krugman summary international chapter three

8/22/2019 Krugman Summary International Chapter Three

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Copyright 2012 Pearson Addison-Wesley. All rights reserved.

Chapter 3

Labor

Productivityand ComparativeAdvantage: TheRicardian Model


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Copyright 2012 Pearson Addison-Wesley. All rights reserved.3-2

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Opportunity costs and comparativeadvantage

A one-factor Ricardian model

Production possibilities Gains from trade

Wages and trade

Misconceptions about comparativeadvantage

Transportation costs and non-traded goods

Empirical evidence


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Introduction

Theories of why trade occurs:

Differences across countries in labor, laborskills, physical capital, natural resources, and

technology

Economies of scale (larger scale of production ismore efficient)


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Introduction (cont.)

Sources of differences across countries thatlead to gains from trade:

The Ricardian model (Chapter 3) examines

differences in the productivity of labor(due todifferences in technology) between countries.

The Heckscher-Ohlin model (Chapter 4)examines differences in labor, labor skills,

physical capital, land, or other factors ofproduction between countries.


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Copyright 2012 Pearson Addison-Wesley. All rights reserved. 3-5

Comparative Advantage andOpportunity Cost

The Ricardian model uses the concepts ofopportunity costand comparativeadvantage.

The opportunity cost of producingsomethingmeasures the cost of not beingable to produce something else with the

resources used.


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Comparative Advantage andOpportunity Cost (cont.)

For example, a limited number ofworkers could produce either roses orcomputers.

The opportunity cost of producing computers isthe amount of roses not produced.

The opportunity cost of producing roses is the

amount of computers not produced.


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Suppose that in the U.S. 10 million rosescould be produced with the same resourcesthat could produce 100,000 computers.

Suppose that in Colombia 10 million rosescould be produced with the same resourcesthat could produce 30,000 computers.

Workers in Columbia would be lessproductive than those in the U.S. inmanufacturing computers.


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Colombia has a lower opportunity cost ofproducing roses.

Colombia can produce 10 million roses,

compared to 30,000 computers that it couldotherwise produce.

The U.S. can produce 10 million roses,compared to 100,000 computers that it could

otherwise produce.


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The U.S. has a lower opportunity cost of producingcomputers.

Colombia can produce 30,000 computers, compared to 10million roses that it could otherwise produce.

The U.S. can produce 100,000 computers, compared to10 million roses that it could otherwise produce.

The U.S. can produce 30,000 computers, compared to 3.3million roses that it could otherwise produce.


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A country has a comparative advantagein producing a good if the opportunity costof producing that good is lower in the

country than in other countries. The U.S. has a comparative advantage in

computer production.

Colombia has a comparative advantage in roseproduction.


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Suppose initially that Colombia producescomputers and the U.S. produces roses,and that both countries want to consume

computers and roses. Can both countries be made better off?


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Table 3-1: Hypothetical Changes inProduction


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Comparative Advantage and Trade

When countries specialize in production in whichthey have a comparative advantage, more goodsand services can be produced and consumed.

Have U.S. stop growing roses and use those resources tomake 100,000 computers instead. Have Colombia stopmaking 30,000 computers and grow roses instead.

If produce goods in which have a comparative advantage(U.S. produces computers and Colombia roses), they

could still consume the same 10 million roses, but couldconsume 100,000 30,000 = 70,000 more computers.


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A One-Factor Ricardian Model

The simple example with roses andcomputers explains the intuition behind theRicardian model.

We formalize these ideas by constructing aone-factor Ricardian model using thefollowing assumptions:


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A One-Factor Ricardian Model(cont.)

1. Labor is the only factor of production.

2. Labor productivity varies acrosscountries due to differences in

technology, but labor productivity ineach country is constant.

3. The supply of labor in each country isconstant.


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4. Two goods: wine and cheese.

5. Competition allows workers to be paida competitive wage equal to the

value of what they produce, and allowsthem to work in the industry that paysthe highest wage.

