Economics of Trade International Political Economy Prof. Tyson Roberts 1 Economics of Trade • Comparative Advantage => Trade increases aggregate welfare for all countries • Stolper-Samuelson => The benefits of trade are not equally distributed within countries (winners and losers) – More on this next week • Spatial analysis & Pareto improvements 2 Aggregate Trade Benefits: Comparative Advantage (Ricardo) 3 The basic Ricardo model • Two countries • Two products • One factor of production (e.g., labor) 4 Home • 1200 labor units (e.g., 30 workers working 40 hours each) • 30 labor units to make iPods – Q: How many iPods could be made per week if all workers make iPods? • 5 labor units to make pair of running shoes – Q: How many pairs of shoes could be made per week if all workers make shoes? 5 Calculation for production possibility • 1200 labor units (per week) • 30 labor units to make iPods – Q: How many iPods could be made per week if all workers make iPods? 1200 labor/ 30 labor per iPod = 40 iPods – A: 40 iPods 6 Home • 30 labor units to make iPods – Can produce up to 40 iPods • 5 labor units to make pair of running shoes – Can produce up to 240 pairs of shoes • Opportunity cost ≈ Price – What is the cost of iPods in terms of shoes? – What is the cost of shoes in terms of iPods? 7 Opportunity cost is the cost of any activity measured in terms of the value of the next best alternative forgone 8 Opportunity cost calculation • 30 labor units to make iPods • 5 labor units to make pair of running shoes – Q: What is the opportunity cost of iPods in terms of shoes? 30 labor units could make 1 iPod or 30/5 = 6 shoes. – A: Opportunity cost of 1 iPod = 6 shoes 9 Home • 1200 labor units (e.g., 30 workers working 40 hours each) • 30 labor units to make iPods – Can produce up to 40 iPods • 5 labor units to make pair of running shoes – Can produce up to 240 pairs of shoes • Opportunity cost ≈ Price – “Price” of 1 iPod is 6 pairs of shoes – “Price” of 1 pair shoes is 1/6 iPod 10 • What is the production possibility frontier for Home? Draw it. – Hint: Assume all labor is dedicated to each product to find intercepts, then draw line between the two intercepts. 11 Production possibility frontier Home 40 iPods Slope = -1/6 Shoes 240 12 Production possibility frontier Home 40 39 Slope = -1/6 iPods 1 6 Shoes 234 240 13 How many shoes & iPods Home will produce/consume depends on indifference (utility) curves More iPods & shoes is better Consumers are willing to give up some quantity for right mix 40 iPods Shoes 240 14 Foreign • 720 labor units (e.g., 18 workers working 40 hours each) • 12 labor units to make iPods – Q: How many iPods could be made per week if all workers make iPods? • 4 labor units to make pair of running shoes – Q: How many shoes could be made per week if all workers make shoes? 15 Foreign • 720 labor units (e.g., 18 workers working 40 hours each) • 12 labor units to make iPods – Can produce up to 60 iPods • 4 labor units to make pair of running shoes – Can produce up to 180 pairs of shoes • Opportunity cost ≈ Price – What is the cost of iPods in terms of shoes? – What is the cost of shoes in terms of iPods? 16 Foreign • 720 labor units (e.g., 18 workers working 40 hours each) • 12 labor units to make iPods – Can produce up to 60 iPods • 4 labor units to make pair of running shoes – Can produce up to 180 pairs of shoes • Opportunity cost ≈ Price – “Price” of 1 iPod is 3 pairs of shoes (12 hours/4 hours) – “Price” of 1 pair of shoes is 1/3 iPod (4 hours/12 hours) 17 Production possibility frontier Frontier 60 iPods Slope = -1/3 Shoes 180 18 What matters for trade is comparative, not absolute, advantage • Note Foreign has absolute advantage in both iPods & shoes – 12 vs. 30 labor units to make iPods – 4 vs. 5 labor units to make shoes • Does this mean that with trade, Foreign will make iPods & shoes and Home will make nothing? • No. 19 What matters for trade is comparative, not absolute, advantage • Relative to Home, Foreign has a comparative advantage in producing iPods – It (opportunity) costs fewer (3 vs. 6) shoes to make an iPod in Foreign than in Home • Relative to Foreign, Home has a comparative advantage in producing shoes – It (opportunity) costs fewer iPods (1/6 vs. 1/3) to make shoes in Home than in Foreign 20 Home Price of iPods 6 shoes Price of Shoes 1/6 = 0.167 iPods Foreign Cheaper Cheaper 3 shoes 1/3 = 0.333 iPods 21 Trade increases PPF for Home • Assume demand curves in Home & Foreign are such that the international price of shoes per iPod is 4 (and price of iPods per shoes is ¼) • Now it is cheaper for Home to trade for iPods than to make them (4 shoes < 6 shoes) • Home can “indirectly produce” iPods by making shoes and trading for iPods – Can make 240 pairs of shoes and trade for 60 iPods – Trade is like an improvement in technology! 22 Home Trade Cheaper 4 shoes Price of iPods 6 shoes Price of Shoes 1/6 = 0.167 iPods 1/4 = 0.25 iPods Foreign Cheaper 3 shoes 1/3 = 0.333 iPods 23 Production possibility frontier Home with trade 60 40 iPods Shoes 240 24 Trade increases PPF for Foreign • Assume demand curves in Home & Foreign are such that the price of shoes per iPod is 4 (and price of iPods per shoes is ¼) • Now it is cheaper for Foreign to trade for shoes than to make them (¼ iPod <⅓ iPod) • Foreign can “indirectly produce” shoes by making iPods and trading for shoes – Can make 60 iPods and trade for 240 pairs shoes 25 Production possibility frontier Foreign with trade 60 iPods Shoes 180 240 26 The mix of shoes & iPods produced/traded depends on the indifference curves/utility functions of consumers in both countries (demand for shoes relative to iPods) 60 iPods Shoes 180 240 27 Trade & Rate of Growth • Comparative advantage alone does not produce an increase in “steady state” (i.e. long run) economic growth, only an increased growth rate during transition from closed to trade 28 Trade & Rate of Growth • If specialization generates additional benefits, then increased trade can increase long run economic growth rate • Economic growth effects of trade are also determined by positive and negative externalities – Technology spillovers => higher growth rate – Income inequality => political instability => lower growth rate 29 Some Determinants of Trade • Differences in comparative advantage • Geography – Access to ocean, wealthy neighbors, etc. • Technology – Navigation, steam engines, telecom, etc. • Policy – Tariffs, quotas, monopolies, exchange rate regime 30 Distribution of Trade Benefits (Heckscher-Ohlin => Stolper-Samuelson) 31 Basic H-O & SS models • Two countries • Two products • Two factors of production (e.g., labor & capital) – Next week we’ll look at 3 factors: labor, capital, & land 32 PPF with TWO factors • Each factor assumed to have diminishing marginal returns (DMRs) – For given amount of capital, labor has DMRs – For given amount of labor capital has DMRs • Factors can substitute for one another 33 Diminishing marginal returns of labor, holding capital constant • • • • • • • • • Assume one sewing machine 1st worker, work 9am-5pm => 10 shirts 2nd worker, work 5pm-1am => 9 shirts (sleepy) 3rd worker, work 1am-9am => 8 shirts (very sleepy) 4th worker, help 1st worker => 7 shirts 5th worker, help 2nd worker => 6 shirts 6th worker, help 3rd worker => 5 shirts 7th worker, help 1st & 4th worker => 4 shirts Etc. 34 Diminishing marginal returns of capital, holding laborconstant • Assume one worker • 1st sewing machine => 10 shirts per day • 2nd sewing machine => 7 more shirts (use one for sleeves and one for torsos) • 3rd sewing machine => 3 more shirts (use when a machine has problems) • 4th sewing machine => 1 more shirt (use when 2 machines have problems) • Etc. 35 If there is little labor per capital, adding labor has a large effect & adding capital has a small effect 1 If there is a lot of labor per capital, adding labor has a small effect & adding capital has a large effect 2 Output per Capital and Labor 1800 1600 1400 Output 1200 1000 2 800 600 400 200 1 Capital = 200 0 20 40 60 80 100 120 140 160 180 200 220 240 260 280 300 320 340 360 380 400 Labor Capital = 100 So in labor scarce countries, wages are higher relative to profits 36 Production functions depend on the good • iPods