Gains from trade in classical Today

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Gains from trade in classicalTodays class

• Todays class will demonstrate the benefits of
  trading using comparative advantage
• without specialization in production
• with specialization in production
• Then you will work through an example in groups,
  if we have time.

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Gains from trade

• The point of the exercise it to show that there
  are two distinct sources of gains from trade
• Gain from consumption a country can consume
  outside its production possibility frontier even
  if it doesnt change its production
• Gain from specialization of production a
  country and the world can gain from
  specialization that leads to greater world output.

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Example

• In the example, we will have 2 countries A, and
  B.
• Each country will have a certain amount of labour
  available to it.
• A has 9,000 hours of labour
• B has 16,000 hours of labour
• Each country can make two goods cloth and wine

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Example

• In the first table, we show how many hours each
  country chooses to put into the production of
  each good.
• This determines both
• the total output of the good for each country
• the total consumption of the good for each
  country.

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Example

• In the first table, we also show the price ratios
  that prevail in each country for the two goods,
  as well as the price ratio that could prevail if
  the countries traded.
• Here is Table 1

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C - A Example
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Example with trade

• In table 2, we show the situation for each
  country WITH trade.
• There is a twist however, when comparing this
  table to what we did last week

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Example with trade

• In this table, we first look at the situation if
  the countries did NOT specialize, but traded with
  each other.
• This situation could occur if factors of
  production were completely immobile, so that all
  workers who made cloth could only make cloth, and
  all workers who made wine could only make wine.
• It could also happen if the government simply
  decreed that people could not change professions.

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Example with trade

• The case without specialization shows that there
  is a potential to gain from trade only through a
  change in consumption pattern.
• The second part of the table shows the extra gain
  from specialization in production and trade.

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C- A Example p. 2
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Gains from Trade Graphical Analysis

• Next we show the gains from trade graphically.
• The first set of graphs were drawn by me, by hand.

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Gains from Trade Graphical Analysis

• The first graph shows the production possibility
  frontier (ppf) for country A.
• Assuming complete mobility of workers, the ppf is
  a straight line.
• If all 9,000 hours produced cloth, the country
  could produce 9,000 cloth,
• If all 9,000 hours produced wine, the country
  could produce 3,000 wine.
• Given perfect mobility of labour, the country can
  produce anywhere along the straight line joining
  these two points (or anywhere inside the triangle.

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Gains from Trade Graphical Analysis

• The consumption for the country without trade
  MUST be a point along the production possibility
  frontier.
• In this example, the country happens to choose
  the point (W,C) ( 1,000 , 6,000) (this is an
  assumption for the purpose of the example)
• In the graph, there is a point off to the right.
• It is the consumption point with trade but no
  specialization. (the next graph shows how its
  found.)

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Comparative Advantage Graphs

• Country A
• can produce 9000 cloth
• or 3,000 wine,
• or any linear combination in between
• with no trade, produces and consumes at A
• with trade, country produces at A, consumes at C1

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Gains from trade continued

• In the second graph, I draw the line that shows
  trade between the two countries with no change in
  production.
• because there is no change in production, the
  line must touch the PPF at the same production
  point as the case in autarky.
• however, because people can purchase goods at a
  different price, then they can buy more wine than
  they did before and sell more cloth.
• This leads to a change in consumption. This
  change represents a gain because the country
  could not produce this consumption bundle itself
  (it is outside the countrys ppf)

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Gains from trade continued

• This last point bears repeating
• The change in consumption represents a gain
  because the country could not produce this
  consumption bundle itself (it is outside the
  countrys ppf)
• When a country doesnt trade, its maximum
  consumption (consumption possibility frontier
  (cpf) is the countrys ppf
• When a country trades, it can consume anywhere
  along the trade line. This trade line determines
  the countrys consumption possibility frontier.
• In this example the ppf has slope 13 the trade
  line has slope 1 2.5.

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Comparative Advantage Graphs

• Without trade, ppf slope equals cpf slope 1W3C
  (slope 3)
• With trade ppf unchanged, cpf slope is 1W2.5C
  (slope2.5)
• cpf extends from production point to consumption
  point, also called trade line

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Recap

• The preceding graph is important because we will
  use similar analysis for neoclassical trade
  theory.
• REMEMBER
• when a country is not trading, it is consuming
  along its ppf.
• when a country trades, it produces at a point ON
  its ppf, and consumes at a point ON the trade
  line. This is because it can sell one good to the
  other country in exchange for another.

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Example continued

• The next graph adds the consumption point with
  specialization to the previous graph. (point C2A
  )
• It does not yet show how we get to that point.

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Comparative Advantage Graphs

• With specialisation and trade country can consume
  4000C and 2000 wine - point C2
• (produce 9000C sell 5000 to buy 2000W)

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Complete specialization for country A

• The final graph shows that country A can
  completely specialize in cloth, trade 2.5 cloth
  for 1 wine, and consume at point C2A.
• Recall, country A has 9,000 hours.
• The consumption point C2A would require 10,000
  hours for A to produce at home.

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Comparative Advantage Graphs

• CPF with complete specialization extends from
  production point (W,C) (0, 9000) to consumption
  point
• (W,C)(2000,4000)

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Country B

• Country B gains from trade in a similar way to
  country A.
• In country B,
• in autarky, 8000 cloth can be produced,
• (16,000 hrs / 2)
• or 4000 wine
• (16,000 hrs /4)
• or any combination of the above. (Linear ppf)

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Country B

• In country B, we assume an initial production
  point of (W,C) (2500 , 3000)
• Without trade, it can consume (2500, 3000), if it
  wanted to change output, it could consume and
  produce anywhere along ppf
• RECALL without trade,
• production consumption

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Country B

• With trade but no specialization,
• country still produces (W, C) (2500 , 3000)
• But, it can trade at price Pw/Pc 2.5.
• With trade AND specialization,
• country produces (W, C) (0, 4000)
• It can still trade at price Pw/Pc 2.5
• It can consume along this price line CFB2 by
  buying cloth and selling wine to country A.

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C A Example Country B

• For country B, we have all three lines combined
  in one graph.

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Questions?

• You have an example to do next

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You Do

• Assume there are 2 countries A and B.
• A has 15,000 hours of labour that it could use to
  make paper or scissors.
• It takes 3 hours to make paper, 5 hours to make
  scissors.
• (It takes B 14 hours to make paper, and 6 hours
  to make scissors)

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You Do

• In which good does A have a comparative
  advantage?
• Which good will A specialize in if A chose to
  specialize?

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You Do

• Now, concentrating on A.
• Draw a graph with As ppf.
• What is the price ratio, Pp/Ps in A ?
• Assume A consumes at point
• (P, S) (2000, 1800)
• Now let A trade with B. We will assume the trade
  price is Pp/ Ps 4/3.

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You do continued

• With a world trade price of 4/3, draw the cpf1
  for country A.
• If A chose to sell 500 paper for scissors, how
  much of each good would it consume?
• How many hours would it take A to produce the
  same consumption bundle on its own?
• If A chose to specialize in paper production and
  consumed the same amount of paper as in A, how
  many scissors could it consume?
• How many hours would it take A to produce the
  same consumption bundle on its own?
• Draw the cpf1 for country A on the same graph,
  showing the new consumption point with
  specialization and trade.