Krugman’s Trade Policy History Course: https://webspace.princeton.edu/users/pkrugman/WWS%20543 _readings.pdf
Preview Why do countries engage in international trade? Opportunity costs and comparative advantage A one-factor Ricardian model Production possibilities Gains from trade Wages and trade Misconceptions about comparative advantage Transportation costs and non-traded goods Empirical evidence
Introduction Theories of why trade occurs: Differences across countries in labor, labor skills, physical capital, natural resources, and technology Countries can benefit from their own differences by reaching an arrangement in which each does the things it does relatively well. Economies of scale: Countries might specialize in a limited range of goods and produce them at a large scale: (larger scale of production is more efficient) Worth the 2008 Nobel Prize!
Worth the Nobel Prize! Press Release 13 October 2008 The Royal Swedish Academy of SciencesThe Royal Swedish Academy of Sciences has decided to award The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2008 to Paul Krugman Princeton University, NJ, USA "for his analysis of trade patterns and location of economic activity" International Trade and Economic Geography Patterns of trade and location have always been key issues in the economic debate. What are the effects of free trade and globalization? What are the driving forces behind worldwide urbanization? Paul Krugman has formulated a new theory to answer these questions. He has thereby integrated the previously disparate research fields of international trade and economic geography. Krugman’s approach is based on the premise that many goods and services can be produced more cheaply in long series, a concept generally known as economies of scale. Meanwhile, consumers demand a varied supply of goods. As a result, small-scale production for a local market is replaced by large-scale production for the world market, where firms with similar products compete with one another. Traditional trade theory assumes that countries are different and explains why some countries export agricultural products whereas others export industrial goods. The new theory clarifies why worldwide trade is in fact dominated by countries which not only have similar conditions, but also trade in similar products – for instance, a country such as Sweden that both exports and imports cars. This kind of trade enables specialization and large-scale production, which result in lower prices and a greater diversity of commodities. Economies of scale combined with reduced transport costs also help to explain why an increasingly larger share of the world population lives in cities and why similar economic activities are concentrated in the same locations. Lower transport costs can trigger a self-reinforcing process whereby a growing metropolitan population gives rise to increased large-scale production, higher real wages and a more diversified supply of goods. This, in turn, stimulates further migration to cities. Krugman’s theories have shown that the outcome of these processes can well be that regions become divided into a high- technology urbanized core and a less developed “periphery”.
Introduction Sources of differences across countries that lead to gains from trade: The Ricardian model (Chapter 3) examines differences in the productivity of labor between countries. Differences in Technology The Heckscher-Ohlin model (Chapter 4) examines differences in labor, labor skills, physical capital, land, or other factors of production between countries. Differences in Endowments
The Ricardian model A domestic firm may lose out in international competition even if it is the lowest cost producer in the world. Even if you have an “Absolute advantage” you can lose in international trade Even though you do not have an absolute advantage in the production of some goods or trade you can win in the international trade, if you have a “comparative advantage”.
Comparative Advantage and Opportunity Cost The Ricardian model uses the concepts of opportunity cost and comparative advantage. The opportunity cost of producing something measures the cost of not being able to produce something else with the resources used. Paul Samuelson: Comparative advantage is the best example I know of an economic principle that is undeniably true yet not obvious to intelligent people!
A One – Factor economy: Assumptions Two countries (“Home” and “Foreign”) with a single factor of production (Labour). Only two goods are produced: wine and cheese. Goods are homogeneous (they that are either physically identical or at least viewed as identical by buyers). Labour productivity in each country and industry is constant, but varies between countries and between industries (due o differences in technology). In other words we are assuming constant labour productivity. The supply of labor in each country is constant.\ and fully employed.
A One – Factor economy: Assumptions (cont.) Labour is freely and costlessly mobile between industries within a country, but it is completely immobile across countries Production takes place under conditions of perfect competition: many small firms in each industry firms choose output to maximize profit output is homogeneous free entry and free exit of firms perfect information Consumptions takes place under conditions of utility maximization. Countries indifferent curves are homothetic (if ratios of commodities of consumers are equal, with expansion of the budget constraint, then you are homothetic) Competition allows workers to be paid a“competitive” wage equal to the value of what they produce There are no transportation costs
A One-Factor Ricardian Model Definitions: Unit labour requirement: the number of hours required to produce a pound of cheese or a gallon of wine. Unit requirements is the inverse of productivity! (The more cheese and wine a worker can produce in an hour, the lower the unit labour requirement). a LW : unit labour requirements in wine production in the Home country = 1/Marginal Product of Labour a LC : unit labour requirements in cheese production in the Home country For example, a LC = 1 means that 1 hour of labour produces one pound of cheese in the home country. For example, a LW = 2 means that 2 hours of labour produces one gallon of wine in the home country.
