Comparative Advantage Flashcards
What is comparative advantage and what are the two models?
When a country’s relative autarkic price ratio of one good in terms of another is lower than that of other countries.
There are two explanations: Ricardian model and Heckscher-Ohlin model.
What is the Ricardian model of comparative advantage?
A model of international trade based on differences in technologies between countries
Outline the Ricardian model using japan and Vietnam with the example of rice and motorcycles.
- Japan and Vietnam produce 2 goods, rice and motorcycles, and we assumed the only resource is labour
- The demand side is simplified so that demand for rice and motorcycles in Vietnam and japan is such that these two goods are consumed in the same fixed proportions
- Diagram for Vietnam and for japan with quantity of motorcycles on y axis and quantity of rice on x axis
- the amount of labour to produce rice is aVR in Vietnam and aJR in japan
- the amount of labour to produce motorcycles is aVM in Vietnam and aJM in japan
These are descriptions of technology in Vietnam and japan
Explain how to calculate total labour for both countries
- We need to combine technology with resources in the form of economy-wide constraints for the two countries
- Quantity of rice is qVR in Vietnam and qJR in japan
- Quantity of motorcycles is qVM in Vietnam and qJM in Japan
- total amount of labour in Vietnam, Lv = aVRqVR + aVMqVM
- total amount of labour in japan, Lj = aJRqJR + aJMqJM
-the labour used in rice production + the labour used in motorcycle production must equal the total labour available in each country
Explain the PPF in the Ricardian model for Vietnam and japan
- first suppose we allocate all labour in Vietnam to rice production so that qVM=0 (no motorcycles produced)
- using algebra, qVR = Lv/aVR, this is the x intercept
- the same method is used on the y intercept and for japan
- for Vietnam, the ppf has slope = -aVR/aVM and japan’s ppf has slope = -aJR/aJM
- the ppfs plot the the highest potential combinations of rice and motorcycles achievable for both countries by recognising the resources (labour) and technology available
- any point on the ppf represents labour being fully employed
How can we interpret the law of comparative advantage from the ppfs in the Ricardian models?
The slope of each ppf gives the opportunity cost of the good on the x axis (rice), ie the number of units of motorcycles that would need to be forgone to produce an extra unit of rice
The steeper the ppf, the higher the opportunity cost of rice.
Vietnam has a flatter ppf than japan, thus it has a lower opportunity cost of rice but Japan has a lower opportunity cost of motorcycles as this is the inverse of the opp cost of rice
Comparative advantage is shown in terms of relative opportunity costs:
aVR/aVM < aJR/aJM : Vietnam has an opp cost of rice
aJM/aJR < aVM/aVR : japan has an opp cost of motorcycles
A
How do we find the autarky equilibrium points for Japan and Vietnam in the Ricardian model?
By combining the demand curves and ppfs for each country
The intersection nis the equilibrium points
At each equilibrium point, the ppf line giving the relative prices is flatter in Vietnam than japan, so the opportunity cost of rice is lower in Vietnam than japan.
Under autarky: price of rice/price of motorcycles in Vietnam < price of rice/price of motorcycles in japan
Ie the relative prices of rice is lower in Vietnam than in japan
Assess the impact of trade on production in japan and Vietnam in the Ricardian model
If japan and Vietnam abandon autarky in favour of trade, the world relative prices of rice will be between the two autarky price ratios.
Adding this price ratio line to each country’s ppf and demand curve diagram, we see that the slope of the world rice price ratio is steeper than Vietnam’s and shallower than japan’s
The change in relative prices affects production in both countries, moving production from equilibrium A to B
For Vietnam, the relative price has increased after trade, creating an incentive to produce rice
For japan, the relative price has decreased after trade, cresting an incentive to produce motorcycles
A key characteristic of the Ricardian model is that the movement from autarky to trade involves complete specialisation in production according to comparative advantage .
After trade, japan specialises fully in motorcycles and Vietnam specialises fully in rice.
Assess the impact on consumption for Vietnam and Japan after trade in the Ricardian model
Consumption occurs at point C where the world price lines intersect the demand curves. The production and consumption quantities are different due to trade.
In Vietnam, production of rice exceeds consumption of rice, and the difference is exported. Production of motorcycles (0) falls short of consumption of motorcycles, so the difference is imported.
In japan, production of motorcycles exceeds consumption of motorcycles and the difference is exported. Production of rice (0) falls short of rice consumption, so the difference is imported.
What is the impact of trade for Vietnam and japan in the Ricardian model?
Post-trade consumption points in both countries are greater for rice and motorcycles than under autarky, implying economic welfare has increased.
Japan and Vietnam have experienced mutual gains from trade based on comparative advantage.
This shows that just because a country doesn’t have an absolute advantage in any good, it can still export due to comparative advantage.
