Copyright © 2010 Pearson Addison-Wesley. All rights reserved. Chapter 3 The Classical Model of International Trade

Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 3-2 Topics to be Covered Mercantilism Classical Trade Model Assumptions Smith’s Absolute Advantage Ricardo’s Comparative Advantage Specialization in Production International Terms of Trade International Trade Equilibrium Gains from Free Trade Trade and Wages

Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 3-3 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-3 Introduction Theories of why trade occurs can be grouped into three categories: Market size and distance between markets determine how much countries buy and sell. These transactions benefit both buyers and sellers. Differences in labor, labor skills, physical capital, natural resources, and technology create productive advantages for countries. Economies of scale (a larger scale is more efficient) create productive advantages for countries.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 3-4 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-4 Introduction (cont.) The Ricardian model (chapter 3) says differences in the productivity of labor between countries cause productive differences, leading to gains from trade. –Differences in productivity are usually explained by differences in technology. The Heckscher-Ohlin model (chapter 4) says differences in labor, labor skills, physical capital, land, or other factors of production between countries cause productive differences, leading to gains from trade.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 3-5 Mercantilism A system of government institutions and policies designed to restrict international trade The source of a country’s wealth is gold or money. Two means of increasing a country’s wealth are colonialism and international trade. A country must export more and import less.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 3-6 Adam Smith Attacked the mercantilist system Advocated free international trade Emphasized advantages of specialization and international division of labor whereby nations specialize in the production of only a few goods

Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 3-7 Additional Assumptions Assumption 8—Resources cannot move between countries. Assumption 9—There are no trade barriers. Assumption 10—Exports must pay for imports.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 3-8 Assumptions of the Classical Model Assumption 11—Labor is the only relevant resource. –Labor Theory of Value states that the pre-trade price of a good is determined by the amount of labor it took to produce it. Assumption 12—Constant returns to scale between labor and output prevails. –Constant returns implies a fixed ratio between the labor used and the output level produced.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved. 3-9 Absolute Advantage The ability of a country to produce a good using fewer productive inputs than is possible anywhere else in the world Adam Smith’s principle—countries should specialize in the production of goods in which they have an absolute advantage.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Illustration of Absolute Advantage Table of labor requirements for two goods TABLE 3.1 Absolute Advantage as a Basis for Trade 1 1 Numbers in the table denote labor required to produce one unit.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved World Gains from Trade TABLE 3.2 Per Unit Gains from Specialization When Country A Moves to Specialize in Soybeans (S), and Country B in Textiles (T)

Copyright © 2010 Pearson Addison-Wesley. All rights reserved What Causes Each Country to Follow Its Absolute Advantage? Market forces combined with free trade Given that the labor cost equals the wage rate (W) times the amount of labor input: (refer to Table 3.1)

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Absolute Advantage (cont.) In country B:

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Summary of Smith’s Principle For various reasons such as different technologies and climate, countries will produce different goods. World output will increase if countries specialize in their absolute advantage products. This situation is the natural outcome of market forces combined with free trade. A good is cheapest in the country that has absolute advantage in its production.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved What If One Country Has Absolute Advantage in Both Goods? David Ricardo’s Law of Comparative Advantage—countries should specialize where they have their greatest absolute advantage (if they have absolute advantage in both goods) or in their least absolute disadvantage (if they have absolute advantage in neither good).

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Copyright © 2009 Pearson Addison-Wesley. All rights reserved Comparative Advantage and Opportunity Cost The Ricardian model uses the concepts of opportunity cost and comparative advantage. The opportunity cost of producing something measures the cost of not being able to produce something else because resources have already been used.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Copyright © 2009 Pearson Addison-Wesley. All rights reserved Comparative Advantage and Opportunity Cost (cont.) Suppose that in the U.S. 10 million roses could be produced with the same resources that could produce 100,000 computers. Suppose that in Palestine 10 million roses could be produced with the same resources that could produce 30,000 computers. Workers in Palestine would be less productive than those in the U.S. in manufacturing computers. Quick quiz: what is the opportunity cost for Palestine if it decides to produce roses?

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Copyright © 2009 Pearson Addison-Wesley. All rights reserved Comparative Advantage and Opportunity Cost (cont.) The U.S. has a comparative advantage in computer production: it uses its resources more efficiently in producing computers compared to other uses. Palestine has a comparative advantage in rose production: it uses its resources more efficiently in producing roses compared to other uses. Suppose initially that Palestine produces computers and the U.S. produces roses, and that both countries want to consume computers and roses. Can both countries be made better off?