A One-Factor Ricardian Model Definitions: Labor supply L indicates the total number of hours worked in the home country (a constant number). Cheese production Q C indicates how many pounds of cheese are produced. Wine production Q W indicates how many gallons of wine are produced. From now on “*” notates foreign country variables
Ricardian Production Functions Cheese Wine Qc, Q*c Qw, Q*w Qc Q*c Qw Q*w Lc, L*c Lw, L*w The slope of the production function is the marginal product of labour. This is why the production function is a straight line: the marginal product of labour is constant.
The Ricardian PPF in Home These production functions will allow us to generate a PPF. Qw Production function PPF for wine in Home Max Qw Lw Max Qc Qc Production function for cheese in Home Labour constraint (slope -1) Lc
Production Possibilities The production possibility frontier (PPF) of an economy shows the maximum amount of a good that can be produced once the decision has been made to produce any given amount of the other good (and viceversa). Remember: any economy has a fixed amount of resources there are limits on what it can produce (trade-offs)! The production possibility frontier of the home economy is: a LC Q C + a LW Q W ≤ L Total gallons of wine produced Labor required for each pound of cheese produced Total pounds of cheese produced Labor required for each gallon of wine produced Total amount of labor resources (labour constraint)
Example: L= 1,000 hours a LW = 2 a LC = 1 1) The economy devotes all its labour (L) to cheese production: a LC Q C = L 1*Q C = 1000 Q C = 1000 pounds of cheese 2) The economy devotes all its labour (L) to cheese production: a WC Q C = W 2*Q C = 1000 Q C = 500 gallons of wine
Home’s Production Possibility Frontier The line PF shows the maximum amount of cheese Home can produce given any production of wine ad viceversa
Production Possibilities The opportunity cost (trade- off) of cheese in terms of wine is how many gallons of wine Home must stop producing in order to make one more pound of cheese. Q W = L/a LW – a LC / a LW * Q C The opportunity cost of cheese appears as the absolute value of the slope of the PPF. (“marginal rate of transformation how we can transform one good into an other) a LC /a LW In our example: 1 /2 (The opportunity cost of producing 1 pound of cheese in terms of wine is half a gallon of wine) When the PPF is a straight line, the opportunity cost of a pound of cheese in terms of wine is constant
Relative Prices, Wages, and Supply So, what will be produced, and where? To answer we have to look at prices! Let P C be the price of cheese and P W be the price of wine. Relative prices of the two goods the price of one good in terms of the other: P C /P W is the relative price of cheese (in terms of wine)
Relative Prices, Wages, and Supply (cont.) In a competitive economy, firms hire workers up to the point where the nominal wage exactly equals the value of the marginal product of labour. hourly wages of cheese makers equal the value of the cheese produced in an hour: W C =P C /a LC = VMPL C hourly wages of wine makers equal the value of the wine produced in an hour: W W =P W /a LW = VMPL W
Relative Prices, Wages, and Supply (cont.) Before any trade occurs, the relative price of cheese to wine reflects the opportunity cost of cheese in terms of wine in each country. For example, at Home: P LC /P LW = a LC /a LW This is because workers will only work in the industry with the highest wage! Wages must be equal for both goods to be produced.
Relative Prices, Wages, and Supply If the country wants to consume both wine and cheese then, in the absence of international trade, Home would have to produce both goods for itself. BUT: Home will produce both goods only if the relative price of cheese is just equal to its opportunity cost. Relative prices must adjust so that wages are equal in the wine and cheese industries. Given that the opportunity cost is equal to a LC /a LW (the ratio of unit labor requirements in cheese and wine) in absence of international trade, the relative prices of goods are equal to their relative unit labour requirements.
Relative Prices, Wages, and Supply If W C > W W, workers will only make cheese (the economy will specialize in the production of cheese). 1) P C /a LC > P W /a LW P C / P W > a LC /a LW Relative price > opportunity cost 2) If W C < W W, workers will only make wine (the economy will specialize in the production of cheese). P C /a LC < P W /a LW P C / P W < a LC /a LW Relative price < opportunity cost If P C / P W = a LC /a LW workers will be indifferent to working in either wine or cheese. Relative price = opportunity cost
Example Home: If P C / P W = a LC /a LW = 1/2, then suppose that P C = €7 and P W = €14 Then W C = P C /a LC = € 7/1 = €7 and W W = P W /a LW = € 14/2 = €7 Foreign: If P* C / P* W = a* LC /a* LW = 6/3, then suppose that P* C = €14 and P* W = €7 Then W* C = P* C /a* LC = € 14/6 = €2.3 and W* W = P* W /a* LW = € 7/3 = € 2.3
Trade in the Ricardian Model In the absence of any trade, the relative price of cheese to wine will be higher in Foreign than in Home It will be profitable to ship cheese from Home to Foreign (and wine from Foreign to Home) This alters the relative price of cheese and wine Where does the relative price of cheese to wine settle?
