Lecture 1. Classic and Neoclassic Trade Models. Carlos Llano References: Feentra y Taylor (2011). Comercio Internacional. Ed. Reverte. Krugman P. Obsfeld and Melitz: International Economics. Prentice Hall, 2012. Chapter . van Marrewijk C. (2009): The New Introduction to Geographical Economics. Cambridge University Press.

Introduction. U.S. Imports of Snowboards Why do countries trade? Ranking of the main exporters? Why? Ranking of the countries with the largest gains in trade share? And with largest losses? Why? Ranking of the lowest / highest price levels? Why?

1. Introduction In the classic models: Ricardian Model: H-O Model: Trade is based on comparative advantage. Countries gain from trade if they are different. Ricardian Model: Key: Differences in productivity Home (H): exports good 1, which is produced with higher relative productivity; imports good 2, Foreign (F) produces good 2 more efficiently. H-O Model: Key: Differences in factor endowments. H exports good 1, whose production is intensive in the relatively abundant factor (K or L), and imports good 2 F is specialized in producing the good that is more intensive in the factor that is relatively more abundant in F.

New Economic Geography 1. Introduction New Trade Theory (NTT) General equilibrium framework Imperfect competition Transport costs. Krugman, 79 Krugman, 80 Factor mobility (migration + firms) Dynamics between economics and geography: 1st nature ►2nd nature ► circular causation New Economic Geography (NEG) Krugman, 91 Fujita, Krugman Venables, 1999 Heterogeneous firms. Alternative ways for firm’s internationalization: Export vs FDI. New-New Trade Theory (NNTT)

2. The Ricardian Model References: Feentra y Taylor (2011). Comercio Internacional. Ed. Reverte.

Introduction This chapter explains comparative advantage by looking at how technology differences across countries affects trade This is referred to as the Ricardian model because it was proposed by the 19th century economist David Ricardo

The Home Country We will use two goods to develop a Ricardian model of trade: Wheat and Cloth There are two countries, Home and Foreign.

Road Map Part 1. Home country, before trade Part 2. Home and Foreign countries, who exports wheat and who exports cloth? Comparative advantage Part 3. Is trade “good” or “bad”?

The Home Country We will assume that labor is the only resource used to produce both goods One worker can produce 4 bushels of wheat or 2 yards of cloth The Marginal Product of Labor is the extra output obtained by using one more unit of labor MPLW = 4 and MPLC = 2 Key Assumption: Marginal Products of Labor are fixed Suppose Home has 25 workers; i.e. = 25. Labor endowment.

The Home Country: Summary Cloth MPL wheat Labor Home 2 4 25 Home Production Possibilities Frontier We can use the marginal products of labor to construct Home’s PPF. Assume there are 25 workers in Home. If all the workers were employed in wheat, the country could produce 100 bushels If they were all employed in cloth they could produce 50 yards. The PPF connects these two points

The PPF at “Home” in autarky.

Notes: PPF Slope: formular Showing these calculations we can see: Labor = 25, MPLW = 4, MPLC = 2 If Home produces wheat only, QW = MPLW*L = 25*4 = 100 If Home produces cloth only, QC = MPLC*L = 25*2 = 50 This gives us a straight line PPF which is a unique feature of the Ricardian model Assumes marginal production of labor is constant

Notes: Slope of PPF and Opportunity Cost The slope of the PPF can be calculated as the ratio of marginal products of the two goods The slope also equals the opportunity cost of wheat – the amount of cloth that must be given up to obtain one more unit of wheat – if we put wheat quantity on the horizontal axis. Labor used in 1 wheat = labor used in ½ cloth; i.e. cost of 1 wheat = cost of ½ cloth

Indifference Curves: the consumer`s preferences Cloth, QC (yards) The country is indifferent between A and B U0 < U1 < U2 B A U2 U1 U0 Wheat, QW (bushels)

The Indifference Curves (Home) Given Home’s PPF, we still don’t know how much Home will choose to produce We need information about the country’s preferences – we need indifference curves. A single indifference curve shows the combinations of wheat and cloth that the country can consume and be equally satisfied. Indifference curves increase in utility as the curves move northeast. All points on a single indifferent curve have the same level of utility. A country cannot produce outside their PPF so, without trade, they are constrained in their utility by the PPF.

closed-economy equilibrium (Home) Figure 2.2 The country could produce at point D but would be at a higher level of utility at point A. The country is better off on U2 but cannot produce that much At point A, on U1, is the best the country can do Cloth, QC (yards) C 50 D B A U2 25 Home closed-economy equilibrium U1 Home PPF U0 50 100 Wheat, QW (bushels)

