University of Papua New Guinea International Economics Lecture 12 - Revision Lecture: Trade Models

The University of Papua New Guinea Slide 1 Lecture 12: Revision Lecture – Trade Models Michael Cornish Overview Recap: why bother with trade models? The Ricardian Model The Specific Factors Model The Heckscher-Ohlin Model The Standard Trade Model Modern Trade Models (x4 models) External Economies of Scale Internal Economies of Scale

The University of Papua New Guinea Slide 2 Lecture 12: Revision Lecture – Trade Models Michael Cornish Recap: why bother with trade models? What is the purpose of a trade model? –To answer to main questions: 1.What drives trade? 2.How does trade affect the economy (i.e. how does it affect people)? Are there gains in welfare? What are the distributional effects?

The University of Papua New Guinea Slide 3 Lecture 12: Revision Lecture – Trade Models Michael Cornish The Ricardian Model 1.What drives trade? –Differences in labour productivity 2 products, 2 economies, 1 factor of production (L) Assumptions: –Perfect competition, homogenous labour General equation for production: L ≥ ( α L1 * Q 1 ) + ( α L2 * Q 2 )

The University of Papua New Guinea Slide 4 Lecture 12: Revision Lecture – Trade Models Michael Cornish Our wine and cheese economy... (‘Home’) Remember: A straight- line PPF means constant opportunity cost!

The University of Papua New Guinea Slide 5 Lecture 12: Revision Lecture – Trade Models Michael Cornish The Ricardian Model Wages: w = (P / α ) (e.g., w C = (P C / α LC ) In the absence of trade, we expect relative prices to equal relative costs (and thus wages would equalise!) –In Home: P 1 /P 2 = α L1 / α L2 »E.g., P C /P W = α LC / α LW –In Foreign: P* 1 /P* 2 = α* L1 / α* L2 »E.g., P* C /P* W = α* LC / α* LW

The University of Papua New Guinea Slide 6 Lecture 12: Revision Lecture – Trade Models Michael Cornish The Ricardian Model But what will world prices be with trade? We need to have a model that does not just look at the market for cheese, or the market for wine… …but instead models both markets together! This is called general equilibrium analysis –I.e., relative demand and relative supply

The University of Papua New Guinea Slide 7 Lecture 12: Revision Lecture – Trade Models Michael Cornish General equilibrium analysis: relative supply No supply of cheese if price drops below α C / α W Both Home and Foreign specialise in cheese if price is above α* C / α* W Any price in between leads to Home to fully specialise in cheese, and Foreign to fully specialise in wine The quantities produced when both countries fully specialise

The University of Papua New Guinea Slide 8 Lecture 12: Revision Lecture – Trade Models Michael Cornish General equilibrium analysis: relative demand and relative supply Any RD that intersects on a flat part of RS will lead to complete specialisation in one country, and no specialisation in the other [e.g. RD 2 or RD 3 ] Any RD that intersects relative supply between these prices leads to both countries fully specialising [e.g. RD 1 ] Note: RD is exogenously determined (‘given’ to us, we are not calculating it!)

The University of Papua New Guinea Slide 9 Lecture 12: Revision Lecture – Trade Models Michael Cornish The Ricardian Model RD 1 : Both Home and foreign fully specialise according to their comparative advantage RD 2 : Foreign fully specialises in wine, Home does not specialise (produces both) RD 3 : Home fully specialises in cheese, Foreign does not specialise (produces both) Note: Countries will never specialise against their comparative advantage (except with domestic distortions)

The University of Papua New Guinea Slide 10 Lecture 12: Revision Lecture – Trade Models Michael Cornish The Ricardian Model 2.How does trade affect the economy? –Comparative advantage creates gains from trade (i.e. welfare gains) –Countries (either fully or partially) specialise according to their comparative advantage

The University of Papua New Guinea Slide 11 Lecture 12: Revision Lecture – Trade Models Michael Cornish The Specific Factors Model 1.What drives trade? –The model does not explicitly address this – it assumes changes in prices are exogenously determined by trade…! –Instead it looks at the distributional effects caused by trade

The University of Papua New Guinea Slide 12 Lecture 12: Revision Lecture – Trade Models Michael Cornish The Specific Factors Model 2 products Three factors of production –Can be any three, but convention is to use: L: Labour, the mobile, ‘non-specific’ factor K: Capital, a fixed and ‘specific’ factor T: Land, a fixed ‘specific’ factor Assumptions: –Perfect competition, homogenous labour

