Comparative Advantage - Free Essay Example

Sample details Pages: 7 Words: 1998 Downloads: 10 Date added: 2017/09/12 Category Advertising Essay Did you like this example? Chapter 2 Labor Productivity and Comparative Advantage: The Ricardian Model Chapter Organization  §  §  §  §  §  §  §  §  § Introduction The Concept of Comparative Advantage A One-Factor Economy Trade in a One-Factor World Misconceptions About Comparative Advantage Comparative Advantage with Many Goods Adding Transport Costs and Nontraded Goods Empirical Evidence on the Ricardian Model Summary Slide 2- 2 Prepared by Iordanis Petsas To Accompany International Economics: Theory and Policy Sixth Edition Policy, by Paul R. Krugman and Maurice Obstfeld Copyright  © 2003 Pearson Education, Inc. Introduction  § Countries engage in international trade for two basic reasons: The Concept of Comparative Advantage  §  § On Valentine’s Day the U. S. demand for roses is about 10 million roses. Growing roses in the U. S. in the winter is difficult. †¢ They are different from each other in terms of climate, land, capital, labor, and technology. †¢ They try to achieve scale economies in production.  § The Ricardian model is based on technological differences across countries. †¢ Heated greenhouses should be used. †¢ The costs for energy, capital, and labor are substantial. †¢ These technological differences are reflected in ifferences in the productivity of labor.  § Slide 2- 3 Resources for the production of roses could be used to produce other goods, say computers. Slide 2- 4 Copyright  © 2003 Pearson Education, Inc. Copyright  © 2003 Pearson Education, Inc. The Concept of Comparative Advantage  § Opportunity Cost The Concept of Comparative Advantage  § The principle of comparative advantage: †¢ If each country exports the goods in which it has comparative advantage (lower opportunity costs), then all countries can in principle gain from trade. †¢ The opportunity cost of roses in terms of computers is he number of computers that could be produced with the same resources as a given number of roses.  § Comparative Advantage †¢ A country has a comparative advantage in producing a good if the opportunity cost of producing that good in terms of other goods is lower in that country than it is in other countries.  § What determines comparative advantage? †¢ Answering this question would help us understand how country differences determine the pattern of trade (which goods a country exports). Copyright  © 2003 Pearson Education, Inc. Slide 2- 5 Copyright  © 2003 Pearson Education, Inc. Slide 2- 6 1 Don’t waste time! Our writers will create an original "Comparative Advantage" essay for you Create order A One-Factor Economy  § Assume that we are dealing with an economy (which we call Home). In this economy: A One-Factor Economy  § The constant labor productivity is modeled with the specification of unit labor requirements: †¢ The unit labor requirement is the number of hours of labor required to produce one unit of output. – Denote with a L W the unit labor requirement for wine (e. g. if a LW = 2, then one needs 2 hours of labor to produce one gallon of wine). – Denote with a L C the unit labor requirement for cheese (e. g. if a LC = 1, then one needs 1 hour of labor to produce a pound of cheese). †¢ †¢ †¢ †¢ Labor is the only factor of production. Only two goods (say wine and cheese) are produced. The supply of labor is fixed in each country. The productivity of labor in each good is fixed. Perfect competition prevails in all markets.  § Copyright  © 2003 Pearson Education, Inc. Slide 2- 7 The economy’s total resources are defin ed as L, the total labor supply (e. g. if L = 120, then this economy is endowed with 120 hours of labor or 120 workers). Slide 2- 8 Copyright  © 2003 Pearson Education, Inc. A One-Factor Economy  § Production Possibilities A One-Factor Economy Figure 2-1: Home’s Production Possibility Frontier Home wine production, QW , in gallons †¢ The production possibility frontier (PPF) of an economy shows the maximum amount of a good (say wine) that can be produced for any given amount of another (say cheese), and vice versa. †¢ The PPF of our economy is given by the following equation: aLCQC + aLWQW = L (2-1) L/aLW P Absolute value of slope equals opportunity cost of cheese in terms of wine Copyright  © 2003 Pearson Education, Inc. Slide 2- 9 Copyright  © 2003 Pearson Education, Inc. F L/aLC Home cheese production, QC, in pounds Slide 2- 10 A One-Factor Economy Relative Prices and Supply †¢ The particular amounts of each good produced are determined by prices. †¢ The relative price of good X (cheese) in terms of good Y (wine) is the amount of good Y (wine) that can be exchanged for one unit of good X (cheese). †¢ Examples of relative prices: – If a price of a can of Coke is $0. 