6. Two countries: home and foreign.


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A unit labor requirement indicates the constantnumber of hours of labor required to produce oneunit of output.

aLC is the unit labor requirement for cheese in the home

country. For example, aLC= 1 means that 1 hour of laborproduces one pound of cheese in the home country.

aLW is the unit labor requirement for wine in the homecountry. For example, aLW= 2 means that 2 hours oflabor produces one gallon of wine in the home country.

A high unit labor requirement means low laborproductivity.


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Labor supply L indicates the total numberof hours worked in the home country (aconstant number).

Cheese production QC indicates how manypounds of cheese are produced.

Wine production QW indicates how manygallons of wine are produced.


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Production Possibilities

The production possibility frontier (PPF) of an economy showsthe maximum amount of a goods that can be produced for a fixedamount of resources.

The production possibility frontier of the home economy is:

aLCQC+ aLWQW L

Total gallons

of wine

produced

Labor required for

each pound of

cheese produced

Total

pounds of

cheese

produced

Labor required for

each gallon of

wine produced

Total amount oflabor resources


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Production Possibilities (cont.)

Maximum home cheese production isQC= L/aLC when QW= 0.

Maximum home wine production isQW= L/aLWwhen QC= 0.


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For example, suppose that the economyslabor supply is 1,000 hours.

The PPF equation aLCQC+ aLWQW Lbecomes QC+ 2QW 1,000.

Maximum cheese production is 1,000

pounds. Maximum wine production is 500 gallons.


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Fig. 3-1: Homes ProductionPossibility Frontier


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The opportunity cost of cheese is how manygallons of wine Home must stop producing inorder to make one more pound of cheese:

aLC/aLW

This cost is constant because the unit laborrequirements are both constant.

The opportunity cost of cheese appears as theabsolute value of the slope of the PPF.

QW= L/aLW(aLC/aLW)QC


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Producing an additional pound of cheeserequires aLChours of labor.

Each hour devoted to cheese productioncould have been used instead to producean amount of wine equal to

1 hour/(aLWhours/gallon of wine)

= (1/aLW) gallons of wine


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For example, if 1 hour of labor is moved tocheese production, that additional hourcould haveproduced

1 hour/(2 hours/gallon of wine)

= gallon of wine.

Opportunity cost of producing one pound ofcheese is gallon of wine.


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Relative Prices, Wages, and Supply

Let PCbe the price of cheese and PWbe theprice of wine.

Due to competition,

hourly wages of cheese makers equal the value of thecheese produced in an hour: PC/aLC

hourly wages of wine makers equal the value of the wineproduced in an hour: PW/aLW

Because workers like high wages, they willwork in the industry that pays the higherwage.


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Relative Prices, Wages, and Supply(cont.)

If the price of cheese relative to the priceof wine exceeds the opportunity cost ofproducing cheese PC/PW > aLC/aLW,

Then the wage in cheese will exceed the wagein wine PC/aLC> PW/aLW

So workers will make only cheese (the economyspecializes in cheese production).


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Relative Prices, Wages, and Supply(cont.)

If the price of cheese relative to the priceof wine is less than the opportunity cost ofproducing cheese PC/PW


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Production, Prices, and Wages

If the price of cheese relative to the priceof wine equals the opportunity cost ofproducing cheese PC/PW =aLC/aLW,

then the wage in cheese equals the wage inwine PC/aLC= PW/aLW

so workers will be willing to make both wineand cheese.


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Production, Prices, and Wages(cont.)

For example, suppose cheese sells for PC=$4/pound and wine sells for PW= $7/gallon.

Wage paid producing cheese is PC/aLC = ($4/pound)(1

pound/hour) = $4/hour.

Wage paid producing wine is PW/aLW = ($7/gallon)(1/2gallon/hour) = $3.50/hour.

Workers would be willing to make only cheese (therelative price of cheese 4/7 exceeds the opportunity costof cheese of ).


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If the price of cheese drops to PC= $3/pound:

Wage paid producing cheese drops to PC/aLC =($3/pound)(1 pound/hour) = $3/hour.

