Economics and Development International trade Giorgia Giovannetti Professor of Economics, University of Firenze E-mail: giorgia.giovannetti@unifi.it 07/11/2017 1

During the last lecture…

Short summary of key concepts Absolute advantage: When a country has the best technology for producing a good, it has an absolute advantage in the production of that good. Comparative Advantage: A country has a comparative advantage in producing those goods that it produces best compared with how well it produces other goods.

Short summary of key concepts Ricardo explains trade with technological differences across countries Main hypotheses: Identical consumers preferences Perfect competition in all markets (Price = Marginal Cost) Different technologies between countries (simple technologies with fixed coefficients) with constant returns to scale Marginal products of labor are constant (The Marginal Product of Labor is the extra output obtained by using one more unit of labor)

Short summary of key concepts Opportunity cost of good x: MPLy /MPLx Denotes the units of a good that I can renounce in order to have an additional unit of the other good Relative price of good x: Px/Py Denotes the relative price of the good in the numerator, measured in terms of how much of the good in the denominator must be given up

Short summary of key concepts Determination of wages In competitive markets, labor can move freely between industries. Labor will move to the higher paid industry. This will continue until there is equalization of wages between industries. Wages are equal to Wx =Px ⋅ MPLx = Py ⋅ MPLy = Wy The equalization of wages will give us the following: Px/Py = MPLy/MPLx

exercise 2 You are given the information shown in the table about the production relationship between Wonderland and the rest of the world and use the standard Ricardian assumptions: Wonderland has 40 million labor hours in total and the rest of the world has 30 million labor hours in total per year.   Labor Hours per Bottle of Wine Labor Hours per Pound of Cheese Wonderland 10 5 Rest of the World 6 2

Short summary of key concepts Marginal Cost = Wage ⋅ Hours of Labor Marginal Cost = Price (In perfect competition) Relative price of good x: Px/Py Wages are equal to Px ⋅ MPLx = Py ⋅ MPLy then Px/Py = MPLy/MPLx Where MPLy /MPLx is the opportunity cost of good x

2 pounds of cheese per 1 bottle of wine exercise 2: Question b B) Which country has comparative advantage in wine? In cheese? Comparative advantage means lower opportunity costs. Therefore, wonderland has comparative advantage in producing wine and ROW has comparative advantage in producing cheese.   Labor Hours per Bottle of Wine Labor Hours per Pound of Cheese Wonderland 2 (Because Pw/Pc= 10/5= 2) 2 pounds of cheese per 1 bottle of wine 1/2 (Because Pc/Pw= 5/10= 1/2) Rest of the World 3 (Because Pw/Pc= 6/2= 3) 1/3 (Because Pc/Pw= 2/6= 1/3)

exercise 2: Question c C: Graph each country’s PPF. Use indifference curve to show the no-trade equilibrium (label as point A) for each country. (Suppose Wonderland consumes 4 million pounds of cheese and the rest of the world consumes 6 pounds of cheese). We know from the exercise that Wonderland has 40 million labor hours in total and the rest of the world has 30 million labor hours in total per year.

exercise 2: Question c 1) We need to identify the quantities of wine and cheese Wonderland: 10QW + 5QC = 40 QC=40 (total hours)/5 (hours for one unit of cheese) = 8 pounds of cheese QW=40 (total hours)/10 (hours for one unit of wine) = 4 battles of wine ROW: 6 Q*W + 2Q*C = 30 Q*W =30/6 = 5 battles of wine Q*C=30/2 = 15 pounds of cheese

exercise 2: Question c 2) Then, we can draw the graph From the exercise we know that Wonderland consumes 4 million pounds of cheese and the rest of the world consumes 6 pounds of cheese. So, since we know the slope of the PPF and the intercept we can calculate the quantity of wine! y= a+ bx For Wonderland: 4= 8-2x x=2 For RoW: 6= 15–3x x=3 15

exercise 2: Question d When trade is opened between Wonderland and the rest of the world, what the pattern of trade is? If the world price ratio is 0.4 bottle of wine per pound of cheese (Be careful this is not Pw/Pc but Pc/Pw), what happens to production in each country? (Label the new production point in each country as point P) PC/PW = 0.4 and therefore, PW/PC = 2.5

Today’s lecture

exercise 2: Question d Now countries open to trade In the Ricardo model, when countries open to trade: each country exports the good for which it has a CA. Wonderland exports wine and RoW exports Cheese

exercise 2: Question d Therefore, when countries open to trade: Two countries are in a trade equilibrium when: the relative price of each good is the same in the two countries the amount of each good that the countries want to trade is equal Wonderland Rest of the World Quantity of wine Price of wine Quantity of cheese Price of cheese

Back to exercise 2: Question d Label the new production point in each country as point P 15 New price line (pink line) showing the world price. The world price line shows the range of consumption possibilities that a country can achieve by specializing in one good and trading.