Notes: Figure 2.2 Home Equilibrium Without trade, the PPF acts like a budget constraint for the country The country will produce at its highest level of utility within the limits of the PPF In the graph, the highest level of utility that can be reached and still stay within the PPF is U1 with production at point A

Wage Equation In competitive markets, suppose for cloth P = $2 and MPL = 4. How much salary (w) are firms willing to pay? Cost of a marginal worker to the firm = wage Value of a marginal worker to the firm = the value of one more hour of production = 4 cloth x $2/cloth = $8 So firms are happy if w = $8

Wage Equation w = P*MPL The value of one more worker equals the amount of goods produced by this worker (MPL) times the price of the good. Predictions: (1) you earn more if your products are worth more; (2) you earn more if you are more productive

Relative Prices at closed-economy equilibrium W=P*MPL holds for both wheat and cloth Since labor can move freely between industries, wages must be equalized: The right had size is the slope of the PPF and the opportunity cost of obtaining one more bushel of wheat. The left hand side is the relative price of wheat. Value of 1 wheat = ½ value of 1 cloth

Relative Prices and OC The price ratio, PW/PC, always denotes the relative price of the good in the numerator, measured in terms of how much of the good in the denominator must be given up. For the good on the horizontal axis of the PPF picture, |PPF slope| = OC = relative price before trade

Real Wages Before Trade Real Wage = wage/price Real wage for wheat = wage/price_of_wheat; i.e. quantity of wheat the wage can buy Calculate the real wage for wheat Calculate the real wage for cloth

Real Wages Before Trade (Autarky) Real wage for wheat = wage/price_of_wheat; i.e. quantity of wheat the wage can buy Since Home produces both wheat and cloth, Home wage is: w = PW*MPLW = PC*MPLC The real wage for wheat = w/PW = (PW*MPLW)/PW = MPLW = 4 wheat The real wage for cloth = w/PC = (PC*MPLC)/PC MPLC = 2 cloth Before trade, real wage = marginal product of labor

The Foreign Country: Summary Cloth MPL wheat Labor Foreign 1 100 Foreign Production Possibilities Frontier MPL*W = 1, MPL*C = 1 Key Assumption: Marginal Products of Labor are fixed Assume there are 100 workers available in Foreign If all workers were employed in wheat they could produce 100 bushels. If all workers were employed in cloth they could produce 100 yards. The Foreign country’s PPF connects these two points.

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Foreign PPF © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

closed-economy equilibrium (Foreign) Figure 2.4 A* 50 100 Wheat , (bushels) Cloth, (yards) 100 Foreign before-trade equilibrium Foreign PPF 50 |The slope of the PPF| = the opportunity cost of wheat = the before-trade relative price of wheat, P*W/P*C = 1

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Pattern of Trade Which country exports wheat and which country exports cloth? Assume: no trade cost © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Absolute Advantage = Higher MPL MPL, Cloth (Yard/worker) MPL, wheat (Bushel/worker) Labor Home 2 4 25 Foreign 1 100 Absolute advantage = higher MPL at Home. Foreign’s technology is inferior to Home’s Home has an absolute advantage in both wheat and cloth as compared to Foreign Clearly, Home can’t export both wheat and cloth when trade opens up.

Comparative Advantage = Lower OC MPL, Cloth (Yard/worker) MPL, wheat (Bushel/worker) Labor Home 2 4 25 Foreign 1 100 What the Opportunity Costs for Goods in Home and Foreign are? Cloth (Yard) Wheat (Bushel) Home 4/2 = 2 wheat 2/4 = 1/2 cloth Foreign 1/1 =1 wheat 1/1 = 1 cloth © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Notes: OC Table Comparative Advantage = Lower Opp. Cost A country has a comparative advantage in a good when it has a lower opportunity cost of producing that good Ej: Foreign has a comparative advantage in producing cloth Foreign’s Opportunity cost of cloth is lower (1 vs 2) Home has a comparative advantage in producing wheat Home’s opportunity cost of wheat is lower (1/2 vs 1)

Why does comparative advantage drive trade patterns? Because OC = relative prices before trade Wheat (Bushel) Home ½ cloth Foreign 1 cloth © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Notes: Relative Price Table Why does Home export wheat? Relative price of wheat in Home is PW/PC = 1/2 Relative price of wheat in Foreign is PW*/PC* = 1 Therefore Home would want to export their wheat to Foreign – they can make it for 0.50 cloth and export it for 1 cloth! The opposite is true for cloth Home will export wheat and Foreign will export cloth Both countries export the good for which they have the comparative advantage

Comparative Advantage in Apparel, Textiles, and Wheat US Textile and apparel industries face intense import competition Burlington Industries announced in January 1999 it would reduce production capacity by 25% due to increased imports from Asia After layoffs they employed 17,400 persons in the US with a 1999 sales of $1.6 billion Sales per employee were therefore $92,000 This is the average for all US apparel producers Textiles are even more productive with annual sales per employee of $140,000 in the US © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Comparative Advantage in Apparel, Textile and Wheat Table 2.2

