Download Trade and Technology: The Ricardian Model Readings: Chapter 2

Lecture 1. Classic and Neoclassic Trade
Models.
Carlos Llano
References:
Feentra y Taylor (2010). Comercio Internacional. Ed. Reverte.
Krugman P. Obsfeld and Melitz: International Economics. Prentice Hall, 2012. Chapter .
van Marrewijk C. (2009): The New Introduction to Geographical Economics. Cambridge University
Press.
Introduction. U.S. Imports of Snowboards: 2009-05
• Why do countries trade?
2



Ranking of the main exporters in 2009? Why?
Ranking of the countries with the largest gains in trade share between 2009/05? And losses? Why?
Ranking of the lowest / highest price levels? Why?
2
1. Introduction
In the classic models:
•
•
Trade is based on comparative advantage.
Countries gain from trade if they are different.
Ricardian Model:
•
•
Key: Differences in productivity
Home (H): exports good 1, which is produced with higher
•
relative productivity; imports good 2,
Foreign (F) produces good 2 more efficiently.
H-O Model:
•
•
•
Key: Differences in factor endowments.
H exports good 1, whose production is intensive in the
relatively abundant factor (K or L), and imports good 2
F is specialized in producing the good that is more intensive
in the factor that is relatively more abundant in F.
1. Introduction
New Trade
Theory (NTT)
 General equilibrium
framework
 Imperfect competition
 Transport costs.
Krugman, 79
Krugman, 80
 Factor mobility (migration + firms)
New
Economic
Geography
(NEG)
New-New
Trade
Theory
(NNTT)
 Dynamics between economics and
geography:
 1st nature ►2nd nature ► circular
causation
 Heterogeneous firms.
 Alternative ways for firm’s
internationalization:
 Export vs FDI.
Krugman, 91
Fujita,
Krugman
Venables,
1999
2. The Ricardian Model
References:
Feentra y Taylor (2011). Comercio Internacional. Ed. Reverte.
Introduction
• This chapter explains comparative advantage by looking at
how technology differences across countries affects trade.
• This is referred to as the Ricardian model because it was
proposed by the 19th century economist David Ricardo.
Assumptions:
• Two goods: Wheat ; Cloth.
• Two countries: Home (H); Foreign (F).
• One factor of production (immobile between countries; mobile
between sectors within each country): Labor.
Road map:
• Part 1. Home country, before trade.
• Part 2. Home and Foreign countries, who exports wheat and
who exports cloth?
– Comparative advantage
• Part 3. Is trade “good” or “bad”?
The Home Country
• We will assume that labor is the only resource
used to produce both goods
• One worker can produce 4 bushels of wheat
or 2 yards of cloth
• The Marginal Product of Labor is the extra
output obtained by using 1 more unit of labor
• MPLW = 4 ;
• MPLC = 2
• Assumption: Marginal Product of Labor=
fixed
• Suppose Home has 25 workers; i.e. L = 25.
Labor endowment.
The Home Country: Summary
Home
Cloth
MPL
Wheat
MPL
Labor
2
4
25
• Home Production Possibilities Frontier
– We use the MPL to construct Home’s PPF.
– Assume there are 25 workers in Home.
– If all the workers were employed in wheat, the country
could produce 100 bushels
– If they were all employed in cloth they could produce 50
yards.
– The PPF connects these two points
The PPF at “Home” in autarky.
PPF Slope. The opportunity cost.
• Showing these calculations we can see:
– Labor = 25, MPLW = 4, MPLC = 2
– If Home produces wheat only, QW = MPLW*L = 25*4 = 100
– If Home produces cloth only, QC = MPLC*L = 25*2 = 50
• This gives us a straight line PPF which is a unique feature
of the Ricardian model
– Assumes marginal production of labor is constant
QC MPLC  L
MPLC
50
SlopePPF  



1
MPLW
100 QW MPLW  L
2
• The slope equals the opportunity cost of wheat
 [the amount of cloth that must be given up to obtain 1 more unit
of wheat]
 Labor used in 1 wheat = labor used in ½ cloth;
 i.e. cost of 1 wheat = cost of ½ cloth
Indifference Curves: the consumer`s
preferences
Cloth, QC
(yards)
The country is indifferent between A
and B
U0 < U1 < U2
B
A
U1
U2
U0
Wheat, QW
(bushels)
A country cannot produce outside their PPF so, without trade,
they are constrained in their utility by the PPF.
closed-economy equilibrium (Home)
Cloth, QC
(yards)
C
50
D
•
The country could produce at point
D but would be at a higher level of
utility at point A.
