Technology and Trade Dr. Petre Badulescu.

Technology and Trade Dr. Petre Badulescu

Lecture 1-2, International economics
Topics to be covered Reasons for trade The classical and neoclassical theories of international trade Ricardo model Determining the patterns of international trade Solving for international prices Dr. Petre Badulescu Lecture 1-2, International economics

Introduction The international economy is very complex. • Most countries participate. • Each country may be different from the other in terms of: endowment of productive resources, and economical and technological developing level. Many countries have many trade partners and thousands different product types are exchanged. How can we understand and explain why countries trade products with each other? Dr. Petre Badulescu Lecture 1-2, International economics

Introduction To answer this question we examine the reasons for trade, which include differences in the technology used in each country (i.e., differences in each country’s ability to manufacture products) differences in total amount of resources (land, labor, capital) differences in the costs of offshoring (i.e., producing the various parts of a good in different countries and then assembling it in a final location) the proximity of countries to each other (i.e. how close they are to one another -geographic distance between countries) Dr. Petre Badulescu Lecture 1-2, International economics

Introduction In this lecture, we focus on technology differences across countries as an explanation for trade, the classical theory of international trade. This explanation is often called as the “Ricardo Model” after the nineteenth-century economist David Ricardo. The model explains how the level of a country’s technology affects wages and, in turn, helps to explain how a country’s technology affects its trade pattern. We also explain the concept of comparative advantage and why it works as an explanation for trade patterns. Dr. Petre Badulescu Lecture 1-2, International economics

Introduction Lecture’s disposition The reasons why countries trade Absolute and comparative advantage Assumptions of the Ricardian model The no-trade equilibrium using each country’s PPF and indifference curve Factor prices and international prices Export supply curve and import demand curve and the international trade equilibrium A country’s terms of trade and its effect on the country Dr. Petre Badulescu Lecture 1-2, International economics

Reasons for trade Proximity The closer countries are the lower the costs of transportation. For example, the largest trading partner of most European countries is another European country. Sometimes neighboring countries take advantage of their proximity by joining into a free-trade area, in which the countries have no restrictions on trade between them. Dr. Petre Badulescu Lecture 1-2, International economics

Reasons for trade Resources Geography includes the natural resources (such as land and minerals) found in a country, as well as its labor resources (labor of various education and skill levels) and capital (machinery and structures). A country’s resources are often collectively called its factors of production, the land, labor, and capital used to produce goods and services. Dr. Petre Badulescu Lecture 1-2, International economics

Reasons for trade Absolute advantage When a country has the best technology for producing a good, it has an absolute advantage in the production of that good. Comparative Advantage Absolute advantage is not a good explanation for trade patterns. Instead, comparative advantage is the primary explanation for trade among countries. A country has comparative advantage in producing those goods that it produces best compared with how well it produces other goods. Dr. Petre Badulescu Lecture 1-2, International economics