The University of Papua New Guinea Slide 13 Lecture 12: Revision Lecture – Trade Models Michael Cornish The ‘four-way’ graph

The University of Papua New Guinea Slide 14 Lecture 12: Revision Lecture – Trade Models Michael Cornish The Specific Factors Model Because we assume labour can move freely, wages should be identical in both sectors (e.g., w Food = w Cloth ) Wages: w = MPL C * P C = MPL F * P F –Thus: – MPL F / MPL C = – P C / P F

The University of Papua New Guinea Slide 15 Lecture 12: Revision Lecture – Trade Models Michael Cornish Determining the equilibrium wage... Note: The assumption is that the demand for labour in each sector is equal to the value of the produce of labour (P * MPL) [which is the willingness to pay a certain level of wage]

The University of Papua New Guinea Slide 16 Lecture 12: Revision Lecture – Trade Models Michael Cornish In domestic equilibrium

The University of Papua New Guinea Slide 17 Lecture 12: Revision Lecture – Trade Models Michael Cornish An increase in one price only (e.g. cloth) 1. Labour shifts from the food sector into the cloth sector...

The University of Papua New Guinea Slide 18 Lecture 12: Revision Lecture – Trade Models Michael Cornish 2....the relative price changes 1. As labour shifts from the food sector into the cloth sector...

The University of Papua New Guinea Slide 19 Lecture 12: Revision Lecture – Trade Models Michael Cornish The effect on the PPF from an increase in one price only (e.g. cloth) 2. The relative price changes

The University of Papua New Guinea Slide 20 Lecture 12: Revision Lecture – Trade Models Michael Cornish The Specific Factors Model 2.How does trade affect the economy? –Trade benefits the factor that is specific to the export market, but hurts the factor that is specific to the import market –The effects upon the non-specific factor (L) are ambiguous

The University of Papua New Guinea Slide 21 Lecture 12: Revision Lecture – Trade Models Michael Cornish The Heckscher-Ohlin Model 1.What drives trade? –Differences in resource endowments (i.e. differences in the relative abundance of factors of production)

The University of Papua New Guinea Slide 22 Lecture 12: Revision Lecture – Trade Models Michael Cornish The Heckscher-Ohlin Model Simple version – the ‘2 x 2 x 2 Model’: –2 economies –2 products –2 factors of production »Convention is L and K Assumptions: Perfect competition, homogenous labour

The University of Papua New Guinea Slide 23 Lecture 12: Revision Lecture – Trade Models Michael Cornish Cloth production is more labour- intensive than food production; food is more capital-intensive Relative factor demand curves

The University of Papua New Guinea Slide 24 Lecture 12: Revision Lecture – Trade Models Michael Cornish Linking relative product prices (P C /P F ) with relative factor prices (w/r)

The University of Papua New Guinea Slide 25 Lecture 12: Revision Lecture – Trade Models Michael Cornish And now linking it all together: relative product prices (P C /P F ), relative factor prices (w/r), & input combinations If we increase P C / P F … Then we decrease the L-K ratio used in both products

The University of Papua New Guinea Slide 26 Lecture 12: Revision Lecture – Trade Models Michael Cornish General equilibrium analysis: relative demand and relative supply Note: Relative demand is assumed to be universal (the same regardless of the country) RS* = Relative Supply in Foreign

The University of Papua New Guinea Slide 27 Lecture 12: Revision Lecture – Trade Models Michael Cornish 1. Production Opening to trade shifts production from Q A to Q* With trade, more cloth is produced and less food 2. Consumption Consumption can now be at any point along the red ‘trade’ line!

The University of Papua New Guinea Slide 28 Lecture 12: Revision Lecture – Trade Models Michael Cornish The Heckscher-Ohlin Model 2.How does trade affect the economy? The Heckscher-Ohlin Theorem: The country that is relatively abundant in a factor will export the product that uses that factor intensively in its production –E.g., In our example, Home was relatively more abundant in labour than Foreign, and ended up exporting the labour-intensive product, cloth

The University of Papua New Guinea Slide 29 Lecture 12: Revision Lecture – Trade Models Michael Cornish The Heckscher-Ohlin Model 2.How does trade affect the economy? (cont.) Factor price equalisation Opening to trade equalises the prices of factors Owners of the country’s abundant factor gains from trade, but owners of a country’s scarce factors lose

