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ECONOMICS 3150M. Winter 2014 Professor Lazar Office: N205J, Schulich 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


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

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”


  • 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