•
The country is better off on U2 but
cannot produce that much
•
At point A, on U1, is the best the
country can do
B
A
U2
25
Home closed-economy
equilibrium
U1
Home PPF
U0
50
100
Wheat, QW
(bushels)
Wage Equation
• In competitive markets, suppose for cloth:
 P = $2 ;
 MPL = 4.
¿How much salary (w) are firms willing to pay?
• Cost of a marginal worker to the firm = wage
• Value of a marginal worker to the firm = the
value of one more hour of production =
4 cloth x $2/cloth = $8
• So firms are happy if w = $8
Wage Equation
• w = P*MPL
– The value of one more worker equals the amount
of goods produced by this worker (MPL) times the
price of the good.
– Predictions:
• (1) you earn more if your products are worth more;
• (2) you earn more if you are more productive
Relative Prices at closed-economy equilibrium
• W=P*MPL holds for both wheat and cloth
• Since labor can move freely between industries
(within each country), wages must be equalized:
PW * MPLW  PC * MPLC
PW MPLC 1


PC MPLW 2
Relative price of
wheat =
Value of 1 wheat =
½ value of 1 cloth
Slope of the PPF =
the opportunity cost
of obtaining one
more bushel of
wheat.
Relative Prices and OC
• The price ratio, PW/PC, always 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.
• For the good on the horizontal axis of the PPF
picture, |PPF slope| = OC = relative price
before trade
Real Wages Before Trade (Autarky)
• Real Wages
 Real wage for wheat = wage/price_of_wheat;
i.e. quantity of wheat the wage can buy
 Since Home produces both wheat and cloth,
Home wage is: w = PW*MPLW = PC*MPLC
 The real wage for wheat =
w/PW = (PW*MPLW)/PW = MPLW = 4 wheat
 The real wage for cloth =
w/PC = (PC*MPLC)/PC MPLC = 2 cloth
• Before trade, real wage = marginal product
of labor
The Foreign Country: Summary
Foreign
Cloth
MPL
1
wheat
MPL
1
Labor
100
– Foreign Production Possibilities Frontier
•
•
•
•
MPL*W = 1, MPL*C = 1
Key Assumption: Marginal Products of Labor are fixed
Assume there are 100 workers available in Foreign
If all workers were employed in wheat they could
produce 100 bushels.
• If all workers were employed in cloth they could
produce 100 yards.
• The Foreign country’s PPF connects these two points.
Foreign PPF
© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
closed-economy equilibrium (Foreign)
Cloth, (yards)
|The slope of the PPF| = the
opportunity cost of wheat =
the before-trade relative price
of wheat, P*W/P*C = 1
100
A*
50
Foreign before-trade
equilibrium
Foreign PPF
50
100
Wheat , (bushels)
Pattern of Trade
• Which country exports wheat and which
country exports cloth?
• Assume: no trade cost
© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Absolute Advantage = Higher MPL
MPL, Cloth
(Yard/worker)
MPL, wheat
Labor
(Bushel/worker)
Home
2
4
25
Foreign
1
1
100
– Absolute advantage = higher MPL at Home.
– Foreign’s technology is inferior to Home’s
– Home has an absolute advantage in both wheat
and cloth as compared to Foreign
– Clearly, Home can’t export both wheat and cloth
when trade opens up.
Comparative Advantage = Lower OC
MPL, Cloth
(Yard/worker)
MPL, wheat
Labor
(Bushel/worker)
Home
2
4
25
Foreign
1
1
100
What the Opportunity Costs for Goods in Home and
Foreign are?
Cloth (Yard)
Wheat (Bushel)
Home
4/2 = 2 wheat
2/4 = 1/2 cloth
Foreign
1/1 =1 wheat
1/1 = 1 cloth
© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Notes: OC Table
• Comparative Advantage = Lower Opp. Cost
– A country has a comparative advantage in a good
when it has a lower opportunity cost of producing
that good
– I.E.:
•
•
•
•
Foreign has a comparative advantage in producing cloth
Foreign’s Opportunity cost of cloth is lower (1 vs 2)
Home has a comparative advantage in producing wheat
Home’s opportunity cost of wheat is lower (1/2 vs 1)
Why does comparative advantage drive
trade patterns?
