1. Lecture 1. Classic and Neoclassic Trade Models.
Carlos Llano
References:
Feentra y Taylor (2010). Comercio Internacional. Ed. Reverte.
Krugman P. Obsfeld and Melitz: International Economics. Prentice Hall, Chapter .
van Marrewijk C. (2009): The New Introduction to Geographical Economics. Cambridge University Press.

2. Introduction. U.S. Imports of Snowboards: 2009-05
Why do countries trade?
Ranking of the main exporters in 2009? Why?
Ranking of the countries with the largest gains in trade share between 2009/05? And losses? Why?
Ranking of the lowest / highest price levels? Why?

3. 1. Introduction In the classic models: Ricardian Model: H-O Model:
Trade is based on comparative advantage.
Countries gain from trade if they are different.
Ricardian Model:
Key: Differences in productivity
Home (H): exports good 1, which is produced with higher relative productivity; imports good 2,
Foreign (F) produces good 2 more efficiently.
H-O Model:
Key: Differences in factor endowments.
H exports good 1, whose production is intensive in the relatively abundant factor (K or L), and imports good 2
F is specialized in producing the good that is more intensive in the factor that is relatively more abundant in F.

4. New Economic Geography
1. Introduction
New Trade
Theory (NTT)
General equilibrium framework
Imperfect competition
Transport costs.
Krugman, 79
Krugman, 80
Factor mobility (migration + firms)
Dynamics between economics and geography:
1st nature ►2nd nature ► circular causation
New Economic Geography
(NEG)
Krugman, 91
Fujita, Krugman Venables, 1999
Heterogeneous firms.
Alternative ways for firm’s internationalization:
Export vs FDI.
New-New Trade Theory
(NNTT)

5. 2. The Ricardian Model References:
Feentra y Taylor (2011). Comercio Internacional. Ed. Reverte.

6. Introduction Assumptions: Road map:
This chapter explains comparative advantage by looking at how technology differences across countries affects trade.
This is referred to as the Ricardian model because it was proposed by the 19th century economist David Ricardo.
Assumptions:
Two goods: Wheat ; Cloth.
Two countries: Home (H); Foreign (F).
One factor of production (immobile between countries; mobile between sectors within each country): Labor.
Road map:
Part 1. Home country, before trade.
Part 2. Home and Foreign countries, who exports wheat and who exports cloth?
Comparative advantage
Part 3. Is trade “good” or “bad”?

7. The Home Country
We will assume that labor is the only resource used to produce both goods
One worker can produce 4 bushels of wheat or 2 yards of cloth
The Marginal Product of Labor is the extra output obtained by using 1 more unit of labor
MPLW = 4 ;
MPLC = 2
Assumption: Marginal Product of Labor= fixed
Suppose Home has 25 workers; i.e. = 25. Labor endowment.

8. The Home Country: Summary
Cloth
MPL
Wheat
Labor
Home 2 4 25
Home Production Possibilities Frontier
We use the MPL to construct Home’s PPF.
Assume there are 25 workers in Home.
If all the 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

9. The PPF at “Home” in autarky.

10. PPF Slope. The opportunity cost.
Showing these calculations we can see:
Labor = 25, MPLW = 4, MPLC = 2
If Home produces wheat only, QW = MPLW*L = 25*4 = 100
If Home produces cloth only, QC = MPLC*L = 25*2 = 50
This gives us a straight line PPF which is a unique feature of the Ricardian model
Assumes marginal production of labor is constant
The slope equals the opportunity cost of wheat
[the amount of cloth that must be given up to obtain 1 more unit of wheat]
Labor used in 1 wheat = labor used in ½ cloth;
i.e. cost of 1 wheat = cost of ½ cloth

11. Indifference Curves: the consumer`s preferences
Cloth, QC (yards)
The country is indifferent between A and B
U0 < U1 < U2 B A U2 U1 U0
Wheat, QW (bushels)
A country cannot produce outside their PPF so, without trade, they are constrained in their utility by the PPF.