Wage paid producing wine is still$3.50/hour if price ofwine is still $7/gallon.

Now workers would be willing to make only wine (therelative price of cheese 3/7 is now less than theopportunity cost of cheese of ).


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If the home country wants to consume both wineand cheese (in the absence of international trade),relative prices must adjust so that wages areequal in the wine and cheese industries.

IfPC/aLC= PW/aLW workers will have no incentive to worksolely in the cheese industry or the wine industry, so thatproduction of both goods can occur.

Production (and consumption) of both goods occurs when

the relative price of a good equals the opportunity cost ofproducing that good:

PC/PW= aLC/aLW


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Trade in the Ricardian Model

Suppose the home country is moreefficient in wine and cheese production.

It has an absolute advantage in allproduction: its unit labor requirementsfor wine and cheese production arelower than those in the foreign country:

aLC< a*LC and aLW< a*LW


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Trade in the Ricardian Model (cont.)

A country can be more efficient inproducing both goods, but it will have acomparative advantage in only one

good. Even if a country is the most (or least)

efficient producer of all goods, it still canbenefit from trade.


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Suppose that the home country has acomparative advantage in cheeseproduction: its opportunity cost ofproducing cheese is lower than in theforeign country.

aLC/aLW < a*LC/a

*LW

where * notates foreign country variables

When the home country increases cheeseproduction, it reduces wine production lessthan the foreign country would.


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Since the slope of the PPF indicates theopportunity cost of cheese in terms ofwine, Foreigns PPF is steeper than Homes.

To produce one pound of cheese, must stopproducing more gallons of wine in Foreign thanin Home.


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Fig. 3-2: Foreigns ProductionPossibility Frontier


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Before any trade occurs, the relative price ofcheese to wine reflects the opportunity cost ofcheese in terms of wine in each country.

In the absence of any trade, the relative price

of cheese to wine will be higher in Foreignthan in Home if Foreign has the higheropportunity cost of cheese.

It will be profitable to ship cheese from Home

to Foreign (and wine from Foreign to Home) where does the relative price of cheese to winesettle?


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To see how all countries can benefit fromtrade, need to find relative prices whentrade exists.

First calculate the world relative supply ofcheese: the quantity of cheese supplied byall countries relative to the quantity of winesupplied by all countries

RS = (QC+ Q*C)/(QW+ Q

*W)


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Relative Supply and RelativeDemand

If the relative price of cheese falls below theopportunity cost of cheese in both countries PC/PW< aLC/aLW< a

*LC/a

*LW,

no cheese would be produced.

domestic and foreign workers would be willing to produceonly wine (where wage is higher).


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Relative Supply and RelativeDemand (cont.)

When the relative price of cheese equals theopportunity cost in the home country PC/PW=aLC

/aLW< a*LC/a

*LW,

domestic workers are indifferent about producing wine or

cheese (wage when producing wine same as wage whenproducing cheese).

foreign workers produce only wine.


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When the relative price of cheese settles strictly inbetween the opportunity costs of cheese aLC/aLW< Pc/PW


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When the relative price of cheese equals theopportunity cost in the foreign country

aLC/aLW < PC/PW=a*LC/a

*LW,

foreign workers are indifferent about producing wine orcheese (wage when producing wine same as wage whenproducing cheese).

domestic workers produce only cheese.


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If the relative price of cheese rises above theopportunity cost of cheese in both countries

aLC/aLW< a*LC/a

*LW < PC/PW,

no wine is produced.

home and foreign workers are willing to produce onlycheese (where wage is higher).


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Relative Supply and Relative Demand(cont.)

World relative supply is a step function:

First step at relative price of cheese equal to Homesopportunity cost aLC/aLW, which equals 1/2 in theexample.

Jumps when world relative supply of cheese equalsHomes maximum cheese production divided by Foreignsmaximum wine production (L / aLC) / (L

*/ a*LW), whichequals 1 in the example.

