Download Revision Lecture: Trade Models

International Economics
Revision Lecture: Trade Models
University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
Overview
• Recap: why bother with trade models?
• The Ricardian Model
• The Specific Factors Model
• The Heckscher-Ohlin Model
• The Standard Trade Model
• Modern Trade Models
– External Economies of Scale
• Internal Economies of Scale
Slide 1
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
Recap: why bother with trade models?
• What is the purpose of a trade model?
– To answer to main questions:
1. What drives trade?
2. How does trade affect the economy
(i.e. how does it affect people)?
• Are there gains in welfare?
• What are the distributional effects?
Slide 2
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
The Ricardian Model
1. What drives trade?
– Differences in labour productivity
• 2 products, 2 economies, 1 factor of production (L)
• Assumptions:
– Perfect competition, homogenous labour
• General equation for production:
L ≥ (αL1 * Q1) + (αL2 * Q2)
Slide 3
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
Our wine and cheese economy... (‘Home’)
Remember: A straightline PPF means constant
opportunity cost!
Slide 4
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
The Ricardian Model
• Wages: w = (P / α)
(e.g., wC = (PC / αLC)
• In the absence of trade, we expect relative prices to
equal relative costs (and thus wages would equalise!)
– In Home: P1 /P2 = αL1 / αL2
» E.g., PC /PW = αLC /αLW
– In Foreign: P*1 /P*2 = α*L1 /α*L2
» E.g., P*C /P*W = α*LC /α*LW
Slide 5
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
The Ricardian Model
• But what will world prices be with trade?
• We need to have a model that does not just
look at the market for cheese, or the market
for wine…
…but instead models both markets
together!
• This is called general equilibrium analysis
– I.e., relative demand and relative supply
Slide 6
The University of Papua New Guinea
Revision Lecture: Trade Models
General equilibrium analysis:
relative supply
Any price in
between leads to
Home to fully
specialise in cheese,
and Foreign to fully
specialise in wine
No supply of
cheese if price
drops below
αC / αW
Slide 7
Michael Cornish
Both Home
and Foreign
specialise in
cheese if price is
above α*C / α*W
The quantities
produced when
both countries
fully specialise
The University of Papua New Guinea
Revision Lecture: Trade Models
General equilibrium analysis:
relative demand and relative supply
Michael Cornish
Note: RD is exogenously
determined (‘given’ to us,
we are not calculating it!)
Any RD that intersects
relative supply
between these prices
leads to both countries
fully specialising
[e.g. RD1]
Any RD that intersects
on a flat part of RS will
lead to complete
specialisation in one
country, and no
specialisation in the
2
3
other
Slide 8 [e.g. RD or RD ]
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
The Ricardian Model
• RD1: Both Home and foreign fully specialise
according to their comparative advantage
• RD2: Foreign fully specialises in wine, Home does
not specialise (produces both)
• RD3: Home fully specialises in cheese, Foreign does
not specialise (produces both)
Note: Countries will never specialise
against their comparative advantage
(except with domestic distortions)
Slide 9
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
The Ricardian Model
2. How does trade affect the economy?
– Comparative advantage creates gains
from trade (i.e. welfare gains)
– Countries (either fully or partially)
specialise according to their comparative
advantage
Slide 10
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
The Specific Factors Model
1. What drives trade?
– The model does not explicitly address
this – it assumes changes in prices are
exogenously determined by trade…!
– Instead it looks at the distributional
effects caused by trade
Slide 11
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
The Specific Factors Model
• 2 products
• Three factors of production
– Can be any three, but convention is to use:
• L: Labour, the mobile, ‘non-specific’ factor
• K: Capital, a fixed and ‘specific’ factor
• T: Land, a fixed ‘specific’ factor
• Assumptions:
– Perfect competition, homogenous labour
Slide 12
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
The ‘four-way’ graph
Slide 13
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
The Specific Factors Model
• Because we assume labour can move
freely, wages should be identical in both
sectors (e.g., wFood = wCloth)
• Wages: w = MPLC * PC = MPLF * PF
– Thus: – MPLF / MPLC = – PC / PF
Slide 14
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
Determining the equilibrium wage...
Note:
The assumption is that
the demand for labour
in each sector is equal
to the value of the
produce of labour
(P * MPL) [which is the
willingness to pay a
certain
level of wage]
Slide
15
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
In domestic equilibrium
Slide 16
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
An increase in one price only (e.g. cloth)
1.
Labour shifts
from the food
sector into the
cloth sector...
Slide 17
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
2.
...the
relative price
changes
1.
As labour
shifts from the
food sector
into the cloth
sector...
Slide 18
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
The effect on the PPF from an increase
in one price only (e.g. cloth)
2.
