Lecture 1 Part 2

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Lecture 1 Part 2

• Comparative Advantage 1
• Labor Productivity and Trade

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2.1. Introduction

• The gains from trade arise because trade allows
  countries to specialize their production in a way
  that allocates all resources to their most
  productive uses.
• Trade frees each countrys residents from having
  to consume goods in the same combination in which
  the domestic economy can produce them.
• Trade has the potential for expanding (world)
  output by efficiently allocating the worlds
  scarce resources to their most productive uses.

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2.2. Early thinking about Trade

• During the 17th and 18th centuries the doctrine
  of mercantilism represented the dominant attitude
  toward international trade.
• Gold and silver circulated as money, so the
  quantity of them that any country held symbolized
  that nations wealth and power.
• National leaders wanted to accumulate as much
  gold and silver as possible.
• They tried to produce and export as much as
  possible, while keeping imports to a minimum.

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2.2. Early thinking about Trade

• The mercantilists policy prescription was to
  encourage exports and restrict imports, since
  mercantilists viewed trade as a way to accumulate
  gold.
• Mercantilists assumed that trade was a zero-sum
  game.
• In a poker game, whatever one player wins, the
  other players lose.

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2.3. The Decline of mercantilism (and the Birth
of Economics)

• In 1752, David Hume pointed out two weaknesses in
  the mercantilists logic.
• It is not the quantity of gold and silver that a
  country holds what matters, but the quantity of
  goods and services that these precious metals can
  buy.
• Individuals get satisfaction from goods, not from
  metals.
• There is a problem with the long-run viability of
  mercantilist policies.
• As a country accumulates more gold and silver,
  its money supply will increase, and domestic
  prices will go up too.
• Domestic goods become expensive, and imported
  goods become cheap (in relative terms).
• As exports fall and imports rise, the quantity of
  gold and silver falls in the domestic economy.

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2.3. The Decline of mercantilism (and the Birth
of Economics)

• In 1776, by assuming that each country could
  produce some goods using less labor than its
  trading partners, Adam Smith showed that all
  parties to international trade could benefit.
• Trade improved the allocation of labor, ensuring
  that each good would be produced in the country
  that required the least labor.
• The result would be a larger quantity of goods
  and services produced in the world.
• With more goods in the world, all countries could
  be made better off.
• In 1817, David Ricardo showed that Smith failed
  to capture all of trade potential benefits.

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2.4. Keeping things simple some assumptions

• Perfect competition in both output and factor
  markets.
• All agents are price takers.
• PMC (for each good).
• Fixed endowment of resources available
• They are fully employed and homogeneous.
• Firms technology do not vary within a particular
  country.
• Transportation costs are zero.
• Moreover, no barriers to trade.

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2.4. Keeping things simple some assumptions

• Factors of production are mobile among industries
  within each country, but completely immobile
  among countries.
• Price of each factor must be equal in all
  industries within each country.
• Prices of factors across countries will be
  different.
• The world consists of two countries (A and B),
  each using a single input (labor, L) to produce
  two goods (X and Y).

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2.5. The Ricardian World without Trade

• To answer the question Does international trade
  benefit participants?, we have to compare a
  world without (international) trade with a world
  with trade.
• Autarky is case of self-sufficiency, or no trade.
• In autarky, each country must produce the goods
  that its residents want to consume.
• The resource-allocation decision made by a
  country in autarky is simultaneously a production
  decision and a consumption decision.
• To make this decision, the country must take into
  account the availability of resources, the
  technology, and the preferences of its citizens.

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2.5.1. Production in Autarky

• The PPF represents all the alternate combinations
  of goods X and Y that the economy can produce
  (using all the resources, and being efficient in
  production).
• LAcountry As labor endowment.
• aLXunits of L required to produce 1 unit of X in
  country A (3 workers are needed to produce 1 X).
• aLY
• The more productive country As labor is in
  producing X, the smaller aLX.
• LA/aLXmaximum quantity of X that can be produced
  in country A.

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2.5.1. Production in Autarky

• The MRTA is the rate at which units of X can be
  transformed into units of Y in country A.
• For every unit of X forgone, aLX units of L are
  freed up.
• With aLX units of L, aLX/aLY units of Y can be
  produced.
• That is, MRTA -aLX/aLY.
• MRTA gives the OC of good X (in terms of Y).
• The number of units of Y forgone to produce an
  additional unit of X.
• The Ricardian model implies that the PPF is a
  straight line.
• This model is sometimes called a constant-cost
  model.
• In autarky, the production opportunity set equals
  the consumption opportunity set.

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Figure 1 What Can Country A Produce?
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2.5.2. Consumption in Autarky

• MRSThe slope of an indifference curve.
• We use community indifference curves.
• Increased availability of goods increases
  potential utility.
• Whenever a larger quantity of goods become
  available, it is possible to make every
  individual better off.
• However, whether actual utility increases depends
  on the distribution of income.

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Figure 2b Indifference Curves