production tends to use more capital than labor, relative to shoes – “Capital intensive” • Shoe production tends to use more labor than capital, relative to iPod production – “Labor intensive” 37 Comparative advantage may be a function of factor endowments • Home – 300 units of capital, 1200 units of labor • Capital:Labor is ¼ – Can produce up to 40 iPods and up to 240 shoes • Foreign – 720 units of capital, 720 units of labor • Capital: Labor is 1 (comparatively more capital abundant) – Can produce up to 60 iPods and up to 180 shoes • Comparative advantage in making iPods (capital intensive) 38 Winners and Losers from Trade • Heckscher-Ohlin – Countries will export products that use their comparatively abundant factor(s) more intensively & import products that use their comparatively scarce factor(s) => – Increased PPFs for all trading countries => – All national economies (& consumers) win 39 Winners and Losers from Trade • Stolper-Samuelson – Under some economic assumptions (constant returns, perfect competition, etc.), – Increased relative price of a good => – Increased returns for factor(s) used intensively in the production of that good, and – Reduced returns for other factor(s) – Some factor owners (in each country) win, others lose with regard to earnings 40 Relative factor endowments affect relative factor prices (relatively scarce factors earn more) • Relative labor abundance Lower wages relative to profits without trade Trade: Export labor-intensive goods Domestic price of labor-intensive goods rises; price of capital intensive goods falls Increased real wages with trade • Relative capital abundance Lower profits relative to wages without trade Trade: Export capital-intensive goods Domestic price of capital-intensive goods rises; price of labor-intensive goods falls Increased real profits with trade 41 Winners and Losers from Free Trade • Winners – Consumers: Lower prices (on average), more consumption – Relative abundant factor owners: higher returns for factor (labor, capital, or land) • Losers – Relative scarce factor owners: lower returns for factor 42 Conclusions • Free trade has potential to increase total production and consumption in the world, and in every country that participates, through more efficient allocation of production activities • Within countries, some may be losers from trade – Comparative disadvantaged producers, owners of scarce factors – Note that people have multiple attributes (e.g., workers are also consumers) 43 Conclusions • Long term effects may be more complicated – If a country shifts from high growth to low growth sector, it may benefit in the short run but miss out on potential growth in the long run 44 One more example • Now assume that demand curves in Home & Foreign are such that the price of shoes per iPod is 5 (and price of iPods per shoes is 1/5) • What is the new PPF for Home and Frontier after trade? 45 Production possibility frontier: Home with trade Home can make 240 shoes and buy 240/5 = 48 iPods 48 40 iPods Shoes 240 46 Production possibility frontier: Foreign with trade Foreign can make 60 iPods and buy 60 x 5 = 300 pairs shoes 60 BUT Home cannot make 300 shoes! iPods Shoes 180 300 47 Home can only make 240 pairs shoes 48 40 iPods Shoes 240 48 Production possibility frontier: Foreign with trade So Foreign can make 48 iPods and trade for 48 x 5 = 240 Shoes Then Foreign can take the remaining 720 – (48 x 12) = 144 hours and make 144/4 = 36 Shoes 60 Foreign can buy 240 Shoes and make 36 Shoes Total possible shoes = 276 iPods Shoes 180 240 276 300 49 Another way to look at Pareto Improvements 50 economy. Edgeworth box: Each player is on a corner. Each axis is a product. Baker • Consumers have endow ments w = (( w11, w 21) , ( w 12, w 22)) , and locally non-satiated preferences; they can exchange goods in order to increase their level of utility. • A n allocation x = (( x11, x21) , ( x12, x22)) represents the amounts of each good that are allocated to each consumer. • A nonw asteful allocation is one for w hich xl 1 + xl 2 = w̄ l , for l = 1, 2. • Given tw o consumers, tw o goods, and no