Economics of Trade International Political Economy Prof. Tyson Roberts 1

Economics of Trade Comparative Advantage => Trade increases aggregate welfare for all countries Stolper-Samuelson => The benefits of trade are not equally distributed within countries (winners and losers) – More on this next week Spatial analysis & Pareto improvements 2

Aggregate Trade Benefits: Comparative Advantage (Ricardo) 3

The basic Ricardo model Two countries Two products One factor of production (e.g., labor) 4

Home 1200 labor units (e.g., 30 workers working 40 hours each) 30 labor units to make iPods – Q: How many iPods could be made per week if all workers make iPods? 5 labor units to make pair of running shoes – Q: How many pairs of shoes could be made per week if all workers make shoes? 5

Calculation for production possibility 1200 labor units (per week) 30 labor units to make iPods – Q: How many iPods could be made per week if all workers make iPods? 1200 labor/ 30 labor per iPod = 40 iPods – A: 40 iPods 6

Home 30 labor units to make iPods – Can produce up to 40 iPods 5 labor units to make pair of running shoes – Can produce up to 240 pairs of shoes Opportunity cost ≈ Price – What is the cost of iPods in terms of shoes? – What is the cost of shoes in terms of iPods? 7

Opportunity cost is the cost of any activity measured in terms of the value of the next best alternative forgone 8

Opportunity cost calculation 30 labor units to make iPods 5 labor units to make pair of running shoes – Q: What is the opportunity cost of iPods in terms of shoes? 30 labor units could make 1 iPod or 30/5 = 6 shoes. – A: Opportunity cost of 1 iPod = 6 shoes 9

Home 1200 labor units (e.g., 30 workers working 40 hours each) 30 labor units to make iPods – Can produce up to 40 iPods 5 labor units to make pair of running shoes – Can produce up to 240 pairs of shoes Opportunity cost ≈ Price – “Price” of 1 iPod is 6 pairs of shoes – “Price” of 1 pair shoes is 1/6 iPod 10

What is the production possibility frontier for Home? Draw it. – Hint: Assume all labor is dedicated to each product to find intercepts, then draw line between the two intercepts. 11

Production possibility frontier Home Shoes iPods 12 Slope = -1/6

Production possibility frontier Home Shoes iPods 13 Slope = -1/

How many shoes & iPods Home will produce/consume depends on indifference (utility) curves More iPods & shoes is better Consumers are willing to give up some quantity for right mix Shoes iPods 14

Foreign 720 labor units (e.g., 18 workers working 40 hours each) 12 labor units to make iPods – Q: How many iPods could be made per week if all workers make iPods? 4 labor units to make pair of running shoes – Q: How many shoes could be made per week if all workers make shoes? 15

Foreign 720 labor units (e.g., 18 workers working 40 hours each) 12 labor units to make iPods – Can produce up to 60 iPods 4 labor units to make pair of running shoes – Can produce up to 180 pairs of shoes Opportunity cost ≈ Price – What is the cost of iPods in terms of shoes? – What is the cost of shoes in terms of iPods? 16

Foreign 720 labor units (e.g., 18 workers working 40 hours each) 12 labor units to make iPods – Can produce up to 60 iPods 4 labor units to make pair of running shoes – Can produce up to 180 pairs of shoes Opportunity cost ≈ Price – “Price” of 1 iPod is 3 pairs of shoes (12 hours/4 hours) – “Price” of 1 pair of shoes is 1/3 iPod (4 hours/12 hours) 17

Production possibility frontier Frontier Shoes 180 iPods Slope = -1/3

What matters for trade is comparative, not absolute, advantage Note Foreign has absolute advantage in both iPods & shoes – 12 vs. 30 labor units to make iPods – 4 vs. 5 labor units to make shoes Does this mean that with trade, Foreign will make iPods & shoes and Home will make nothing? No. 19

What matters for trade is comparative, not absolute, advantage Relative to Home, Foreign has a comparative advantage in producing iPods – It (opportunity) costs fewer (3 vs. 6) shoes to make an iPod in Foreign than in Home Relative to Foreign, Home has a comparative advantage in producing shoes – It (opportunity) costs fewer iPods (1/6 vs. 1/3) to make shoes in Home than in Foreign 20

