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.
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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)
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Production possibility frontier
Frontier
60
iPods
Slope = -1/3
Shoes
180
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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.
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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
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Home
Price of iPods
6 shoes
Price of Shoes
1/6 = 0.167 iPods
Foreign
Cheaper
Cheaper 3 shoes
1/3 = 0.333 iPods
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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!
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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
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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
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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
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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.
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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
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