International Trade MGMT 418 Komeil Shaeri

Chapter 3 The Classical World of David Ricardo and Comparative Advantage The Principles of Political Economy and Taxation (1817)

Comparative Advantage  One has a comparative advantage over another in producing a particular good if he can produce that good at a lower relative opportunity cost or autarky price, i.e. at a lower relative marginal cost prior to trade.

Assumptions of the Basic Ricardian Model 1.Each country has a fixed endowment of resources, and all units of each particular resource is identical. 2.The factors of production are completely mobile between alternative uses within a country. It implies that the prices of factors of production also are the same among these alternative uses. 3.The factors of production are completely immobile externally, ie, they do not move between countries. 4.Labor theory of value is employed in the model.  No other inputs are used in the production process,  Any other input is measured in terms of labor embodied in the production process,  The other input/labor ratio is the same in all industries, ie, the good embodying two hours of labor is twice as expensive as a good using only one hour. 5.The level of technology is fixed for both countries.

Assumptions cont Costs of production are constant, ie, the supply curve for any good is horizontal. 7. There is full employment. 8. The economy is characterized by perfect competition. 9. There is no government intervention. 10. Transportation costs are zero. 11. Two-country, two-commodity model

Ricardian Comparative Advantage WineClothPrice ratios in Autarky Portugal80 hrs/bbl90 hrs/yd1 W:8/9 C (or 1C:9/8W) England120 hrs/bbl100 hrs/yd1 W:6/5 C (or 1C:5/6W) The labor requirements per unit of production reflect the technology in each country and imply relative value of each commodity. Above Portugal has an absolute advantage in production of both commodities. However, Portugal is relatively more efficient in production of wine than cloth.

Autarky ratios Autarky (pretrade) price ratios show the price ratios when the country has no international trade. In England, 1barrel of wine should exchange for 6/5 yards of cloth (since the same labor time is embodied in each quantity), while in Portugal, 1 barrel would exchange for only 8/9 yard of cloth. Thus Portugal gains if it produces wine and exchanges 1 barrel for 6/5 yards. And England gains if it produces cloth and exchanges 1 yard for 9/8 barrels of wine (instead of 5/6 barrel at home)

Gains from trade Autarky price ratios: England →1 barrel of wine exchanges for 1.2 (6/5) yards of cloth Portugal →1 barrel of wine exchanges for 0.89 (8/9) yards of cloth So England gains if she buys wine at any price less than 1.2 C, and Portugal gains when she buys more than 0.89 C for 1W.

Terms of Trade Terms of trade is the international price ratios of commodities in international trade. After trade, there will be a common price for wine and cloth in England and Portugal. Because the demand for cloth in England will rise in order to exchange it for wine from Portugal. Thus, the prices of both wine and cloth will change. There will be a new equilibrium depending on the demand in two countries. This new price will not be only determined by the labor content.

The equilibrium terms of trade This equilibrium will bring about a balanced trade, where exports = imports in total value, for each country. If one of the countries have a trade surplus, the price-specie-flow mechanism starts, and the surplus is eliminated, because prices and wages increase in the surplus country, and imports increase, bringing trade to equilibrium.

Export concentration of selected countries CountryX categories%of total X Argentina (1994)food and live animals35.3 Colombia (1994)basic manufactures18.1 Cuba (1989)food and live animals80.1 Iceland (1994)food and live animals76.6 Japan (1994)machines, transport equipment,71.9 basic manufactures10.8 New Zealand (1994)food and live animals,42.2 crude materials (exc. Oil)19.0 Saudi Arabia (1992)minerals, fuels, etc,92.5 chemicals and related products 4.5

Comparative advantage and total gains from trade – Table 3 Ricardian production characteristics ClothWine Price ratios in autarky Country A1 hr/yd3 hrs/bbl1W:3C (1C:1/3W) Country B2 hrs/yd4 hrs/bbl1W:2C (1C:1/2W) Country A has a comparative advantage in production of cloth and B has comparative advantage in wine. In the above example, Country B benefits when it can exchange 1W with 3C. And

Comparative advantage and total gains from trade – Table 3  Country A gains nothing because it pays the same relative price that it faces in autarky (exchanging 3C with 1W)  Country A benefits, when it switches one worker from wine production to cloth production.

Equilibrium terms of trade It lies between the two countries’ comparative strength and elasticity of demand of each country for the other’s product. It is referred to as reciprocal demand, a concept developed by John Stuart Mill in 1848.

Location of factors of production If the return on a factor of production is larger than the other one, the other moves to that location until productivity and returns are equalized. This explains the movement of labor between countries and between the regions in the same country.

Resource constraints Suppose Country A has 9,000 hrs of labor available, and Country B has 16,000 hrs of labor available. As in Table 3, Country A can produce 9,000 (9000/1) yards of cloth and no wine, or 3,000 (9000/3) barrels of wine and no cloth, or any combination in between absorbing 9,000 hrs of labor. Country B can produce 8,000 (16000/2) yds of cloth and no wine, 4,000 (16000/4) bbl of wine and no cloth, or any combination in between absorbing 16,000 hrs of labor.

Complete specialization In the previous example, neither of the countries changed their production of wine and cloth. In, all resources are devoted to the production of one good, with no production of the other good. In complete specialization, all resources are devoted to the production of one good, with no production of the other good. If Country A produces only cloth and Country B produces only wine, they exchange 2,000 bbl of W with 5,000 yds of cloth. Country A has 10,000 hrs (4,000x1 + 2,000x3), Country B has 18,000 hrs (5,000x2 + 2,000x4). So both countries are better-off.

Maximum gains from trade Economic incentives cause production to move to the endpoint of the frontier, where the maximum gains from trade is realized. The cost of producing one wine is two yards of cloth, but the return of producing 1 barrel of wine is 2.5 yards of cloth. So production of both goods in two countries expand to the endpoint at the PPF with specialization.

Comparative advantage and the developing countries In 1880’s, cost differences were taken as given and part of the environment (governed by natural endowment of a country’s resources). Eg, quantity of usable land, the quality of soil, the presence of natural resources, the climate, cultural characteristics influencing things such as entrepreneurship, labor skills, and organizational capacity. So there is a basis for trade between developing countries, and between industrialized (which are more effficient in the production of all commodities) and developing countries. Developing countries should participate in trade and use their resources, which otherwise would remain idle. They would buy many consumption, and other goods from the developed countries.

Ricardo He argued that benefits from trade resulted not from the employment of underused resources, but from the more efficient use of domestic resources which come about through specialization and producing according to comparative advantage.

John Stuart Mill He pointed out the dynamic effects of trade, such as acquiring foreign capital and technology, the impact of trade on allocation of resources, and the accumulation of savings. Also contacts with foreign countries and cultures could help break the binding chains of tradition, alter wants, and stimulate enterpreneurship, inventions, and innovations. There could be some negative consequences of trade, such as, producing goods that have few links with the rest of the economy, producing export goods at the expense of goods required for the domestic needs, and dual economy.

Developing countries They complain that they trade at a disadvantage with powerful industrialized countries. The terms of trade is determined by developed countries and for the benefit of them. As a result trade makes poor countries poorer, and rich countries richer as the international statistics show.