5, and the p rice of a chocolate bar is $1, then the relative price of Coke is the amount of chocolate bars that can be exchanged for one unit of Coke, which is 0. 5. – The relative price of a chocolate bar in terms of Coke is 2 cans of Coke per bar. Copyright  © 2003 Pearson Education, Inc. Slide 2- 11 A One-Factor Economy  § Denote with PC the dollar price of cheese and with PW the dollar price of wine. Denote with wW the dollar wage in the wine industry and with wC the dollar wage in the cheese industry. Then under perfect competition, the non-negative profit condition implies:  § †¢ If PW / aW wW, then there is no production of QW. †¢ If PW / aW = wW, then there is production of Q W. †¢ If PC / aC wC, then there is no production of Q C. †¢ If PC / aC = wC, then there is production of QC. Copyright  © 2003 Pearson Education, Inc. Slide 2- 12 2 A One-Factor Economy  § The above relations imply that if the relative price of cheese (PC / PW ) exceeds its opportunity cost (aLC / aLW ), then the economy will specialize in the production of cheese. Trade in a One-Factor World  § Assumptions of the model: †¢ There are two countries in the world (Home and Foreign). †¢ Each of the two countries produces two goods (say †¢ †¢ †¢ †¢ †¢ †¢ wine and cheese). Labor is the only factor of production. The supply of labor is fixed in each country. The productivity of labor in each good is fixed. Labor is not mobile across the two countries. Perfect competition prevails in all markets. All variables with an asterisk refer to the Foreign country. Slide 2- 14  § In the absence of trade, both goods are produced, and therefore PC / PW = aLC /a LW. Copyright  © 2003 Pearson Education, Inc. Slide 2- 13 Copyright  © 2003 Pearson Education, Inc. Trade in a One-Factor World  § Absolute Advantage Trade in a One-Factor World  § Comparative Advantage †¢ A country has an absolute advantage in a production of a good if it has a lower unit labor requirement than the foreign country in this good. †¢ Assume that aLC a*LC and aLW a* LW – This assumption implies that Home has an absolute advantage in the production of both goods. Another way to see this is to notice that Home is more productive in the production of both goods than Foreign. – Even if Home has an absolute advantage in both goods, beneficial trade is possible. †¢ Assume that aLC /aLW a*LC /a*LW (2-2) – This assumption implies that the opportunity cost of cheese in terms of wine is lower in Home than it is in Foreign. – In other words, in the absence of trade, the relative price of cheese at Home is lower than the relative price of cheese at Foreign.  §  § The pattern of trade will be determined by the concept of comparative advantage. Slide 2- 15 Home has a comparative advantage in cheese and will export it to Foreign in exchange for wine. Slide 2- 16 Copyright  © 2003 Pearson Education, Inc. Copyright  © 2003 Pearson Education, Inc. Trade in a One-Factor World Figure 2-2: Foreign’s Production Possibility Frontier Foreign wine production, Q*W, in gallons Trade in a One-Factor World  § Determining the Relative Price After Trade †¢ What determines the relative price (e. g. , P C / PW) after trade? – To answer this question we have to define the relative supply and relative demand for cheese in the world as a whole. The relative supply of cheese equals the total quantity of cheese supplied by both countries at each given relative price divided by the total quantity of wine supplied, ( QC + Q* C )/(Q W + Q *W). – The relative demand of cheese in the world is a similar concept. Slide 2- 17 Copyright  © 2003 Pearson Education, Inc. Slide 2- 18 L*/a*LW F* +1 P* L*/a*LC Foreign cheese pro duction, Q*C , in pounds Copyright  © 2003 Pearson Education, Inc. 3 Trade in a One-Factor World Figure 2-3: