Trade Theory: The High Points Carbaugh, Chap. 2

Comparative Advantage and Prices Cloth (yards) Wine (bottles) Nation Labor Wage Quant. Price Quant. Price US 1 hr $20/hr 40 $0.50 40 $0.50 UK 1 hr £5/hr 10 £0.50 20 £0.25 UK 1 hr $8 10 $0.80 20 $0.40 (at $1.6 = £1) So What? Carbaugh, Chap. 2

What did we see? No matter how inefficient one nation is compared to another, it will always be least inefficient in something. That’s where it has a comparative advantage. That’s what it should specialize in. Prices adjust so that each nation has the lowest price for the good that it has a comparative advantage, the good that it sells to others. Wages in a low-productivity country fall until something that it produces can be sold cheaply on the world market. The currency of a low-productivity country depreciates until something that it produces looks cheap to those who buy it. Carbaugh, Chap. 2

What else did we see? Measured in the same currency, wages are higher in a high-productivity country than in a low-productivity country. Low productivity workers must settle for lower wages to keep their jobs. Exchange rate adjustments can substitute for wage adjustments. There is generally less resistance to depreciation than to wage cuts. (There is often plenty of resistance to depreciation.) Carbaugh, Chap. 2

Specialization and trade make it possible to consume bundles of goods that a nation could not possibly produce by itself. Trading possibilities line (terms of trade 1:1) B’ Trading possibilities line (terms of trade 1:1) tt D’ E C’ Wheat Wheat A’ C A F tt D B Carbaugh, Chap. 2

Parable of the barefoot shoemaker: At times, the terms of trade for what you specialize in are so favorable that you choose to trade away just about everything that you produce … in exchange for what others produce. Carbaugh, Chap. 2

Barriers to trade: if you insist on pushing the production of something that you don’t have comparative advantage in, you can’t possibly consume as much as you could with specialization and free trade. D E tt’ tt C A Crude oil B Carbaugh, Chap. 2

Production possibilities schedule under increasing costs Increasing opportunity costs Production possibilities schedule under increasing costs A Slope 1A = 1W Slope 1A = 4W Wheat B Carbaugh, Chap. 2

Trading under increasing costs You stop short of complete specialization: after a point (pt B), it becomes more costly to produce more of your export good than you can sell it for, the terms of trade (tt). B C tt (1A =1W) Trading possibilities line A tUS (1A = 0.33W) Wheat Carbaugh, Chap. 2

Trading Under Increasing Costs Trade leads to cost and price convergence: in an ideal world, every nation produces to the point where its costs match the prevailing world price (terms of trade tt) B’ C’ D’ tt (1A =1W) Trading possibilities line tC (1A = 3W) Wheat A’ Carbaugh, Chap. 2

Trading Under Increasing Costs In the real world, trade stops short of complete specialization and complete cost and price convergence. Transportation and other transaction costs put a wedge between between cost of production in an exporting country and the price that covers total costs in an importing country. As transportation and transaction costs fall, the volume of trade increases and prices across nations increasingly converge. Everyplace begins to look the same. Welcome to Mc World Carbaugh, Chap. 2