12. closed-economy equilibrium (Home)
The country could produce at point D but would be at a higher level of utility at point A.
The country is better off on U2 but cannot produce that much
At point A, on U1, is the best the country can do
Cloth, QC (yards) C 50 D B A U2 25
Home closed-economy equilibrium U1
Home PPF U0 50
100
Wheat, QW (bushels)

13. Wage Equation In competitive markets, suppose for cloth:
MPL = 4.
¿How much salary (w) are firms willing to pay?
Cost of a marginal worker to the firm = wage
Value of a marginal worker to the firm = the value of one more hour of production =
4 cloth x $2/cloth = $8
So firms are happy if w = $8

14. Wage Equation
w = P*MPL
The value of one more worker equals the amount of goods produced by this worker (MPL) times the price of the good.
Predictions:
(1) you earn more if your products are worth more;
(2) you earn more if you are more productive

15. Relative Prices at closed-economy equilibrium
W=P*MPL holds for both wheat and cloth
Since labor can move freely between industries (within each country), wages must be equalized:
Slope of the PPF = the opportunity cost of obtaining one more bushel of wheat.
Relative price of wheat =
Value of 1 wheat = ½ value of 1 cloth

16. Relative Prices and OC
The price ratio, PW/PC, always denotes the relative price of the good in the numerator, measured in terms of how much of the good in the denominator must be given up.
For the good on the horizontal axis of the PPF picture, |PPF slope| = OC = relative price before trade

17. Real Wages Before Trade (Autarky)
Real wage for wheat = wage/price_of_wheat; i.e. quantity of wheat the wage can buy
Since Home produces both wheat and cloth, Home wage is: w = PW*MPLW = PC*MPLC
The real wage for wheat =
w/PW = (PW*MPLW)/PW = MPLW = 4 wheat
The real wage for cloth =
w/PC = (PC*MPLC)/PC MPLC = 2 cloth
Before trade, real wage = marginal product of labor

18. The Foreign Country: Summary
Cloth
MPL
wheat
Labor
Foreign 1
100
Foreign Production Possibilities Frontier
MPL*W = 1, MPL*C = 1
Key Assumption: Marginal Products of Labor are fixed
Assume there are 100 workers available in Foreign
If all workers were employed in wheat they could produce 100 bushels.
If all workers were employed in cloth they could produce 100 yards.
The Foreign country’s PPF connects these two points.

19. © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Foreign PPF
© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

20. closed-economy equilibrium (Foreign)A*
Wheat , (bushels)
Cloth, (yards)
100
Foreign before-trade equilibrium
Foreign PPF 50
|The slope of the PPF| = the opportunity cost of wheat = the before-trade relative price of wheat, P*W/P*C = 1

21. © 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Pattern of Trade
Which country exports wheat and which country exports cloth?
Assume: no trade cost
© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

22. Absolute Advantage = Higher MPL
MPL, Cloth (Yard/worker)
MPL, wheat (Bushel/worker)
Labor
Home 2 4 25
Foreign 1
100
Absolute advantage = higher MPL at Home.
Foreign’s technology is inferior to Home’s
Home has an absolute advantage in both wheat and cloth as compared to Foreign
Clearly, Home can’t export both wheat and cloth when trade opens up.

23. Comparative Advantage = Lower OC
MPL, Cloth (Yard/worker)
MPL, wheat (Bushel/worker)
Labor
Home 2 4 25
Foreign 1
100
What the Opportunity Costs for Goods in Home and Foreign are?
Cloth (Yard)
Wheat (Bushel)
Home
4/2 = 2 wheat
2/4 = 1/2 cloth
Foreign
1/1 =1 wheat
1/1 = 1 cloth
© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

24. Notes: OC Table Comparative Advantage = Lower Opp. Cost
A country has a comparative advantage in a good when it has a lower opportunity cost of producing that good
I.E.:
Foreign has a comparative advantage in producing cloth
Foreign’s Opportunity cost of cloth is lower (1 vs 2)
Home has a comparative advantage in producing wheat
Home’s opportunity cost of wheat is lower (1/2 vs 1)