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Copyright © 2009 Pearson Addison-Wesley. All rights reserved Comparative Advantage and Opportunity Cost (cont.) A country has a comparative advantage in producing a good if the opportunity cost of producing that good is lower in the country than it is in other countries. A country with a comparative advantage in producing a good uses its resources most efficiently when it produces that good compared to producing other goods.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved TABLE 3.3 Comparative Advantage as a Basis for Trade 1 1 Numbers in the table denote labor hours per unit of output.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved From Table 3.3 Country A has absolute advantage in both goods S and T. A is 4x more efficient than B in production of good S (compare 3 hours with 12 hours). A is only (4/3)x more efficient than B in production of good T. Thus, A has comparative advantage in S. With trade, A will completely specialize in S. Do likewise for country B!

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Gains from Trade based on Comparative Advantage TABLE 3.4 Per Unit Gains from Specialization According to Comparative Advantage as Country A Produces More S, and Country B Produces More T

Copyright © 2010 Pearson Addison-Wesley. All rights reserved General Equilibrium Solution of the Classical Trade Model Assume labor endowments for each country: –A has 12,000 labor hours –B has 9,600 labor hours Straight-line Production Possibilities Frontier (PPF) –Slope of PPF = pre-trade relative price (P S /P T ) Autarky or pre-trade equilibrium (consumption and production) –Tangency point of PPF and Community Indifference Curve (CIC)

Copyright © 2010 Pearson Addison-Wesley. All rights reserved FIGURE 3.1 Production Possibility Frontiers for Country A and Country B

Copyright © 2010 Pearson Addison-Wesley. All rights reserved FIGURE 3.2 Pretrade Equilibriums for Country A and Country B

Copyright © 2010 Pearson Addison-Wesley. All rights reserved TRADE BASED ON OPPORTUNITY COSTS Note Unit Labor Costs in 24 Developing Economies for Selected Sectors, 2000 (Ratios relative to the U.S.) Country Food ProductsTextilesClothing Electrical Machinery Transport Equipment Argentina Bolivia Brazil Chile Columbia Cote d’Ivoire Ecuador Egypt Ghana India Indonesia Kenya

Copyright © 2010 Pearson Addison-Wesley. All rights reserved TRADE BASED ON OPPORTUNITY COSTS Unit Labor Costs in 24 Developing Economies for Selected Sectors, 2000 (Ratios relative to the U.S.) Country Food ProductsTextilesClothing Electrical Machinery Transport Equipment Malaysia Mexico Morocco Nigeria Peru Philippines Korea Taiwan Thailand Turkey Uruguay Venezuela

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Comparative Advantage With Many Goods Suppose now there are N goods produced, indexed by i = 1,2,…N. The domestic country’s unit labor requirement for good i is a Li, and that of the foreign country is a * Li

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Comparative Advantage With Many Goods (cont.) Goods will be produced wherever it is cheaper to produce them. Let w represent the wage rate in the domestic country and w * represent the wage rate in the foreign country. –If wa L1 < w * a * L1 then only the domestic country will produce good 1, since total wage payments are less there. –If the relative productivity of a country in producing a good is higher than the relative wage, then the good will be produced in that country.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Comparative Advantage With Many Goods (cont.) Suppose there are 5 goods produced in the world:

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Comparative Advantage With Many Goods (cont.) If each country specializes in goods that use resources productively and trades the products for those that it wants to consume, then each benefits. –If a country tries to produce all goods for itself, resources are “wasted”. The domestic country has high productivity in apples, bananas, and caviar that give it a cost advantage, despite its high wage. The foreign country has low wages that give it a cost advantage, despite its low productivity in date production.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved International Terms of Trade Terms of Trade (TOT)—The target universe of the import and export price indexes consist of all goods and services sold by a country residents to foreign buyers (exports)and purchased from abroad by a country residents (imports) TOT is the relative price at which trade occurs between countries. The TOT will lie between the autarky prices of the two countries; in our example, ½ (A’s price) < TOT < 3/2 (B’s price)

Copyright © 2010 Pearson Addison-Wesley. All rights reserved For example, if a country exports 50 dollars worth of product in exchange for 100 dollars worth of imported product, that country's terms of trade are 50/100 = 0.5. The terms of trade for the other country must be the reciprocal (100/50 = 2). When this number is falling, the country is said to have "deteriorating terms of trade". If multiplied by 100, these calculations can be expressed as a percentage (50% and 200% respectively).