Back to exercise 2: Question d Answer: The production point is point P. When the world price ratio is .4 bottle wine per pound of cheese, PC/PW = .4 and therefore, PW/PC = 2.5. In this case, the world price ratio is between these two country’s opportunity costs, therefore, Wonderland will specialize in producing wine (4m bottles of wine) and ROW will specialize in producing cheese (15m pounds of cheese). 15 New price line (pink line) showing the world price. The world price line shows the range of consumption possibilities that a country can achieve by specializing in one good and trading.

exercise 2: Question e Suppose that 2 million bottles of wine and 5 million pounds of cheese are traded. Show the consumption of each good in each country graphically using indifference curve (label the consumption point C)? Wonderland exports wine and RoW exports cheese. The quantity of cheese imported by Wonderland is the same of the quantity of cheese exported by RoW (5m pounds), and the quantity of wine exported by Wonderland is the same of the quantity of wine imported by RoW (2m bottles).

Excercize 2: Question e 5 million pound of cheese imported by Wonderland and exported by RoW (Wonderland produces 0 of cheese). Thus, RoW still produces 15 of cheese but consumes 10 and export 5. 2 million of bottle of wine imported by RoW and Exported by Wonderland (RoW produces 0 of wine). Thus, Wonderland still produces 4 millions bottles of wine but consumes 2 and exports 2. 15

Excercize 2: Question e 5 million pound of cheese imported by Wonderland and exported by RoW (Wonderland produces 0 of cheese). Thus, RoW still produces 15 of cheese but consumes 10 and export 5. 2 million of bottle of wine imported by RoW and exported by Wonderland (RoW produces 0 of wine). Thus, Wonderland still produces 4 millions bottles of wine but consumes 2 and exports 2. 15 X M X M

exercise 3: Labor productivity coefficients for the US and Mexico are given in the following table: Country Corn Melons Labor Endowment United States 5 2 1000 Mexico 1

exercise 3 : Question a Who has the absolute advantage in corn? in melons? Country Corn Melons Labor Endowment United States 5 2 1000 Mexico 1

exercise 3 : Question a Who has the absolute advantage in corn? in melons? Answer: Absolute advantage goes to the more productive country. The US therefore has an absolute advantage in both corn and melons. Country Corn Melons Labor Endowment United States 5 2 1000 Mexico 1

exercise 3 : Question b Who has a comparative advantage in corn? in melons? Explain any differences from your previous answer. Country Corn Melons Labor Endowment United States 5 2 1000 Mexico 1

exercise 3 : Question b Who has a comparative advantage in corn? in melons? Explain any differences from your previous answer. Country Corn Melons Labor Endowment United States 2/5 5/2 1000 Mexico 1

exercise 3 : Question b Who has a comparative advantage in corn? in melons? Explain any differences from your previous answer. The US is therefore the low opportunity cost producer of corn (2/5 < 1) and Mexico the low opportunity cost producer of melons (1 < 5/2) Country Corn Melons Labor Endowment United States 2/5 melon 5/2 1000 Mexico 1

exercise 3 : Question c What are the limits on relative price before trade opens between the two countries?

exercise 3 : Question c What are the limits on relative price before trade opens between the two countries? The Mexican price ratio would be Pc/Pm = 1. The US price ratio is Pc/Pm = 2/5. Prices reflect opportunity costs in both the US and Mexico. The price ratio after trade must therefore lie between 2/5 and 1.

exercise 3 : Question c PPF?

