Trade Models Overview: Recap, Ricardian Model, Specific Factors Model, Heckscher-Ohlin Model, Standard Trade Model, Mode

1. International Economics Lecture 12 - Revision Lecture: Trade Models

2. Overview • Recap: why bother with trade models? • The Ricardian Model • The Specific Factors Model • The Heckscher-Ohlin Model • The Standard Trade Model • Modern Trade Models (x4 models) • External Economies of Scale • Internal Economies of Scale

3. Recap: why bother with trade models? • What is the purpose of a trade model? • To answer to main questions: • What drives trade? • How does trade affect the economy (i.e. how does it affect people)? • Are there gains in welfare? • What are the distributional effects?

4. The Ricardian Model • What drives trade? • Differences in labour productivity • 2 products, 2 economies, 1 factor of production (L) • Assumptions: • Perfect competition, homogenous labour • General equation for production: L ≥ (αL1 * Q1) + (αL2 * Q2)

5. Our wine and cheese economy... (‘Home’) Remember: A straight-line PPF means constant opportunity cost!

6. The Ricardian Model • Wages: w = (P / α) (e.g., wC = (PC / αLC) • In the absence of trade, we expect relative prices to equal relative costs (and thus wages would equalise!) • In Home: P1 /P2 = αL1 / αL2 • E.g., PC /PW = αLC /αLW • In Foreign: P*1 /P*2 = α*L1 /α*L2 • E.g., P*C /P*W = α*LC /α*LW

7. The Ricardian Model • But what will world prices be with trade? • We need to have a model that does not just look at the market for cheese, or the market for wine… …but instead models both markets together! • This is called general equilibrium analysis • I.e., relative demand and relative supply

8. General equilibrium analysis: relative supply Both Home and Foreign specialise in cheese if price is above α*C / α*W Any price in between leads to Home to fully specialise in cheese, and Foreign to fully specialise in wine The quantities produced when both countries fully specialise No supply of cheese if price drops below αC / αW

9. Note: RD is exogenously determined (‘given’ to us, we are not calculating it!) General equilibrium analysis: relative demand and relative supply Any RD that intersects relative supply between these prices leads to both countries fully specialising [e.g. RD1] Any RD that intersects on a flat part of RS will lead to complete specialisation in one country, and no specialisation in the other [e.g. RD2 or RD3]

10. The Ricardian Model • RD1: Both Home and foreign fully specialise according to their comparative advantage • RD2: Foreign fully specialises in wine, Home does not specialise (produces both) • RD3: Home fully specialises in cheese, Foreign does not specialise (produces both) Note: Countries will never specialise against their comparative advantage (except with domestic distortions)

11. The Ricardian Model • How does trade affect the economy? • Comparative advantage creates gains from trade (i.e. welfare gains) • Countries (either fully or partially) specialise according to their comparative advantage

12. The Specific Factors Model • What drives trade? • The model does not explicitly address this – it assumes changes in prices are exogenously determined by trade…! • Instead it looks at the distributional effects caused by trade

13. The Specific Factors Model • 2 products • Three factors of production • Can be any three, but convention is to use: • L: Labour, the mobile, ‘non-specific’ factor • K: Capital, a fixed and ‘specific’ factor • T: Land, a fixed ‘specific’ factor • Assumptions: • Perfect competition, homogenous labour

14. The ‘four-way’ graph

15. The Specific Factors Model • Because we assume labour can move freely, wages should be identical in both sectors (e.g., wFood = wCloth) • Wages: w = MPLC * PC = MPLF * PF • Thus: – MPLF / MPLC = – PC / PF

16. Determining the equilibrium wage... Note: The assumption is that the demand for labour in each sector is equal to the value of the produce of labour (P * MPL) [which is the willingness to pay a certain level of wage]

17. In domestic equilibrium

18. An increase in one price only (e.g. cloth) 1.Labour shifts from the food sector into the cloth sector...

19. 2. ...the relative price changes 1.As labour shifts from the food sector into the cloth sector...

