Week 7 Lesson 1 Flashcards
Overview of Comparative Advantage Models
Definition:
Comparative advantage models explain inter-industry trade patterns based on differences in:
- Productivity
- Technology
- Human Capital
- Resource Endowment
- Geography
Core idea:
Countries specialise in producing goods where they have a comparative advantage, maximising efficiency and global trade benefits
The Ricardian Model (1817)
Key assumptions:
- One factor of production: Labor
- No migration: Labor cannot move between countries.
- Constant productivity: Labor productivity differs across countries due to technology but is constant within each country.
- Two industries or two goods
- Two countries: Home and Foreign
- Compretition allows workers to be paid a “competitive” wage equal to the value of what they produce, and allows them to work in the industry that pays the highest wage
- Identical preferences
Core idea:
- Trade benefits arise from comparative advantage, not absolute productivity
- Opportunity cost: What is given up to produce on good over another
Example:
- US: Lower opportunity cost in producing computers
- Colombia: Lower opportunity cost in producing roses
- Trade benefits both as they specialise and exchange goods
Takeaway: Countries should specialise based on comparative advantage to maximise global efficiency
Comparative Advantage and Opportunity Costs
Key idea:
- Countries allocate limited resources efficiently
- Wages reflect productivity, and workers move to industries with higher wages
Implications:
- Comparative advantages are not based on absolute productivities but on opportunity costs
- Each country will have a comparative advantage (lower opportunity cost) in one product
- Wages reflect productivty
- Free mobility of workers between industries ensure that relative prices in each country are equal to opportunity cost
- Before trade each country will have a lower relative price of the product in which it has a comparative advantage
Real-World Example:
US: High investment in R&D and technology innovation leads them to export computers
Colombia: Cheap labour and adequate climate leads them to export roses
Roses and Computers:
- Suppose that in the U.S. 10 million roses could be produced with the same resources that could produce 100,000 computers
- Suppose that in Colombia 10 million roses could be produce with the same resources that could produce 30,000 computers.
- Workers in Colombia would be less productive than those in the U.S. in manufacturing computers
- Colombia has a lower opportunity cost of producing roses and hence has a comparative advantage as the opportunity cost is lower
The U.S. has a lower opportunity cost of producing computers and hence has a comparative advantage
Predictions:
- The difference in prices, pre-trade, creates a potential for trade
- Each country will export the product in which it has a comparative advantage
- Trade will lead to convergence of relative prices
- In each country, the relative price of the exported product increase
- Because wages are linked to prices, wages in the exporting industry increase
- The assumption of perfect mobility of workers between industries imply that in each country workers experience an increase in real wages
Key takeaway:
Trade minimises effiency by aligning production with comparative advantage
Gains from trade
Key idea:
- Gains arise from specialisation and using income from exports to import desired goods
- Trade expands consumption possibilities beyond domestic production limits
Benefits of trade:
- Higher wages: export-focused industries see wage growth
- Resource efficiency: Countries focus on what they produce best
- Expanded consumption: Access to more goods/services globally
Key takeaway:
Trade improves resource allocation, raises wages, and expands consumption options
The Heckscher-Ohlin Model (H-O Model)
Core idea:
The Heckscher-Ohlin theory argues that trade occurs due to differences in labour, labour skills, physical capital, capital, or other factors of production across countries.
The Ricardian model does not take into account any differences in resources. So it does not take into account that Canada would be an exported of wood.
Assumptions:
- Factor Abundance: Countries differ in labour and capital supply (some countries have more labour than capital)
- Factor intensity: industries use resources differently (e.g., food = capital-intensive, cloth = labour-intensive)
- No migration: Factos of production can move between industries but not across borders
Example:
- Country A (Labor-Abundant): Exports labor-intensive goods (e.g., cloth).
- Country B (Capital-Abundant): Exports capital-intensive goods (e.g., food).
Factor Prices and Input Choices:
- Assume that at any given factor prices, cloth production uses more labour relative to capital than food production uses:
Lc/Kc>Lf/Kf
- Production of cloth is relatively labour intensive, while production of food is relatively capital intensive
- Relative factor demand curve for cloth CC lies outside that for food FF
Key Takeaway:
Countries export goods that use their abundant resources most intensively.
Relative Factor Abundance (In the Heckscher-Ohlin Model)
Relative Factor Abundance:
- Country B is larger than Country A (but that does not really matter_
- Labour, in comparison to capital, is relatively more abundance in Country A
- Capital, in comparison to labour, is relatively more abudance in Country B
Short answer: Models of comparative advantage
Models of comparative advantage explain why countries trade by focusing on differences in productivity, technology, human capital, resource endowment, and geography. These models highlight inter-industry trade patterns, showing that countries specialize in goods where they have a comparative advantage—producing them at a lower opportunity cost. For example, a country with advanced technology might specialize in producing computers, while another with abundant agricultural resources focuses on food production. The key takeaway is that trade benefits all participants by improving efficiency and allowing consumption beyond their domestic production limits.
Short answer: The Ricardian model
The Ricardian Model, developed by David Ricardo, explains trade based on labor productivity differences across countries due to technology differences.