Equilibrium with trade The relative price of wheat in the trade equilibrium will be between the before-trade prices in the two countries For now lets assume the free-trade price, PWT/PCT = 2/3. This is between the price of ½ in Home and 1 in Foreign. We can now take this price and see how trade changes production and consumption in each country

Notes: Equilibrium with trade How prices change after trade As Home exports wheat, quantity of wheat sold at Home falls The price of wheat at Home goes up More wheat goes into Foreign’s market The price of wheat in Foreign falls For the same reason, as Foreign exports cloth, the quantity sold in Foreign falls. Therefore, the price in Foreign for cloth rises, and the price of cloth in Home falls.

Notes: Equilibrium with trade Trade Equilibrium Two countries are in a trade equilibrium when the relative price of wheat is the same in the two countries – this means the relative price of cloth is also the same in both countries. This is because we assume there is no trade cost

Opportunity Costs in Home and Foreign Pattern of Production Opportunity Costs in Home and Foreign Cloth (Yard) Wheat (Bushel) Home 4/2 = 2 wheat 2/4 = 1/2 cloth Foreign 1/1 =1 wheat 1/1 = 1 cloth PWT/PCT = 2/3. Home exports wheat. How many wheat does Home make?

Complete specialization Home’s workers will want to work in wheat and no cloth will be produced With trade, Home will be fully specialized in wheat production!

Is trade good or bad: Home PWT/PCT = 2/3. Home exports wheat Cloth, QC (yards) 50 A 25 Home closed-economy equilibrium U1 Home PPF 50 100 Wheat, QW (bushels)

Consumption Possibility Frontier (CPF), Home The new world price, PWT /PCT = 2/3, shows us the new range of consumption possibilities The country can now achieve a higher utility with the new consumption possibilities U1 A 50 100 Wheat , QW (bushels) Cloth, QC (yards) B Home production 50 25 CPF, Slope = –2/3 U2

Is trade good or bad: Foreign PWT/PCT = 2/3. Foreign exports cloth Cloth, (yards) Foreign PPF 100 Foreign closed-economy equilibrium A* U0 100 Wheat, (bushels)

CPF, Foreign The new world price, PWT /PCT = 2/3, shows us the new range of consumption possibilities The country can now achieve a higher utility with the new consumption possibilities Foreign production 60 100 Wheat, (bushels) Cloth, (yards) 100 60 B* World price line, Slope = –2/3 U0 U1 C* Foreign consumption

Notes: Gains from Trade Gains from trade for BOTH countries! Under the new production, each country specializes fully in the good for which they have the comparative advantage They then export some of their production and import some of the other good from the other country Home specializes in wheat and Foreign specializes in cloth The new indifference curves show the new consumption points. The difference between production and consumption give us trade patterns

Gains from Trade: intuition International Trade Trade allows both countries to engage in consumption possibilities they did not have before trade This is a demonstration of gains from trade Intuition: trade increases the choices a country can make (the PPF remains available after trade); both countries gain because they help each other out.

Trade is Balanced: Foreign Foreign produces 0 wheat but consumes 60 so imports equal 60. Foreign produces 100 cloth but consumes only 60 so exports equal 40 Foreign production 60 100 Wheat, (bushels) Cloth, (yards) 100 60 B* World price line, Slope = –2/3 U0 U1 C* Foreign consumption Foreign exports 40 yards of cloth Foreign imports 60 bushels of wheat

Trade is Balanced: Home Home produces 100 wheat but consumes only 40 so exports equal 60 Home produces 0 cloth but consumes 40 so imports equal 40. U1 40 100 Wheat , QW (bushels) Cloth, QC (yards) C B U2 World price line, Slope = –2/3 50 40 Home consumption Home imports 40 yards of cloth Home production Home exports 60 bushels of wheat

Trade and Wages How do wages change after trade for Home and Foreign? Under free trade, which country has a higher wage? Wages actually differ – they are determined by absolute advantage – not comparative advantage Real wages: = wage/price.

Real Wages Before Trade: Home Before trade, real wage = marginal product of labor since Home makes both wheat and cloth The real wage for wheat = MPLW = 4 wheat The real wage for cloth = MPLC = 2 cloth

Real Wages After Trade: Home Solving for Real Wages Across Countries Since Home produces and exports wheat, Home wage is: w = PWT*MPLW The real wage for wheat = w/PWT = (PWT*MPLW)/PWT = MPLW = 4 wheat. Same as before trade The real wage for cloth = w/PCT = (PWT*MPLW)/PCT =(PWT/PCT)*MPLW = (2/3)*4 = 8/3 cloth. Higher than before trade. Trade increases real wage for cloth! Same intuition as gains from trade.