The relative
price changes
Slide 19
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
The Specific Factors Model
2. How does trade affect the economy?
– Trade benefits the factor that is specific
to the export market, but hurts the
factor that is specific to the import
market
– The effects upon the non-specific factor
(L) are ambiguous
Slide 20
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
The Heckscher-Ohlin Model
1. What drives trade?
– Differences in resource endowments
(i.e. differences in the relative
abundance of factors of production)
Slide 21
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
The Heckscher-Ohlin Model
• Simple version – the ‘2 x 2 x 2 Model’:
– 2 economies
– 2 products
– 2 factors of production
» Convention is L and K
Assumptions:
• Perfect competition, homogenous labour
Slide 22
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
Relative factor demand curves
Cloth production
is more labourintensive than
food production;
food is more
capital-intensive
Slide 23
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
Linking relative product prices (PC/PF)
with relative factor prices (w/r)
Slide 24
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
And now linking it all together: relative product prices
(PC/PF), relative factor prices (w/r), & input combinations
Then we
decrease
the L-K ratio
used in both
products
If we increase
P C / P F…
Slide 25
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
General equilibrium analysis:
relative demand and relative supply
RS* = Relative
Supply in Foreign
Note:
Relative demand is assumed
to be universal (the same
regardless of the country)
Slide 26
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
2. Consumption
Consumption can now
be at any point along
the red ‘trade’ line!
1. Production
Opening to trade shifts
production from QA to Q*
With trade, more cloth is
produced and less food
Slide 27
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
The Heckscher-Ohlin Model
2. How does trade affect the economy?
The Heckscher-Ohlin Theorem:
• The country that is relatively abundant in a
factor will export the product that uses that
factor intensively in its production
– E.g., In our example, Home was relatively more
abundant in labour than Foreign, and ended up
exporting the labour-intensive product, cloth
Slide 28
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
The Heckscher-Ohlin Model
2. How does trade affect the economy?
(cont.)
Factor price equalisation
• Opening to trade equalises the prices of
factors
• Owners of the country’s abundant factor
gains from trade, but owners of a country’s
scarce factors lose
Slide 29
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
The Standard Trade Model
• Extends the Heckscher-Ohlin Model
– Adds in consumption preferences
– Otherwise, same assumptions, same
conclusions!
» Note: following diagrams are
assuming cloth is the exported
product
Slide 30
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
Adding indifference curves
Slide 31
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
Trade triangles [in green]
Slide 32
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
RS = Domestic RS
As the terms of trade
increase [(PC/PF)],
welfare increases
[D3 => D1= > D2]
Slide 33
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
Modern trade models
1. Differences in demand
2. Linder’s Representative Demand
3. Vernon’s Product Life Cycle Theory
4. The Gravity Model
Slide 34
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
Differences in demand: an example
Source:
Structure of the Global
Markets for Meat, by
John Dyck and Kenneth
Nelson, USDA,
Economic Research
Service, September
2003
Slide 35
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
Linder’s Representative Demand:
Trade between countries of similar
income levels because they
demand similar products
Variations of rice in
Australian shops...
...versus
Papua New
Guinea!
[You see the
same thing in
Fiji, Indonesia,
rural China,
etc.!]
Slide 36
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
Vernon’s Product Life Cycle Theory
Slide 37
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
Modern trade models: The Gravity Model
• Trade due to size and proximity of economies:
– Tij = (A * Yi * Yj) / Dij
– Tij: value of trade between country i and j
– Yi: GDP of country i
– Yj: GDP of country j
– Dij: distance between country i and j
– A: a constant
• This is necessary to reflect the general level
of trade in both countries relative to GDP
Slide 38
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
External economies of scale
• External economies of scale occur when the
cost per unit of production depends on the size of
the industry, but not necessarily on the size of
any one firm
• Causes:
1. Specialised suppliers
2. Labour market pooling
Classic example:
Silicon Valley for
computer and
IT design
3. Knowledge spillovers
Slide 39
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
External economies of scale: With trade
Slide 40
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
External economies of scale: Established/entrenched advantage
Slide 41
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
Internal economies of scale
• Internal economies of scale occur when the
cost per unit of production depends on the size
of an individual firm, but not necessarily the
size of the industry…
1. CC: The more firms there are in the industry,
the higher the average cost
2. PP: The more firms there are in the industry,
the lower the price they charge
Slide 42
The University of Papua New Guinea
Revision Lecture: Trade Models
Slide 43
Michael Cornish
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
Explanatory note for previous slide...
Slide 44
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
Internal
economies
of scale:
Opening to
trade
Note:
As discussed,
QIndustry
leads to lower
costs (for any
given n), and
no change in
the price
charged (for
any45given n)
Slide
The University of Papua New Guinea
Revision Lecture: Trade Models
Michael Cornish
Formulas that will be provided in
the mid-semester test
• For the Ricardian Model:
General equation: L ≥ (αL1 * Q1) + (αL2 * Q2)
• The Gravity Model:
– Tij = (A * Yi * Yj) / Dij
• Internal economies of scale:
1. QFirm = QIndustry * [(1/n) – b * (P –
)]
2. ATC = FC/QFirm + MC = [n * (FC/QIndustry)] + MC
3. (P – MC) = 1 / (b * n)
Slide 46
The University of Papua New Guinea