Introduction and Ricardian Model Flashcards
What does it mean to trade?
- Mutually agree - both parties agree
- Exports
- Imports
Why do we trade?
- Different opportunity costs
-> next best thing you could have done with you time
Why do opportunity costs differ?
- different benefits (we don’t do a lot with this)
- different production costs
-> Technology - Ricardian model
-> Input availability (endowments) - Heckscher Ohlin model
-> Productivity - New Trade theory
What are the assumptions of the Ricardian model?
Identical homothetic preferences
(homothetic - demand side of the economy: utility function + indifference curves)
Constant share of income on each good - taking income inequality problem out of demand. Income distribution =/ demand.
2 countries: home and foreign*
2 goods: x and y
No trade costs
Why do firms have different opportunity costs?
Differences in endowment
-> the most productive firms trade
Ricardian Model Production
- Perfect Competition: price takers, no influence on prices
- Production function:
Constant returns to sale: Double inputs, double outputs
Uses one factor (labour)L-, exogenously endowed
x = 2Lx so that unit labour requirement is alx = 0.5
y = 1/4ly so that unit labour requirement is aly = 4
Endowment of labour: Lx + Ly </ L-
What does x = 2Lx so that unit labour requirement is alx = 0.5 mean?
Need 1/2 worker to get 1 unit of x.
What does y = 1/4ly so that unit labour requirement is aly = 4
Need 4 workers to get 1 unit of y.
What does a Production Possibilities Frontier (PPF) show?
All of the feasible, efficient output levels
What is the slope of the Production Possibilities Frontier (PPF) driven by?
technology
What are the properties of indifference curves (IC)?
- everywhere on an IC is the same for preferences
- higher IC is better
- ICs don’t cross - not transitive: goes against the rational consumer
- ICs tend to be bendy
- some degree of substitution
If a country is on a higher IC, the entire country is better off.
What is Autarky?
No trade
-> country has to make what it consumes
What is comparative advantage?
the country with a lower opportunity cost has a comparative advantage
-> A country always has comparative advantage in something
What is absolute advantage?
Country that has lower input requirement (how many workers it takes to make more)
What happens as trade occurs?
Home exports x:
- Home x price rises
Foreign Imports x:
- Fgn x price falls
Prices converge until they are equal across countries
Who benefits when two countries open up for trade in terms of technology?
Both countries benefit
Do countries almost always completely specialize in their exported product
No, not completely
When does a countries Production Possibilities Frontiers (PPF) expand/go left?
changes to endowments and/or technology
When two countries open up for trade with each other
prices converge between the autarky prices
Why do countries choose to trade?
With limited resources, it is necessary for countries to cut back on the production of one good in order to produce more of another.
For example, if only pizza and beer were made in a country, if they desire more beer, they must cut back on the amount of pizza being produced. This is the opportunity cost of pizza.
What is an opportunity cost?
Opportunity cost is essentially the benefit a person misses out on by choosing one option over another.
When the opportunity cost of making good X is lower for country A than for country B, we say that A has a comparative advantage in good X.