20. The effect on the PPF from an increase in one price only (e.g. cloth) 2. The relative price changes

21. The Specific Factors Model • How does trade affect the economy? • Trade benefits the factor that is specific to the export market, but hurts the factor that is specific to the import market • The effects upon the non-specific factor (L) are ambiguous

22. The Heckscher-Ohlin Model • What drives trade? • Differences in resource endowments (i.e. differences in the relative abundance of factors of production)

23. The Heckscher-Ohlin Model • Simple version – the ‘2 x 2 x 2 Model’: • 2 economies • 2 products • 2 factors of production • Convention is L and K Assumptions: • Perfect competition, homogenous labour

24. Relative factor demand curves Cloth production is more labour-intensive than food production; food is more capital-intensive

25. Linking relative product prices (PC/PF) with relative factor prices (w/r)

26. And now linking it all together: relative product prices (PC/PF), relative factor prices (w/r), & input combinations Then we decrease the L-K ratio used in both products If we increase PC / PF…

27. General equilibrium analysis: relative demand and relative supply RS* = Relative Supply in Foreign Note: Relative demand is assumed to be universal (the same regardless of the country)

28. 2. Consumption Consumption can now be at any point along the red ‘trade’ line! 1. Production Opening to trade shifts production from QA to Q* With trade, more cloth is produced and less food

29. The Heckscher-Ohlin Model • How does trade affect the economy? The Heckscher-Ohlin Theorem: • The country that is relatively abundant in a factor will export the product that uses that factor intensively in its production • E.g., In our example, Home was relatively more abundant in labour than Foreign, and ended up exporting the labour-intensive product, cloth

30. The Heckscher-Ohlin Model • How does trade affect the economy? (cont.) Factor price equalisation • Opening to trade equalises the prices of factors • Owners of the country’s abundant factor gains from trade, but owners of a country’s scarce factors lose

31. The Standard Trade Model • Extends the Heckscher-Ohlin Model • Adds in consumption preferences • Otherwise, same assumptions, same conclusions! • Note: following diagrams are assuming cloth is the exported product

32. Adding indifference curves

33. Trade triangles [in green]

34. RS = Domestic RS As the terms of trade increase [(PC/PF)], welfare increases [D3 => D1= > D2]

35. Modern trade models • Differences in demand • Linder’s Representative Demand • Vernon’s Product Life Cycle Theory • The Gravity Model

36. Differences in demand: an example Source: Structure of the Global Markets for Meat, by John Dyck and Kenneth Nelson, USDA, Economic Research Service, September 2003

37. Linder’s Representative Demand: Trade between countries of similar income levels because they demand similar products Variations of rice in Australian shops... ...versus Papua New Guinea! [You see the same thing in Fiji, Indonesia, rural China, etc.!]

38. Vernon’s Product Life Cycle Theory

39. Modern trade models: The Gravity Model • Trade due to size and proximity of economies: • Tij = (A * Yi * Yj) / Dij • Tij: value of trade between country i and j • Yi: GDP of country i • Yj: GDP of country j • Dij: distance between country i and j • A: a constant • This is necessary to reflect the general level of trade in both countries relative to GDP

40. External economies of scale • External economies of scale occur when the cost per unit of production depends on the size of the industry, but not necessarily on the size of any one firm • Causes: • Specialised suppliers • Labour market pooling • Knowledge spillovers Classic example: Silicon Valley for computer and IT design

41. External economies of scale: With trade

42. External economies of scale: Established/entrenched advantage

43. Internal economies of scale • Internal economies of scale occur when the cost per unit of production depends on the size of an individual firm, but not necessarily the size of the industry… • CC: The more firms there are in the industry, the higher the average cost • PP: The more firms there are in the industry, the lower the price they charge

45. Explanatory note for previous slide...

46. Internal economies of scale: Opening to trade Note: As discussed, QIndustryleads to lower costs (for any given n), and no change in the price charged (for any given n)

47. Formulas that will be provided in the mid-semester test • For the Ricardian Model: General equation: L ≥ (αL1 * Q1) + (αL2 * Q2) • The Gravity Model: • Tij = (A * Yi * Yj) / Dij • Internal economies of scale: 1.QFirm = QIndustry * [(1/n) – b * (P – )] 2. ATC = FC/QFirm + MC = [n * (FC/QIndustry)] + MC 3. (P – MC) = 1 / (b * n)