The classical and neoclassical theories of international trade
Specialization from comparative advantage Trade is driven by differences in relative prices under autarky (no-trade) Why do these differences exist? - Differences in technology–the Ricardo model the relative supply of production factors–the Heckscher-Ohlin model Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Introduction - theoretical intuition Assume two countries are producing and consuming two products. Even if the one country is more productive than the other in producing both products, so both countries gain from specialising on its own product and then trade products with each other. Example: Sweden is more productive than Thailand in producing both mobile phones and clothes, because of better technology. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Introduction - theoretical intuition Yet both countries benefit with Sweden producing phones and exporting to Thailand and Thailand producing clothes and exporting to Sweden. Why? Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Introduction - theoretical intuition If both countries specialise on the product where they have a comparative advantage, which is the product where they have lowest opportunity cost, so there will be produced a maximum quantity of products in all, and both countries will be better off purchasing mobile phones or coats from the other country instead of producing itself both products. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Introduction – Survey of the Model Differences in technology between countries Different labour productivities Price differences between countries Incentive for countries to trade Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Assumptions 1. Rational behaviour Economic agents are goal-oriented. Consumers maximize satisfaction (subject to constraints). Firms maximize profit (subject to constraints). Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Assumptions 2. Two-country, Two-good World Two countries: Home and Foreign (*) Two goods: Wheat (W) and Cloth (C) - Goods are identical in both countries. - Some of both goods are always consumed in both countries. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Assumptions 3. Fixed Resources and Technology Tool of analysis: Production Possibilities Frontier (PPF) PPF—shows maximum amount of one good that can be produced given the country’s fixed resources and technology and the level of output of the other good. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Assumptions 4. Perfect Competition in Both Industries in Both Countries Price equals marginal cost Labor unions are not present 5. Resources Perfectly Mobile Between Industries Resources earn the same payments in both industries within a country. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Assumptions 6. Economy Indifference Curve Represents demand side of the economy Indifference Curve—shows combinations of two goods, such as wheat and cloth, that yield the same level of satisfaction to a person or economy. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Assumptions 7. Resources cannot move between countries. 8. There are no trade barriers or transportation costs → the same product prices when international trade takes place. 9. Exports must pay for imports. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Assumptions 10. Labor (L) is the only relevant resource. The pre-trade price of a good is determined by the amount of labor it took to produce it. 11. Constant returns to scale between labor and output prevails. Constant returns implies a fixed ratio between the labor used and the output level produced. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Definitions Labor productivity = production per labor unit Assumed to be constant within the country and is denoted by MPLW for wheat and MPLC for cloth. Can e.g. be measured as the number of units of the product that a worker can produce in one hour. Labor required to produce one unit Denoted by aLW = 1/MPLW for wheat and aLC = 1/MPLC for cloth. Can e.g. be measured as the number of hours it takes for a worker to produce one extra unit of the product. Autarky: Absence of international trade. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model General Equilibrium Solution Assume labor endowments for each country: Home has 25 workers = Labor units = L Foreign has 100 workers = Labor units = L* Straight-line Production Possibilities Frontier (PPF) Slope of PPF (∆C/∆W)= pre-trade relative price (PW /PC ) PW and PC denote the market prices of wheat and cloth Autarky or pre-trade equilibrium (consumption and production) Tangency point of PPF and Economy Indifference Curve Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model General Equilibrium Solution The Home Country Labor is the only resource used to produce both goods. The marginal product of labor (MPL) is the extra output obtained by using one more unit of labor. One worker produces either 4 bushels of wheat, so MPLW = 4, or 2 yards of cloth, so MPLC = 2. The input-output coefficient (aL) is the reciprocal of the MPL: aLC = 1/MPLC, and aLR = 1/MPLR. aLC represents the labor required to produce 1 yard of cloth, and aLW = the labor required to produce 1 bushel of wheat. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model General Equilibrium Solution The Home Country Production Possibilities Frontier Using the marginal products for producing wheat and cloth, we can graph Home’s PPF. The slope of the PPF is the opportunity cost of the good on the horizontal axis–i.e., wheat, the amount of cloth that must be given up to obtain one more unit of wheat. If all 25 workers were employed in wheat, the country could produce 100 bushels. If they were all employed in cloth they could produce 50 yards. The PPF connects these two points. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Home Production Possibilities Frontier (PPFH)
Labour = 25, aLW = 1/MPLW = 1/4, aLC = 1/MPLC = 1/2 Cloth, C yards The Home PPF is a straight line between 50 yards of cloth and 100 bushels of wheat. The slope of the PPF equals the negative of the opportunity cost of wheat. Equivalently, the magnitude of the slope can be expressed as the ratio of the marginal products of labor for the two goods. Home’s PPF equation: L = aLW·W + aLC·C C = 50 – (½)·W Slope = –(MPLC /MPLW) = –1/2 2·25=50 ∆C = 1 bushel ∆W = –½ yard The Home PPF is a straight line between 50 yards of cloth and 100 bushels of wheat. The slope of the PPF equals the negative of the opportunity cost of wheat, that is, the amount of cloth that must be given up (1/2 yard) to obtain 1 more bushel of wheat. Equivalently, the magnitude of the slope can be expressed as the ratio of the marginal products of labor for the two goods. This Production Possibilities Frontier is based on the following assumptions: Labor = 25, MPLW = 4, MPLC = 2 QW = MPLW(L) = 25(4) = 100 QC = MPLC(L) = 25(2) = 50 The linear shape of the PPF is a unique feature of the Ricardian model. Without trade, the PPF acts as a budget constraint for the country. PPFH 4·25=100 Wheat, W bushels Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Home Indifference Curve (U) There are several ways to represent demand in the Home economy, but we will start by using indifference curves. All points on an indifference curve have the same level of utility. Points on higher indifference curves have higher utility. Indifference curves are often used to show the preferences of an individual. Each indifference curve shows the combinations of two goods, such as wheat and cloth, that a person or economy can consume and be equally satisfied. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Home Equilibrium with no trade
Cloth, C yards Equilibrium – tangency point of the PPF and U Points A and B lie on the same indifference curve and give the Home consumers the level of utility U1. The highest level of Home utility on the PPF is obtained at point A, which is the “no-trade” or the “pre-trade” equilibrium. Point D is also on the PPF but would give lower utility. Point C represents a higher utility level but is off of the PPF, so it is not attainable in the absence of international trade. Why? B D A With perfectly competitive markets, the country will produce at its highest level of utility within the limits of the PPF. Wheat, W bushels Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model The Home Country Opportunity Cost and Prices
Whereas the slope of the PPF reflects the opportunity cost of producing one more bushel of wheat, under perfect competition the opportunity cost of wheat should also equal the relative market price of wheat. Price reflects the opportunity cost of a good. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model The Home Country Wages In competitive markets profit maximizing firms hire workers up to the point at which the hourly wage equals the value of one more hour of production. The value of one more hour of labor equals the amount of goods produced in that hour (MPL) times the price of the good (P). Labor hired up to the point where wage equals P • MPL for each industry. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model The Home Country Wages
