Comp Advantage (real wage increased in terms of imported good! specialise in good they have CA in increases consumption possibilities) Flashcards
Recall the ‘No trade model’ assumptions (4)
Identical tech and tastes
Same relative factor endowments
Constant RTS
No distortions
Which assumption do we relax for the Ricardian model?
Identical technology (since differences in tech drive changes in relative labour productivity)
So we assume differences in technology.
What does actually this mean?
Goods are produced with different amounts of labour
Ricardian model
5 Assumptions
Labour is the only factor
Labour productivity varies ACROSS countries, but labour productivity WITHIN the country is constant (rmb CRTS)
2 goods
Labour mobile between industries not countries
Competition allows workers to be paid a wage equal to what they produce, and allows them to work in the industry that pays the highest wage.
aLC and aLW: hours of labour to produce one unit
So high a means low productivity
L is total number of work hours available
Qc and Qw is quantity produced
What is the production possibility frontier? (PPF)
aLCQc + alwQw <=L
What is the opportunity cost of an additional cheese
aLC/aLW
Since an additional cheese requires aLC hours.
Which could’ve been used to produce 1/alw amount of wine.
How can we show the opportunity cost of cheese is the slope of the PPF (equation)
Qw = L/aLW - (aLC/aLW)Qc
What is wage expression for cheese and wine industry? (2)
Wc = Pc/aLC and Ww = Pw/aLW
Since mobile labour, they work where wages are higher.
Using this… If Pc/alc> Pw/alw , which good is produced
Cheese
Assuming convex (average>extremes) preferences,
In autarky what would consumers consume, and what happens to the market as a result?
C) What would the expression be?
Both wine and cheese
So relative prices must adjust so wages equal in both industries to ensure both goods are produced
C) Pc/Pw = aLc/aLw
(Relative price = opportunity cost)
Home country is more efficient in both wine and cheese production. What is this called?
B) hows it expressed
Absolute advantage (as lower unit labour requirements)
aLC < aLC and aLW < aLW
So a country can be more efficient in producing both goods (absolute advantage)
But, it will have a comparative advantage in ONLY ONE good unless..
Unless countries identical (aLc/aLw = aLc/aLw)
(So a country can have absolute advantage for both, but will only have comparative advantage in one)
What would PPFs look like graphically, say we assume:
aLC /aLW < aLC /aLW
Linear as CRS (no DMR since only one factor (labour)
And slope is opportunity cost. Since home has a lower opportunity cost, foreign PPF will be steeper (higher opportunity cost of cheese in terms of wine)
At autarky (no trade), will the relative price of cheese to wine be higher foreign or home?
B) Upon this, is it profitable to break autarky and sell cheese to foreign, and wine from foreign to home?
C) How do we find where relative prices settle
Foreign, as higher opportunity cost of cheese (steeper slope of alc/alw)
B) Yes, home should export cheese, and foreign should export wine
C) RICARDIAN MODEL - TRADE IS BASED OFF RELATIVE PRICES. As to where relative price settles… we need to find world relative supply
World relative supply of cheese expression
RS = Qc + Qc / Qw + Qw
(Quantity of h&f cheese / Q of h&f wine)
Pg 13:
When will:
A)no cheese be produced
B)home be indifferent to producing either, while foreign produces wine
C)Both countries specialise (whichever good they have a comparative advantage)
D)Home produces cheese, foreign is indifferent
E)No wine produced
A) Pc/Pw < aLc/aLw < a*Lc/aLw
(Since opp cost is greater than the rel price for both home and foreign)
B)
Pc/Pw = aLc/aLw < a*Lc/aLw
Home is indifferent (simple) but foreign opp cost of cheese is higher, so produce other good i.e wine
C) aLc/aLw < Pc/Pw < a*Lc/aLw
Since home has lower opp cost (produce cheese) and also lower than rel price, and foreign has higher opp cost for cheese that is above rel price so no point in producing so specialise in wine.
D) aLc/aLw < Pc/Pw = a*Lc/aLw
E) aLc/aLw < a*Lc/aLw < Pc/Pw
That shows relative supply in those scenarios.
Relative supply diagram pg 13
Y axis rel price of cheese Pc/Pw
X axis world supply Qc+Qc / Qw+Qw
Lower horizontal line marks alc/alw (home)
Top horizontal line marks alc/alw (foreign)
Vertical line is where both countries specialise entirely
What happens to relative demand of cheese if the relative price of cheese increases
demand less cheese and more wine, so relative QD of cheese falls!
What is this known as?
The substitution effect!! (Swapping wine for cheese since cheese becomes relatively more expensive in relation to wine
How to find the equilibrium relative price of cheese
b) intuition of the intersection
Where RD and RS curves intersect
B) Intersection is where both countries specialise. (Home only cheese foreign only wine)
(So relative prices determine amount produced, and relative prices are determined by RD & RS (INTERSECTION))
Scenario 2:
World relative price of cheese is equal to the opportunity cost of cheese at Home aLC /aLW, and less than opportunity cost of cheese in foreign
B0 Pg 16 graph
Pc/Pw = alc/alw < alc/alw
Ie home is indifferent in production. They don’t specialise in either. Foreign just producers wine
B) graph, relative demand line falls down to show
Pc/Pw=alc/alw line
So where do gains from trade come from?