What are limitations of the Ricardian model of comparative advantage?
- assume that labour is the sole resource, there is perfect competition, full employment, profit maximisation, no movement of labour and countries only differ in technological efficiency
- despite the overall economy in both countries benefitting, individual groups may lose out
- some goods traded do not contribute to welfare
What is the HO Model of comparative advantage?
Differences in relative prices due to differences in factors of production ie land, labour, capital and production knowledge
How do different factor endowments shape which industries countries specialise in?
Countries can specialise in land, capital and knowledge intensive industries.
- agriculture and commodity economies (gold, coffee) requires a lot of land per person and natural resources
- labour intensive industries (textiles, assembly of electronic goods) requires a high amount of low skilled labour
- capital intensive industries (steel, mining) requires a lot of machinery per person
- knowledge intensive industries include product design, education etc
Rich countries tend to import agriculture and labour based industries and export knowledge and capital based industries
Outline the assumptions of the HO model
- technologies are assumed to be identical across countries
- technology/knowledge is importable
- perfect competition
- No transaction or transportation costs
- same demand in two countries
- factor mobility in countries
Outline the HO model with the example of Vietnam and japan
Vietnam and japan produce rice and motorcycles.
Suppose Vietnam has a relatively large endowment of land so is relatively land-abundant.
Vietnam’s ratio of land to physical capital is larger than japan’s.
Vietnam has a comparative advantage in rice.
Suppose japan has a relatively large endowment of physical capital so is relatively capital abundant.
Japan’s ratio of physical capital to land is larger than Vietnam’s
Japan has a comparative advantage in motorcycles.
Vietnam exports rice and imports motorcycles and vice versa for Japan .
Vietnam increases rice production and decreases motorcycle production and vice versa for japan
As of the HO model, explain the ppfs of japan and Vietnam
PPFs have qty of motorcycles on y axis and qty of rice on x axis
Vietnam’s ppf is biased towards rice and japan’s is biased towards motorcycle production.
Combining their ppfs with their demand curves, the slope of the ppf where the demand curve intersects it gives the relative prices of rice, Pr/Pm.
Drawing tangency lines to the ppf at this point shows that the opportunity cost of rice is lower in Vietnam as the tangent is shallower.
(Pr/Pm)^V < (Pr/Pm)^J ; this is an expression of a pattern of comparative advantage
Explain the impact of moving from autarky to trade in the HO model
If Vietnam and japan abandoned autarky in favour of trade, the world relative prices of rice will be between the two autarky prices.
In the ppf demand curve diagram the world price is steeper than the Vietnam autarky price line and flatter than the japan autarky price line.
The tangencies of these world price lines with the respective ppfs determine the new production points in Vietnam and japan. These points are labelled B.
Moving to trade involves an increase in rice production in Vietnam and an increase in motorcycle production for japan, both countries have specialised towards a good they have a comparative advantages in.
Consumption occurs at C where the world price lines intersect the demand curve
Trade has increased the consumption of rice and motorcycles so economic welfare has increased and japan and Vietnam have experienced mutual gains from trade.
What is the impact of FDI on patterns of comparative advantages in the HO model?
Suppose we allow for an FDI flow from japan to Vietnam, whereby the motorcycle factory closes in japan and opens in Vietnam.
This changes the relative factor endowments. Japan becomes less capital-abundant and Vietnam becomes more capital-abundant.
In Vietnam, the ppf shifts out while in japan the ppf shifts in.
The autarky price ratios change to the new points along the demand curves.
In Vietnam, the price ratios change of rice to motorcycles increases and in japan this ratio decreases.
The gap between the two autarky price ratios shrinks and the pattern of comparative advantage weakens
Thus, FDI can acts as a substitute for trade.
What is the impact of migration on patterns of comparative advantage in the HO model?
Suppose we allow for migration flow from Vietnam to japan. This changes the relative factor endowments.
Japan becomes more labour abundant (and less capital abundant) and Vietnam becomes less labour abundant (and more capital abundant)
In Vietnam the ppf shifts inwards and in japan the ppf shifts outwards.
The autarky price ratios change according to the new autarky points along the demand curves.
In Vietnam, the price ratios change of rice to motorcycles increases while in japan this ratio decreases.
The gap between the autarky prices narrows and comparative advantages eakens.
Thus migration can acts as a substitute for trade.
What are limitations of the HO model?
- assumes only 2 FOP, perfect competition, full employment and profit maximisation
- the two resources are assumed not to move between the countries but this can be relaxed
- it assumes countries only differ by factor endowments
- gains from trade affect the country as a whole but individual groups lose out
- some goods traded do not benefit welfare
- doesn’t explain horizontal intra-industry trade, ie why similar countries trade with each other
