1. Introduction Classical economics and comparative advantage Analysis of comparative advantage Production possibility frontier and autarky Terms of trade and gains from trade Application: Kenya and the EU More countries and world ppf The Balassa index II Conclusions CHAPTER 3; COMPARATIVE ADVANTAGE International Trade & the World Economy;  Charles van Marrewijk

3. Introduction Classical economics and comparative advantage Analysis of comparative advantage Production possibility frontier and autarky Terms of trade and gains from trade Application: Kenya and the EU More countries and world ppf The Balassa index II Conclusions CHAPTER 3; COMPARATIVE ADVANTAGE International Trade & the World Economy;  Charles van Marrewijk

4. Introduction International Trade & the World Economy;  Charles van Marrewijk David Ricardo (1772-1823)

5. Introduction Classical economics and comparative advantage Analysis of comparative advantage Production possibility frontier and autarky Terms of trade and gains from trade Application: Kenya and the EU More countries and world ppf The Balassa index II Conclusions CHAPTER 3; COMPARATIVE ADVANTAGE International Trade & the World Economy;  Charles van Marrewijk

6. Classical economics and comparative advantage International Trade & the World Economy;  Charles van Marrewijk One of the few ideas in economics that is true without being obvious According to Paul Samuelson (1915-; Nobel prize 1970) the theory of comparative advantage is Technological differences between nations are the classical driving force behind international trade flows. According to David Ricardo relative or comparative differences are important, not absolute differences. The idea of comparative advantage is often misunderstood, see Paul Krugman (1953-) “Ricardo’s difficult idea” at http://web.mit.edu/krugman/www

7. Introduction Classical economics and comparative advantage Analysis of comparative advantage Production possibility frontier and autarky Terms of trade and gains from trade Application: Kenya and the EU More countries and world ppf The Balassa index II Conclusions CHAPTER 3; COMPARATIVE ADVANTAGE International Trade & the World Economy;  Charles van Marrewijk

8. 2 countries; EU and Kenya International trade based on differences in technologyassumptions No transport costs 2 goods; Food and Chemicals 1 factor of production; labor L Constant returns to scale; CRS Labor mobility between sectors, not between countries Perfect competition unit labor requirement= units of labor required to produce one unit of a final good By assumption this is independent of the number of laborers active in a sector (CRS), but may differ between the two countries. Let be the for good F in EU, etcunit labor requirement International Trade & the World Economy;  Charles van Marrewijk Analysis of comparative advantage

9. Productivity table to summarize the state of technology Note that the EU is more efficient than Kenya in the production of both goods, requiring 2 < 4 laborers for Food and 8 < 24 laborers for Chemicals. Why would the EU trade with Kenya? Note: EU is twice more productive in Food, and three times in Chem. In autarky (without international trade) both countries will produce both goods if consumers demand both Food and Chemicals. International Trade & the World Economy;  Charles van Marrewijk Analysis of comparative advantage

10. According to David Ricardo both countries can gain from international trade through specialization (EU producing more chemicals and Kenya producing more food): Suppose Kenya produces 1 chemical less, this frees up 24 laborers. These 24 laborers can now produce 24/4 = 6 units of food To keep the production level of chemicals constant, the EU should make 1 chemical more. This requires 8 laborers. These 8 laborers could have made 8/2 = 4 units of food. Conclusion: EUKenyachange world prod. production of chem.+1-10 production of food-4+6+2 The extra production represents gains from trade International Trade & the World Economy;  Charles van Marrewijk Analysis of comparative advantage

11. Introduction Classical economics and comparative advantage Analysis of comparative advantage Production possibility frontier and autarky Terms of trade and gains from trade Application: Kenya and the EU More countries and world ppf The Balassa index II Conclusions CHAPTER 3; COMPARATIVE ADVANTAGE International Trade & the World Economy;  Charles van Marrewijk

12. Production possibility frontier and autarky International Trade & the World Economy;  Charles van Marrewijk Production possibility frontier (ppf) = All possible combinations of efficient production points given the available factors of production and the state of technology. Note: ppf depends on available factors of production ppf depends on state of technology ppf does not depend on type of market competition

