Comparative Advantage
International Trade – Session 1
Daniel TRAÇA
1
Globalization I:
Increased trade in goods and services
…mostly for East Asia; it has fallen for Africa
Trade has grown faster than GDP
Exports (% GDP)
Trade (% GDP)
40
35
30
25
20
30
15
0
15
10
1980
1985
World
•
45
1990
High income
1995
Low & middle income
E-Asia &
Pac.
Lat. Am. & Mid East, N South Asia
Carib.
Af
1960
1970
1980
1990
Sub-S.
Africa
1998
International Trade involves mostly exchanges among high income
countries.
•
Developing countries have increased their relevance, particularly East Asia,
but are still a small part.
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Trade in services and merchandise
• Most of world trade is in goods
(merchandise) – 82%.
Share of goods and commercial services in total trade
(Percentages, based on balance of payments data)
Export Shares
• Services trail behind, but are
the fastest growing
component.
– Outsourcing is the latest trend
Import Shares
Goods
Commercial
Services
Goods
Commercial
Services
World
81.4
18.6
81.4
18.6
North America
77.2
22.8
85.9
14.1
Latin America
86.0
14.0
84.1
15.9
Western Europe
78.8
21.2
79.4
20.6
Africa
81.5
18.5
76.8
23.2
Egypt
42.5
57.8
68.2
31.8
Nigeria
93.8
6.2
71.1
28.9
Asia
85.7
14.3
81.3
18.7
India
71.4
28.6
73.4
26.6
Indonesia
92.8
7.2
72.3
27.7
Japan
87.1
12.9
74.8
25.2
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Globalization II:
Foreign Investment - complex strategies of
multinationals
Global FDI Flows
FDI in millions of dollars
FDI per capita (dollars)
FDI as percentage of GDP
FDI as percentage of exports
2000
1995
1990
1985
1980
1975
1970
1,270,764 331,068 202,297 56,583 54,725 25,850 12,542
210.3
58.8
41.4
12.8
13.6
9.8
5.3
3.12
1.13
0.96
0.48
0.52
0.49
0.48
19.99
6.45
6.05
3.10
2.95
3.33
4.56
Share of FDI flows, by group
Gross foreign direct investment (% of GDP)
8
100%
6
75%
4
50%
Low income
2
Middle income
25%
High income
0
1976
1981
World
1986
High income
1991
1996
Low & middle income
0%
1980
1985
1990
1995
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Drivers of Modern Globalization
• Lower transport and
communication costs
• Development of international
institutions
– The WTO
– Regional Trade Agreements
• Political decisions toward de-
regulation and liberalization of
trade and FDI regulations
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Theory and practice of international trade
and foreign investment
WHAT WE WILL LEARN…
•
Why do countries export certain goods and imports others?
•
What do countries and populations gain and loose from trade?
•
Why do multinationals exist and what are their effects?
•
Why do governments protect their industries and what are the costs and
benefits?
•
What are the effects of different protectionist instruments?
•
How do the institutions that regulate global trade work?
•
What have been the economic and social consequences of the rise in trade
and foreign investment with developing nations?
•
What has globalization brought to developing countries?
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Organization of the course
• Theories of international trade
– Comparative advantage
– Gains from trade: static and
dynamic
– Losers and winners
• Trade policy
– Policy Instruments
– The case for free-trade and
exceptions
– Policies for Strategic sectors
– Political economy and the realist
view
• The effects of modern
globalization
– Trade and the developing
countries
– Multinationals and FDI
– The effects in industrialized
countries
• Institutions of global trade
– The W.T.O
– Regional agreements
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Materials and exams
course website: www.danieltraca.com
•
Download class slides before class from website
– Also available at GES
•
Practice exams and answer keys available at website.
List of required sections available from website
•
Recommended textbook
– “International Economics, 7th ed”by Krugman P. and Obstfeld M., Addison-Wesley
• Available in French
– Additional readings available at website
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The theory of Comparative Advantage
9
Absolute Advantage
•
“It is the maxim of every prudent master of the
family, never attempt to make at home what it will
cost him more to make than buy … What is prudent
in the conduct of every family can scarce be folly in
that of a great kingdom If a foreign country can
supply us with a commodity cheaper than we
ourselves can make it, better buy it of them …”
– Adam Smith 1776
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Absolute Advantage
Output per worker (productivity)
Manufacturing
(pieces)
Food
(bushels)
NORTH
10
8
SOUTH
3
9
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Gains from specialization
Output
before
after
1 northerner
(FOOD to
MANUF)
8 Food
10 Manuf
1 southerner
(MANUF to
FOOD)
3 Manuf
9
• North specializes in
Manufacturing and South in
Food
• There is more of both goods, if
specialization follows absolute
advantage
Food
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Comparative Advantage
•
"A country … enabled to manufacture
commodities with much less labour that her
neighbours may, in return for such commodities,
import a fraction of the corn required for its
consumption, even if … corn could be grown
with much less labour than in the country from
which it was imported."
