Topic 1 Why Nations Trade: The Classic Trade Theories

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Topic 1Why Nations Trade The Classic Trade
Theories

• Textbook Chapter 2

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Learning objectives

• Understand how the Ricardian model explains trade
  and its gains.
• Learn the role of the relative prices in the
  distribution of the gains from trade.
• Understand the determination of relative wages in
  a two-good model and a many-good model.

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Questions

• Who exports what?
• What are the limits for mutually beneficial trade
  based on specialization?
• How are the relative price and relative wage
  determined?

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Opportunity cost

• To produce one pound of cheese requires aLC
  person hours, each of which could be used to
  produce 1/aLW gallons of wine.
• Opportunity cost of cheese in terms of wine is
  the ratio of unit labor requirements in cheese
  and wine aLC/aLW.

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Production possibility frontier

• Given limited resources, to produce more of one
  good means to sacrifice some of another good.
• The absolute value of the slope of PF measures
  the opportunity cost of home good X (a pound of
  cheese) in terms of home good Y (gallons of wine).

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Figure 2-1 Homes Production Possibility
Frontier
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Figure 2-2 Foreigns Production Possibility
Frontier
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An example of PF

• If aLC1, aLW2, L10,
• What is the opportunity cost of a pound of cheese
  in terms of wine?
• Can the economy produce 10 pounds of cheese?
• Can the economy produce 10 gallons of wine?
• Can the economy produce 5 pounds of cheese and
  2.5 gallons of wine?

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Absolute advantage

• In a one-factor world with two countries and two
  goods, Home has an absolute advantage in cheese
  if it can produce a pound of cheese with less
  labor than Foreign, i.e., aLCltaLC.
• Accordingly, Home is more efficient in producing
  cheese than Foreign.

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Comparative advantage

• In a one-factor world with two countries and two
  goods, Home has a comparative advantage in cheese
  if its opportunity cost of cheese in terms of
  wine (aLC/aLW) is less than that in Foreign
  (aLC/aLW).
• Accordingly, it is more efficient for Home to
  export cheese to and import wine from Foreign.

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What will actually be produced?

• The movement of labor to whichever sector that
  pays the higher wage determines the supply of
  cheese and wine.
• The economy will specialize in the production of
  cheese if VMPLCgtVMPLW, (i.e., PC/aLC gt
• PW /aLW, or PC/PWgtaLC/aLW) it will specialize
  in wine if PC/PWltaLC/aLW only when
  PC/PWaLC/aLW, will both goods be produced.
• Lets assume that aLC/aLW lt aLC/aLW.

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Figure 2-3 World Relative Supply and Demand
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Relative prices

• If PC/PWlt aLC/aLW, no world supply of cheese
• If PC/PW aLC/aLW, relative world supply of
  cheese ranges from 0 to (L/aLC)/(L/aLW)
• If PC/PWgt aLC/aLW, relative world supply of
  cheese is (L/aLC)/(L/aLW)
• If PC/PW aLC/aLW, relative world supply of
  cheese ranges from (L/aLC)/(L/aLW) to infinity
• If PC/PWgt aLC/aLW, relative world supply of
  cheese becomes infinite.

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A numerical example
Cheese Wine Home aLC 1
hr./lb. aLW 2 hr./gal. Foreign aLC
6 hr./lb. aLW 3 hr./gal.

• Can a nation with absolute advantage like Home
  benefit from trading with a nation with absolute
  disadvantage like Foreign? Why?

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Gains from trade

• If both countries specialize in the good they
  have comparative advantages, we must have
• PC/PWgt aLC/aLW for Home, which implies
• (1/ aLC)(PC/PW)gt 1/aLW, and
• PC/PWlt aLC/aLW for Foreign, which implies (1/
  aLW)(PW/PC)gt 1/aLC

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Figure 2-4 Trade Expands Consumption
Possibilities
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Gains from specialization and trade

• Specialization and trade will benefit both
  countries if the relative price of cheese is such
  that
• aLC/aLWltPC/PWlt aLC/aLW, i.e.,
• 1/2ltPC/PWlt 6/3.

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Gains from specialization and trade

• Alternatively, since
• PC/PW (w?aLC)/(w?aLW),
• specialization and trade will benefit both
  countries if the relative wage is such that
• aLW/aLWltw/wlt aLC/aLC, i.e.,
• 3/2lt w/wlt6/1.

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Relative wages

• In our example, workers in Home earn the value of
  1 pound of cheese per hour of labor (1/ aLC),
  while workers in Foreign earn the value of 1/3 of
  a gallon of wine per hour (1 / aLW).
• Relative wage is relative price times the
  post-specialization relative productivity
• w/wVMP/VMP (PC/ aLC)/(PW/ aLW)
• (PC/PW)(1/aLC)/ (1/aLW)
• (1/1)/(1/3)3

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Relative wages (contd)

• Relative wage is between the pre-specialization
  relative productivities
• (1/aLW)/ (1/aLW)lt w/wlt(1/aLC)/ (1/aLC)
• Home has a cost advantage in cheese due to its
  relatively high productivity more than offsetting
  relatively high wage rate similarly, Foreign has
  a cost advantage in wine due to its relatively
  low wage rate.

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Three myths

• Should a country wait until it becomes strong
  enough to stand up to foreign competition before
  joining trade?
• Is pauper labor-based competition unfair to
  high-wage countries?
• Does trade exploit low-wage countries?

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Comparative advantage with many goods

• Cost of making good i is the unit labor
  requirement times the wage rate.
• Goods will always be produced where it is
  cheapest to make them.
• The rule to determine the pattern of trade any
  good i for which aLi/aLigtw/w will be produced
  in Home, while any good for which aLi/aLiltw/w
  will be produced in Foreign.

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Comparative advantage with many goods (contd)

• With N goods, we determine the pattern of trade
  by
• Lining up them in decreasing order of aLi/aLi so
  that
• aL1/aL1gt aL2/aL2 gt aL3/aL3 gtgt aLN/aLN.
• Finding the relative wage rate of Home workers
• Cutting in that lineup with w/w
• All the goods to the left of the cut end up
  being produced in Home all the goods to the
  right of the cut end up being produced in Foreign.

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Determining relative wage

• Who produces what depends on the relative wage
  rate, not the other way round.
• The relative wage rate is determined by
• Relative supply of home labor (RS)
• Relative demand of home labor (RD)
• The allocation rule for patterns of trade
  determines the stepped shape of RD.

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Home and Foreign Unit Labor Requirements An
Example
Goods Home ULR Foreign ULR Relative Home
Productivity (aLi) (aLi)
Advantage (aLi/aLi) Apples 1
10 10 Bananas 5 40 8 Caviar
3 12 4 Dates 6
12 2 Enchiladas 12 9 0.75
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Figure 2-5 Determination of Relative Wages
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Summary

• Comparative advantage determines production
  pattern.
• Production and consumption perspectives of gains
  from trade.
• The relative prices explains the distribution of
  trade gains and implies a relative wage rate.
• The relative demand for labor determines relative
  wages in a world of many goods.