Chapter 3: Part 3

1
Chapter 3 Part 3

• Overview
• Results from productivity growth analysis
• From Handout 2
• Extension of Ricardian Model
• Trade prediction with many goods
• The effect of trade/transportation costs
• Empirical support for Ricardian Model

2
The Effects of Productivity Growth in the Foreign
Country

• If productivity growth is in the foreign
  countrys export sector
• Domestic country
• Terms of trade improve and the domestic country
  will be able to acquire foreign goods more
  cheaply
• Consumption Possibility expands
• Domestic country will be unambiguously better
  off.
• Foreign country
• Terms of trade worsen
• Production possibility expands
• Foreign country may be better or worse off
• The net effect depends on how large the growth in
  productivity is relative to the negative terms of
  trade effect

3
Comparative Advantage With Many Goods

• Ricardian model
• Two countries
• One factor (labor)
• Two goods
• Free trade
• Comparative Advantage With Many Goods
• Two countries
• One factor (labor)
• Many goods
• Introduce trade and/or transportation costs

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Comparative Advantage With Many Goods

• There are two countries domestic and foreign
• One factor of production Labor (L)
• N goods indexed by i1, 2, 3,, N
• All industries are perfectly competitive
• zero profits in all industries

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Comparative Advantage With Many Goods

• For each good i 1,2,N.
• domestic countrys unit labor requirement for
  good i aLi
• the productivity of the domestic country for good
  i 1/ aLi
• foreign countrys unit labor requirement for good
  i aLi
• the productivity of the foreign country for good
  i 1/ aLi

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Comparative Advantage With Many Goods

• w represents the wage rate in the domestic
  country
• w represents the wage rate in the foreign
  country
• Unit costs for good i are the costs of producing
  one unit of output of good i
• Unit costs of production of good i in domestic
  country is waLi
• Unit costs of production of good i in foreign
  country is waLi

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Comparative Advantage With Many Goods Free
Trade Case

• Goods will be purchased from the cheapest
  producers.
• Pi Price charged for good i by a domestic firm
• PiPrice charged for good i by a foreign firm
• Under zero profit and no trade costs, we know
  that the unit price will equal unit costs.
• PiwaLi
• PiwaLi

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Comparative Advantage With Many Goods Free
Trade Case

• If waLi lt waLi , the domestic country can
  produce good i most cheaply
• If waLi gt waLi then the foreign country can
  produce good i most cheaply
• If the relative productivity of a country in
  producing a good is higher than the relative
  wage, then the good will be produced in that
  country.
• Production and Trade Prediction
• If aLi /aLi gt w/w, good i produced by domestic
  country
• If aLi /aLi lt w/w, good i produced by foreign
  country

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Comparative Advantage With Many Goods Free
Trade Case

• Graphic Representation
• Order the goods according to the domestic
  countrys relative productivity
• Domestic country has the highest relative
  productivity in good 1, second highest in good
  2etc

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Comparative Advantage With Many Goods Free
Trade Case

• Let i define the good that satisfies aLi
  /aLiw/w
• For all goods ilti with aLi /aLi gt w/w the
  domestic country will produce and export
• For all goods igti with aLi /aLi lt w/w the
  foreign country will produce and export
• Given the relative wage, we can determine the
  range of goods produced in each country

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Comparative Advantage With Many Goods Free
Trade Case
aL1 /aL1 gtw/w goods produced by the domestic
countryaL1 /aL1 ltw/w goods produced by the
foreign country
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Comparative Advantage With Many Goods Free
Trade Case

• The domestic country produces goods 1-i
• The foreign country produces goods i-N
• Each country specializes in the goods in which it
  is relatively most productive and trades for the
  other goods.
• All goods (except for i) are traded

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Example Comparative Advantage With Many Goods
Free Trade Case

• There are two countries US and Mexico
• There are 4 goods
• Pencils, Calculators, Shirts, Flash drives

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Example Comparative Advantage With Many Goods
Free Trade Case
The following table describes the unit labor
requirements of the four goods for each country,
and the relative productivities for the US
(aMEXLi /aUSLi )
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Example Comparative Advantage With Many Goods
Free Trade Case

• Suppose that wUS/wMEX 2.5.
• What goods will the US produce and what goods
  will Mexico produce?

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Example Comparative Advantage With Many Goods
Free Trade Case

• The US will produce and export flash drives and
  calculators
• The relative productivities of the US in
  producing flash drives and calculators are higher
  than the relative wage
• Mexico will produce and export pencils and shirts
• The relative productivities of US in producing
  pencils and shirts are lower than the relative
  wage. These goods are more cheaply produced in
  Mexico.

