1

Comparative advantage: A basic example

ProductivitiesEndowments (here, labor

forces)Wine Drape

Portugal 8 4 5

UK 1 2 20

Assumptions

• Two countries (Portugal and the UK)• Two industries (wine and drape)• One factor of production (labor), hence one type of agent in each country (workers)• Constant returns to scale• No transportation costs• No government intervention• Perfect competition

Portugal’s production-possibility frontier and the autarky (before-trade) equilibrium

Wine

Drape

40

20

Production possibility frontier(supply side)

Consumption point withoutinternational trade

Consumer preferences(demand side)

The UK’s production-possibility frontierand the autarky equilibrium

Wine

Drape

20

40

Production possibility frontier(supply side)

Consumption point withoutinternational trade

Indifference curve (demand curve))

The world’s production-possibility frontierand trading equilibrium

Wine

Drape

40

40

World production possibility frontier

Consumption point withinternational trade

Consumer preferences(common to all countries)

United Kingdom

Portugal

world price ratio(demand-determined)

5

The gains from exchange

Production Consumption

Wine Drape Wine Drape

Portugal 40 0 20 20

UK 0 40 20 20

Total 40 40 40 40

6

The gains from exchange revisited

Indifference curves

Wine

ProductionPossibility

Frontier

Drape

world priceratio

7

The gains from specialization

Indifference curves

Wine

ProductionPossibility

FrontierDrape

world priceratio

Productionpoint

8

The Rybszinski theorem

initial production possibilityfrontier

steelproduction possibility frontierafter an increase in the capital endowment

production possibility frontierafter an increase in the labor endowment

drape

9

The Heckscher-Ohlin theorem

“trade triangle”

steel

drape

(world & domestic)indifference curves

domestic price ratio (before trade)

domesticPPF

world price ratio(drape is cheaper)

hom

e st

eel e

xpor

ts

home drape imports

10

The gains from trade (i): initial equilibrium

D

D*

P P

S

S*

Pa

P*a

Country F (relatively inefficient)Country H (relatively efficient)

Quantities

11

P P*Country H

Pw

a b

c d

P*a

Pa

Country F

Equilibrium price

Method 1: Equate segments ab and cd

12

Home ES

a b c d

ab = cd

Foreign ED*a b c d

Pa

Pa*

Equilibrium price

Method 2

a) Construct excess supply (ES) and excess demand (ED) curves

ab = cd

Export supply

Import demand

13

Pw

S

D

S*

D*

ESP*a

E=M*

ED*

Equilibrium price, method 2

b) Match the home ES and foreign ED curves on single « world » market

Pa*

Pa

Country H(exporter)

Country F(importer)« World » market

Quantities

14

AP

(a) Importer country’s domestic market (b) same thing seen on world market

World price

C

EDD

G

B

HF J

I

Kpa

p*

Gains from goods trade

Importer country

consumers’ gain, producers’ loss = neutral

15

Gains from goods trade

Exporter country

A ES

EF

FD

B

pa

p*

C

E G H

I

World price

(a) Exporter country’s domestic market (b) same thing seen on world market

producers’ gain, consumers’ loss = neutral

16

Net increase in importer country’s welfare = CS gain – PS loss

Who gains from trade

Size and « similarity »

ED

ES

Net increase in exporter country’s welfare = PS gain – CS loss ED

ES

ED

ESSIZE

SIMILARITY

ED

ES

ED

ES

More « different » exporter gains more from trade

Larger exporter gains less from trade

17

Very similar to trade in G&S:

Identical causes: differences in prices (factor rewards)

Identical consequences: some gains, other loose, and there is a net potential gain.

Gains from factors trade

Starting point: autarky

r

K

ra

K

Return to capital

Value of marginal product of capital

Economy’s capital stock

Return to other factors

+ = GDP (equal to GNP in autarky)

18

Two countries, H relatively well endowed with capital.

Initially, rH < rF, so capital has an incentive to migrate from H to F

In equilibrium, the marginal products of capital are equalized.

Gains from capital movements: EBC for H, EIB for F.

rW

rH

rFEI

B

C

A

D G

VH = pFK

VF = p*F*K

Gains from factors tradeCapital flow from Home to Foreign

Home capital stock (before outflow)

Foreign capital stock (before inflow)

Extension of foreign capital stock (because of inflow)

19

VH=pFK

VF=p*F*K

Gains from factors trade

GNP vs. GDP, efficiency gain

GNP GNP*

Home country’s GDP

Foreign country’s GDP

Efficiency gain from capital flow

20

IRL

NLD

CHE

SWE

ISL

NOR

FINDNK

AUT

GBRDEU

ITAFRA

ESP

TUR

PRT

GRC

0

20

40

60

80

100

120

140

1.00E+09 1.00E+10 1.00E+11 1.00E+12 1.00E+13

PPP GDP

trad

e sh

are

(% o

f GD

P)

Openness and size

Larger countries

trade less (not so obvious)

Trade share in GDP

GDP at purchasing power parity

Not very open given their size

(should trade more)

21

“Fob”: free-on-board; “cif”: cum insurance and freight.

Transport cost per unit:

Pcif = Pfob + = Pa +

Condition for trade to take place:

Pa + Pa*

If condition violated, good is said to be non-traded

Transportation costs

EScif

ED*

P*a

Pwcif

Pa

ESfob

Pwfob

Less trade