HomeForeign Price of iPods6 shoes3 shoes Price of Shoes1/6 = iPods1/3 = iPods 21 Cheaper

Trade increases PPF for Home Assume demand curves in Home & Foreign are such that the international price of shoes per iPod is 4 (and price of iPods per shoes is ¼) Now it is cheaper for Home to trade for iPods than to make them (4 shoes < 6 shoes) Home can “indirectly produce” iPods by making shoes and trading for iPods – Can make 240 pairs of shoes and trade for 60 iPods – Trade is like an improvement in technology! 22

HomeTradeForeign Price of iPods6 shoes4 shoes3 shoes Price of Shoes1/6 = iPods1/4 = 0.25 iPods1/3 = iPods 23 Cheaper

Production possibility frontier Home with trade Shoes iPods 60 24

Trade increases PPF for Foreign Assume demand curves in Home & Foreign are such that the price of shoes per iPod is 4 (and price of iPods per shoes is ¼) Now it is cheaper for Foreign to trade for shoes than to make them (¼ iPod <⅓ iPod) Foreign can “indirectly produce” shoes by making iPods and trading for shoes – Can make 60 iPods and trade for 240 pairs shoes 25

Production possibility frontier Foreign with trade Shoes 180 iPods

The mix of shoes & iPods produced/traded depends on the indifference curves/utility functions of consumers in both countries (demand for shoes relative to iPods) Shoes 180 iPods

Trade & Rate of Growth Comparative advantage alone does not produce an increase in “steady state” (i.e. long run) economic growth, only an increased growth rate during transition from closed to trade 28

Trade & Rate of Growth If specialization generates additional benefits, then increased trade can increase long run economic growth rate Economic growth effects of trade are also determined by positive and negative externalities – Technology spillovers => higher growth rate – Income inequality => political instability => lower growth rate 29

Some Determinants of Trade Differences in comparative advantage Geography – Access to ocean, wealthy neighbors, etc. Technology – Navigation, steam engines, telecom, etc. Policy – Tariffs, quotas, monopolies, exchange rate regime 30

Distribution of Trade Benefits (Heckscher-Ohlin => Stolper-Samuelson) 31

Basic H-O & SS models Two countries Two products Two factors of production (e.g., labor & capital) – Next week we’ll look at 3 factors: labor, capital, & land 32

PPF with TWO factors Each factor assumed to have diminishing marginal returns (DMRs) – For given amount of capital, labor has DMRs – For given amount of labor capital has DMRs Factors can substitute for one another 33

Diminishing marginal returns of labor, holding capital constant Assume one sewing machine – 1 st worker, work 9am-5pm => 10 shirts – 2 nd worker, work 5pm-1am => 9 shirts (sleepy) – 3 rd worker, work 1am-9am => 8 shirts (very sleepy) – 4 th worker, help 1 st worker => 7 shirts – 5 th worker, help 2 nd worker => 6 shirts – 6 th worker, help 3 rd worker => 5 shirts – 7 th worker, help 1 st & 4 th worker => 4 shirts – Etc. 34

When Workers per Machine is low, Workers are productive/valuable. When Workers per Machine is high, Workers are less productive/valuable So in labor-abundant countries (relative to capital), wages should be low and profits to capital should be high. 35

Diminishing marginal returns of capital, holding labor constant Assume one worker – 1 st sewing machine => 10 shirts per day – 2 nd sewing machine => 7 more shirts (use one for sleeves and one for torsos) – 3 rd sewing machine => 3 more shirts (use when a machine has problems) – 4 th sewing machine => 1 more shirt (use when 2 machines have problems) – Etc. 36

When Machines per Worker is low, Machines are productive/valuable. When Machines per worker is high, Machines are less productive/valuable So in capital-abundant countries (relative to labor), wages should be high and profits to capital should be low. 37

Production functions depend on the good iPods production tends to use more capital than labor, relative to shoes – “Capital intensive” Shoe production tends to use more labor than capital, relative to iPod production – “Labor intensive” 38