Copyright © 2010 Pearson Addison-Wesley. All rights reserved In the more realistic case of many products exchanged between many countries, terms of trade can be calculated using a Laspeyre price index. In this case, a nation's terms of trade is the ratio of the Laspeyre price index of exports to the Laspeyre price index of imports. price of exports in the current period quantity of exports in the base period price of exports in the base period price of imports in the current period quantity of imports in the base period price of imports in the base period

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Distribution of the Gains from Trade –The difference between the opportunity cost of producing the product domestically versus the cost of purchasing the product from another country determines the gains a country receives from trade –A change in a country’s terms of trade may reflect a change in international economic conditions or it may reflect a change in domestic economic conditions THE TERMS OF TRADE

Copyright © 2010 Pearson Addison-Wesley. All rights reserved THE TERMS OF TRADE NOTECommodity Terms of Trade for 7 Industrial Countries, (2000 = 100) Terms of Trade Index Country Canada France Germany Italy Japan U.K U.S

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Terms of Trade and Gains from Trade The closer the terms of trade are to one country’s pre-trade price ratio, the greater the gain for the other country. Importance of being unimportant—when small countries trade with big countries, the small countries are likely to enjoy most of the mutual gains from trade.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Post-trade Equilibrium The country with a lower autarky price of a good has comparative advantage in that good. With constant opportunity cost (straight-line PPF), the country will completely specialize in its comparative advantage product once trade begins. With trade, the country will now consume on the TOT line which represents its Consumption Possibility Frontier.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Figure 3.3 the line labeled TOT has tow important features, its slope equal to the terms of trade. Second the line connected to each country PPF at the international trade production point for that country. The TOT represents the consumption possibility frontier for a country that engage in international trade. This is the country consumption bundle obtained from I trade.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved FIGURE 3.3 Posttrade Equilibriums for Country A and Country B

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Consumption Possibility Frontier Refers to the various combinations of goods that a country can obtain by taking advantage of international trade.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Trade Triangle Trade Triangle—a geometric device that shows the amounts a country is willing to trade at a particular world price. The trade triangle shows the desired exports and imports of a country given the terms of trade. In international trade equilibrium, the countries’ trade triangles are congruent. this correct because the assumption goods must pay for goods.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Walras Law Walras Law—states that if there are n markets in the world and any n-1 of these markets are in equilibrium, then so too will be the nth market. Larger trade triangle indicate that resident of country A want trade more than their counterpart. In this case, how equilibrium be attained? The geometric answer is, the smaller triangle must become larger, and the larger triangle must become smaller.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved How Can Trading Equilibrium Be Attained? By reciprocal demand –Reciprocal demand is the interaction of the demand by two countries for the other country’s export good in determining the international exchange ratio –The country with the greater demand for the other country’s product will be willing to sacrifice more of its goods in exchange for that product NOTE

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Summary of Ricardo’s Model It is not necessary for a country to possess absolute advantage in order to participate in trade. What is required is comparative advantage in production. A country will specialize in and export that good in which its has comparative advantage, i.e., has a lower pre-trade relative price than in the other country. The terms of trade or world price will settle between the autarky prices of the two countries and is determined by reciprocal demand.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Gains from Trade Consumption gain Production gain Who benefits from I trade? Do both countries gain from trade, or is one made better off at the expense of the other?

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Gains from Trade (cont.) FIGURE 3.4 The Gains from Trade (Country A)

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Static Gains from trade are gains in word output that result from specialization and trade Dynamic gains from trade are gains from trade over time that occur because trade induces greater efficiency in the use of existing resources DYNAMIC GAINS FROM TRADE

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Relationship Between Trade and Wages Given the following pre-trade relationships:

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Trade and Wages (cont.) Following the line of comparative advantage and given an exchange rate E which translates B’s currency units into A’s: Substituting the information from (3.1) into the above inequalities:

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Trade and Wages (cont.) Solving the system of inequalities (3.3) simultaneously, we get: or, after combining terms: The center term is called the relative wage ratio, or A’s wage rate divided by B’s wage (expressed in terms of A’s currency)

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Trade and Wages (cont.) According to Equation (3.5), in order for trade to occur based on comparative advantage, A’s workers must earn more than B’s workers. Why? Because of differences in labor productivities. A’s workers are more productive than B’s workers. What happens if wages get out of line with productivity levels?

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Two Valuable Lessons For trade to occur between countries with different labor productivities, wages must be higher in one country than in the other. A country can lose its comparative advantage if wages get out of line with productivity.

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Evaluation of the Classical Model The model does not explain why differences in productivity levels between countries exist. It makes extreme and unrealistic predictions such as countries will completely specialize in the production of exportables only. It maintains that the gains from trade are greater between countries of dissimilar production technologies (despite the fact that most trade occurs between DCs with similar technology and income levels).

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Evaluation (cont.) The classical model is a useful tool because: –It provides a motive for trade between developed and developing countries –It explains why high-wage countries may still benefit from trade even when faced with low- wage competing countries

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Equation 3.6

Copyright © 2010 Pearson Addison-Wesley. All rights reserved Equation 3.7