Extend the Ricardo’s Model Loose the assumptions of Ricardo’s Model Review the Assumptions of Ricardo’s Model, Loose those assumptions and see what will happen to Ricardo’s model Summary 2. Other extensions

Review the Main Assumptions 2*2*1 model: One input(L), Two outputs, Two countries Costs are constant and there are no economies of scale. Factors of production are perfectly mobile. Perfect Competition (Goods are identical) No transaction costs (No transport costs, No tariffs or other trade barriers, Perfect knowledge, etc)

Loose the Assumptions 1 (1) One input Two or more inputs H-O Model Specific Factor Model Talk about it later

Loose the Assumptions 1 (2) Two outputs &Two countries Ricardo Model with Many Goods or Many Countries Ricardo’s model no essential change Many Goods and Two Countries Many Countries and Two Goods

Many Goods and Two Countries Setting up the model: list relative productivity by order (note: * is US) Deriving the relative demand for labor Determining the relative wage Determining the comparative advantages αL1*/ αL1> αL2*/ αL2>…… > αLi*/ αLi If or than china has advantage in product i

Example If = 5，then China has advantage in apple and Banana, US has advantage in other three goods; If =4,then China and US both can produce caviar; If =1，then China can export apple, banana, caviar and Dates.

Many Countries and Two Goods Setting up the model: list relative costs by order Deriving the relative supply Determining the relative price Determining the comparative advantages < <…<

Principle In the case of two products and many countries, one country’s comparative advantage is determined by the relative costs of the products it produces and the relative price in the world market . If < , this country has comparative advantage in product 1.

Example USA France China Thailand Nation L per Unit Relative cost Rice Wheat Suppose the relative price of Rice in equilibrium is 2, then Thailand and China produce and export Rice, while USA and France produce and export Wheat.

Determining the relative price Relative productions of Rice Relative Demand Relative price of Rice 4 2.5 2 1.5 1 Relative Supply

Determining the relative price Relative price of Rice is determined by the produce capability of Thailand in Rice, that of USA in Wheat and the relative demand of 4 countries. If the produce capability of Thailand in Rice is strong, while that of USA in Wheat is weak, the relative supply of Rice is large; or else it is small.

Determining the relative price When the relative demand of Rice is given, the larger the relative supply of Rice is, the lower the relative price of Rice in equilibrium, and the less countries Rice productions will need, even just Thailand is enough. But if the produce capability of USA in Wheat is strong, while that of Thailand in Rice is weak, the relative price of Rice will be higher.

Loose the Assumptions 2 (1) Increasing opportunity costs or decreasing returns to scale Costs are constant QC QW PPF

International Trade under Increasing Opportunity Cost Autarky The Patten of Production and Trade Comparison Conclusion

Autarky Foreign Home

The Patten of Production and Trade Foreign C’ TOT= Export Import P’ C Import P Export Home TOT=

Increasing Opportunity Cost Comparison Home C TOT= Import Export Increasing Opportunity Cost Constant Cost

Conclusion The principle of comparative advantage is still effective under the increasing opportunity cost. However, pure specialization is impossible.

Loose the Assumptions 2 (2) Decreasing opportunity costs or decreasing returns to scale Costs are constant QC QW PPF

Trade gains under decreasing costs QC QW PPF A B A’ B’ C’ C Trade gain TOT

Loose the Assumptions 2 (3) Economics-of-scale and imperfect competition model No economies of scale Talk about it later

Loose the Assumptions 3 Factors of production are perfectly mobile Transfer Costs Factors of production are perfectly mobile Factors of production can’t move freely among sectors Industry Obstruct Reduce the volume of international trade Increasing the production costs of export

Goods are idiosyncratic Loose the Assumptions 4 Goods are identical Goods are idiosyncratic Intra-sector Trade Talk about it later

Loose the Assumptions 5 (1) Perfect knowledge Imperfect knowledge Reduce the volume of international trade More difficult to find the right goods and reach contractions

Loose the Assumptions 5 (2) No transport costs transport costs Reduce the volume of international trade Non-traded Goods

Loose the Assumptions 5 (3) No tariffs or other trade barriers Trade Barriers Reduce the volume of international trade Increasing the Transaction Costs Talk about it later

Summary Loosing some assumptions of Ricardian Model will not affect the Law of Comparative Advantage substantially, but increase the transaction costs in international trade, and lead to imperfect specialization, reduce the volume of international trade. But loosing the assumptions that goods are identical and there are no economies of scale is the base of intra-sector trade and economics-of-scale model.

Increasing Transaction Costs What is transaction costs? —— expenses of searching for a trading partner, specifying the product(s) to be traded, negotiating the price and contract,and the ex post costs. Who find the “transaction costs”? Reasons of transaction costs especially in IT Imperfect Information(Knowledge) Transport Cost Trade Barrier Political Risk

Ronald H. Coase Great Britain University of Chicago, USA Major Work “The Firm，the Market，and the Law” “The Nature of the Firm”

Trade gains with transaction costs Before trade (autarky) A country: 1 Wheat=a Cloth B country: 1 Wheat=b Cloth1 Cloth=1/b Wheat After trade TOT: 1 Wheat=P Cloth1 Cloth=1/P Wheat Transaction costs: F per unit Wheat or Cloth A country: exchange 1 Wheat not less than a Cloth, ie P-F>a B country: exchange 1 Cloth not less than 1/b Wheat, ie (1/P)-F>1/b

Trade with transaction costs and increasing opportunity costs TOT A: no trade P & C: Productions & Consumptions under trade without transaction costs P’ & C’: Productions & Consumptions under trade with transaction costs TOT-F O A P P’ C C’

Imperfect Specialization Increasing Opportunity Cost Transaction Costs The Size of Trader (talk about it later) The existence of more than one factor of production reduce the tendency toward specialization

Other Extensions for Ricardian’s Model Trade Between Big Country and Small Country Trade with Currency (not barter)

Trade Between Big Country and Small Country There is an implicit assumption in Ricardian two-country model that the size of the two countries are similar, so they can give up the productions without comparative advantage, and input all the resources to the production with comparative advantage. But in reality, the size of the trading countries may be very different. For example, China’s population as well as land is hundreds of times of Sri Lanka’s, so even China has comparative advantage in Cloth, while Sri Lanka in Wheat, China can’t produce Cloth only under free trade. Because even all Wheat produced by Sri Lanka are exported to China, they still can’t meet the consumption need in China.

Trade Between Big Country and Small Country So，If trade happens between big country and small country, small country can only produce the product with comparative advantage, but big country still need to produce both products. Case Study:Who will feed China?

Imperfect Specialization for Big and Small Countries QC P Qw O C China Sri Lanka TOT O QC

Trade with Currency Bicycle Toy USA (Dollar) 100 25 China (RMB) 400 50 Suppose RMB/Dollar=X For Bicycle, if 100X>400(ie X>4), no trade in Bicycle and Toy(25×4＝100>50); For Toy, if 25X<50(ie X<2), no trade in Toy and Bicycle(100×2＝200<400). So X must be between 2 and 4, if there is trade