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Comparative advantage: A basic example Assumptions • Two countries (Portugal and the UK) • Two industries (wine and drape) • One factor of production (labor), hence one type of agent in each country (workers) • Constant returns to scale • No transportation costs • No government intervention • Perfect competition Wine Drape Endowments (here, labor forces) Portugal 8 4 5 UK 1 2 20 Productivities 1 Portugal’s production-possibility frontier and the autarky (before-trade) equilibrium Wine 40 Consumer preferences (demand side) Consumption point without international trade Production possibility frontier (supply side) 20 Drape The UK’s production-possibility frontier and the autarky equilibrium Wine Production possibility frontier (supply side) 20 Consumption point without international trade Indifference curve (demand curve)) Drape 40 The world’s production-possibility frontier and trading equilibrium Wine 40 World production possibility frontier world price ratio (demand-determined) Consumer preferences (common to all countries) Consumption point with international trade Drape 40 The gains from exchange Production Consumption Wine Drape Wine Drape Portugal 40 0 20 20 UK 0 40 20 20 Total 40 40 40 40 5 The gains from exchange revisited Wine Indifference curves Production Possibility Frontier world price ratio Drape 6 The gains from specialization Wine Production point Indifference curves world price ratio Production Possibility Frontier Drape 7 The Rybszinski theorem steel production possibility frontier after an increase in the capital endowment initial production possibility frontier production possibility frontier after an increase in the labor endowment drape 8 The Heckscher-Ohlin theorem (world & domestic) indifference curves home steel exports steel world price ratio (drape is cheaper) “trade triangle” domestic PPF drape home drape imports domestic price ratio (before trade) 9 The gains from trade (i): initial equilibrium P P S* S P*a Pa D* D Quantities Country H (relatively efficient) Country F (relatively inefficient) 10 Equilibrium price Method 1: Equate segments ab and cd P P* Country H a b Country F P* a Pw Pa c d 11 Equilibrium price Method 2 a) Construct excess supply (ES) and excess demand (ED) curves ab = cd a b Home ES c d Pa Export supply Pa* ab = cd a b c d Foreign ED* Import demand 12 Equilibrium price, method 2 b) Match the home ES and foreign ED curves on single « world » market S* Pa* ES P*a S Pw Pa D* ED* D Quantities E=M* Country H (exporter) « World » market Country F (importer) 13 Gains from goods trade Importer country consumers’ gain, producers’ loss = neutral P A B K C G pa F H J p* I World price D ED (a) Importer country’s domestic market (b) same thing seen on world market 14 Gains from goods trade Exporter country producers’ gain, consumers’ loss = neutral A ES F E D C p* G H World price B pa I EF (a) Exporter country’s domestic market (b) same thing seen on world market 15 Who gains from trade Size and « similarity » More « different » exporter gains more from trade Net increase in importer country’s welfare = CS gain – PS loss ES ES ED ED SIMILARITY ES Larger exporter gains less from trade ED ES Net increase in exporter country’s welfare = PS gain – CS loss SIZE ES ED ED 16 Gains from factors trade Starting point: autarky Value of marginal product of capital r Economy’s capital stock Very similar to trade in G&S: Identical causes: differences in prices (factor rewards) Return to other factors ra Identical consequences: some gains, other loose, and there is a net potential gain. Return to capital K K + = GDP (equal to GNP in autarky) 17 Gains from factors trade Capital flow from Home to Foreign Two countries, H relatively well endowed with capital. Initially, rH < rF, so capital has an incentive to migrate from H to F VF = p*F*K A VH = pFK I rF E rW B rH D G C In equilibrium, the marginal products of capital are equalized. Gains from capital movements: EBC for H, EIB for F. Home capital stock (before outflow) Foreign capital stock (before inflow) Extension of foreign capital stock (because of inflow) 18 Gains from factors trade GNP vs. GDP, efficiency gain VH=pFK GNP Home country’s GDP VF=p*F*K GNP* Efficiency gain from capital flow Foreign country’s GDP 19 Openness and size Trade share in GDP 140 120 IRL NLD Larger countries trade less (not so obvious) trade share (% of GDP) 100 CHE SWE NOR 80 ISL DNK FIN AUT 60 DEU GBR PRT 40 Not very open given their size (should trade more) ESP FRA ITA GRC 20 0 1.00E+09 TUR 1.00E+10 1.00E+11 1.00E+12 1.00E+13 PPP GDP GDP at purchasing power parity 20 Transportation costs “Fob”: free-on-board; “cif”: cum insurance and freight. Transport cost per unit: Pcif = Pfob + = Pa + Condition for trade to take place: EScif P*a Pa + Pa* If condition violated, good is said to be non-traded ESfob Pwcif Pwfob ED* Pa Less trade 21