THEORY OF COMPARATIVE ADVANTAGE

CLASS 3Relative comparative advantage

&Introduction to neoclassical trade

theory

2

Smith’s model: 2*2

• Abs. Advantage and the course of trade:

– USA: wheat (6>1) → EX:W, IM: C

– GB: cloth (3>1) → EX:C, IM: W

• Gains from trade: let’s assume that USA and GB exchange 6W for 3 C → what are the gains for both countries

• USA: EX=6W: the production takes 1 hour

IM=3C: own production would take 3 hours

gain: 2 hours of labour=12W/2C (hours of labour=1; consumption equals 3 hours of own labour)

• GB: EX=3C: the production takes 1 hour

• IM=6W: own production would take 6 hours

gain: 5 hours of labour=5W/15C (hours of labour=1; consumption equals 6 hours of own labour)

BOTH COUNTRIES GAIN BY SPECIALIZING AND TRADING

q=Q/hrs of labor USA GB WHEAT (bushels/hr) 6 1

CLOTH (yard/hr) 1 3

3

D. RICARDO: THEORY OF COMPARATIVE ADVANTAGE

• USA: absolute advantage in production of both goods• Can trade still be beneficial for both countries?

– Smith: NO.– Ricardo: YES: concept of COMPARATIVE (RELATIVE)

ADVANTAGES = in product in which country has greater absolute advantage or minor absolute disadvantage

– USA: 6x more productive in W compared to GB1,5x more productive in C compared to GB

– CA: USA: W (its abs. Advantage is greater in production of W)

GB: C (its abs. disadvantage is minor in production of C)– Trade direction and gains form trade: A country will gain by specializing

in the production of good in which it has a comparative advantage, exporting this good and importing other(s) (in which it has a com. disadvantage).

q=Q/hrs of labor USA GB WHEAT (bushels/hr) 6 1

CLOTH (yard/hr) 3 2

4

THEORY OF COMPARATIVE ADVANTAGE: gains from INTERNATIONAL TRADE

• Determine the “national relative prices” in case of no trade• Let countries exchange 6 units of W for 6 units of C: show that such trade

is beneficial for both countries!1. CA: USA: W, GB: C2. Direction of IT:

– USA: EX 6W, IM 6C– GB: EX 6C, IM 6W

3. Gains from IT:• USA: EX=6W: the production takes 1 hour

IM=6C: own production would take 2 hours gain: 1 hour of labour=6W/3C

• GB: EX=6C: the production takes 3 hoursIM=6W: own production would take 6 hoursgain: 3 hours of labour=3W/6C

– BOTH COUNTRIES HAVE GAIN FROM IT (=9W/9C)

q=Q/hrs of labor USA GB WHEAT (bushels/hr) 6 1

CLOTH (yard/hr) 3 2

5

T.CA-International price range

1. Calculate unit production costs/price for W and C in each country before IT: P=1/q

2. Calculate relative costs/prices (price ratio) for W and C each country before IT (=autarky equilibrium price ratio) → relative costs/prices determine opportunity costs)

3. Determine once again the comparative advantages!• This time by comparing relative prices of goods in both countries

4. International relative price range (price range which ensures beneficial IT for both countries)

• Rel. price in exporting country < world rel. price < Rel. price in importing country

q=Q/hrs of labor USA GB WHEAT (bushels/hr) 6 1

CLOTH (yard/hr) 3 2

6

Ricardo’s constant rel. costs and the production-possibility curve (PPC)

• PPC shows all the combination of output of different goods that an economy can produce with full employment of resources (L) and maximum productivity (best available technology)

• Ricardo: Constant relative (opportunity) costs → linear PPC (straight line)

PX*QX+ PY*QY ≤ L orQX/qx + QY/qy ≤ L

• Absolute value of the slope of PPC = MRTYX=OCX=PX/PY=qY/qX

7

Gains from specialisation and tradeNO TRADE (AUTARKY)• the consumption possibilities are bounded by the PPC • production equilibrium point = consumption eq. point• autarky relative price is equal to rel. costs (slope of PPC)DETERMINATION OF CA • country with the lower relative cost in production of a good has a CA• comparison of the slopes of the PPCs!FREE TRADE: each country can trade at Pw• Production: complete specialisation according to CA (point A/A’)• Consumption: above the PPC on the trade line• (determination of consumption point → indifference curves)

QYQY

ACountry 2Country 1

QX QX

A’

QYQY

ACountry 2Country 1

QX QX

A’

8

• Changes in consumption and production equilibria as a country moves from autarky to free trade

Country A Country B

x x

y y

C1

C’1

C2

C’2

P’2

P2

9

Example 1Consider following example, using standard Ricardian assumptions:

410MOONITED Rep.

1015VINTLAND

L hours per kg of

CHEESE

L hours per bottle ofWINE

410MOONITED Rep.

1015VINTLAND

L hours per kg of

CHEESE

L hours per bottle ofWINE

Vintland has 30 million hours of labour in total per year. Moonited Republic has 20 million hours of labour per year.

a) Which country has an absolute advantage in wine? In cheese? b) Which country has a comparative advantage in wine? In cheese? c) Graph each country’s production-possibility curve. Using community

indifference curves, show the no-trade equilibrium for each country (assuming that with no trade, Vintland consumes 1.5 million kilos of cheese and Moonited Republic consumes 3 million kilos of cheese.

