3. What Determines a Country’s Comparative Advantage? Exogenous factors are the most obvious

4. Climate (long growing season)

5. Natural Resources (petroleum reserves)

6. But there are also endogenous factors: education, skills, capital,... Implies that comparative advantage can change over time: electronic goods to pharmaceutical goods to internet software to ….

7. Let’s take a closer look at how capital (K) and labor (L) affect comparative advantage –Definitions: capital abundant country: has high K/L labor abundant country: has low K/L capital intensive production: uses high K/L labor intensive production: uses low K/L Capital abundant countries: comparative advantage in capital intensive production Labor abundant countries: comparative advantage in labor intensive production

8. Factor Price Equalization Factor prices: –wage rate for labor –rental rate for capital Factor price equalization: even if factors are not mobile, factor prices will tend to equalize with trade

9. What causes factor price equalization? suppose U.S. has high K/L suppose Mexico has low K/L then opening up trade will shift –U.S. production toward capital intensive goods thus demand for capital rises in U.S –M. production toward labor intensive goods thus demand for labor rises in Mexico U.S. wages fall and Mexican wages rise –that is a move toward factor price equalization –assumes ceteris paribus, productivity would rise

10. Gains from Expanded Markets Theory combines two features of production –economies of scale (declining ATC over the relevant range of production) –product differentiation: leads to monopolistic competition Focuses on intraindustry trade (same industry) –comparative advantage focuses on interindustry trade (different industries)

11. Getting a sense of the gains from expanded markets

12. Now let’s develop a model to show the gains from expanded markets First derive a relationship between –the number of firms, –the size of the market –costs per unit (ATC) Second, derive a relationship between the number of firms and the price Third, combine the two relationships

17. Now, summarize the results using a new curve

18. Recall results from monopolistic competition model Product differentiation Firms face downward sloping demand curve With more firms in the industry, the demand curve shifts –and gets flatter (a point we did not emphasize earlier), so the price falls –sketch this by hand:

19. Now, summarize the result that more firms lead to a lower price in another new curve

20. Put the two new curves in the same diagram; look at the long run equilibrium

21. Finally, open up the economy; curve shifts showing effect of a larger market

22. End of Lecture