We can use the equality of the wage across industries to obtain the following equation: PW •MPLW = wage = PC •MPLC → PW/PC = MPLC/MPLW The right side of the last equation is the slope of the PPF; which is the opportunity cost of obtaining one more bushel of wheat. The left side of the equation is the relative market price of wheat. This equation says that the relative price of wheat (on the left) and opportunity cost of wheat (on the right) must be equal in the no-trade equilibrium at point A. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model The Foreign Country A Foreign worker can produce one bushel of wheat or one yard of cloth. MP*LW = 1, MP*LC = 1 Labor available in Foreign =100 workers = L*. If all workers were employed in wheat they could produce 100 bushels. If all workers were employed in cloth they could produce 100 yards. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model The Foreign Country
Foreign Production Possibilities Frontier (PPFF) Cloth, C yards Foreign’s PPFF equation: The Foreign PPF is a straight line between 100 yards of cloth and 100 bushels of wheat. The slope of the PPF equals the negative of the opportunity cost of wheat, that is, the amount of cloth that must be given up (1 yard) to obtain 1 more bushel of wheat. C = 100 – W 1·100 = 100 Slope = –(MP*LC /MP*LW) = –1 ∆C = 1 bushel Labour = 100, a*LW = 1/MP*LW = 1, a*LC = 1/MP*LC = 1 ∆W = –1 yard 1·100 = 100 Wheat, W bushels Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Foreign Equilibrium with no trade
The Foreign Country Foreign Equilibrium with no trade Cloth, C yards The highest level of Foreign utility on the PPF is obtained at point A*, which is the no-trade equilibrium. Equilibrium – tangency point of the PPF and U Why? The slope of the PPF, equals the opportunity cost of wheat, and also equals the relative market price of wheat. Foreign’s no-trade relative market price of wheat is P*W/P*C = 1. Wheat, W bushels Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Our example: Alternatively: Labor productivities (How many product units can a worker produce?) Labor requirements (How many labor units it takes to produce the products?) Wheat Cloth Home MPLW = 4 MPLC = 2 Foreign MP*LW = 1 MP*LC = 1 Wheat Cloth Home aLW = 1/4 aLC = 1/2 Foreign a*LW = 1 a*LC = 1 Labor productivities (How many product units can a worker produce per hour?) Alternatively: Labor requirements (How many labor units (hours) it takes to produce the products?) Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model The opportunity costs Wheat (1 Bushel) Cloth (1 Yard) Home ½ Yard of Cloth 2 Bushels of Wheat Foreign 1 Yard of Cloth 1 Bushel of Cloth The opportunity cost of wheat in terms of cloth is lower in Home than in Foreign (1/2 is lower than 1). The opportunity cost of cloth in terms of wheat is lower in Foreign than in Home (1 is lower than 2). The opportunity cost of wheat in terms of cloth is 1/2 in Home and 1 in Foreign. The opportunity cost of cloth in terms of wheat is 2 in Home and 1 in Foreign. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Comparative Advantage A country has a comparative advantage in a good when it has a lower opportunity cost of producing the good than another country. Foreign has a comparative advantage in producing cloth. Why? Home has a comparative advantage in producing wheat. Why? A completely equivalent way to express these comparative advantages is to say that for Home is the relative productivity higher for wheat than for cloth, and vice-versa for Foreign. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Comparative Advantage When a country has the best technology for producing a good, it has an absolute advantage in the production of that good. That country produces the good with less productive resources than is possible anywhere else in the world. Foreign has an absolute advantage in the production of both goods. Gains from trade are based on comparative and not absolute advantages according to Ricardo model. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Comparative Advantage The slope of the PPF, which equals the opportunity cost of wheat, also equals the relative market price of wheat. Foreign’s no-trade relative market price of wheat is P*W/P*C = 1, and of cloth is P*C/P*W = 1. Home’s no-trade relative market price of wheat is PW/PC = 1/2, which is less than Foreign’s. Home’s no-trade relative price of cloth is PC/PW = 2. This difference in the relative prices reflects the comparative advantage that Home has in the production of wheat, and Foreign in cloth. Taking the reciprocal of the relative market price of wheat in each country, we also see that Foreign’s no-trade relative price of cloth is P*C/P*W = 1, which is less than Home’s no-trade relative price of cloth, PC/PW = 2. Therefore, Foreign has a comparative advantage in the production of cloth. Dr. Petre Badulescu Lecture 1-2, International economics

