ECONOMICS 3150M

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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

Winter 2014

Professor Lazar

Office: N205J, Schulich

[email protected]

736-5068

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
• Implications for productivity, incomes per capita, migration
• 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
• 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
• 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)
• 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
• 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
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