25. Why does comparative advantage drive trade patterns?
Because OC = relative prices before trade
Wheat (Bushel)
Home
½ cloth
Foreign
1 cloth
© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

26. Notes: Relative Price Table
Why does Home export wheat?
Relative price of wheat in Home is PW/PC = 1/2
Relative price of wheat in Foreign is PW*/PC* = 1
Therefore Home would want to export their wheat to Foreign – they can make it for 0.50 cloth and export it for 1 cloth!
The opposite is true for cloth
Home will export wheat and Foreign will export cloth
Both countries export the good for which they have the comparative advantage

27. Equilibrium with trade
The relative price of wheat in the trade equilibrium will be between the before-trade prices in the two countries:
Lets assume the free-trade price, PWT/PCT = 2/3.
This is between the price of ½ (Home) and 1 (Foreign).
We can now take this price and see how trade changes production and consumption in each country

28. Notes: Equilibrium with trade
¿How prices change after trade?
As Home exports wheat, quantity of wheat sold at Home falls
The price of wheat at Home goes up
More wheat goes into Foreign’s market
The price of wheat in Foreign falls
For the same reason, as Foreign exports cloth, the quantity sold in Foreign falls. Therefore, the price in Foreign for cloth rises, and the price of cloth in Home falls.

29. Notes: Equilibrium with trade
Trade Equilibrium
Two countries are in a trade equilibrium when the relative price of wheat is the same in the two countries – this means the relative price of cloth is also the same in both countries.
This is because we assume there is no trade cost

30. Complete specialization
Opportunity Costs in Home and Foreign
Cloth (Yard)
Wheat (Bushel)
Home
4/2 = 2 wheat
2/4 = 1/2 cloth
Foreign
1/1 =1 wheat
1/1 = 1 cloth
Free-trade relative prices: PWT/PCT = 2/3.
Home exports wheat. No cloths will be produced in Home.
Home’s workers will want to work in wheat and no cloth will be produced
With trade, Home will be fully specialized in wheat production!

31. Is trade good or bad: Home
PWT/PCT = 2/3.
Home exports wheat
Cloth, QC (yards) 50 A 25
Home closed-economy equilibrium U1
Home PPF 50
100
Wheat, QW (bushels)

32. Consumption Possibility Frontier (CPF), Home
The new world price, PWT /PCT = 2/3, shows us the new range of consumption possibilities
The country can now achieve a higher utility with the new consumption possibilities U1 A
Wheat , QW (bushels)
Cloth, QC (yards) B
Home production 50 25
CPF, Slope = –2/3 U2

33. Is trade good or bad: Foreign
PWT/PCT = 2/3.
Foreign exports cloth
Cloth, (yards)
Foreign PPF
100
Foreign closed-economy equilibrium A* U0
Wheat, (bushels)

34. CPF, Foreign
The new world price, PWT /PCT = 2/3, shows us the new range of consumption possibilities
The country can now achieve a higher utility with the new consumption possibilities
Foreign production
Wheat, (bushels)
Cloth, (yards)
100 60 B*
World price line, Slope = –2/3 U0 U1 C*
Foreign consumption

35. Notes: Gains from Trade
Gains from trade for BOTH countries!
Under the new production, each country specializes fully in the good for which they have the comparative advantage
They then export some of their production and import some of the other good from the other country
Home specializes in wheat and Foreign specializes in cloth
The new indifference curves show the new consumption points.
The difference between production and consumption give us trade patterns

36. Gains from Trade: intuition
International Trade
Trade allows both countries to engage in consumption possibilities they did not have before trade
Intuition: trade increases the choices a country can make; both countries gain because they help each other out.