Terms of Trade The real wage for cloth =(PWT/PCT)*MPLW The Terms of Trade for Home = PWT/PCT An increase in PWT or a fall in PCT will raise Home’s terms of trade An increase in the terms of trade is good for a country They earn more for its exports They pay less for their imports Home real wage for cloth is higher In general, the price of a country’s exports divided by the price of its imports. Foreign’s Terms of Trade = PCT/PWT

Real Wages Before Trade: Foreign Before trade, real wage = marginal product of labor since Foreign makes both wheat and cloth The real wage for wheat = MPLW* = 1 wheat The real wage for cloth = MPLC* = 1 cloth

Real Wages After Trade: Foreign Solving for Wages Across Countries Since Foreign produces and exports cloth, Foreign wage is: w* = PCT *MPLC* The real wage for cloth = w*/PCT = (PCT*MPLC*)/PCT = MPLC* = 1 cloth, same as before trade The real wage for wheat = w*/PWT = (PCT*MPLC*)/PWT = (PCT/PWT)*MPLC* = (3/2)*1 = 3/2 wheat, higher than before trade Again, free trade increases real wages!

Comparing Wages Across Countries Summarizing Home real wage is 4 bushels of wheat 8/3 yards of cloth Foreign real wage is 3/2 bushels of wheat 1 yard of cloth The ratio Home_wage/Foreign_wage = 8/3, so Foreign workers earn less What is the intuition for this?

Comparing Wage Across Countries What determines w/w*? Since Home produces and exports wheat, Home wage is: w = PWT*MPLW Since Foreign produces and exports cloth, Foreign wage is: w* = PCT *MPLC*

Summary: Comparing Wages Across Countries Home_wage/Foreign_wage depends on Home country’s TOT and absolute advantage So comparative advantage gives you trade patterns, and absolute advantage gives you high wages The intuition: the only way a country with poor technology can export at a price others are willing to pay is by having low wages.

Predictions In a given year, the countries that have better technology should have higher wages (i.e. comparing across countries) Over time, as a given country develops better technology, its wages will rise (i.e. looking at changes for a given country)

Labor Productivity and Wages for 2001 Figure 2.7

Notes: Figure 2.7. Labor productivity can be measured by the value-added per hour in manufacturing Value-added is the difference between sales revenue in an industry and the costs of intermediate inputs Equals the payments to labor and capital in an industry. The Ricardian model ignores capital so we can measure labor productivity as value-added divided by the number of hours worked, or value-added per hour Figure 2.7 shows value added per hour in manufacturing for several countries Countries with higher labor productivity pay higher wages, just as the Ricardian model predicts

Labor Productivity and Wage Over Time

Notes: Figure 2.8. We can also see the connection between productivity and wages over time Figure 2.8 shows the general upward movement in labor productivity is matched by upward movement in wages This is also predicted by the Ricardian Model

4 Solving for International Prices Home exports wheat, so we will derive a Home export supply curve, which shows the amount it wants to export at various relative prices. Foreign imports wheat, so we will derive a Foreign import demand curve, which shows the amount of wheat that it will import at various relative prices.

Home Export Supply Curve FIGURE 2-9 (1 of 2) When the relative price of wheat is 1/2, Home will export any amount of wheat between 0 and 50 bushels, along the segment A B of the Home export supply curve. Home Export Supply Panel (a) repeats Figure 2-5 showing the trade equilibrium for Home with production at point B and consumption at point C. Panel (b) shows the Home export supply of wheat.

Home Export Supply Curve FIGURE 2-9 (2 of 2) Home Export Supply (continued) For relative prices above 1/2, Home exports more than 50 bushels, along the segment B C. For example, at the relative price of 2/3, Home exports 60 bushels of wheat.

Foreign Import Demand Curve FIGURE 2-10 (1 of 2) Foreign Import Demand Panel (a) repeats Figure 2-6. Panel (b) shows Foreign import demand for wheat. When the relative price of wheat is 1, Foreign will import any amount of wheat between 0 and 50 bushels, along the segment A*B* of the Foreign import demand curve.

Foreign Import Demand Curve FIGURE 2-10 (2 of 2) Foreign Import Demand (continued) For relative prices below 1, Foreign imports more than 50 bushels, along the segment B*C*. For example, at the relative price of 2/3, Foreign imports 60 bushels of wheat.

International Trade Equilibrium FIGURE 2-11 World Market for Wheat Putting together the Home export supply curve and the Foreign import demand curve for wheat, the world equilibrium is established at point C, where the relative price of wheat is 2/3. At this price, Home exports of 60 bushels just equal Foreign imports of wheat.