10

Example 1

d) When trade is allowed, which country exports which good? If the equilibrium international price ratio is 0.5 bottle of vine per kilo of cheese, what happens to production in each country?

e) In this free-trade equilibrium, 2 million kilos of cheese and 1 million bottles of wine are traded. What is the consumption point in each country with free trade? Show this graphically using community indifference curves.

f) Does each country gain from trade? Explain why, referring to your graphs.

410MOONITED Rep.

1015VINTLAND

L hours per kg of

CHEESE

L hours per bottle ofWINE

410MOONITED Rep.

1015VINTLAND

L hours per kg of

CHEESE

L hours per bottle ofWINE

11

Example 2

a) Where do absolute advantages lie? Would trade have happened according to A.Smith? What about comparative advantages?

b) What if Slovenia has 20 units of labor at its disposal and Croatia has 30 units. Draw the production possibility frontiers and explain how the graph indicates comparative advantage.

c) Assume that free trade happens as 1 unit of apples get traded for 3 units of peas. Show the autarky and free-trade equilibria on the graph.

Quantity per unit of labor

Slovenia Croatia

peas 10 6apples 2 4

12

Example 3

• Determine the exchange ratio within which mutually beneficial trade can take place.

• Assume that in free-trade equilibrium 8 units of food are exchanged for 6 units of manufacturing products. What is the gain from free trade in country A and B in terms of food?

Quantity per unit of labor

Country A Country B

Food 10 6Manufactures 8 4

Introduction of money/currency

• Up to this point all prices were measured in terms of the labor employed in their production

• If wages are allowed to differ between the two countries, they become an important determinants of the costs of production and the price competitiveness

P = Lw/Q

• In order to compare prices, we will have to rely on the use of exchange rates of the two countries’ currencies

13

14

Example 4

• Determine the span of exchange rates that ensure that trade will take place in line with the predictions of classical trade theory, if you know that a unit of labor costs 2$ in the US and 1£ in GB.

costs in L units per unit of wool

costs in L units per unit of steel

United States 3 2Great Britain 4 4

15

Solution of example 4

• For the comparative advantage to “work”, GB has to export wool and the US steel. This will not happen if the exchange rates are either too high or too low.

condition 1 (wool): PGB < PUS

L*wGB < L*wUS

4*1£*t ($/ £) < 3*2$

t ($/ £) < 3/2 $/ £

Determines the upper limit of the exchange rate range.

16

Solution of example 4 (cont.)

condition 2 (steel): PGB > PUS

L*wGB > L*wUS

4*1£*t ($/ £) > 2*2$

t ($/ £) > 1/2 $/ £

Determines the lower limit of the exchange rate range. The range of exchange rates that allows trade between the two countries to take place according to their comparative advantage:

1/2 $/ £ < t($/ £) < 3/2 $/ £

Example 5

• Assume that the ¥/€ exchange rate is 1€=100¥. Determine the range of relative wages that would make comparative-advantage based trade possible.

17

costs in L units per unit of steel

costs in L units per unit of cheese

France 6 2Japan 4 3

Neoclassical trade theory

Heckscher-Ohlin

Heckscher-Ohlin-Samuelson model

19

Increasing marginal costs

• More than one factor of production (neoclassical theory): – Increasing marginal costs: Different products use factor

inputs in different proportions therefore the proportion in which resources are released from one industry is different from the prevailing factor proportion in the other industry to which released resources are shifted (similar to the law of diminishing returns) ➩ increasing opportunity costs (OCX=-ΔY/ΔX)↑ : as one industry expands, increasing amounts of the other good must be given up to produce extra unit of expanding output.

– Increasing opportunity costs + constant returns to scale ➩ concave PPC ➩incomplete specialization in production

20

Community indifference curvesAdding the demand conditions:• Preferences of consumers are presented by community

indifference curve: shows the various consumption combinations of good X and Y that yield equivalent satisfaction for the community or country.

• Different preferences (tastes) among countries → different indifference curve

• Adding the indifference curves allows us to determine:– Autarky equilibrium in production and consumption and

autarky eq. Price– Consumption point in free trade – World price (TOT)

• “usual” assumptions for preferences of an individual (more is preferred to less, transitivity of preferences) + community indif. Curve must not intersect (income redistribution effect).

21

Slope of the indifference curve = marginal rate of substitution

• community indiff. curves are downward-sloping: if consumers reduce the level of consumption of one good they have to increase consumption of the other good to maintain the same satisfaction level

• The slope (in absolute value) reflects marginal rate of substitution: MRSYX= - ΔY/ΔX = MUX/MUY : amount of good Y the consumers are willing to give up for consumption of additional unit of X (unchanged utility)

• MRSYX is diminishing as we move toward consumption of a greater number of units of good X along any given indifference curve → law of diminishing marginal utility → Indifference curves are convex to the origin.

22

X

Y

I4

I1

I2

I3

Px/Py

Autarky equilibrium in neoclassical trade