APPLICATION Comparative Advantage in Apparel, Textiles, and Wheat Apparel, Textiles, and Wheat in the United States and China Sales per employee for the apparel and textile industries in the United States and China, as well as bushels per hour in producing wheat. The United States has an absolute advantage in all of these products, but it has a comparative advantage in producing wheat. This table shows that a worker in the United States generates seven times more apparel sales and 16 times more textiles sale per year than a worker in China. With its absolute advantage in the production of both industries, why does the United States import apparel and textiles from China and other Asian countries? The answer has to do with the fact that a typical grain farmer in the United States is 275 (=27.5/0.1) times more productive than a farmer in China. With its absolute advantage and comparative advantage in the production of grain, the United States exports grain to China in exchange for apparel and textiles. MPL=37.5/1.35 = 27.5/0.1 = Dr. Petre Badulescu Lecture 1-2, International economics

Determining the Pattern of International Trade
Ricardo Model Determining the Pattern of International Trade International Trade Equilibrium The two countries open up for trade. What happens when goods are traded between Home and Foreign? We will see that the country’s no-trade relative price determines which product it will export and which it will import. The no-trade relative price equals its opportunity cost of production. The pattern of exports and imports will be determined by the opportunity costs of production in each country—their comparative advantage. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Determining the Pattern of International Trade International Trade Equilibrium The relative price of cloth in Foreign is P*C/P*W = 1. The relative price of cloth in Home is PC/PW = 2. Therefore Foreign would want to export their cloth to Home—they can make it for $1 and export it for more than $1. The opposite is true for wheat. Home will export wheat and Foreign will export cloth. Both countries export the good for which they have the comparative advantage. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Determining the Pattern of International Trade International Trade Equilibrium How Trade Occurs? As Home exports wheat, quantity of wheat sold at Home falls. The price of wheat at Home is bid up. More wheat goes into Foreign’s market. The price of wheat in Foreign falls. As Foreign exports cloth, the quantity sold in Foreign falls, and the price in Foreign for cloth rises. The price of cloth at Home falls. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Determining the Pattern of International Trade International Trade Equilibrium The two countries are in an international trade equilibrium when the relative price of wheat is the same in the two countries. → This means that the relative price of cloth is also the same in both countries. To fully understand the international trade equilibrium, we are interested in two issues: Determining the equilibrium relative price of wheat (or C) Seeing how the shift from the no-trade equilibrium to the international trade equilibrium affects production and consumption in both Home and Foreign. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Determining the Pattern of International Trade International Trade Equilibrium The relative price of wheat in the trade equilibrium will be between the no-trade price in the two countries. For now we will assume the free-trade price of PW/PC is 2/3. ½ (Home’s price) < 2/3 < 1 (Foreign’s price). We can now take this price and see how trade changes production and consumption in each country. The world price line shows the range of consumption possibilities that a country can achieve by specializing in one good and engaging in international trade. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Determining the Pattern of International Trade International Trade Equilibrium Observe that trade leads to a complete specialization of the production in accordance with the countries’ comparative advantages. This is because of the constant opportunity cost. Home specializes in the production of only wheat (the good where it has a comparative advantage) Exports a part of the production to Foreign Foreign specializes in the production of only cloth (the good where it has a comparative advantage) Exports a part of the production to Home Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Determining the Pattern of International Trade International Trade Equilibrium Home Equilibrium with Trade With a world relative price of wheat of 2/3, Home production will occur at point B. Through international trade, Home is able to export each bushel of wheat it produces in exchange for 2/3 yard of cloth. Change in Production and Consumption Home producers of wheat can earn more than the opportunity cost of wheat by selling it to Foreign. Home will therefore shift labor resources toward the production of wheat and increase its production. Remember wages are calculated by the price of the good times its marginal product. Given the information from before, we can calculate the ratio of wages in the two industries. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Determining the Pattern of International Trade International Trade Equilibrium Home Equilibrium with Trade As wheat is exported, Home moves up the world price line BC. Home consumption occurs at point C, at the tangent point with indifference curve U2, since this is the highest possible utility curve on the world price line. Change in Production and Consumption Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Determining the Pattern of International Trade International Trade Equilibrium Home Equilibrium with Trade Given these levels of production and consumption, we can see that total exports are 60 bushels of wheat in exchange for imports of 40 yards of cloth and also that Home consumes 10 fewer bushels of wheat and 15 more yards of cloth relative to its pre-trade levels. Change in Production and Consumption Home’s exports and imports are equal when valued in the same units. Home exports 60 bushels of wheat; multiplying this by the price of wheat in terms of cloth, 2/3, gives 40. This equals the amount of cloth that is imported. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Determining the Pattern of International Trade International Trade Equilibrium Home Equilibrium with Trade International Trade Gains Home obtains a higher utility with international trade than in the absence of international trade (U2 is higher than U1); the finding that Home’s utility increases with trade is our first demonstration of the gains from trade, by which we mean the ability of a country to obtain higher utility for its citizens under free trade than with no trade. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Determining the Pattern of International Trade International Trade Equilibrium Pattern of Trade and Gains from Trade Foreign Equilibrium with Trade With a world relative price of wheat of 2/3, Foreign production will occur at point B*. Through international trade, Foreign is able to export 2/3 yard of cloth in exchange for 1 bushel of wheat, moving down the world price line. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Determining the Pattern of International Trade International Trade Equilibrium Pattern of Trade and Gains from Trade Foreign Equilibrium with Trade Foreign Equilibrium with Trade Foreign consumption occurs at point C*, and total exports are 40 yards of cloth in exchange for imports of 60 bushels of wheat. Relative to its pre-trade wheat and cloth consumption (point A*), Foreign consumes 10 more bushels of wheat and 10 more yards of cloth. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Determining the Pattern of International Trade Pattern of Trade and Gains from Trade Each country is exporting the good for which it has the comparative advantage. This confirms that the pattern of trade is determined by comparative advantage. This is the first lesson of the Ricardo model. There are gains from trade for both countries. This is the second lesson of the Ricardo model. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Determining the Pattern of International Trade Solving for Wages across Countries and Gains from Trade Home wage = MPLW = 4 bushels of wheat or (PW/PC)·MPLW = (2/3)·4 = 8/3 yard of cloth Foreign wage = (P*C/P*W)·MPLW = (3/2)·1 = 3/2 yard of cloth or MP*LC = 1 yard of cloth As our example shows, wages are determined by absolute advantage. In contrast, the pattern of trade is determined by comparative advantage. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Solving for Wages across Countries and Gains from Trade As stated before, in competitive labor markets, firms will pay workers the value of their marginal product. Since Home produces and exports wheat, they will be paid in terms of that good—the real wage is MPLW = 4 bushels of wheat. The workers sell the wheat on the world market at a relative price of PW/PC = 2/3. We can use this to calculate the real wage in terms of cloth: (PW/PC)MPLW = (2/3)·4 = 8/3 yards. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Solving for Wages across Countries and Gains from Trade We can do this for Foreign as well and summarize: Home real wage is: 4 bushels of wheat 8/3 yards of cloth. Foreign real wage is: 3/2 bushels of wheat 1 yard of cloth. Foreign workers earn less than Home workers as measured by their ability to purchase either good. This fact reflects Home’s absolute advantage in the production of both goods. Dr. Petre Badulescu Lecture 1-2, International economics

