International Economics International Trade Theory A One-Factor Economy – The Ricardian Model February 15, 2007

2 What is International Economics About? Determining the gains from trade –Mutual benefits exists even if two countries produce goods at different efficiency level. –While nations generally gain from international trade, it may hurt particular groups within a nation (because it affects the income distribution). Determining the pattern of trade How much trade Balance of payments Exchange rate –The key difference between international and other areas of economics is that countries usually have their own currency (International policy coordination) (International capital market)

3 International Theories of Trade Countries engage in international trade for two basic reasons: 1.They are different from each other – all should specialise in products that they can produce relatively well (at lower cost or higher productivity) 2.Achieving economies of scale in production – division of labour

4 Why specialise? Above are the two products that the model-economy of Hungary can produce. The production of both products needs certain resources (labour and capital – in a one factor economy we only consider labour) The total amount of resources available in Hungary enables the economy to either produce cars, or boxes of medicine. ProductsCar (pc)Medicine (box) Quantities

5 What (and how much of it) shall Hungary produce? 1.Autarky: domestic consumer preferences 2.Open economy: world preferences –The world market presents unlimited demand –Because of the unlimited demand Hungary may fully specialise in either of the two products –E.g.: Hungary will produce boxes of medicine, in this case no cars can be produced at all –There is always a trade-off: Hungary can either produce cars, or boxes of medicine –Opportunity cost: the opportunity cost of medicine in terms of cars is the number of cars ( ) could have been produced with the resources used to produce medicine.

6 ProductCar (pc) Medicine (box) Measurelh/pclh/box Unit labour requirement 11/1000 Unit labour requirement: how much it costs (in terms of labour hour) to Hungary to produce one car, or a box of medicine a LC : unit labour requirement of producing a car – It takes one hour to produce a car in Hungary a LM : unit labour requirement of producing a box of medicine – It takes 3,6 seconds to produce a box of medicine in Hungary

7 ProductCar (pc)Medicine (box) Measurepc/lhbox/lh Unit labour productivity Unit labour productivity: How many cars or boxes of medicine can Hungary produce in one labour hour

8 What shall Hungary produce? Both countries should specialise in the product they produce more efficiently as compared to the other country Hungary – compared to Slovakia – is more efficient in producing medicine, but less efficient in the production of cars Absolute advantage: when one country can produce a unit of good with less labour than the other, it has an absolute advantage in the production of that product Both countries should specialise in the production of the good they produce with an absolute advantage Hungary will produce medicine, and Slovakia cars Car (pc)Medicine Hungary1 lh/pc 1/1000 lh/box Slovakia½ lh/pc1/500 lh/box

9 What if Slovakia was more efficient in the production of both cars, and medicine? Slovakia has an absolute advantage in both products Let the unit labour requirements in case of Slovakia be a* LC and a* LM respectively The opportunity cost of medicine in terms of cars in Hungary is: a LM /a LC The opportunity cost of medicine in terms of cars in Slovakia is: a* LM /a* LC The economy will specialise in the production of medicine, if the relative price of medicine (measured in cars) exceeds its opportunity cost Car (pc)Medicine Hungary1 lh/pc1/1000 lh/box Slovakia½ lh/pc1/4000 lh/box

10 An economy has limited resources (L= ) The combination of goods that can be produced if all resources are used is shown by the Production Possibility Frontier (PF) a LC ×Q C (labour used to produce cars)+ a LM ×Q M (labour used to produce medicine) ≤ L QCQC QCQC QMQM QMQM L/a LC = L/a LC = L/a LM = L/aLM= SlovakiaHungary Absolute value of slope: m = a LM /a LC = 1/1000 Absolute value of slope: m = a LM /a LC = 1/2000

11 Comparative advantage We introduce the concept of comparative advantage: –2×2 model –One country has absolute advantage in the production of both goods A country has a comparative advantage in producing a good if the opportunity cost of producing that good in terms of the other good is lower in the country than it is the other country a* LM /a* LC = 1/2000 < a LM /a LC = 1/1000 The opportunity cost of medicine in terms of cars is lower in Slovakia than it is in Hungary Slovakia will specialise in the production of medicine, and Hungary will concentrate on the production of cars

12 What the international price is going to be? In this model relative prices are used The domestic relative price of products is equal to their opportunity costs However, the international/world relative price will have to be a trae-off value that is different from both domestic trade-offs (1/1000 and 1/2000, if the opportunity cost of medicine is analysed) The exact value of the international/world relative price is determined by the relative supply (RS) and demand (RD) curves

13 PM/PC (a LM /a LC ) Relative price of medicine (Q M +Q* M )/(Q C +Q* C ) Relative quantity of medicine a* LM /a* LC = 1/2000 a LM /a LC = 1/1000 (L*/a* LM )/(L/a LC ) = / = From here on Hungary will also produce medicine RD RS P i – international/world relative price At this point Slovakia will devote all its resources to the production of medicine

14 How much Hungary will gain from international trade? If both countries specialise in the production of goods that they have a comparative advantage in, they will both benefit from international trade Indirect ‘production’: an indirect way of making medicine is to produce the good that Hungary has a competitive advantage in, an then trade it for medicine Hungary benefits from the indirect ‘production’, because it can get access to more units of medicine this way, than it would otherwise, through the use of its resources to make boxes of medicine

15 Hungary can produce 1/a LM units of medicine in 1 hour (1/1/1000 = 1000) Or, alternatively in 1 hour Hungary can make 1/a LC cars (1/1 = 1 pc) We know that a LC /a LM (opportunity cost of cars in Hungary) < P C /P M (P i – world relative price of cars – see slide nr. 9, or the figure on slide nr. 13) By restructuring the above we get: 1/a LM < (P C /P M )(1/a LC ) Units of medicine Hungary can produce in an hour Units of cars Hungary can produce in an hour Units of medicine Hungary can indirectly ‘produce’ in an hour by making cars and exchanging them to medicine

16 Exercises 1.Let this table represent a Ricardian model, where data are given in unit labour requirements: The combination of goods produced are also given: a)How many excess goods can be produced in the two countries (after specialisation), if unit labour requirements don’t change? b)Which of these world relative prices would be beneficial for both countries: P cloth /P wine = ¾; 3/2; 2; 3; 4; 6? WineCloth England24 Portugal312 WineCloth England2010 Portugal107

17 2.How will comparative advantages change if the data were given in unit labour productivity in Exercise 1, instead of unit labour requirements? 3.In a Ricardian model the unit labour requirement of producing cloth in England is 2 lh. England has a 1,5 times productivity lead over Portugal in the production of cloth. It is also known, that at a 1 unit of wine = 2,5 units of baize world relative price neither country can benefit from international trade. a ) Give the comparative advantages of the two countries! b) What is the unit labour requirement of wine in Portugal?