Second step at relative price of cheese equal to Foreignsopportunity cost a*LC/a

*LW, which equals 2 in the

example.

l i l d l i


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Relative demand of cheese is the quantity ofcheese demanded in all countries relative to thequantity of wine demanded in all countries.

As the price of cheese relative to the price of winerises, consumers in all countries will tend topurchase less cheese and more wine so that therelative quantity demanded of cheese falls.

Fi 3 3 W ld R l i S l d


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Fig. 3-3: World Relative Supply andDemand


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Gains From Trade

Gains from trade come from specializing inthe type of production which usesresources most efficiently, and using the

income generated from that production tobuy the goods and services that countriesdesire.

where using resources most efficiently means

producing a good in which a country has acomparative advantage.


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Gains From Trade (cont.)

Domestic workers earn a higher incomefrom cheese production because therelative price of cheese increases with

trade. Foreign workers earn a higher income from

wine production because the relative priceof cheese decreases with trade (making

cheese cheaper) and the relative price ofwine increases with trade.


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Think of trade as an indirect method ofproduction that converts cheese intowine or vice versa.

Without trade, a country has to allocateresources to produce all of the goodsthat it wants to consume.

With trade, a country can specialize its

production and exchange for the mix ofgoods that it wants to consume.


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Consumption possibilities expand beyondthe production possibility frontier whentrade is allowed.

With trade, consumption in each country isexpanded because world production isexpanded when each country specializes inproducing the good in which it has a

comparative advantage.

Fi 3 4 T d E d


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Fig. 3-4: Trade ExpandsConsumption Possibilities


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A Numerical Example

What is the home countrys opportunity costof producing cheese? aLC/aLW= , toproduce one pound of cheese, stop producing gallon of wine.

Cheese Wine

HomeaLC= 1 hour/lb

aLW= 2 hours/gallon

Foreign a*LC= 6 hours/lb a*LW

= 3 hours/gallon

Unit labor requirements for home and foreign countries


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A Numerical Example (cont.)

The home country is more efficient in bothindustries, but has a comparativeadvantage only in cheese production.

1/2 = aLC/aLW< a*LC/a

*LW= 2

The foreign country is less efficient in both

industries, but has a comparativeadvantage in wine production.


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With trade, the equilibrium relative price ofcheese to wine settles between the twoopportunity costs of cheese.

Suppose that the intersection of RS and RDoccurs at PC/PW= 1 so one pound of cheesetrades for one gallon of wine.

Trade causes the relative price of cheese to

rise in the home country and fall in foreign.


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With trade, the foreign country can buyone pound of cheese for PC/PW= onegallon of wine, instead of stopping production ofa*LC/a

*LW= 2

gallons of wine to free up enough labor toproduce one pound of cheese in the absence oftrade.

Suppose L* = 3,000. The foreign country cantrade its 1,000 gallons maximum production ofwine for 1,000 pounds of cheese, instead of the500 pounds of cheese it could produce itself.


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With trade, the home country can buy onegallon of wine for PW/PC= one pound ofcheese, instead of stopping production ofaLW/aLC= two

pounds of cheese to free up enough labor toproduce one gallon of wine in the absence of trade.

The home country can trade its 1,000

pounds maximum production of cheese for1,000 gallons of wine, instead of the 500gallons of wine it could produce itself.


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Relative Wages

Relative wages are the wages of the homecountry relative to the wages in the foreigncountry.

Productivity (technological) differences determine

relative wage differences across countries. The home wage relative to the foreign wage will

settle in between the ratio of how much betterHome is at making cheese and how much better it

is at making wine compared to Foreign. Relative wages cause Home to have a cost

advantage in only cheese and Foreign to have acost advantage in only wine.


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Relative Wages (cont.)

Suppose that PC = $12/pound and PW=$12/gallon.

Since domestic workers specialize in cheeseproduction after trade, their hourly wages will be

PC/aLC= $12 /1= $12

Since foreign workers specialize in wine productionafter trade, their hourly wages will be

PW/a

*

LW= $12/3 = $4 The relative wage of domestic workers is therefore

$12/$4 = 3


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The relative wage lies between the ratio of theproductivities in each industry.