Ricardo Model Gains from Trade Observe that the countries achieve increased consumption possibilities! – Thus even Foreign that had absolute disadvantage in the both goods. Consumption gains Production gains Dr. Petre Badulescu Lecture 1-2, International economics

APPLICATION Labor Productivity and Wages Labor Productivity and Wages, 2001 Labor productivity is measured by value-added per hour of work and can be compared with the wages paid in manufacturing in various countries. The general ranking of countries—from highest to lowest—in terms of labor productivity is the same as the ranking in terms of wages: countries with higher labor productivity pay higher wages, just as the Ricardo model predicts. Dr. Petre Badulescu Lecture 1-2, International economics

APPLICATION Labor Productivity and Wages The trends in labor productivity and wages can also be graphed over time. The general upward movement in labor productivity is matched by upward movements in wages, as predicted by the Ricardo model. Dr. Petre Badulescu Lecture 1-2, International economics

Solving for international prices
How is the world price determined? Home exports wheat, so we will derive a Home export supply curve, which shows the amount it wants to export at various relative prices. Foreign imports wheat, so we will derive a Foreign import demand curve, which shows the amount of wheat that it will import at various relative prices. To determine the world relative market price of wheat, we will use supply and demand curves. Home exports wheat, so … Dr. Petre Badulescu Lecture 1-2, International economics

Home Export Supply Curve Home Export Supply Panel (a) repeats Figure 2-5 showing the trade equilibrium for Home with production at point B and consumption at point C. Panel (b) shows the Home export supply of wheat. Dr. Petre Badulescu Lecture 1-2, International economics

Home Export Supply Curve Home Export Supply (continued) For relative prices above 1/2, Home exports more than 50 bushels, along the segment B C. For example, at the relative price of 2/3, Home exports 60 bushels of wheat. Dr. Petre Badulescu Lecture 1-2, International economics

