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Lecture 4 – Ricardo model

Lecture 4 – Ricardo model. Readings: Ch 1 & 2 of Krugman and Obstfeld. Structure. Ricardo model Mutually beneficial trade: Absolute advantage Mutually beneficial trade: Comparative advantage What are gains from trade? Gains from exchange Gains from specialisation. Case of NO trade.

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Lecture 4 – Ricardo model

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  1. Lecture 4 – Ricardo model Readings: Ch 1 & 2 of Krugman and Obstfeld

  2. Structure Ricardo model Mutually beneficial trade: Absolute advantage Mutually beneficial trade: Comparative advantage What are gains from trade? Gains from exchange Gains from specialisation

  3. Case of NO trade Two countries with: Identical technology Identical tastes Identical endowments No distortions Y I1 P X No opportunity for mutually benefical trade as price ratios (p) are the same in both countries

  4. Determinants of trade We have already argued that differences in relative prices cause trade. We take the simple no-trade model and analyse how changes in the assumptions affect trade flows: Identical production functions among countries (same technology) Same relative factor endowments in all countries Constant returns to scale Identical and homogenous tastes in all countries Absence of distortions (taxes, subsidies, imperfect competition)

  5. Ricardo: Differences in technology What causes different pre-trade prices? Technology Assume: labour as the only factor input Different technology means: “the amount of Labour to produce one unit of output differs across countries”

  6. Absolute vs Comparative Assume: Labour only constraint (only input factor), two goods, constant returns to scale ax = Lx/Qx 1/ax = MPLx by = Ly/Qy 1/by = MPLy Where: L = Lx + Ly a and b are the unit labour requirements (or inverse of the MPL) for industry X & Y respectively

  7. Absolute Advantage (Adam Smith, 1776) Unit labour requirements (hours) Industry Home Foreign X axh = 1 axf = 2 Y byh = 3 byf = 1 Home has ABSOLUTE advantage in production of X: axh = 1 < 2 = axf (hence: MPLxh > MPLxf) Foreign has ABSOLUTE advantage in production of X: byh = 3 > 1 = byf (hence: MPLyh < MPLyf ) Absolute Advantage = more EFFICIENT in production of particular good

  8. USA Is Absolute Advantage Adequate? How much trade does absolute advantage predict?

  9. Comparative Advantage (Ricardo 1772-1823) Unit labour requirements (hours) Industry Home Foreign X axh = 1 axf = 6 Y byh = 2 byf = 3 Home: absolute advantage in both production of X and Y: axh = 1 < 6 = axfbyh = 2 < 3 = byf Home is more EFFICIENT in producing both goods Are there still any gains from trade?

  10. Comparative Advantage: Thought experiment Take a standard UCT commune (digs) Unit labour requirements (hours) ActivityJohn Pete Meal/resident axh = 1 axf = 6 Shop/resident byh = 2 byf = 3 Pete is clearly a lazy lout How best do you allocate your time? Options: No trade: Both cook and shop Trade A: Pete cooks and John Shops Trade B: Pete shops and John cooks

  11. Possible solutions ActivityJohn Pete Meal/resident axh = 1 axf = 6 Shop/resident byh = 2 byf = 3

  12. Comparative Advantage Even though John has absolute advantage, there are still gains from trade. Why? Consider relative efficiency: ActivityJohn/ Pete Meal/resident John is 6 times as efficient Shop/resident John is 1.5 times as efficient Comparative advantage is about relative efficiency. Whenever differences in relative efficiency are evident, then mutual gains from trade are possible

  13. Lets go back to our country example Opportunity Cost : Home: The opportunity cost of producing 1 unit of X is to sacrifice ½ units of Y axh/byh= ½ (= MPLYh/MPLXh ) Foreign: The opportunity cost of producing 1 unit of X is to sacrifice 2 units of Y axf/byf= (6)/(3) = 2 (MPLYf/MPLXf) Therefore: axh/byh < axf/byf = 1/2 < 2 Foreign is LEAST INEFFICIENT in producing Y It has a COMPARATIVE ADVANTAGE in Y

  14. CA: Why is there an incentive to trade? Remember: There is an incentive to trade when relative prices differ Foreign: PX/PY = 2 Home: PX/PY= 1/2 Because the pre-trade price ratios differ, there are gains from trade!!!! After trade, the world price ratio: 1/2 < P* < 2

  15. CA: Graphical Y Foreign Home Y LH/bxf New world price ratio: 1/2 < P* < 2 Slope is opportunity cost of X i.t.o Y LH/bxh 2 1/2 1 1 X LH/axh X LH/axf

  16. Specialisation CA: Graphical Y Foreign Home Y LH/bxf Assume World Price settles at P* =1 LH/bxh 2 1/2 1 1 X LH/axh X LH/axf

  17. Gains from trade: Intuitive explanation Gains from Exchange New world price ratio P* = 1 Terms of Trade: 1 unit of X can be exchanged for 1 unit of Y Home: Pre-trade: 1 units of X would get you ½ unit Y Post-trade: by specializing in X, home can exchange 1 X for 1 Y, hence gains an additional ½ Y for each X Foreign: Pre-trade: opportunity cost of producing 1 unit of X was to sacrifice 2 units of Y Post-trade: by specializing in Y, Foreign can exchange 1 Y for 1 X, hence gains an additional ½ X for each Y (or 1 X for each 2 Y) Gains from Specialisation By shifting production towards good with a CA, countries can specialise in the good that they are relatively productive in, and hence shift out their consumption possibility frontier.

  18. Provisional conclusions Why do we gain from trade? Trade enables us to purchase cheap imports Trade enables a country to specialise in producing goods it is relatively efficient at producing Do consumers and workers gain? Cost of living declines as import prices fall Productivity of workers increase as they move to efficient sectors

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