Trade in the Ricardian Model Now let’s introduce trade. Suppose the Home country is more efficient in wine and cheese production than the Foreign country. It has an absolute advantage in all production: its unit labor requirements for wine and cheese production are lower than those in the foreign country: a LC < a * LC and a LW < a * LW 1< 6 2<3
Trade in the Ricardian Model Adam Smith: All countries would gain simultaneously if they practiced free trade and specialized in accordance with their absolute advantage. David Ricardo: Even if a country is the most (or least) efficient producer of all goods, it still can benefit from trade. We have to look at the comparative advantages!
Trade in the Ricardian Model Suppose that the Home country has a comparative advantage in cheese production: its opportunity cost of producing cheese is lower than in the Foreign country. a LC /a LW < a * LC /a * LW 1/2 < 6/3 =2 When the home country increases cheese production, it reduces wine production less than the foreign country would. Foreign has a comparative advantage over Home in wine production because: a* LW /a* LC < a LW /a LC 3/6 = 1/2<2/1 =2
Trade in the Ricardian Model N.B.: It is always the case, in a two countries two goods model, that if one country has a comparative advantage of one good, the other country MUST have a comparative advantage in the production of the other good!
Trade in the Ricardian Model Since the slope of the PPF indicates the opportunity cost of cheese in terms of wine, Foreign’s PPF is steeper than Home’s. In other words: The PPF is relatively biased in the direction of cheese for the Home country. We can also say the Home has a comparative advantage over Foreign only in cheese production because: a LC / a * LC < a LW /a * LW 1/6 < 2/3
Relative Supply and Relative Demand We need to consider both supply and demand. The (world) relative supply curve, RS, of cheese is the quantity of cheese supplied by all countries relative to the quantity of wine supplied by all countries RS = (Q C + Q * C )/(Q W + Q * W ) At each relative price of cheese P C /P W Relative demand of cheese is the quantity of cheese demanded in all countries relative to the quantity of wine demanded in all countries
The (World) Relative Supply Curve Production decisions in both Home and Foreign are given by: 1.If P C /P W > a LC /a LW specialize in cheese 2.If P C /P W = a LC /a LW produce both goods according to demand 3.If P C /P W < a LC /a LW specialize in wine
Study that chart, and read the textbook carefully!
Gains From Trade: specialization Each country specialize in the production of only one good: Home only produces cheese and no wine Foreign only produces wine and no cheese
Relative prices after trade Generally, opening up to trade leads to the price of a good falling in between its pre-trade levels in the two countries. World equilibrium is at point 1: 1.the relative price of cheese has risen in Home and fallen in Foreign. 2.the relative price of wine has risen in Foreign and fallen in Home The relative prices of the traded goods will converge!
Home’s Gain From Trade Given that relative prices in Home increase from 1/2 to 1: Qw Pc/Pw=1 Pc/Pw=1/2 B Dw=Sw A Iw Dc=Sc Qc Ec
Home’s Gain From Trade Home has moved to a higher Country Indifference Curve (the red one): we have a higher level of the aggregate economic welfare. Trade has benefited Home at the aggregate level!
A Numerical Example What is the home country’s opportunity cost of producing cheese? a LC /a LW = ½, to produce one pound of cheese, stop producing ½ gallon of wine. CheeseWine Homea LC = 1 hour/lba LW = 2 hours/gallon Foreigna * LC = 6 hours/lba * LW = 3 hours/gallon Unit labor requirements for home and foreign countries
A Numerical Example (cont.) The home country is more efficient in both industries, but has a comparative advantage only in cheese production. 1/2 = a LC /a LW < a * LC /a * LW = 2 The foreign country is less efficient in both industries, but has a comparative advantage in wine production.
A Numerical Example (cont.) With trade, the equilibrium relative price of cheese to wine settles between the two opportunity costs of cheese. Suppose that the intersection of RS and RD occurs at P C /P W = 1 so one pound of cheese trades for one gallon of wine. Trade causes the relative price of cheese to rise in the home country and fall in foreign.
A Numerical Example (cont.) With trade, the foreign country can buy one pound of cheese for P C /P W = one gallon of wine, instead of stopping production of a * LC /a * LW = 2 gallons of wine to free up enough labor to produce one pound of cheese in the absence of trade.
A Numerical Example (cont.) With trade, the home country can buy one gallon of wine for P W /P C = one pound of cheese, instead of stopping production of a LW /a LC = two pounds of cheese to free up enough labor to produce one gallon of wine in the absence of trade.
Relative Wages after trade The Ricardian model predicts relative prices will equalize across countries after trade. What about relative wages? Relative wages are the wages of the home country relative to the wages in the foreign country. Productivity (technological) differences determine relative wage differences across countries. Remember: these are reflected in the unit labor costs.
