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ECONOMICS 3150M. Winter 2014 Professor Lazar Office: N205J, Schulich flazar@yorku.ca 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

flazar@yorku.ca

736-5068

Lecture 16: March 10Ch. 2, 3, 4, 5

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

• 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

• 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

• 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

• 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*

• 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

• 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

• 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

• 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”

• 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.

• 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

• 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

• 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

• 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

• 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

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

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