Foreign Import Demand Curve Foreign Import Demand Panel (a) repeats Figure 2-6. Panel (b) shows Foreign import demand for wheat. When the relative price of wheat is 1, Foreign will import any amount of wheat between 0 and 50 bushels, along the segment A*B* of the Foreign import demand curve. Dr. Petre Badulescu Lecture 1-2, International economics

Foreign Import Demand Curve Foreign Import Demand (continued) For relative prices below 1, Foreign imports more than 50 bushels, along the segment B*C*. For example, at the relative price of 2/3, Foreign imports 60 bushels of wheat. Dr. Petre Badulescu Lecture 1-2, International economics

International Trade Equilibrium World Market for Wheat Putting together the Home export supply curve and the Foreign import demand curve for wheat, the world equilibrium is established at point C, where the relative price of wheat is 2/3. At this price, Home exports of 60 bushels just equals Foreign import of wheat. At this price, Home exports of 60 bushels just equal Foreign imports of wheat. Dr. Petre Badulescu Lecture 1-2, International economics

International Trade Equilibrium The Terms of Trade The price of a country’s exports divided by the price of its imports is called the terms of trade (t o t). Home exports wheat, (PW /PC) is its terms of trade. An increase in the price of W (Home’s export) or a fall in the price of C (home’s import) would both raise its t o t. Generally, an increase in the t o t is good for a country because it is earning more for its exports or paying less for its imports, thus making it better off. Foreign exports cloth, (PC/PW) is its terms of trade. In this case, having a higher price for cloth (Foreign’s export) or a lower price for wheat (Foreign’s import) would make the Foreign country better off. Dr. Petre Badulescu Lecture 1-2, International economics

APPLICATION The Terms of Trade for Primary Commodities Latin American economist Raúl Prebisch and British economist Hans Singer each put forward the hypothesis that the price of primary commodities would decline over time relative to the price of manufactured goods. Support for Hypothesis: As people/countries become richer, they spend a smaller share of their income on food For mineral products, industrialized countries continually find substitutes in the production of manufactured products. Evidence against Hypothesis: Technological progress in manufactured goods can certainly lead to a fall in the price of these goods as they become easier to produce. At least for oil, the cartel restricting prices has caused an increase in the terms of trade for oil-exporting countries. Many developing countries export primary commodities (that is, agricultural products and minerals), whereas industrial countries export manufactured products. Dr. Petre Badulescu Lecture 1-2, International economics

APPLICATION The Terms of Trade for Primary Commodities FIGURE 2-12 (panel a) Many developing countries export primary commodities (that is, agricultural products and minerals), whereas industrial countries export manufactured products. Relative Price of Primary Commodities Shown here are the prices of various primary commodities relative to an overall manufacturing price, from 1900 to The relative prices of some primary commodities have fallen over time (panel a)… Dr. Petre Badulescu Lecture 1-2, International economics

APPLICATION The Terms of Trade for Primary Commodities FIGURE 2-12 (panel b) Many developing countries export primary commodities (that is, agricultural products and minerals), whereas industrial countries export manufactured products. Shown here are the prices of various primary commodities relative to an overall manufacturing price, from 1900 to The relative prices of some primary commodities have fallen over time (panel a)… Relative Price of Primary Commodities … whereas other commodities have had rising relative prices (panel b)… Dr. Petre Badulescu Lecture 1-2, International economics

APPLICATION The Terms of Trade for Primary Commodities FIGURE 2-12 (panel c) Many developing countries export primary commodities (that is, agricultural products and minerals), whereas industrial countries export manufactured products.Shown here are the prices of various primary commodities relative to an overall manufacturing price, from 1900 to The relative prices of some primary commodities have fallen over time (panel a)whereas other commodities have had rising relative prices (panel b)… Relative Price of Primary Commodities … Other commodity prices show no consistent trend over time (panel c). Dr. Petre Badulescu Lecture 1-2, International economics

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