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Comparative Advantage Models

1. Single Factor, Ricardian Model

- Assumptions:
- One factor of production: X1
- Two goods: Y1, Y2
- Constant returns to scale [Y = F(X1), δ=1]
- PF: Yi = i1 X1 [i1: units of product i per unit of factor of production 1]
- Resulting PPF:
- Y1/ i1 + Y2/ 21 0X1
- Opportunity cost of Y1 in terms of Y2: 21/ 11
- No adjustment problems since sole factor of production can move costlessly and instantaneously between products

Single Factor Ricardian Model

- Utility maximization optimal production and consumption point, P1, P2
- Slope of straight line PFF:
- P2/P1
- 11/ 21
- Relationship between relative prices and opportunity costs

Single Factor Ricardian Model

- Two countries, two products, one factor of production
- Conditions for pre-trade relative prices to differ [i.e. {P1/P2}A {P1/P2}B]
- Different production functions: i1(A) i1(B)
- Different tastes will not produce different relative prices
- Absolute advantage vs. comparative advantage
- Implications for productivity, incomes per capita, migration
- Comparative advantage
- Country has comparative advantage in product with lower relative opportunity cost
- Country A has comparative advantage in product 1 if
- [21/ 11 ]A < [21/ 11]B
- {P1/P2}A < {P1/P2}B

Single Factor Ricardian Model

- Trade between A and B will equalize relative prices {P1/P2}A = {P1/P2}B
- Equilibrium relative prices post-trade between original pre-trade ratios
- If A is large country and B a small country, equilibrium relative prices post-trade closer to pre-trade ratio in A
- Specialization – small country, not necessarily for large country
- Transportation costs
- Protection of industries
- Terms of trade: price of exported product relative to price of imported product
- For country: P1/P2

Single Factor Ricardian Model

- Gains from trade
- Consumption, production – pre-trade and post-trade
- Exports, imports
- Higher level of utility, higher level of real income/GDP
- Equilibrium in currency market will result in current account balance = 0
- Total value of exports = total value of imports
- D/S of country’s currency depend upon current account transactions only
- For Country A: P1AEX(Y1) = P2BIM(Y2)E*
- With no trade costs: P1A = P1BE* and P2A = P2BE*

Single Factor Ricardian Model

- Conclusions:
- Extreme degree of specialization
- No impact on distribution of income within each country – no losers (full employment, one factor of production)
- Gains from trade
- No explanation of differences in production functions and relative and absolute productivities
- Volumes of exports and imports not determined

Extension of Ricardian Model

- Many products (i = 1, N), one factor of production
- Assumptions:
- Constant returns to scale
- Perfect competition: Pi = MCi
- MCi = P(X1)/i1
- Allocation of production in two country world (A, B)
- Product i produced in country with lower MC
- Produced in A: {P(X1)E/ i1}A < {P(X1)/ i1}B

{[P(X1)]AE /[P(X1)]B} < {i1}A / {i1}B

- Produced in B: {[P(X1)]AE /[P(X1)]B} >{i1}A / {i1}B

Extension of Ricardian Model

- Order the products 1 to N so that

{11}A / {11}B < {21}A / {21}B < …….. < {N1}A / {N1}B

- All products 1 through K are produced in B and exported by B:

{[P(X1)]AE /[P(X1)]B} > {K1}A / {K1}B and

{[P(X1)]AE /[P(X1)]B} < {K+11}A / {K+11}B

Extension of Ricardian Model

- Products K+1 through N are produced and exported by A
- Not all products may be traded – depends upon trade costs non-traded products
- Specialization, but if B is a large country, B also may produce, but not export some or all of the products 1 through K
- Assumes that E is at equilibrium level so that value of A’s exports = value of B’s imports
- If value of E changes so too does cut-off point “K”

Services

- 2010
- World merchandise exports: US$15.2 T
- World commercial services exports: US$3.7T (20%)
- P. 21: “”current dominance of world trade by manufactures…may be only temporary. In the long run, trade in services, delivered electronically, may become the most important component of world trade.”
- Measurement problem with services
- Unit of financial service; consulting service, legal service, call center service, etc.

Heckscher-Ohlin Model

- 2X2X2 model
- Two countries
- 2 factors of production
- 2 products – different factor intensities
- Identical production technologies and state of technology
- Different relative resource availabilities: {X1/X2}A {X1/X2}B
- Basis for trade: different resource availabilities which give rise to different pre-trade relative prices
- Comparative advantage: interaction between relative abundance (supply) of resources (factors of production) and technology of production (relative intensity with which different factors of production used in production of different goods)
- Counties export goods whose production is intensive in factors with which the countries are abundantly endowed

Heckscher-Ohlin Model

- Factor intensity:{X1/X2}i
- Min TC = P(X1)X1 + P(X2)X2

s.t. 0Y1 = F1(X1, X2, T)

- Factor intensity determined by intersection of isoquant and budget line
- Constant returns to scale and factor intensity
- Factor intensity {X1/X2}1depends upon {P(X2)/P(X1)}
- If {P(X2)/P(X1)} {X1/X2}1
- Relative prices of factors of production depend upon relative availabilities of factors of production
- If {X1/X2}A {P(X2)/P(X1)}A

Heckscher-Ohlin Model

- Relative prices of products {P1/P2} depend upon relative prices of factors of production [P=MC] {P(X1)/P(X2)}and relative factor intensities
- Assume Y1 uses X1 relatively more intensively than Y2

{X1/X2}1 > {X1/X2}2

- As {P(X1)/P(X2)} so too does P1/P2

Heckscher-Ohlin Model

- If {X1/X2}A > {X1/X2}Bthen {P(X1)/P(X2)}A < {P(X1)/P(X2)}B and {P1/P2}A < {P1/P2}B
- A has comparative advantage in Y1 (Y1 uses X1 relatively more intensively and A has relative abundance of X1)
- A will export Y1 and import Y2
- Specialization not necessary outcome even if one of the countries is a small country and the other is a large country
- Trade will tend to equalize relative prices of products and factors of production

Heckscher-Ohlin Model

- Winners and losers
- Net utility/income gains
- Full employment and no transition costs
- D for Y1 post-trade D for X1 in A P(X1) in A
- S of Y2 post-trade D for X2 in A P(X2) in A
- Welfare effects of changes in terms of trade: {P1/P2} for A
- Assume improvement in terms of trade for A
- Leads to improvement in aggregate welfare in A and increase in trade volumes
- Owners of a country’s abundant factors gain from trade; owners of country’s scarce factors lose relatively and may lose in absolute values as well
- Implications for income distribution between X1 and X2
- D for X1 in A
- D for X2 in A

Heckscher-Ohlin Model

Increase in availability of factors of production in country A

- Proportionate increase in both factors of production no change in relative availabilities
- Increase in volume of trade
- Change in terms of trade deterioration because of S of Y1 from country A and D for Y2 from country A
- Increase in X1 (or disproportionate increase in X1)
- Biased growth
- Change in shape of PPF for country A change in relative prices, change in terms of trade
- Larger impacts on volume of trade and terms of trade
- Growth leads to more trade

Heckscher-Ohlin Model

Determinants of relative abundance of factors of production

- Natural resources including climate
- Exploration/development
- Climate change
- Labor
- Skill level
- Education, training
- Population growth, demographics
- Capital
- Types
- Investment
- Technology
- R&D
- Production, products

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