World Relative Supply and Demand Relative price of cheese, P C/PW a* * LC/a LW Trade in a One-Factor World  § The Gains from Trade If countries specialize according to their RS 1 aLC/aLW 2 RD Q L/aLC L*/a*LW RD comparative advantage, they all gain from this specialization and trade. †¢ We will demonstrate these gains from trade in two ways. †¢ First, we can think of trade as a new way of producing goods and services (that is, a new technology). Copyright  © 2003 Pearson Education, Inc. Relative quantity of cheese, Q C + Q *C QW + Q*W Slide 2- 19 Copyright  © 2003 Pearson Education, Inc. Slide 2- 20 Trade in a One-Factor World †¢ Another way to see the gains from trade is to consider how trade affects the consumption in each of the two countries. The consumption possibility frontier states the maximum amount of consumption of a good a country can obtain for any given amount of the other commodity. †¢ In the absence of trade, the consumption possibility curve is the same as the production possibility curve. †¢ Trade enlarges the consumption possibility for each of the two countries. Copyright  © 2003 Pearson Education, Inc. Slide 2- 21 Trade in a One-Factor World Figure 2-4: Trade Expands Consumption Possibilities Quantity of wine, Q W T Quantity of wine, Q*W F* P F Quantity of cheese, Q C T* P* Quantity of cheese, Q *C (a) Home Copyright  © 2003 Pearson Education, Inc. b) Foreign Slide 2- 22 Trade in a One-Factor World  § Relative Wages Misconceptions About Comparative Advantage  § Productivity and Competitiveness †¢ Because there are technological differences between the two countries, trade in goods does not make the wages equal across the two countries. †¢ A country with absolute advantage in both goods will enjoy a higher wage after trade. †¢ Myth 1: Free trade is beneficial only if a country is strong enough to withstand foreign competition. – This argument fails to recognize that trade is based on comparative not absolute advantage.  § The Pauper Labor Argument Myth 2: Foreign competition is unfair and hurts other countries when it is based on low wages. – Again in our example Foreign has lower wages but still benefits from trade. Copyright  © 2003 Pearson Education, Inc. Slide 2- 23 Copyright  © 2003 Pearson Education, Inc. Slide 2- 24 4 Misconceptions About Comparative Advantage  § Exploitation Comparative Advantage with Many Goods Figure 2-5: Determination of Relative Wages Relative wage Rate, w/w* Apples 10 8 Bananas RS †¢ Myth 3: Trade makes the workers worse off in countries with lower wages. – In the absence of trade these workers would be worse off. Denying the opportunity to export is to condemn poor people to continue to be poor. 4 3 2 0. 75 Caviar Dates Enchiladas RD Relative quantity of labor, L/L* Copyright  © 2003 Pearson Education, Inc. Slide 2- 25 Copyright  © 2003 Pearson Education, Inc. Slide 2- 26 Empirical Evidence on the Ricardian Model Figure 2-6: Productivity and Exports Summary  § We examined the Ricardian model, the simplest model that shows how differences between countries give rise to trade and gains from trade. In this model, labor is the only factor of production and countries differ only in the productivity of labor in different industries. In the Ricardian model, a country will export that commodity in which it has comparative (as opposed to absolute) labor productivity advantage. Slide 2- 28  §  § Copyright  © 2003 Pearson Education, Inc. Slide 2- 27 Copyright  © 2003 Pearson Education, Inc. Summary  § The fact that trade benefits a country can be shown in either of two ways: Summary  § Extending the one-factor, two-good model to a world of many commodities makes it possible to illustrate that transportation costs can give rise to the existence of nontraded goods. The basic prediction of the Ricardian model-that countries will tend to export goods in which they have relatively high productivity- has been confirmed by a number of studies. Slide 2- 30 †¢ We can think of trade as an indirect method of production. †¢ We can show that trade enlarges a country’s consumption possibilities.  §  § The distribution of the gains from trade depends on the relative prices of the goods countries produce. Slide 2- 29 Copyright  © 2003 Pearson Education, Inc. Copyright  © 2003 Pearson Education, Inc. 5