Specialising in the good they have a comparative advantage in, and then using income generated to buy goods they desire.
In autarky no trade, what are real wages determined by?
Labour productivity
If we introduce trade what happens to real wages
Real wage is unchanged in terms of the exported goods, but rise in terms of the now cheaper imported goods.
(Makes sense since gains of trade come from the imported good being cheaper, rather than benefits from exporting)
How to express gains from trade in diagram pg20
Gains from trade come from a rise in real wage in terms of the imported goods. So expansion in consumption possibilities
Add a blue line to PPF (consumption possibility line)
(Home market can now consume more wine (the imported good)
Foreign market can consume more cheese (their imported good)
So that was Ricardian model with only 2 goods (wine and cheese)
Now consider model with multiple (n) goods produced. Indexed by i = 1,2,…N
How are the new unit labour requirements expressed?
B) where are goods produced?
aLi (for home)
a*LI (for foreign)
B) goods are produced wherever cheapest to produce them
If w x aL₁ < w* x a*L₁
What country will produce good 1
Only home country since total wage payments are less there.
How else to determine where a good will be produced?
B) expression
If relative productivity > relative wage, good will be produced in that country.
Rearrange the past inequality
aL₁/aL₁ = w/w
What determines relative wages w/w*
Relative S&D of labour
If relative wages rise, relative demand falls since cost of producing increases, and so less goods produced in the country, further reducing demand for domesitc labour services
Caviar a*li >ali = 4
A) Suppose w/w* increases from 3 to 3.99. Where is it produced and effect on labour
B) what if w/w* increases to 4.01. Where is it produced and effect on labour
Home still produces (as ali/ali > w/w) , but becomes more expensive so demand for caviar and labour falls
B) now relative wages>relative productivity in home for caviar, so caviar industry moves to foreign, causing DISCRETE (complete) drop in demand for home labour
Graph to show relative wage determination (pg 27)
RS is vertical (since it demonstrates the discrete drop once a industry fully moves to foreign - caviar in this instance)
Relative wage on Y axis w/w*
Relative quantitity of labour on X axis L/L*
Recap: For multiple good models - what determines comparative advantage
Cost advantage (from productivity or wage differentials)
2 ways:
1) If w aL₁ < w* aL₁ produce good 1 in home as cheap
2) if relative prod>rel wage aLi/aLi = w/w*
(This is for multiple goods, 2 goods model is based on different relative prices e.g aLc/aLw < Pc/Pw < aLc/aLw means both specialise!)
Comparative advantage is the whole concept of this model.
Why is testing comparative advantage hard IRL (3)
Principle model is weak (real world obviously more than 2 countries and goods)
Latent variable problem: observing Pa and trade at same time is impossible
Periods of autarky rare (so hard to get autarky prices)
So how to proceed upon these issues?
Deardorff: How to solve problem 1 (principle version too weak as simple like 2 countries, 2 goods)
States an economy’s net export vector at autarky prices is negative. (i.e export value should not exceed import value, since they export goods they have a lower opp cost/comparative advantage in, while importing goods expensive to produce domestically! thus gains from trade
How to address problem 1-3.
eval/issues (2)
Add determinants of autarky prices to model
Eval:
hard to do
becomes joint test of CA (not just seeing whether CA actually holds, but is model well specified)
If pA is autarky prices and t is net export vector
How to express
pA < t < 0
(Since t is negative rmb…)
But Pa is so rarely observed.
Bernhofen and Brown observe a near case. Where
Japan was a near closed economy in 1858 before trade was forced upon by the USA in 1859.
Findings using the graphical result
Aligned with CA - exported goods they had a comparative advantage in
And imported goods that had a higher autarky price (expensive to cost domestically)
Issues with relative labour costs itself w/w*
Not really comparable across countries
Overal criticisms of model (7)
Degree of specialisation - countries irl do not fully specialise e.g specific factors shows factors cannot move immediately and costlessly thus partial specialisation
Assumes everyone better off i.e ignores income distribution within countries
Resource differences (some may have better production conditions, or actual goods may differ too)
E.O.S exists for IRS, but this model only uses CRTS
Testing CA (3 problems - principle model weak, latent variable, periods of autarky rarely observed (par Berhofen and Brown on 1858 Japan)
One factor model is too simple - goods are produced with multiple inputs in reality
No reason for relative labour costs (w/w*) ;why one is more productive than another.
So Bernhofen and Brown supports CA;
Does MacDouggal?
Yes :
20/25 cases, countries export in sectors where relative aLi/aLi > w/w.
Eval:
Ignores transport costs, product differentiation, single factor of production etc.