• Because OC = relative prices before trade
Wheat
(Bushel)
Home
½ cloth
Foreign
1 cloth
© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Notes: Relative Price Table
• Why does Home export wheat?
– Relative price of wheat in Home is PW/PC = 1/2
– Relative price of wheat in Foreign is PW*/PC* = 1
– Therefore Home would want to export their
wheat to Foreign – they can make it for 0.50 cloth
and export it for 1 cloth!
• The opposite is true for cloth
– Home will export wheat and Foreign will export
cloth
– Both countries export the good for which they
have the comparative advantage
Equilibrium with trade
• The relative price of wheat in the trade equilibrium
will be between the before-trade prices in the two
countries:
• Lets assume the free-trade price, PWT/PCT = 2/3.
• This is between the price of ½ (Home) and 1
(Foreign).
• We can now take this price and see how trade
changes production and consumption in each
country
Notes: Equilibrium with trade
• ¿How prices change after trade?
– As Home exports wheat, quantity of wheat sold at
Home falls
– The price of wheat at Home goes up
– More wheat goes into Foreign’s market
– The price of wheat in Foreign falls
– For the same reason, as Foreign exports cloth, the
quantity sold in Foreign falls. Therefore, the price
in Foreign for cloth rises, and the price of cloth in
Home falls.
Notes: Equilibrium with trade
• Trade Equilibrium
– Two countries are in a trade equilibrium when the
relative price of wheat is the same in the two
countries – this means the relative price of cloth is
also the same in both countries.
– This is because we assume there is no trade cost
Complete specialization
Opportunity Costs in Home and Foreign
Cloth (Yard)
Wheat (Bushel)
Home
4/2 = 2 wheat
2/4 = 1/2 cloth
Foreign
1/1 =1 wheat
1/1 = 1 cloth
Free-trade relative prices: PWT/PCT = 2/3.
Home exports wheat. No cloths will be produced in Home.
PWT MPLW  2  4  8
      1
T
PC MPLC  3  2  6
Therefore
PWT MPLW  PCT MPLC
Wages Wheat  Wages Cloth
• Home’s workers will want
to work in wheat and no
cloth will be produced
• With trade, Home will be
fully specialized in wheat
production!
Is trade good or bad: Home
PWT/PCT = 2/3.
Home exports wheat
Cloth, QC
(yards)
50
A
Home closed-economy
equilibrium
25
U1
Home PPF
50
100
Wheat, QW
(bushels)
Consumption Possibility Frontier (CPF), Home
• The new world price, PWT /PCT = 2/3,
shows us the new range of
consumption possibilities
Cloth, QC (yards)
• The country can now achieve a higher
utility with the new consumption
possibilities
50
CPF, Slope = –2/3
A
25
U2
U1
Home production
B
50
100
Wheat , QW
(bushels)
Is trade good or bad: Foreign
Cloth, (yards)
Foreign PPF
PWT/PCT = 2/3.
Foreign exports cloth
100
A*
Foreign closed-economy equilibrium
U0
100
Wheat, (bushels)
CPF, Foreign
• The new world price, PWT /PCT = 2/3,
shows us the new range of
consumption possibilities
Foreign production
Cloth, (yards)
100
• The country can now achieve a
higher utility with the new
consumption possibilities
B*
Foreign consumption
C*
60
U1
World price line,
Slope = –2/3
U0
60
100
Wheat, (bushels)
Notes: Gains from Trade
• Gains from trade for BOTH countries!
– Under the new production, each country specializes
fully in the good for which they have the comparative
advantage
– They then export some of their production and import
some of the other good from the other country
– Home specializes in wheat and Foreign specializes in
cloth
– The new indifference curves show the new
consumption points.
– The difference between production and consumption
give us trade patterns
Gains from Trade: intuition
• International Trade
– Trade allows both countries to engage in
consumption possibilities they did not have before
trade
– Intuition: trade increases the choices a country
can make; both countries gain because they help
each other out.
Trade is Balanced: Foreign
• Foreign produces 0 wheat but consumes 60 so imports equal 60.
• Foreign produces 100 cloth but consumes only 60 so exports equal 40
Foreign production
Cloth, (yards)
100
Foreign exports
40 yards of cloth
B*
Foreign consumption
C*
60
U1
World price line,
Slope = –2/3
U0
60
100
Foreign imports 60 bushels of wheat
Wheat, (bushels)
Trade is Balanced: Home
• Home produces 100 wheat but consumes only 40 so exports equal 60
• Home produces 0 cloth but consumes 40 so imports equal 40.
