E&D International Economics, 2 Lecture 8 Giorgia Giovannetti

Plan of the course/lectures Lectures (tentative) 14/9 Introduction: globalization 15/9 Introduction, 2 21/9 Ricardo: an introduction (Marvasi) 22/9 Measuring Globalization, Indicators 28/9 Measuring globalization and specialization, Indicators 2 29/9 Overview trade models 5/10 Overview trade models (Bernard et al 2007; 2011) 6/10 Overview- end (new new trade) 12/10 Trade models: Ricardo and comparative advantage 13/10 H-O, intro 19/10 Trade models: H-O 20/10 Trade models: H-O,2/exercises 26/10 Trade and Imperfect competition 27/10 Trade and imperfect competition 2/11 Geography models/gravity 3/11 Hysteresis, Heterogeneous firms 9/11 Trade policy: TTIP 10/11 EU development Policy 16/11 EU development Policy 17/11 FDI and Multinationals: OLI theory 23/11 FDI and Multinationals Offshoring/trade in tasks 24/11 China and India (BRICS) 30/11 Granularity and aggregate shocks 1/12 212

Summary: The Ricardian Assumptions— Preferences The preferences of all consumers in the world are identical. For any individual, the Marginal Rate of Substitution is independent of the scale of consumption. – An individual’s MRS of wheat for cloth is the maximum amount of wheat that he/she would be willing to pay for one unit of cloth. – Under this assumption, if the amounts of cloth and wheat being consumed are, say, doubled, then the MRS remains unchanged. – In other words, the MRS does not change if the ratio of the amounts of cloth and wheat consumed, cloth/ wheat, does not change.

Summary: Marginal Rate of Substitution Note that a consumer’s MRS of wine for cloth is, simply, a measure of how much the consumer likes cloth. We assume that MRS WC decreases as the consumption of cloth increases relative to the consumption of wheat … …And remains unchanged if the consumption of cloth remains unchanged relative to the consumption of wheat.

The Ricardian Assumptions—Technology Goods are produced (out of resources) with technologies that satisfy Constant Returns to Scale. – That is, if the producer of a commodity, say, doubles the amounts used of all resources, then the amount produced will also double.

The Ricardian Assumptions There is perfect competition in all markets. – That is, no buyer or seller of a commodity has the power to affect the price of the commodity by himself. – More specifically, the market for a commodity is said to be perfectly competitive if: There are many sellers There are many buyers All sellers sell the exact same product Individuals make decisions so as to maximize happiness, whereas Firms make decisions so as to maximize profits Governments do not interfere with the smooth functioning of markets; there are no taxes, subsidies, tariffs, quotas, etc.

Ricardian Model: Main Lessons Trade occurs because technology varies from country to country Even backward can gain from trade with advanced Advanced countries can gain from trade even if their workers have to compete with “cheap labor” countriescheap labor

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 (more wheat in exchange for cloth). – Producers/workers benefit by earning a higher income (by using resources more efficiently and through higher prices/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 (e.g., involuntary prostitution) 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 should completely specialize in production. But this rarely happens for primarily 3 reasons: 1.More than one factor of production reduces the tendency of specialization 2.Protectionism 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.) Non-traded goods and services (e.g., haircuts and auto repairs) exist due to high transportation costs. – Countries tend to spend a large fraction of national income on non-traded goods and services. – This fact has implications for the gravity model and for models that consider how income transfers across countries affect trade.

Test on indicators

From Ricardo to Heckscher-Ohlin In the Ricardo model, trade is partly explained by differences in labor productivity; In H-O it is explained by differences in resources across countries. The Heckscher-Ohlin theory argues that international differences in labor, labor skills, physical capital or land (factors of production) create productive differences that explain why trade occurs. – Countries have relative abundance of factors of production. – Production processes use factors of production with relative intensity.

Heckscher-Ohlin (intuition) The EU exports microchips since it is relatively more abundant of K, that is the factor relatively more used in the production of microchips Opposite for India, which exports shoes Still a theory of comparative advantages (CA), but defined differently  now CA depend on the relative abundancy of production factors and not on technology differences

Heckscher-Ohlin How we proceed: 1.No-Trade Equilibrium & Free Trade Equilibrium 2.Testing the Heckscher-Ohlin theorem: Leontief’s Paradox Effects of Trade on Factor Prices – Effect of Trade on the Wage and Rental of Home – Determination of the Real Wage and Real Rental – Changes in the Real Wage and Rental: A Numerical Example Extending the Heckscher-Ohlin Model – Many Goods, Factors and Countries – Differing Productivities Across Countries The HO model is a long run model because all factors of production can move between the industries.

Heckscher-Ohlin Model There are two countries, Home and Foreign. Each country produces two goods, computers and shoes. Production uses two factors of production, labor (L) and capital (K). This is different from Ricardo (only labour) We can add up the resources used in each industry to get the total for the economy. – Capital in each good for each country K = K C + K S and K* = K* C + K* S – Labor in each good for each country L = L C + L S and L* = L* C + L* S

Assumptions 1.Both factors can move freely between industries. – Capital must earn the same rental rate, R, in both industries. – All labor earns the same wage in both industries. – If not, then capital or labor would move to the industry where it received the higher rate.

Assumptions 2.Shoe production is labor-intensive; it requires more labor per unit of capital to produce shoes than computers, so that L S /K S > L C /K C. 3.Computer production is capital-intensive—more capital per worker is used to produce computers than to produce shoes. 4.Shoes use more labor per unit of capital. 5.The Figure below shows relative demand curves for labor in each industry. Because shoe production is more labor intensive, the relative demand curve for shoes lies to the right of the labor demand for computers.