production, all non-w asteful allocations can be draw n in an Edgew orth Box. • Every point in the box represents a complete allocation of the tw o goods to the tw o consumers. • We w ill analyse the exchanges in the Edgew orth Box, to fi nd an equilibrium outcome. Recap: Edgeworth Box basics Recap: Edgeworth Box preferences Barista economy. • Consumers have endow ments w = (( w11, w 21) , ( w 12, w 22)) , and locally non-satiated preferences; they can exchange goods in order to increase their level of utility. Further from player’s corner means more consumption for that player • A n allocation x = (( x11, x21) , ( x12, x22)) represents the amounts of each good that are allocated to each consumer. • A nonw asteful allocation is one for w hich xl 1 + xl 2 = w̄ l , for l = 1, 2. • Given tw o consumers, tw o goods, and no production, all non-w asteful allocations can be draw n in an Edgew orth Box. Baker Barista gets •allEvery thepoint in the box represents a complete allocation of the tw o goods to the tw o consumers. w ill analyse the exchanges in the Edgew orth Box, to fi nd an equilibrium outcome. coffee, baker• We gets all the bread Recap: Edgeworth Box basics Barista gets all the coffee and bread Recap: Edgeworth Box preferences Barista Baker gets all the coffee and bread Barista gets all bread, baker gets all coffee Each player gets more utility from increasing coffee & bread Each player is willing to give up quantity for an ideal mix M ain concepts of an EB • The w ealth of the consumers is not given exogenously: it is determined by the value of their endow ment at the prices that w ill prevail in the exchange process. • H ence, the budget set of each consumer is given by: Bi ( p) = { xi 2 R 2+ : p · xi p · wi } • A n allocation is said to be Pareto efficient, or Pareto Optimal, if there is no other feasible allocation in the economy for w hich both are at least as w ell off and one is strictly better off. From a given starting point of endowments ω, a Pareto improvement is possible in the space where both players increase their utility • formally, x is P.O. if @x 0 s.t. xi0 %i xi , 8 i, and 9i s.t. xi0 i xi • The locus of points that are P.O. given preferences and endow ments is the Pareto Set. • The part of the Pareto Set in w hich both consumers do at least as w ell as their initial endow ments is the Contract Curve. • M oreover, w e are interested in the equilibrium point(s) of the process of exchange: • a Walrasian equilibrium is a price vector p⇤and an allocation x⇤such that, for every consumer xi⇤ %i xi0 for all xi0 2 Bi ( p⇤) Recap: contract curve, pareto set Starting endowment 3 Market transactions will lead to a Pareto optimal outcome at the equilibrium market price Recap: Edgeworth Box equilibrium 1. Edgeworth box Consider a pure-exchange, private-ow nership economy, consisting in tw o consumers, denoted by i = 1, 2, w ho trade tw o commodities, denoted by l = 1, 2. Each consumer i is characterized by an endow ment vector, w i 2 R 2+ , a consumption set, X i = R 2+ , and regular and continuous preferences, %i on X i . 1. A ssuming that the consumers’ endow ments are w 1 = ( 1, 2) and w 2 = ( 2, 1) , respectively, construct the Edgew orth Box relative to economy under consideration. With reference to the same economy, defi ne the follow ing notions: competitive equilibrium, Pareto-effi cient allocation, Pareto set, contract curve. 2. Find the equation describing the Pareto set (internal solutions); then, taking commodity 1 as the numeraire, hence In political science spatial analysis, the two dimensions are policy Policy 2 Policy 1 Each player has a policy ideal point Player 2 ideal point Policy 2 Player 1 ideal point Policy 1 Each player receives LESS utility further from the ideal point in any direction Policy 2 Policy 1 From a given starting point status quo policy SQ, a Pareto improvement is possible in the space where both players increase their utility SQ Policy 2 Policy 1 Contract curve Coming attractions • Next lecture: Trade Bargaining and the Enforcement Problem • And then: Institutional Solutions to Trade’s Enforcement Problem 60