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ECONOMICS 3150M. Winter 2014 Professor Lazar Office: N205J, Schulich [email protected] 736-5068. Lecture 16: March 10 Ch. 2, 3, 4, 5. Comparative Advantage Models. 1. Single Factor, Ricardian Model Assumptions: One factor of production: X1 Two goods: Y1, Y2

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economics 3150m

ECONOMICS 3150M

Winter 2014

Professor Lazar

Office: N205J, Schulich

[email protected]

736-5068

comparative advantage models
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
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 model1
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 model2
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 model3
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 model4
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
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 model1
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 model2
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
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
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 model1
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 model2
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 model3
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 model4
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 model5
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 model6
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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