It assumes:
- One factor of production (labor).
- Constant labor productivity within each country.
- No migration of labor between countries.
Countries specialize in producing goods where they have a comparative advantage—the lowest opportunity cost. For example, Portugal specializes in wine, while England focuses on cloth. The model shows that even if one country is better at producing everything, both still benefit from trade by specializing based on comparative advantage.
Short Answer: Comparative Advantage and Opportunity Costs
Opportunity cost refers to the value of the next-best alternative foregone when choosing to produce one good over another. In the context of trade, a country has a comparative advantage if the opportunity cost of producing one good is lower than in other countries. For example, if Colombia can produce 10 million roses instead of 30,000 computers, while the U.S. can produce 10 million roses instead of 100,000 computers, Colombia has a comparative advantage in roses, and the U.S. in computers. The Ricardian Model highlights that comparative advantage arises from these relative differences in opportunity costs, not absolute productivity. This principle explains why countries benefit from specializing in goods with the lowest opportunity cost.
Short answer: The Heckscher-Ohlin (H-O) model
The Heckscher-Ohlin (H-O) Model explains trade based on differences in factor sizes —specifically labor and capital. It assumes two factors of production, identical technology across countries, and factor mobility within but not between countries (no migration). A labor-abundant country will specialize in labor-intensive goods (e.g., textiles), while a capital-abundant country will specialize in capital-intensive goods (e.g., machinery). For example, Bangladesh exports textiles, and Germany exports machinery. The H-O Model predicts that trade increases the income of the abundant factor (wages in labor-rich countries, capital returns in capital-rich countries). It highlights how resource distribution shapes trade patterns.
Short answer: Gains from trade (Predictions of trade patterns)
Gains from trade arise when countries specialize in producing goods where they hold a comparative advantage and trade with others. Specialization allows each country to allocate resources more efficiently, increasing total world output. Trade expands consumption possibilities beyond a country’s Production Possibility Frontier (PPF). For example, by trading roses and computers, Colombia and the U.S. can both consume more of each good than if they produced independently. Additionally, wages in export-oriented industries rise as the price of exported goods increases. The core insight is that trade enhances efficiency, increases income, and improves living standards globally.
Short answer: Factor Prices and Input choices
In the H-O Model, factor prices (e.g., wages for labor, returns on capital) determine production costs and trade patterns. Industries adjust their input choices based on changes in these prices.
Key principle:
An increase in the price of a good raises the income of the factor used intensively in its production (Stolper-Samuelson Theorem).
For example:
In labor-abundant countries, an increase in the price of textiles raises wages.
In capital-abundant countries, an increase in machinery prices raises capital returns.
This interaction shows how trade redistributes income across factors of production.
Trade in the H-O model
The Heckscher-Ohlin Model predicts that countries will:
- Export goods that intensively use their abundant factor (e.g., labor or capital).
- Import goods that intensively use their scarce factor.
For example:
- Vietnam (labor-abundant) exports textiles (labor-intensive).
- Japan (capital-abundant) exports electronics (capital-intensive).
Trade causes the relative prices of goods to converge globally, and resources are allocated where they are most productive, leading to increased global efficiency and welfare.
GIRLYPOP VERSION
Okay queen, imagine two countries: “Textilia” (lots of workers, not many factories) and “Machineland” (super techy, loads of factories, few workers).
Textilia: Labor is cheap and plentiful, so they slay at making labor-intensive goods like cute clothes and handmade bags. 👜✨
Machineland: Factories and machines are everywhere, so they dominate in capital-intensive goods like fancy cars and tech gadgets. 🚗💻
When they trade:
Textilia exports clothes.
Machineland exports gadgets.
Everyone wins because each country focuses on what they’re naturally good at, using their abundant resource efficiently. The prices of goods start balancing out across both countries, and trade becomes a win-win collab.
Takeaway: Trade happens because countries specialize based on their resource abundance—Textilia uses its cheap labor, and Machineland uses its expensive machinery. 💖🤝
Short answer: Relative prices and the pattern of trade
In the H-O Model, the relative price of goods reflects the cost of labor and capital. In a labor-abundant country, labor costs less, making labor-intensive goods cheaper. Conversely, in a capital-abundant country, capital costs less, making capital-intensive goods cheaper. When trade begins, the low price of labor-intensive goods in labor-abundant countries leads to their export. Similarly, capital-intensive goods become export goods for capital-abundant countries. Over time, trade drives price convergence and improves global resource efficiency.
GIRLYPOP
Okay babe, let’s talk shopping economics.
In Textilia (labor-abundant country), labor is cheap because there are SO many workers. So, making clothes and handmade goods costs less. 🧵✨
In Machineland (capital-abundant country), capital (factories, machines) is cheap, so building cars and gadgets is more cost-effective. 🚗💻
When they start trading:
Textilia exports cheap clothes to Machineland.
Machineland exports sleek gadgets to Textilia.
Now, the prices of clothes and gadgets start balancing out between the two countries because demand and supply adjust.
Takeaway: Trade happens because goods are cheaper to produce in the country with the right resources, and prices even out globally over time. 💸🌍