18
Trade and Transportation Costs and Non-traded
Goods

• This model predicts that countries should
  completely specialize in production (except
  possibly diversified in one good).
• This implies all goods are traded.
• But this rarely happens for primarily 2 reasons
• More than one factor of production reduces the
  tendency of specialization (Chapter 4)
• Trade Costs Transportation and Protectionism
  (Tariffs, Quotas, etc)
• Trade and Transportation costs can cause
  non-traded goods (goods which are produced in
  both countries and not traded)

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Trade and Transportation Costs and Non-traded
Goods

• Causes of non-traded goods
• Tariffs can raise the costs of imported goods so
  much that they are no longer competitive with
  domestically produced goods
• Non-traded goods and services (e.g., haircuts
  and auto repairs) exist due to high
  transportation costs.
• Ex) suppose it costs 1 to produce a widget in
  the US and the equivalent of 90 cents in Mexico.
  A 20 tariff or trade costs would remove any
  incentive for the US to import this good
• Non-trivial Countries tend to spend a large
  fraction of national income on non-traded goods
  and services.

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Comparative Advantage With Many Goods Trade
Costs

• Now suppose there is a trade cost of T imposed
  on all goods. This will result in non-traded
  goods.

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Comparative Advantage With Many Goods Trade
Costs

• The domestic country will only import a good i if
  the price net of transport costs is cheaper than
  if the good were produced domestically.
• PigtPi Trade CostsPi Pi TPi (1T)
• Or if waLi gt waLi (1T)
• w/w gt aLi (1T) /aLi defines the set of
  goods that are exported by foreign to domestic

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Comparative Advantage With Many Goods Trade
Costs

• The foreign country will only import a good i if
  the price charged net of transport costs is
  cheaper than if the good were produced in in the
  foreign country.
• Pigt PiTrade CostsPi Pi TPi (1T)
• Or if waLi gt waLi(1T)
• w/w lt aLi / (aLi (1T)) defines the set of
  goods that are exported by domestic to foreign

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Comparative Advantage With Many Goods Trade
Costs
aL1 /(aL1 (1T)/ gtw/w goods exported by the
domestic countryaL1(1T) /aL1 ltw/w goods
exported by the foreign countryNon-Traded Goods
(produced in both countries)
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Example Comparative Advantage With Many Goods
Trade Costs

• There are two countries US and Mexico
• There are 4 goods
• Pencils, Calculators, Shirts, Flashdrives
• wUS/wMEX 2.5.
• There is a trade cost of 40 imposed on all
  goods.

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Example Comparative Advantage With Many Goods
Trade Costs

• The US will only import goods if the price net of
  transport costs is cheaper than if the good were
  produced in the US.

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Example Comparative Advantage With Many Goods
Trade Costs

• Since the relative wage is 2.5, this means the US
  will only import those goods that satisfy
• In this case, the US will produce FD,
  Calculators, and Pencils and will only import
  Shirts.

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Example Comparative Advantage With Many Goods
Trade Costs

• Similarly, Mexico will only import those goods
  that satisfy
• So Mexico will produce Calculators, Pencils, and
  Shirts, and import only FDs.

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Empirical Evidence

• Do countries export those goods in which their
  productivity is relatively high?

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Empirical Evidence

• Belassa (1963) study found that US was more
  productive (had an absolute advantage) in all 26
  manufacturing industries
• aBLi /aUSLi gt1 for almost all 26 industries
• Still, British exports (overall) as large as US
  exports

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Empirical Evidence

• Ricardian prediction
• Britain should export primarily in the sectors in
  which it is relatively more productive and the US
  should export primarily in the sectors in which
  it is most productive
• US Exports /British Exports should be higher in
  industries where US/British productivity is
  highest
• (Figure 3-6) shows that data matches this
  prediction

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Empirical Evidence

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Shortcomings of Ricardian Model

• 1. Non-traded goods not predicted in simple model
  but are if add trade and transportation costs to
  the multi-good extension
• 2. Predicts gains from trade for all within a
  country so does not address the effect of trade
  on the distribution of income within a country
  (Chapter 4)

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Shortcomings of Ricardian Model

• 3. Does not predict a role for differences of
  countries resources to explain trade patterns
  (Chapter 4)
• 4. Neglects the role of economies of scale
  (Chapter 6)

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Summary

• A country has a comparative advantage in
  producing a good if the opportunity cost of
  producing that good is lower in the country than
  it is in other countries.
• The Ricardian model focuses only on differences
  in the productivity of labor across countries,
  and it explains gains from trade using the
  concept of comparative advantage.

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Summary (cont.)

• When countries specialize and trade according to
  the Ricardian model
• the relative price of the exported good rises
• Real income for workers rises
• imported goods are less expensive for consumers.
• Productivity growth in one country may actually
  improve welfare in another if this growth is in
  that countrys export sector.
• Trade is predicted to benefit both high
  productivity and low productivity countries

36
Summary (cont.)

• 6. Although trade may change the distribution of
  income within countries, this is not addressed in
  the Ricardian model.
• 7. High productivity or low wages give countries
  a cost advantage that allow them to produce
  efficiently.
• 8. Although empirical evidence supports trade
  based on comparative advantage, transportation
  costs and other factors prevent complete
  specialization in production.