cloth to Portugal in exchange for
  imports of wine.
  
• At least as well off as in autarky.
• Same results for Portugal. Mutual gains from
  trade.

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Relative Wages

• Assume unit of cloth unit of wine sell for
  12.
  
• After trade
• English workers specialize in cloth, receive
  1.20/hr (12 for 10 hrs work)
  
• Portuguese workers specialize in wine, receive
  2.00/hr (12 for 6 hours work)
  
• Relative wage of English workers is 60 of that
  of Portuguese workers.
  
• Note English workers are
• 50 as productive as Portuguese workers in wine
  and
  
• 80 as productive as Portuguese workers in cloth
• Relative wage lies between these two
  productivities.

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BA 187 International Trade

• Visualizing Comparative Advantage

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Visualizing Comparative Advantage

• Rather than rely on numerical examples can
  develop model visually to demonstrate results.
  
• Technology (Constant Costs)
• aLX units of labor for 1 unit of X. (aLX for
  foreign)
  
• aLY units of labor for 1 unit of Y. (aLY for
  foreign)
  
• aLXqX aLYqY Ltotal (aLXqX aLYqY
  Ltotal)
  
• Tastes
• Each country possesses community indifference
  curves, UH for Home and UF for foreign.
  
• Maximize utility subject to production
  constraints determined by technology and labor
  endowment.

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Equilibrium in Autarky
Y
Y
Home
Foreign
aLX/ aLY X
X
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Prices, Wages Production

• Prices, Wages, Production
• Let PX and PY be the price of each good.
• Perfect competition implies wage to worker equals
  value of output produced, PX/aLX or PY/aLY
  
• Labor mobility implies
• If PX/aLX PY/aLY, or equivalently when PX/ PY
  aLX /aLY then economy produces only X.
  
• If PX/aLX
  
• In autarky, economy must produce both goods so
  relative prices of goods must equal their
  relative unit labor requirements, i.e. px PX/
  PY aLX /aLY.

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Potential Gains from Trade
Y
Y
Home
Foreign
X
X
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Equilibrium and Trade
Equilibrium occurs at relative price that makes
the two triangles equal
Y
Y
Home
Foreign
QF
L/aLY
L/aLY
CF
AF
CH
UF
UH
UF
AH
UH
QH
X
L/aLX
L/aLX
X
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Determining Terms of Trade

• How can we determine exactly what the relative
  price will be in equilibrium with trade?
  
• Terms of trade for a country
• Ratio of the price of its export commodity to the
  price of its import commodity.
  
• In our example, terms of trade for Home are
  PX/PY, and PY/PX for Foreign.
  
• Number of analytical tools to determine the
  equilibrium relative price ratio with trade.
  
• KO focus on Relative Demand and Supply analysis.

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Relative Demand and Supply

• Relative analysis focuses on ratio of prices
  PX/PY ratio of total quantities (qX qX)/(qY
  qY).
  
• Relative Demand
• Rise in PX/PY makes X more expensive relative to
  Y.
  
• Substitution away from X towards Y, leads to
  downward-sloping Relative Demand Curve, RD.
  
• Relative Supply
• If PX/PY
• If PX/PY aLX /aLY Home produces X as
  demanded.
  
• If aLX /aLY PX/PY aLX /aLY Home
  specializes in X.
  
• If PX/PY aLX /aLY Both Home Foreign
  produce X.
  

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Relative Demand and Supply
Relative Price of X
PX/PY
Relative Quantity of X
(qX qX)/(qY qY)
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BA 187 International Trade

• Summary of Results from the Classical Model of
  Trade

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Results of Trade

• Mutual Gains from Trade
• Trade enlarges the range of consumption choices
  for each nation over autarky.
  
• Absolute vs. Comparative Advantage
• Gains arise from specializing in producing goods
  in which have a comparative (not absolute)
  advantage.
  
• Trade Specialization
• Expect trade to lead nation to specialize in
  prodn.
  
• Relative Wages
• What matters for trade is relative wage versus
  relative labor productivities.

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Shortcomings of Ricardo Model

• Classical approach has serious shortcoming, in
  that it assumes rather than explains comparative
  advantage.
  
• Classical model does not explain why labor
  productivities differ between nations. It is
  these differences which are the source of
  comparative advantage.
• Ignores how relative resource endowments change
  as countries grow (constant costs assumption).
  
• Benefits of trade come from more efficient use of
  domestic resources through specialization.
  
• Specialization can have negative aspects if it
  results in a lopsided pattern of growth within a
  developing country.
  
• May produce an export enclave rather than a
  well-balanced economy.

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Statements to Address

• Productivity Competitiveness
• Free trade is beneficial only if your country is
  strong enough to stand up to foreign
  competition.
  
• Pauper Labor
• Foreign competition is unfair and hurts other
  countries when it is based on low wages.
  