37. Trade is Balanced: Foreign
Foreign produces 0 wheat but consumes 60 so imports equal 60.
Foreign produces 100 cloth but consumes only 60 so exports equal 40
Foreign production
Wheat, (bushels)
Cloth, (yards)
100 60 B*
World price line, Slope = –2/3 U0 U1 C*
Foreign consumption
Foreign exports 40 yards of cloth
Foreign imports 60 bushels of wheat

38. Trade is Balanced: Home
Home produces 100 wheat but consumes only 40 so exports equal 60
Home produces 0 cloth but consumes 40 so imports equal 40. U1
Wheat , QW (bushels)
Cloth, QC (yards) C B U2
World price line, Slope = –2/3 50 40
Home consumption
Home imports 40 yards of cloth
Home production
Home exports 60 bushels of wheat

39. Trade and Wages How do wages change after trade for Home and Foreign?
Under free trade, which country has a higher wage?
Wages actually differ [they are determined by absolute advantage, not by comparative advantage]
Real wages: = wage/price.

40. Real Wages Before Trade: Home
Before trade, real wage = marginal product of labor since Home makes both wheat and cloth
The real wage for wheat = MPLW = 4 wheat
The real wage for cloth = MPLC = 2 cloth
Real Wages After Trade: Home
Since Home produces and exports “wheat”, Home wage is:
w = PWT*MPLW
The real wage for wheat =
w/PWT = (PWT*MPLW)/PWT = MPLW = 4 wheat. [Same as before trade]
The real wage for cloth =
w/PCT = (PWT*MPLW)/PCT =(PWT/PCT)*MPLW = (2/3)*4 = 8/3 cloth. [Higher than before trade]
Trade increases real wage for cloth!
Same intuition as gains from trade.

41. Terms of Trade The real wage for cloth =(PWT/PCT)*MPLW
The Terms of Trade for Home = PWT/PCT
An increase in PWT or a fall in PCT will raise Home’s terms of trade
An increase in the terms of trade is good for a country
They earn more for its exports
They pay less for their imports
Home real wage for cloth is higher
In general, the price of a country’s exports divided by the price of its imports.
Foreign’s Terms of Trade = PCT/PWT

42. Real Wages Before Trade: Foreign
Before trade, real wage = marginal product of labor since Foreign makes both wheat and cloth
The real wage for wheat = MPLW* = 1 wheat
The real wage for cloth = MPLC* = 1 cloth
Real Wages After Trade: Foreign
Since Foreign produces-exports cloth, its wage is: w* = PCT *MPLC*
The real wage for cloth =
w*/PCT = (PCT*MPLC*)/PCT = MPLC* = 1 cloth, [same as before trade]
The real wage for wheat =
w*/PWT = (PCT*MPLC*)/PWT = (PCT/PWT)*MPLC* = (3/2)*1 = 3/2 wheat, [higher than before trade]
Again, free trade increases real wages!

43. Comparing Wages Across Countries
Summarizing
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
The ratio Home_wage/Foreign_wage = 8/3, so Foreign workers earn less
What is the intuition for this?

44. Comparing Wage Across Countries
What determines w/w*?
Since Home produces and exports wheat, Home wage is: w = PWT*MPLW
Since Foreign produces and exports cloth, Foreign wage is: w* = PCT *MPLC*

45. Summary: Comparing Wages Across Countries
Home_wage/Foreign_wage depends on Home country’s TOT and absolute advantage
So comparative advantage gives you trade patterns, and absolute advantage gives you high wages
The intuition: the only way a country with poor technology can export at a price others are willing to pay is by having low wages.

46. Predictions
In a given year, the countries that have better technology should have higher wages (i.e. comparing across countries)
Over time, as a given country develops better technology, its wages will rise (i.e. looking at changes for a given country)

47. Labor Productivity and Wages for 2001
Figure 2.7

48. Notes: Figure 2.7.
Labor productivity can be measured by the value-added per hour in manufacturing
Value-added is the difference between sales revenue in an industry and the costs of intermediate inputs
Equals the payments to labor and capital in an industry.
The Ricardian model ignores capital so we can measure labor productivity as value-added divided by the number of hours worked, or value-added per hour
Figure 2.7 shows value added per hour in manufacturing for several countries
Countries with higher labor productivity pay higher wages, just as the Ricardian model predicts

49. Labor Productivity and Wage Over Time