The University of Papua New Guinea Slide 30 Lecture 12: Revision Lecture – Trade Models Michael Cornish The Standard Trade Model Extends the Heckscher-Ohlin Model –Adds in consumption preferences –Otherwise, same assumptions, same conclusions! »Note: following diagrams are assuming cloth is the exported product

The University of Papua New Guinea Slide 31 Lecture 12: Revision Lecture – Trade Models Michael Cornish Adding indifference curves

The University of Papua New Guinea Slide 32 Lecture 12: Revision Lecture – Trade Models Michael Cornish Trade triangles [in green]

The University of Papua New Guinea Slide 33 Lecture 12: Revision Lecture – Trade Models Michael Cornish RS = Domestic RS As the terms of trade increase [  (P C /P F )], welfare increases [D 3 => D 1 = > D 2 ]

The University of Papua New Guinea Slide 34 Lecture 12: Revision Lecture – Trade Models Michael Cornish Modern trade models 1.Differences in demand 2.Linder’s Representative Demand 3.Vernon’s Product Life Cycle Theory 4.The Gravity Model

The University of Papua New Guinea Slide 35 Lecture 12: Revision Lecture – Trade Models Michael Cornish Differences in demand: an example Source: Structure of the Global Markets for MeatStructure of the Global Markets for Meat, by John Dyck and Kenneth Nelson, USDA, Economic Research Service, September 2003

The University of Papua New Guinea Slide 36 Lecture 12: Revision Lecture – Trade Models Michael Cornish...versus Papua New Guinea! [You see the same thing in Fiji, Indonesia, rural China, etc.!] Linder’s Representative Demand: Trade between countries of similar income levels because they demand similar products Variations of rice in Australian shops...

The University of Papua New Guinea Slide 37 Lecture 12: Revision Lecture – Trade Models Michael Cornish Vernon’s Product Life Cycle Theory

The University of Papua New Guinea Slide 38 Lecture 12: Revision Lecture – Trade Models Michael Cornish Modern trade models: The Gravity Model Trade due to size and proximity of economies: –T ij = (A * Y i * Y j ) / D ij –T ij : value of trade between country i and j –Y i : GDP of country i –Y j : GDP of country j –D ij : distance between country i and j –A: a constant This is necessary to reflect the general level of trade in both countries relative to GDP

The University of Papua New Guinea Slide 39 Lecture 12: Revision Lecture – Trade Models Michael Cornish External economies of scale External economies of scale occur when the cost per unit of production depends on the size of the industry, but not necessarily on the size of any one firm Causes: 1.Specialised suppliers 2.Labour market pooling 3.Knowledge spillovers Classic example: Silicon Valley for computer and IT design

The University of Papua New Guinea Slide 40 Lecture 12: Revision Lecture – Trade Models Michael Cornish External economies of scale: With trade

The University of Papua New Guinea Slide 41 Lecture 12: Revision Lecture – Trade Models Michael Cornish External economies of scale: Established/entrenched advantage

The University of Papua New Guinea Slide 42 Lecture 12: Revision Lecture – Trade Models Michael Cornish Internal economies of scale Internal economies of scale occur when the cost per unit of production depends on the size of an individual firm, but not necessarily the size of the industry… 1.CC: The more firms there are in the industry, the higher the average cost 2.PP: The more firms there are in the industry, the lower the price they charge

The University of Papua New Guinea Slide 43 Lecture 12: Revision Lecture – Trade Models Michael Cornish

The University of Papua New Guinea Slide 44 Lecture 12: Revision Lecture – Trade Models Michael Cornish Explanatory note for previous slide...

The University of Papua New Guinea Slide 45 Lecture 12: Revision Lecture – Trade Models Michael Cornish Internal economies of scale: Opening to trade Note: As discussed,  Q Industry leads to lower costs (for any given n), and no change in the price charged (for any given n)

The University of Papua New Guinea Slide 46 Lecture 12: Revision Lecture – Trade Models Michael Cornish Formulas that will be provided in the mid-semester test For the Ricardian Model: General equation: L ≥ ( α L1 * Q 1 ) + ( α L2 * Q 2 ) The Gravity Model: –T ij = (A * Y i * Y j ) / D ij Internal economies of scale: 1. Q Firm = Q Industry * [(1/n) – b * (P – )] 2. ATC = FC/Q Firm + MC = [n * (FC/Q Industry )] + MC 3. (P – MC) = 1 / (b * n)