• Exploitation
• Trade exploits a country and makes it worse off
  if its workers receive much lower wages than
  workers in other countries.
  
• Specialization
• There cannot be distinct roles within Mercosur,
  with one country producing primary products while
  another is industrialized Fernando de la Rita,
  Presidential Candidate Argentina

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BA 187 International Trade

• Appendix Small Country vs. Large Country Gains
  from Trade

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Does Trade Exploit Small Nations?

• Examine effects of opening trade between a large
  economy and a small economy. (Think NAFTA)
  
• Is it true that the large nation will use its
  economic clout to exploit the small nation?
  
• Next slide examines this case.
• SC Small Country, LC Large Country
• Begin with both nations in autarky, ASC and
  ALC.
  
• Open trade, change relative prices to find
  equilibrium (equal trade triangles) between the
  countries.
  
• Equilibrium with trade (Consumption, Production)
  given by (CSC, QSC) and (CLC, QLC)
  
• Surprising results for Small vs. Large Country.

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Large/Small Country
Y
Small Country SC
Large Country LC
LC consumption point in autarchy trade
CLC
CSC
ULC
ASC
X
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Summary of Small vs. Large Country

• Small Economy
• Receives maximum gains available by opening
  trade.
  
• As a price-taker, it trades at the relative
  prices set by the large economy.
  
• Completely specializes in good for which it has
  the comparative advantage.
  
• Large Economy
• Receives no gains from trade with small nation.
• No change in its production constraint.
• Produces both goods after trade, though more of
  good in which it has comparative advantage.

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BA 187 International Trade

• Extensions to the Classical Model of Trade

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Adding Money to Ricardo

• So far have dealt with trade in terms of barter
  of one good for another.
  
• How to move to monetary economy?
• Domestic value of good found as PX WaLX
• Link economies through exchange rate.
• e units of foreign currency per unit domestic
  currency
  
• Put price of good in common terms (foreign
  currency)
  
• Domestic Country PX aLX We
• Foreign Country PX aLX W
• Trade occurs based on differences in money
  prices
  

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Example of Money Ricardo

• Assume Exchange Rate of 1 escudo1
• Cheaper to buy cloth in England, buy wine in
  Portugal.
  
• Consistent with relative labor efficiency ( ½ )
  
• Terms of trade for England PCloth/PWine 1/2.4
• If trade not balanced, then specie flows to
  country with trade surplus. Raises prices
  wages, offsets trade.

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The Export Condition

• Monetized version of Classical trade model.
• Country exports any product it can produce most
  inexpensively, given wage rate exchange rate.
  
• Export Condition
• Cost conditions necessary for country to export a
  good.
  
• PX aLX W e
• or aLX/ aLX We/W
• In a monetized world, ability to export depends
  not only on relative labor efficiency but also on
  relative wage rates and the exchange rate.
  
• Establishes limits on wage rates and/or exchange
  rate for trade to take place between countries.

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Wage and Exchange Rate Limits

• Trade in a two-good, two country world requires
  each country produce one good more cheaply. This
  imposes limits on wage rates exchange rates for
  trade to occur.
• Wage Rate Limits (assumes e 11escudo)
• In previous example, England loses export market
  in cloth if English wage rises to 1.2/hr or
  higher.
  
• England gains export market in wine if it wage
  falls to 0.8/hr or lower.
  
• Exchange Rate Limits (assumes wages fixed)
• Similar logic dictates that at if EXR rise to 1.2
  esc/1 or higher England loses export market in
  cloth.
  
• England gains export market in wine if it EXR
  falls to 0.8esc./ 1 or lower.

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Trade in Multi-Commodity World

• Pattern of trade in multi-commodity world depends
  on relative labor requirements versus ratio of
  relative wages.
  
• Also can see effects of change in exchange rate
  or relative wages on the pattern of trade.
  
• Finally trade flows equalized by changes in
  relative wage rates due to flows of gold or
  exchange rate changes.

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Effects of Change in Relative Wages

• Increase in Home wage rate, decrease in Foreign
  wage rate, or rise in exchange rate (home
  currency more valuable)
  
• Makes home country goods more expensive, reduces
  the number of goods exported by the home
  country.
  
• Again any imbalance in trade flows will be
  equalized by changes in relative wage rates due
  to flows of gold or exchange rate changes.

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Determining the Relative Wage
Relative Wage , We/W
Relative Quantity of Labor
L/L
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Evidence on Comparative Advantage

• MacDougall (1951)
• Looked at ratio of labor productivity US vs. UK
  plotted against export volume ratio, US vs. UK.
  
• Found that higher relative productivity for US
  vs. UK associated with higher export volume for
  US vs. UK in that industry.
  
• In addition found that relative productivity
  above relative wage associated with higher export
  volume.
  
• Similar results obtained by Balassa(1963) and
  Stern (1962)