The home country is 6/1 = 6 times as productive in

cheese production, but only 3/2 = 1.5 times asproductive in wine production.

The home country has a wage 3 times higher than theforeign country.


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These relationships imply that both countries havea cost advantage in production. High wages can be offset by high productivity.

Low productivity can be offset by low wages.

In the home economy, producing one pound ofcheese costs $12 (one worker paid $12/hr) butwould have cost $24 (six paid $4/hr) in Foreign.

In the foreign economy, producing one gallon ofwine costs $12 (three workers paid $4/hr) butwould have cost $24 (two paid $12/hr) in Home.


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Because foreign workers have a wage that is only1/3 the wage of domestic workers, they are ableto attain a cost advantage in wine production,despite low productivity.

Because domestic workers have a productivitythat is 6 times that of foreign workers in cheeseproduction, they are able to attain a costadvantage in cheese production, despite high

wages.


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Do Wages Reflect Productivity?

Do relative wages reflect relativeproductivities of the two countries?

Evidence shows that low wages areassociated with low productivity.

Wage of most countries relative to the U.S. issimilar to their productivity relative to the U.S.


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Productivityand Wages

Source: International Monetary Fund, Bureau of Labor Statistics, and The ConferenceBoard

Do Wages Reflect Productivity?


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Do Wages Reflect Productivity?(cont.)

Other evidence shows that wages rise asproductivity rises.

As recently as 1975, wages in South Korea wereonly 5% of those of the United States.

As South Koreas labor productivity rose (toabout half of the U.S. level by 2007), so did itswages (which were more than half of U.S. levelsby 2007).

Misconceptions About Comparative


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Misconceptions About ComparativeAdvantage

1. Free trade is beneficial only if a country is moreproductive than foreign countries.

But even an unproductive country benefits from freetrade by avoiding the high costs for goods that it would

otherwise have to produce domestically. High costs derive from inefficient use of resources.

The benefits of free trade do not depend on absoluteadvantage, rather they depend on comparativeadvantage: specializing in industries that use resources

most efficiently.



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Misconceptions About ComparativeAdvantage (cont.)

2. Free trade with countries that pay low wageshurts high wage countries.

While trade may reduce wages for some workers,thereby affecting the distribution of income within acountry, trade benefits consumers and other workers.

Consumers benefit because they can purchase goodsmore cheaply.

Producers/workers benefit by earning a higher income inthe industries that use resources more efficiently,

allowing them to earn higher prices and wages.



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Misconceptions About ComparativeAdvantage (cont.)

3. Free trade exploits less productive countries.

While labor standards in some countries are less thanexemplary compared to Western standards, they are sowith or without trade.

Are high wages and safe labor practices alternatives totrade? Deeper poverty and exploitation (ex.,involuntary prostitution) may result without exportproduction.

Consumers benefit from free trade by having access tocheaply (efficiently) produced goods.

Producers/workers benefit from having higherprofits/wageshigher compared to the alternative.

Comparative Advantage With Many


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Comparative Advantage With ManyGoods

Suppose now there are Ngoods produced,indexed by i = 1,2,N.

The home countrys unit labor requirement forgood iis a

Li, and that of the foreign country is a*

Li

.

Goods will be produced wherever cheapest toproduce them.



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Comparative Advantage With ManyGoods (cont.)

Let wrepresent the wage rate in the homecountry and w* represent the wage rate inthe foreign country.

IfwaL1 < w*

a*

L1then only the home country willproduce good 1, since total wage payments areless there.

Or equivalently, ifa*L1 /aL1 > w/w*,if the

relative productivity of a country in producing agood is higher than the relative wage, then thegood will be produced in that country.

Table 3-2: Home and Foreign Unit


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Table 3 2: Home and Foreign UnitLabor Requirements

Comparative Advantage with Many


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Comparative Advantage with ManyGoods (cont.)

Suppose there are 5 goods produced in theworld: apples, bananas, caviar, dates, andenchiladas.