Comparative advantage may be a function of factor endowments Home – 300 units of capital, 1200 units of labor Capital:Labor is ¼ – Can produce up to 40 iPods and up to 240 shoes Foreign – 720 units of capital, 720 units of labor Capital: Labor is 1 (comparatively more capital abundant) – Can produce up to 60 iPods and up to 180 shoes Comparative advantage in making iPods (capital intensive) 39

Winners and Losers from Trade Heckscher-Ohlin – Countries will export products that use their comparatively abundant factor(s) more intensively & import products that use their comparatively scarce factor(s) => – Increased PPFs for all trading countries => – All national economies (& consumers) win 40

Winners and Losers from Trade Stolper-Samuelson – Under some economic assumptions (constant returns, perfect competition, etc.), – Increased relative price of a good => – Increased returns for factor(s) used intensively in the production of that good, and – Reduced returns for other factor(s) – Some factor owners (in each country) win, others lose with regard to earnings 41

Relative factor endowments affect relative factor prices (relatively scarce factors earn more) Relative labor abundance  Lower wages relative to profits without trade  Trade: Export labor-intensive goods  Domestic price of labor-intensive goods rises; price of capital intensive goods falls  Increased real wages with trade Relative capital abundance  Lower profits relative to wages without trade  Trade: Export capital-intensive goods  Domestic price of capital-intensive goods rises; price of labor-intensive goods falls  Increased real profits with trade 42

Winners and Losers from Free Trade Winners – Consumers: Lower prices (on average), more consumption – Relative abundant factor owners: higher returns for factor (labor, capital, or land) Losers – Relative scarce factor owners: lower returns for factor 43

Conclusions Free trade has potential to increase total production and consumption in the world, and in every country that participates, through more efficient allocation of production activities Within countries, some may be losers from trade – Comparative disadvantaged producers, owners of scarce factors – Note that people have multiple attributes (e.g., workers are also consumers) 44

Conclusions Long term effects may be more complicated – If a country shifts from high growth to low growth sector, it may benefit in the short run but miss out on potential growth in the long run 45

One more example Now assume that demand curves in Home & Foreign are such that the price of shoes per iPod is 5 (and price of iPods per shoes is 1/5) What is the new PPF for Home and Frontier after trade? 46

Production possibility frontier: Home with trade Home can make 240 shoes and buy 240/5 = 48 iPods Shoes iPods 48 47

Production possibility frontier: Foreign with trade Foreign can make 60 iPods and buy 60 x 5 = 300 pairs shoes Shoes 180 iPods BUT Home cannot make 300 shoes!

Home can only make 240 pairs shoes Shoes iPods 48 49

Production possibility frontier: Foreign with trade So Foreign can make 48 iPods and trade for 48 x 5 = 240 Shoes Then Foreign can take the remaining 720 – (48 x 12) = 144 hours and make 144/4 = 36 Shoes Shoes 180 iPods Foreign can buy 240 Shoes and make 36 Shoes Total possible shoes =

Another way to look at Pareto Improvements 51

Edgeworth box: Each player is on a corner. Each axis is a product. Barista Baker

Further from player’s corner means more consumption for that player Barista Baker Barista gets all the coffee and bread Baker gets all the coffee and bread Barista gets all bread, baker gets all coffee Barista gets all the coffee, baker gets all the bread    

Each player gets more utility from increasing coffee & bread Each player is willing to give up quantity for an ideal mix

From a given starting point of endowments ω, a Pareto improvement is possible in the space where both players increase their utility Starting endowment

Market transactions will lead to a Pareto optimal outcome at the equilibrium market price

In political science spatial analysis, the two dimensions are policy Policy 2 Policy 1

Each player has a policy ideal point Policy 2 Policy 1   Player 1 ideal point Player 2 ideal point

Each player receives LESS utility further from the ideal point in any direction Policy 2 Policy 1  

From a given starting point status quo policy SQ, a Pareto improvement is possible in the space where both players increase their utility Policy 2 Policy 1    SQ Contract curve

Coming attractions Next lecture: Trade Bargaining and the Enforcement Problem And then: Institutional Solutions to Trade’s Enforcement Problem 61