Cloth, QC (yards)
Home consumption
50
C
40
U2
Home imports 40
yards of cloth
World price line, Slope = –2/3
U1
Home production
B
40
100
Home exports 60 bushels of wheat
Wheat , QW
(bushels)
Trade and Wages
• How do wages change after trade for Home
and Foreign?
• Under free trade, which country has a higher
wage?
– Wages actually differ [they are determined by
absolute advantage, not by comparative
advantage]
• Real wages: = wage/price.
Real Wages Before Trade: Home
• Before trade, real wage = marginal product of labor
since Home makes both wheat and cloth
– The real wage for wheat = MPLW = 4 wheat
– The real wage for cloth = MPLC = 2 cloth
Real Wages After Trade: Home
• Since Home produces and exports “wheat”, Home wage is:
w = PWT*MPLW
• The real wage for wheat =
w/PWT = (PWT*MPLW)/PWT = MPLW = 4 wheat. [Same as before trade]
• The real wage for cloth =
w/PCT = (PWT*MPLW)/PCT =(PWT/PCT)*MPLW = (2/3)*4 = 8/3 cloth. [Higher than
before trade]
• Trade increases real wage for cloth!
• Same intuition as gains from trade.
Terms of Trade
• The real wage for cloth =(PWT/PCT)*MPLW
• The Terms of Trade for Home = PWT/PCT
– An increase in PWT or a fall in PCT will raise Home’s
terms of trade
– An increase in the terms of trade is good for a country
• They earn more for its exports
• They pay less for their imports
• Home real wage for cloth is higher
– In general, the price of a country’s exports divided by
the price of its imports.
– Foreign’s Terms of Trade = PCT/PWT
Real Wages Before Trade: Foreign
• Before trade, real wage = marginal product of
labor since Foreign makes both wheat and cloth
– The real wage for wheat = MPLW* = 1 wheat
– The real wage for cloth = MPLC* = 1 cloth
Real Wages After Trade: Foreign
• Since Foreign produces-exports cloth, its wage
is: w* = PCT *MPLC*
• The real wage for cloth =
w*/PCT = (PCT*MPLC*)/PCT = MPLC* = 1 cloth, [same as before trade]
• The real wage for wheat =
w*/PWT = (PCT*MPLC*)/PWT = (PCT/PWT)*MPLC* = (3/2)*1 = 3/2 wheat,
[higher than before trade]
• Again, free trade increases real wages!
Comparing Wages Across Countries
• Summarizing
– Home real wage is
• 4 bushels of wheat
• 8/3 yards of cloth
– Foreign real wage is
• 3/2 bushels of wheat
• 1 yard of cloth
– The ratio Home_wage/Foreign_wage = 8/3, so
Foreign workers earn less
– What is the intuition for this?
Comparing Wage Across Countries
• What determines w/w*?
– Since Home produces and exports wheat, Home
wage is: w = PWT*MPLW
– Since Foreign produces and exports cloth, Foreign
wage is: w* = PCT *MPLC*
w  P MPL
w P MPL
*
T
W
T
C
W
*
C
PWT MPLW
2 4 8
 ( T )(
)  
*
PC MPLC
3 1 3
Summary: Comparing Wages Across Countries
• Home_wage/Foreign_wage depends on Home
country’s TOT and absolute advantage
• So comparative advantage gives you trade
patterns, and absolute advantage gives you
high wages
• The intuition: the only way a country with
poor technology can export at a price others
are willing to pay is by having low wages.
Predictions
• In a given year, the countries that have better
technology should have higher wages (i.e.
comparing across countries)
• Over time, as a given country develops better
technology, its wages will rise (i.e. looking at
changes for a given country)
Labor Productivity and Wages for 2001
Figure 2.7
Notes: Figure 2.7.
• Labor productivity can be measured by the value-added per
hour in manufacturing
– Value-added is the difference between sales revenue in an industry
and the costs of intermediate inputs
– Equals the payments to labor and capital in an industry.
– The Ricardian model ignores capital so we can measure labor
productivity as value-added divided by the number of hours worked,
or value-added per hour
• Figure 2.7 shows value added per hour in manufacturing for
several countries
– Countries with higher labor productivity pay higher wages, just as the
Ricardian model predicts
Labor Productivity and Wage Over Time