Ifw/w*

= 3, the home country will produceapples, bananas, and caviar, while theforeign country will produce dates andenchiladas.

The relative productivities of the home countryin producing apples, bananas, and caviar arehigher than the relative wage.



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If each country specializes in goods that useresources productively and trades the products forthose that it wants to consume, then eachbenefits. If a country tries to produce all goods for itself, resources

are wasted. The home country has high productivity in apples,

bananas, and caviar that give it a cost advantage,despite its high wage.

The foreign country has low wages that give it acost advantage, despite its low productivity in dateproduction.



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How is the relative wage determined? By the relative supply of and relative (derived)

demand for labor services.

The relative (derived) demand for home labor

services falls when w/w*

rises. As domestic laborservices become more expensive relative toforeign labor services, goods produced in the home country become more

expensive, and demand for these goods and the laborservices to produce them falls.

fewer goods will be produced in the home country, furtherreducing the demand for domestic labor services.



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Suppose w/w* increases from 3 to 3.99: The home country would produce apples, bananas, and

caviar, but the demand for these goods and the labor toproduce them would fall as the relative wage rises.

Suppose w/w* increases from 3.99 to 4.01: Caviar is now too expensive to produce in the home

country, so the caviar industry moves to the foreigncountry, causing a discrete (abrupt) drop in the demandfor domestic labor services.

Consider similar effects as w/w* rises from 0.75to10.

Fig. 3-5: Determination of Relative


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Fig. 3 5: Determination of RelativeWages



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Finally, suppose that relative supply of labor isindependent ofw/w* and is fixed at an amountdetermined by the populations in the home andforeign countries.

Transportation Costs and Non-


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Transportation Costs and Nontraded Goods

The Ricardian model predicts thatcountries completely specialize inproduction.

But this rarely happens for three mainreasons:1. More than one factor of production reduces the

tendency of specialization (Chapter 4).

2. Protectionism (Chapters 811).

3. Transportation costs reduce or prevent trade,which may cause each country to produce thesame good or service.

Transportation Costs and Non-


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Transportation Costs and Nontraded Goods (cont.)

Nontraded goods and services (ex.,haircuts and auto repairs) exist due to hightransport costs.

Countries tend to spend a large fraction ofnational income on nontraded goods andservices.

This fact has implications for the gravity model

and for models that consider how incometransfers across countries affect trade.


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Empirical Evidence

Do countries export those goods in which theirproductivity is relatively high?

The ratio of U.S. to British exports in 1951compared to the ratio of U.S. to British laborproductivity in 26 manufacturing industriessuggests yes.

At this time the U.S. had an absolute advantage in

all26 industries, yet the ratio of exports was lowin the least productive sectors of the U.S.


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Fig. 3-6: Productivity and Exports


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Empirical Evidence

Compare Chinese output and productivitywith that of Germany for various industriesusing 1995 data.

Chinese productivity (output per worker) wasonly 5 percent of Germanys on average.

In apparel, Chinese productivity was about 20percent of Germanys, creating a strongcomparative advantage in apparel for China.

Table 3-3: China versus Germany,


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y,1995


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Empirical Evidence

The main implications of the Ricardianmodel are well supported by empiricalevidence:

productivity differences play an important rolein international trade

comparative advantage (not absoluteadvantage) matters for trade


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Summary

1. Differences in the productivity of laboracross countries generate comparativeadvantage.

1. A country has a comparative advantage inproducing a good when its opportunitycost of producing that good is lower than

in other countries.


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Summary

3. Countries export goods in which theyhave a comparative advantage - highproductivity orlow wages give countries acost advantage.

4. With trade, the relative price settles inbetween what the relative prices were ineach country before trade.


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Summary (cont.)

5. Trade benefits all countries due to therelative price of the exported good rising:income for workers who produce exportsrises, and imported goods become lessexpensive.

6. Empirical evidence supports trade basedon comparative advantage, although

transportation costs and other factorsprevent complete specialization inproduction.

krugman summary international chapter three

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