Relative wages after trade Now P C /P W = 1. Let’s assume that P C = P W = € 12 Once countries have specialized: All Home workers will produce cheese: W C = P C /a LC = € 12/1 = €12 > € 7 Home workers are making more money with trade than in autarky! All Foreign workers will produce wine: W* W = P* W /a* LW = € 12/3 = €4 > € 2.3 Foreign workers are making more money with trade than in autarky!
Because foreign workers have a wage that is only 1/3 the wage of domestic workers, they are able to attain a cost advantage in wine production, despite low productivity You have low wages because you have low productivity Because domestic workers have a productivity that is 6 times that of foreign workers in cheese production, they are able to attain a cost advantage in cheese production, despite high wages If you have high wages you also need to have high productivity
Gain from trade Countries with different labour productivities differ acroos industries will gain from trade by: specializing in the type of production which uses resources most efficiently (where “using resources most efficiently” means producing a good in which a country has a comparative advantage). and using the income generated from that production to buy the goods and services that countries desire.
Do Wages Reflect Productivity? Do relative wages reflect relative productivities of the two countries? Evidence shows that low wages are associated with low productivity. Wage of most countries relative to the U.S. is similar to their productivity relative to the U.S.
Productivity and Wages Source: International Monetary Fund, Bureau of Labor Statistics, and The Conference Board
Do Wages Reflect Productivity? (cont.) Other evidence shows that wages rise as productivity rises. As recently as 1975, wages in South Korea were only 5% of those of the United States. As South Korea’s labor productivity rose (to about half of the U.S. level by 2007), so did its wages (which were more than half of U.S. levels by 2007).
Misconceptions About Comparative Advantage 1.Free trade is beneficial only if a country is more productive than foreign countries. But even an unproductive country benefits from free trade by avoiding the high costs for goods that it would otherwise have to produce domestically. High costs derive from inefficient use of resources. The benefits of free trade do not depend on absolute advantage, rather they depend on comparative advantage: specializing in industries that use resources most efficiently.
Misconceptions About Comparative Advantage (cont.) 2.Free trade with countries that pay low wages hurts high wage countries. While trade may reduce wages for some workers, thereby affecting the distribution of income within a country, trade benefits consumers and other workers. Consumers benefit because they can purchase goods more cheaply. Producers/workers benefit by earning a higher income in the industries that use resources more efficiently, allowing them to earn higher prices and wages.
Misconceptions About Comparative Advantage (cont.) 3.Free trade exploits less productive countries. While labor standards in some countries are less than exemplary compared to Western standards, they are so with or without trade. Are high wages and safe labor practices alternatives to trade? Deeper poverty and exploitation may result without export production. Consumers benefit from free trade by having access to cheaply (efficiently) produced goods. Producers/workers benefit from having higher profits/wages—higher compared to the alternative.
Transportation Costs and Non-traded Goods The Ricardian model predicts that countries completely specialize in production. But this rarely happens for three main reasons: 1.More than one factor of production reduces the tendency of specialization (Chapter 4). 2.Protectionism (Chapters 8–11). 3.Transportation costs reduce or prevent trade, which may cause each country to produce the same good or service.
Transportation Costs and Non-traded Goods (cont.) Nontraded goods and services (ex., haircuts and auto repairs) exist due to high transport costs. Countries tend to spend a large fraction of national income on nontraded goods and services. This fact has implications for the gravity model and for models that consider how income transfers across countries affect trade.
Empirical Evidence Do countries export those goods in which their productivity is relatively high? The ratio of U.S. to British exports in 1951 compared to the ratio of U.S. to British labor productivity in 26 manufacturing industries suggests yes. At this time the U.S. had an absolute advantage in all 26 industries, yet the ratio of exports was low in the least productive sectors of the U.S.
Empirical Evidence Compare Chinese output and productivity with that of Germany for various industries using 1995 data. Chinese productivity (output per worker) was only 5 percent of Germany’s on average. In apparel, Chinese productivity was about 20 percent of Germany’s, creating a strong comparative advantage in apparel for China.
Empirical Evidence The main implications of the Ricardian model are well supported by empirical evidence: productivity differences play an important role in international trade comparative advantage (not absolute advantage) matters for trade
Summary 1.Differences in the productivity of labor across countries generate comparative advantage. 1.A country has a comparative advantage in producing a good when its opportunity cost of producing that good is lower than in other countries.
Summary 3.Countries export goods in which they have a comparative advantage - high productivity or low wages give countries a cost advantage. 4.With trade, the relative price settles in between what the relative prices were in each country before trade.
Summary (cont.) 5.Trade benefits all countries due to the relative price of the exported good rising: income for workers who produce exports rises, and imported goods become less expensive. 6.Empirical evidence supports trade based on comparative advantage, although transportation costs and other factors prevent complete specialization in production.