exercise 3 : Question c The PPF is given by 𝑄 𝑚 𝑈𝑆 = 1000 ⋅ 2 = 2000 𝑄 𝑚 𝑈𝑆 = 1000 ⋅ 2 = 2000 𝑄 𝑐 𝑈𝑆 = 1000 ⋅ 5 = 5000 𝑄 𝑚 𝑚𝑒𝑥 = 1000 ⋅ 1= 1000 𝑄 𝑐 𝑚𝑒𝑥 = 1000 ⋅ 1= 1000 𝑄 𝑚 𝑈𝑆 2000 𝑄 𝑐 𝑈𝑆 𝑄 𝑚 𝑚𝑒𝑥 1000 1000 𝑄 𝑐 𝑚𝑒𝑥

exercise 4 Assume that Home and Foreign produce two goods, televisions and cars, and use the following information to answer the questions.

exercise 4: Question a a. What is the marginal product of labor for televisions and cars in the Home country? What is the no-trade relative price of televisions at Home?

exercise 4: Question a a. What is the marginal product of labor for televisions and cars in the Home country? What is the no-trade relative price of televisions at Home? In general, wages are equal to Wtv = Ptv ⋅ MPLtv = Pc ⋅ MPLc = Wc then Px/Py = MPLy/MPLx

exercise 4: Question a Wtv = Ptv ⋅ MPLtv 12= Ptv ⋅2 Ptv= 6 Wc = Pc ⋅ MPLc 12= 4 ⋅ MPLc MPLc =3 Relative price of good x: Px/Py PTV/ P C = 3/2 = MPL C / MPLTV

exercise 4: Question a a. What is the marginal product of labor for televisions and cars in the Home country? What is the no-trade relative price of televisions at Home? Answer: MPLC =3, MPLTV =2, and PTV/ P C = MPL C / MPLTV =3/2

exercise 4: Question b b. What is the marginal product of labor for televisions and cars in Foreign? What is the no-trade relative price of televisions in Foreign?

exercise 4: Question b 𝑊 𝑡𝑣 ∗ = MPL*TV ⋅ P*TV 6 = MPL*TV ⋅ 3 𝑊 𝐶 ∗ =MPL∗C ⋅ P*C 6 = 1 ⋅ P* C P*C =6 P*TV/ P* C = MPL* C / MPL*TV =1/2

exercise 4: Question b b. What is the marginal product of labor for televisions and cars in Foreign? What is the no-trade relative price of televisions in Foreign? Answer: MPL*C =3, MPL*TV =2, and P*TV/ P* C = MPL* C / MPL*TV =1/2

exercise 4 Now we have all the information 𝑊 𝑡𝑣 = 12 𝑊 𝐶 =12 HOME FOREIGN 𝑊 𝑡𝑣 = 12 𝑊 𝐶 =12 𝑊 𝑡𝑣 ∗ = 6 𝑊 𝐶 ∗ =6 MPLTV = 2 MPLC = 3 MPL*TV = 2 MPL∗C = 1 PTV = 6 PC = 4 P*TV = 3 P*C = 6

exercise 4: Question c c. Suppose the world relative price of televisions in the trade equilibrium is PTV/ PC =1. Which good will each country export? Briefly explain why.

(Because Ptv/Pc= MPLc/MPLtv= 3/2) exercise 4: Question c We need to identify the comparative advantage TV Cars Home 3/2 (Because Ptv/Pc= MPLc/MPLtv= 3/2) 2/3 Foreign 1/2 2

(Because Pw/Pc= MPLc/MPLtv= 3/2) exercise 4: Question c We need to identify the comparative advantage Answer: Home will export cars and Foreign will export televisions because Home has a comparative advantage in cars whereas Foreign has a comparative advantage in televisions. TV Cars Home 3/2 (Because Pw/Pc= MPLc/MPLtv= 3/2) 2/3 Foreign 1/2 2

exercise 4: Question d d. In the trade equilibrium, what is the real wage at Home in terms of cars and in terms of televisions? How do these values compare with the real wage in terms of either good in the no-trade equilibrium? We need to calculate the Real Wages relying on the new international price! Remember: F produces and exports TV, while H produces and export Cars. We know from the exercise that the world relative price of televisions in the trade equilibrium is PTV/ PC =1

exercise 3: Question d Therefore, we can calculate the real wages of workers at Home in terms of cars because Home exports cars. Home (exports cars) is better off with trade because its real wage in terms of televisions has increased.