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Topic 1 Why Nations Trade: The Classic Trade Theories

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Understand how the Ricardian model explains trade and its gains. ... Enchiladas 12 9 0.75. 9/7/09. Ying Wu. 26. Figure 2-5 Determination of Relative Wages ... – PowerPoint PPT presentation

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Title: Topic 1 Why Nations Trade: The Classic Trade Theories


1
Topic 1Why Nations Trade The Classic Trade
Theories
  • Textbook Chapter 2

2
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.

3
Questions
  • Who exports what?
  • What are the limits for mutually beneficial trade
    based on specialization?
  • How are the relative price and relative wage
    determined?

4
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.

5
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).

6
Figure 2-1 Homes Production Possibility
Frontier
7
Figure 2-2 Foreigns Production Possibility
Frontier
8
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?

9
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.

10
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.

11
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.

12
Figure 2-3 World Relative Supply and Demand
13
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.

14
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?

15
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

16
Figure 2-4 Trade Expands Consumption
Possibilities
17
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.

18
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.

19
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

20
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.

21
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?

22
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.

23
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.

24
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.

25
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
26
Figure 2-5 Determination of Relative Wages
27
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.
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