1 Chapter 3 -- Classical Model INTERNATIONAL ECONOMICS, ECO 486 Display your name card

2 Learning Objectives Understand five more assumptions Determine and understand comparative and absolute advantage Find international trade equilibrium Explain gains from trade Derive range of wages that will permit trade

3 Learning Objectives Understand five more assumptions Determine and understand comparative and absolute advantage Find international trade equilibrium Explain gains from trade Derive range of wages that will permit trade

4 Assumption #8 Factors of production cannot move between countries

5 Assumption #9 There are no barriers to trade in goods.

6 Assumption #10 Exports must pay for imports Assumptions 8-10 apply to both the Classical and HO Models Assumptions 11 & 12 apply only to Classical Model

7 Assumption #11 Labor is the only relevant factor of production in terms of productivity analysis or costs of production.

8 Assumption #12 Production exhibits constant returns to scale, CRS, between labor and output.

9 CRS Implies Linear PPF See Figure 3.1, page 68

10 Autarky See Figure 3.2, page 69 Given perfect competition,

11 Autarky See Figure 3.2, page 69 Given perfect competition, –P = MC –Autarky price of S equals slope of PPF –Resource payments correspond to their productivity

12 Learning Objectives Understand five more assumptions Determine and understand comparative and absolute advantage Find international trade equilibrium Explain gains from trade Derive range of wages that will permit trade

13 Absolute Advantage Compare one good across countries. Country with lower labor input has an absolute advantage in that good.

14 Comparative Advantage Calculate opportunity costs. Compare one good across countries. Country with lower opportunity cost has a comparative advantage in that good.

15 Which Advantage? Absolute advantage is a special case. Comparative advantage is the general case.

16 Learning Objectives Understand five more assumptions Determine and understand comparative and absolute advantage Find international trade equilibrium Explain gains from trade Derive range of wages that will permit trade

17 Terms of Trade Once trade begins, an international equilibrium results Results in one world price for a good

18 Terms of Trade Once trade begins, an international equilibrium results Results in one world price for a good –called the terms of trade –between the two autarky prices –determined by reciprocal demand

19 International Trade Equilibrium See Figure 3.3, page 71 Complete specialization in Comparative Advantage good CIC & ToT tangent at consumption point Congruent trade triangles imply balanced trade

20 Learning Objectives Understand five more assumptions Determine and understand comparative and absolute advantage Find international trade equilibrium Explain gains from trade Derive range of wages that will permit trade

21 Gains From Trade Higher CIC shows a gain Measure gains from trade using GDP Sources of gain:

22 Gains From Trade Higher CIC shows a gain Measure gains from trade using GDP Sources of gain: –production (gains from specialization) –consumption (ToT price lower than autarky)

23 Learning Objectives Understand five more assumptions Determine and understand comparative and absolute advantage Find international trade equilibrium Explain gains from trade Derive range of wages that will permit trade

24 Perfect Competition Review (Product & Resource Markets) P XC = MC for a good, X, in a country, C MC = w/MPP L (Labor, L, is only var. input) w=MRP L =(MR) MPP L =(P) MPP L =VMP L

25 Perfect Competition Review (Product & Resource Markets) P XC = MC for a good, X, in a country, C MC = w/MPP L (Labor, L, is only var. input) w=MRP L =(MR) MPP L =(P) MPP L =VMP L MRP L = Marginal Revenue Product MR = Marginal Revenue; MPP L = Marginal Physical Product of L VMP L = Value Marginal Product of L

26 Prices & Wages P XC = MC = w/MPP L MPP L is measured as units of X per hour hours XC is stated as hours per unit of X P XC = w C (hours XC )

27 Exchange Rates State exchange rate, E, in US dollars per UK pound – say $2/£ A good will be imported if its foreign pre- trade price (x E) is less than the domestic price  P SA < E x P SB

28 Buy Low... Trade requires  P SA < E x P SB  P TA > E x P TB  autarky prices  A has comparative advantage in S  B has comparative advantage in T

29 Trade & Wages Substitute P XC = w C (hours XC )  w A (hours SA ) < E x w B (hours SB )  w A (hours TA ) > E x w B (hours TB ) To solve divide both sides by (E x w B ) divide both sides by (hours XA )

30 Trade & Wages (Cont.)

31 Trade & Wages (Cont.) Trade will occur if the wage ratio does not exceed the productivity ratio

32 Trade & Wages (Cont.)

33 Trade & Wages (Cont.) If one country is technologically advanced, it must have a higher wage rate.

34 Losing Comparative Advantage If the wage ratio exceeds the productivity ratio, trade will not occur If a currency is overvalued (say $1/£ instead of $2/£), both goods may be cheaper in one country

35 Review Homework

SOYBEANS, S (millions of bushels per year) C Q#8: Degree of Specialization X CIC 1 CIC 2 CIC 0 G Autarky Equilibrium TEXTILES, T (millions of yards per year) PPF C = COMPLETE SPECIALIZATION, ALLOWS GREATER CONSUMPTION X = COMPLETE SPECIALIZATION, P = PARTIAL SPECIALIZATION P D

SOYBEANS, S (millions of bushels per year) L Quantity of Soybeans Demanded H CIC 1 CIC 2 CIC 0 G Autarky General Equilibrium |slope PPF| = P S /P T = 2 yd.T/bu.S TEXTILES, T (millions of yards per year) PPF P S /P T = 1 yd.T/bu.S P S /P T = 2.5 yd.T/bu.S