13. Production possibility frontier and autarky International Trade & the World Economy;  Charles van Marrewijk Autarky prod. and cons. along ppf (determines autarky price ratio)

14. Introduction Classical economics and comparative advantage Analysis of comparative advantage Production possibility frontier and autarky Terms of trade and gains from trade Application: Kenya and the EU More countries and world ppf The Balassa index II Conclusions CHAPTER 3; COMPARATIVE ADVANTAGE International Trade & the World Economy;  Charles van Marrewijk

15. Terms of trade and gains from trade International Trade & the World Economy;  Charles van Marrewijk Both countries gain if international price is in between autarky prices Terms of trade is 4.8 food per unit of chemicals

16. Terms of trade and gains from trade International Trade & the World Economy;  Charles van Marrewijk Only Kenya gains if international price is equal to EU autarky price Terms of trade is 4 food per unit of chemicals

17. Introduction Classical economics and comparative advantage Analysis of comparative advantage Production possibility frontier and autarky Terms of trade and gains from trade Application: Kenya and the EU More countries and world ppf The Balassa index II Conclusions CHAPTER 3; COMPARATIVE ADVANTAGE International Trade & the World Economy;  Charles van Marrewijk

18. Application: Kenya and the EU International Trade & the World Economy;  Charles van Marrewijk Not all exports behave in accordance with comparative advantage (but explains more trade flows than absolute advantage)

19. Introduction Classical economics and comparative advantage Analysis of comparative advantage Production possibility frontier and autarky Terms of trade and gains from trade Application: Kenya and the EU More countries and world ppf The Balassa index II Conclusions CHAPTER 3; COMPARATIVE ADVANTAGE International Trade & the World Economy;  Charles van Marrewijk

20. More countries and world ppf International Trade & the World Economy;  Charles van Marrewijk If we identify more countries and two goods we can calculate individual ppf’s with a slope depending on comparative advantage. Combining these in a world ppf gives rise to a concave frontier (next slide)

21. More countries and world ppf International Trade & the World Economy;  Charles van Marrewijk

22. Introduction Classical economics and comparative advantage Analysis of comparative advantage Production possibility frontier and autarky Terms of trade and gains from trade Application: Kenya and the EU More countries and world ppf The Balassa index II Conclusions CHAPTER 3; COMPARATIVE ADVANTAGE International Trade & the World Economy;  Charles van Marrewijk

23. The Balassa index II International Trade & the World Economy;  Charles van Marrewijk The Ottens (2000) calculations of the Balassa index uses the OECD countries as reference. Sometimes all countries in the world are used. Hinloopen and van Marrewijk (2001) use data on EU exports for 98 sectors to Japan to calculate the Balassa index, such that: similar trade policy access to the Japanese for all countries similar development levels for the EU countries similar distance (physical and pecuniary costs) for all countries which supposedly results in a ‘cleaner’ measure of comparative advantage and the probability density function of the Balassa index as depicted on the next slide.

24. The Balassa index II International Trade & the World Economy;  Charles van Marrewijk The probability density function of the Balassa- index based on monthly-moving annual observations (restricted to 0  BI  4) source: Hinloopen and van Marrewijk (2001)

25. Introduction Classical economics and comparative advantage Analysis of comparative advantage Production possibility frontier and autarky Terms of trade and gains from trade Application: Kenya and the EU More countries and world ppf The Balassa index II Conclusions CHAPTER 3; COMPARATIVE ADVANTAGE International Trade & the World Economy;  Charles van Marrewijk

26. Conclusions International Trade & the World Economy;  Charles van Marrewijk Technological differences between countries are the classical driving force for international trade flows. Only comparative costs, not absolute costs, are important for determining the direction of trade flows. Absolute costs are important for determining a country’s welfare level. Empirically, comparative costs performs somewhat better than absolute costs. Allowing for more countries and more goods is easy, allowing for more than one factor of production is not (see part II).