–
David Ricardo
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Comparative Advantage
North is MORE productive in both goods
Output per worker (Productivity)
Manuf
(pieces)
Food
(bushels)
NORTH
10
10
SOUTH
3
9
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Even so, there are gains from
specialization
Output
before
after
1 northerner
(Food to
Manuf)
10 Food
10
Manuf
2 southerners
(Manuf to
Food)
2x3
6 Manuf
2x9
18 Food
•
A country has Comparative
Advantage in a given good if
its relative productivity in
that good is higher than in
other goods
•
Specialization according to
Comparative Advantage
creates value, by increasing
output.
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How does the market work?
•
Does the decentralized international market achieve this pattern of
specialization? How?
•
Who benefits and who looses from international trade in the free-market?
– Among individuals within a country?
– Among countries?
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In Autarky...
North
Food
They work in both
sectors, and trade
among them at the
autarky relative price
South
Northern worker
The relative price
P=p
Manuf
Manuf/pFood
•In equilibrium, workers
must be indifferent
between the two
sectors.
•They must get the
same wage
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The prices in autarky (closed
economy)
The relative price of Manuf (P) denotes how many bushels of
Food for one piece of Manuf.
Manuf
(pieces)
Food
(bushels)
P
NORTH
10
10
10/10 = 1
SOUTH
3
9
9/3 = 3
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Relative prices, relative supply,
relative demand
P
PS=
Relative Supply (RSs)
South
3
Relative Supply(RSN)
North
PN= 1
Relative demand (RDW)
It is the same in both countries
if preferences are the same
[Manuf/Agro]S
[Manuf/Agro]N
Manuf/Agro
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In Autarky...
Northern worker
Southern worker
South
North
Food
The Northerners
trade among them
at the autarky price
PN = 1
Manuf
Food
The Southerners
trade among them
at the autarky price
PS= 3
Manuf
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Wages and productivity
• Are the wages the same in both sectors? Why?
– If not, where are they higher? Why?
• Are they the same in both countries? Why?
– If not, where are they higher? Why?
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The Production Possibility Frontier
and Welfare
North
Production
Possibility
Frontier
Manuf
10
Northern Workers
in Manuf
+1
Slope = -1
-ProdF / ProdM
The choice of consumers
…determines the allocation of labor
MRS =MUFood/ MUManuf = 1/P =1
UN
Equilibrium P=1,
So that both
goods are
produced
-1/PN = -1
10
Northern
Workers in
Agro
Agro
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The beginnings of Trade…
• Manuf is relatively cheaper in the North.
– An enterprising Northerner takes 1 Manuf to the South and
exchange it for 3 Foods.
– Back in the North, she could sell 1 Foods for 1 Manuf with a net
gain of 1 Food.
• There are gains from exchange because prices are
different: Trade occurs!
– What happens to the relative price of Manuf in North? …
– And in the South?
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Openness in the Short Run...
North
PN >10/10
Food
Manuf
2 . Prices adjust to
new scarcity
P rises in the North and
falls in the South
1 . Trade
starts due to
arbitrage
South
PS < 9/3
Food
Manuf
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In the Long-Run, there is reallocation
North
PN >10/10
Food
South
Each country specializes
completely in, and exports, the
good in which it has
comparative advantage
Manuf
PS < 9/3
Food
Manuf
There is one world price,
which is between the
initial prices
10/10 < PW <9/3
3 . Factors (workers) respond to new prices and profitability -- specialization
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North and South produce
only Manuf
How to determine the world price?
P
Relative Supply (RSW)
World
1<PW <3
North and South specialize
completely
3
1
North and
South
produce
only Food
South produces Food only
North produces both
North produces Manuf only
South produces both
Relative Demand (RDW)
World
Manuf/Food
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The Gains from Trade according to
Comparative Advantage
North
Manuf
10
-1/PW
Manuf
South
UN(Manuf)
-1/PN
3
UN
US(Food)
-1/PW
US
-1/PS
10
Food
9
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Food
Some unrealistic features of the
model, so far…
• What if there are transport costs?
• What if there are more than two goods?
• What if factors cannot adjust to other sectors?
• What if there are more than one factor?
• Why is there always complete specialization?
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Transport Costs and Non-traded
goods
• If there are transport costs, the competitiveness edge of a country
must more than make up for this transport cost.
• Otherwise, the good will not be traded, even if it is cheaper to
produce in one country. This good is called non-tradable.
– In reality, economies spend large proportions of their income in these
type of goods.
• It can become tradable, if transport costs fall or the productivity
advantages widen (globalization).
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Global markets vs. local markets
TRADABLES and NON-TRADABLES
• Tradable goods can travel
across borders and have
international markets that set
prices.
• Non-tradable goods have their
prices set by supply and
demand in local markets.
Nontradables
Goods
– Often, the same good exists in
different countries because it
is produced locally.
• With globalization, many goods
and services have become
tradable.
Services
Tradables
• Cement
• Housing
• McDonalds
Hamburger
• Textiles
• Machinery
• Almost all
goods
• Hairdressers
• Government
services
• Auto-repair
• Almost all
services
•
•
•
•
Consulting
Banking
Telecom’s
Tourism
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Summary
• Comparative advantage:
– Consumers react to price differences and buy from lower price
foreign producers the goods in which their country does not have
comparative advantage (gains from exchange).
– Producers react to price differences and allocate resources to
industries where relative productivity is higher, exporting those
goods (gains from specialization).
• Every country always has an industry in which it has
Comparative Advantage and it is competitive in world
markets for that industry.
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