International Economics M1 EI; M1 EA University Lille 1 Claire Naiditch [email protected] Part 1. Standard trade models The law of comparative advantage Preview Comparative advantage o The concept of comparative advantage n Opportunity costs n Absolute and comparative advantage o A one-factor Ricardian model n Production possibilities n Gains from trade n Wages and trade o o o o o Misconceptions about comparative advantage Comparative advantage with many goods Transportation costs and non-traded goods Empirical evidence Sources of comparative advantage Learning goals o After reading this chapter, you should be able to: n Explain how the Ricardian model, the most basic model of international trade, works and how it illustrates the principle of comparative advantage. n Demonstrate gains from trade and refute common fallacies about international trade. n Describe the empirical evidence o that wages reflect productivity and o that trade patterns reflect relative productivity. Comparative Advantage and Trade - example Fig A.1.: Home’s Production Possibility Frontier A one-factor Ricardian model Relative Prices, Wages, and Supply o Summary QC = 0 QC QC = L/aLC PC /PW aLC /aLW QW = L/aLW QW QW = 0 Fig A.2.: Foreign’s Production Possibility Frontier A one-factor Ricardian model Relative supply and relative demand o Summary QC Q*C = 0 QC = 0 Q*C = 0 QC = L/aLC Q*C QC = L/aLC Q*C = 0 aLC /aLW QW = L/aLW Q*W = L*/a*LW QC = L/aLC Q*C = L*/a*LC a*LC /a*LW QW = 0 Q*W = L*/a*LW QW Q*W = L*/a*LW QW = 0 Q*W QW = 0 Q*W = 0 PC /PW Fig A.3.: World Relative Supply and Demand Fig A.4.: Trade Expands Consumption Possibilities A one-factor Ricardian model A Numerical Example Unit Labor Requirements for Home and Foreign countries Cheese Wine Home aLC = 1 hour/lb aLW = 2 hours/gallon Foreign a*LC = 6 hours/lb a*LW = 3 hours/gallon o What is the home country’s opportunity cost of producing cheese? n aLC /aLW = 1⁄2 n To produce one pound of cheese, stop producing 1⁄2 gallon of wine. Fig A.5.: Productivity and Wage Comparative Advantage with Many Goods Home and Foreign Unit Labor Requirements Good Home Unit Labor Requirement aLi Foreign Unit Labor Requirement a*Li Relative Home Productivity Advantage a*Li/aLi Apples 1 10 10 Bananas 5 40 8 Caviar 3 12 4 Dates 6 12 2 Enchiladas 12 9 0.75 Fig A.6.: Productivity and Wage Fig A.7.: Productivity and Exports Empirical Evidence Bangladesh versus China, 2011 Bangladeshi output per worker as % of China Bangladeshi exports as % of China All industries 28.5 1.0 Apparel 77 15.5 Source: McKinsey and Company, “Bangladesh’s ready-made garments industry: The challenge of growth,” 2012; UN Monthly Bulletin of Statistics. Sources of comparative advantage o What determines comparative advantage? n n n The quantity and quality of factors of production available o o Ex: good quality farmland, oil and gas, fossil fuels Climate and geography o Ex: abundant low-cost labor suitable for volume production of manufacturing products Different proportions of factors of production (HOS) Increasing returns to scale and the division of labor (New trade models) o o o n Increasing returns occur when output grows more than proportionate to inputs. Rising demand in the markets where trade takes place helps to encourage specialization, higher productivity and internal and external economies of scale. These long-run scale economies give regions and countries a significant advantage. Technology o o Investment in research & development which can drive innovation and invention Sources of comparative advantage o What determines comparative advantage? n Fluctuations in the exchange rate, o n Import controls such as tariffs, export subsidies and quotas o n o covering factors such as the standard of product design and innovation, product reliability, quality of after-sales support. Many countries are now building comparative advantage in high-knowledge industries and specializing in specific knowledge sectors – an example here is the division of knowledge in the medical industry, some countries specialize in heart surgery, others in pharmaceuticals. Formal institutions o o o o n n These can be used to create an artificial comparative advantage for a country's domestic producers The non-price competitiveness of producers o n which then affect the relative prices of exports and imports and cause changes in demand from domestic and overseas customers Political institutions and the stability of democracy (influence capital flows) Contract enforcement Financial development Labor market Informal institutions … Summary 1. Differences in the productivity of labor across countries generate comparative advantage. n Institutions may affect these differences 2. A country has a comparative advantage in producing a good when its opportunity cost of producing that good is lower than in other countries. Summary 3. Countries export goods in which they have a comparative advantage - high productivity or low wages give countries a cost advantage. 4. With trade, the relative price settles in between what the relative prices were in each country before trade. Summary 5. Trade benefits all countries due to the relative price of the exported good rising: income for workers who produce exports rises, and imported goods become less expensive. 6. Empirical evidence supports trade based on comparative advantage, although transportation costs and other factors prevent complete specialization in production.