1 ECONOMICS 3150M Winter 2014 Professor Lazar Office: N205J, Schulich

2 Lecture 16: March 10 Ch. 2, 3, 4, 5

3 Comparative Advantage Models 1.Single Factor, Ricardian Model Assumptions: –One factor of production: X1 –Two goods: Y1, Y2 –Constant returns to scale [  Y = F( X1), δ=1] –PF: Y i =  i1 X1 [  i1 : units of product i per unit of factor of production 1] Resulting PPF: –Y1/  i1 + Y2/  21  0 X1 –Opportunity cost of Y1 in terms of Y2:  21 /  11 –No adjustment problems since sole factor of production can move costlessly and instantaneously between products

4 Single Factor Ricardian Model Utility maximization  optimal production and consumption point, P1, P2 –Slope of straight line PFF: P2/P1  11 /  21 –Relationship between relative prices and opportunity costs

5 Single Factor Ricardian Model Two countries, two products, one factor of production –Conditions for pre-trade relative prices to differ [i.e. {P1/P2} A  {P1/P2} B ] Different production functions:  i1 (A)   i1 (B) Different tastes will not produce different relative prices Absolute advantage vs. comparative advantage –Implications for productivity, incomes per capita, migration Comparative advantage –Country has comparative advantage in product with lower relative opportunity cost –Country A has comparative advantage in product 1 if [  21 /  11 ] A < [  21 /  11 ] B {P1/P2} A < {P1/P2} B

6 Single Factor Ricardian Model Trade between A and B will equalize relative prices  {P1/P2} A = {P1/P2} B –Equilibrium relative prices post-trade between original pre-trade ratios –If A is large country and B a small country, equilibrium relative prices post-trade closer to pre-trade ratio in A Specialization – small country, not necessarily for large country –Transportation costs –Protection of industries Terms of trade: price of exported product relative to price of imported product –For country: P1/P2

7 Single Factor Ricardian Model Gains from trade –Consumption, production – pre-trade and post-trade –Exports, imports –Higher level of utility, higher level of real income/GDP Equilibrium in currency market will result in current account balance = 0 –Total value of exports = total value of imports –D/S of country’s currency depend upon current account transactions only –For Country A: P1 A EX(Y1) = P2 B IM(Y2)E* –With no trade costs: P1 A = P1 B E* and P2 A = P2 B E*

8 Single Factor Ricardian Model Conclusions: –Extreme degree of specialization –No impact on distribution of income within each country – no losers (full employment, one factor of production) –Gains from trade –No explanation of differences in production functions and relative and absolute productivities –Volumes of exports and imports not determined

9 Extension of Ricardian Model Many products (i = 1, N), one factor of production Assumptions: –Constant returns to scale –Perfect competition: P i = MC i –MC i = P(X1)/  i1 Allocation of production in two country world (A, B) –Product i produced in country with lower MC –Produced in A: {P(X1)E/  i1 } A < {P(X1)/  i1 } B  {[P(X1)] A E /[P(X1)] B } < {  i1 } A / {  i1 } B –Produced in B: {[P(X1)] A E /[P(X1)] B } >{  i1 } A / {  i1 } B

10 Extension of Ricardian Model Order the products 1 to N so that {  11 } A / {  11 } B < {  21 } A / {  21 } B < …….. < {  N1 } A / {  N1 } B All products 1 through K are produced in B and exported by B: {[P(X1)] A E /[P(X1)] B } > {  K1 } A / {  K1 } B and {[P(X1)] A E /[P(X1)] B } < {  K+11 } A / {  K+11 } B

11 Extension of Ricardian Model Products K+1 through N are produced and exported by A –Not all products may be traded – depends upon trade costs  non-traded products –Specialization, but if B is a large country, B also may produce, but not export some or all of the products 1 through K –Assumes that E is at equilibrium level so that value of A’s exports = value of B’s imports –If value of E changes so too does cut-off point “K”

12 Services 2010 –World merchandise exports: US$15.2 T –World commercial services exports: US$3.7T (20%) P. 21: “”current dominance of world trade by manufactures…may be only temporary. In the long run, trade in services, delivered electronically, may become the most important component of world trade.” Measurement problem with services –Unit of financial service; consulting service, legal service, call center service, etc.

13 Heckscher-Ohlin Model 2X2X2 model –Two countries –2 factors of production –2 products – different factor intensities –Identical production technologies and state of technology –Different relative resource availabilities: {X1/X2} A  {X1/X2} B Basis for trade: different resource availabilities which give rise to different pre-trade relative prices –Comparative advantage: interaction between relative abundance (supply) of resources (factors of production) and technology of production (relative intensity with which different factors of production used in production of different goods) –Counties export goods whose production is intensive in factors with which the countries are abundantly endowed

14 Heckscher-Ohlin Model Factor intensity: {X1/X2} i –Min TC = P(X1)X1 + P(X2)X2 s.t. 0 Y1 = F 1 (X1, X2, T) –Factor intensity determined by intersection of isoquant and budget line –Constant returns to scale and factor intensity Factor intensity {X1/X2} 1 depends upon {P(X2)/P(X1)} –If {P(X2)/P(X1)}   {X1/X2} 1  Relative prices of factors of production depend upon relative availabilities of factors of production –If {X1/X2} A   {P(X2)/P(X1)} A 

15 Heckscher-Ohlin Model Relative prices of products {P1/P2} depend upon relative prices of factors of production [P=MC] {P(X1)/P(X2)} and relative factor intensities –Assume Y1 uses X1 relatively more intensively than Y2  {X1/X2} 1 > {X1/X2} 2 –As {P(X1)/P(X2)}  so too does P1/P2

16 Heckscher-Ohlin Model If {X1/X2} A > {X1/X2} B then {P(X1)/P(X2)} A < {P(X1)/P(X2)} B and {P1/P2} A < {P1/P2} B –A has comparative advantage in Y1 (Y1 uses X1 relatively more intensively and A has relative abundance of X1) –A will export Y1 and import Y2 –Specialization not necessary outcome even if one of the countries is a small country and the other is a large country –Trade will tend to equalize relative prices of products and factors of production

17 Heckscher-Ohlin Model Winners and losers –Net utility/income gains –Full employment and no transition costs –  D for Y1 post-trade   D for X1 in A  P(X1) in A –  S of Y2 post-trade   D for X2 in A   P(X2) in A Welfare effects of changes in terms of trade: {P1/P2} for A –Assume improvement in terms of trade for A –Leads to improvement in aggregate welfare in A and increase in trade volumes –Owners of a country’s abundant factors gain from trade; owners of country’s scarce factors lose relatively and may lose in absolute values as well –Implications for income distribution between X1 and X2  D for X1 in A  D for X2 in A

18 Heckscher-Ohlin Model Increase in availability of factors of production in country A 1.Proportionate increase in both factors of production  no change in relative availabilities Increase in volume of trade Change in terms of trade  deterioration because of  S of Y1 from country A and  D for Y2 from country A 2.Increase in X1 (or disproportionate increase in X1) Biased growth Change in shape of PPF for country A  change in relative prices, change in terms of trade Larger impacts on volume of trade and terms of trade Growth leads to more trade

19 Heckscher-Ohlin Model Determinants of relative abundance of factors of production Natural resources including climate –Exploration/development –Climate change Labor –Skill level –Education, training –Population growth, demographics Capital –Types –Investment Technology –R&D Production, products