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Class 3 Relative Comparative Advantage & Introduction To Neoclassical Trade Theory

This document provides an overview of comparative advantage theory and examples demonstrating how trade benefits countries. It discusses Adam Smith's model showing how countries specialize based on absolute advantage. David Ricardo's model introduced comparative advantage, showing even if one country has an absolute advantage in all goods, trade can still benefit both if they specialize in their comparative advantage. Examples illustrate how opportunity costs determine comparative advantage through production possibility frontiers and gains from trade through increased consumption possibilities. Money and exchange rates are also introduced to compare costs between countries.

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Yulia Ahmed
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145 views

Class 3 Relative Comparative Advantage & Introduction To Neoclassical Trade Theory

This document provides an overview of comparative advantage theory and examples demonstrating how trade benefits countries. It discusses Adam Smith's model showing how countries specialize based on absolute advantage. David Ricardo's model introduced comparative advantage, showing even if one country has an absolute advantage in all goods, trade can still benefit both if they specialize in their comparative advantage. Examples illustrate how opportunity costs determine comparative advantage through production possibility frontiers and gains from trade through increased consumption possibilities. Money and exchange rates are also introduced to compare costs between countries.

Uploaded by

Yulia Ahmed
Copyright
© Attribution Non-Commercial (BY-NC)
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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THEORY OF COMPARATIVE

ADVANTAGE
CLASS 3
Relative comparative advantage &
Introduction to neoclassical trade
theory
Smith’s model: 2*2
q=Q/hrs of labor USA GB
WHEAT (bushels/hr) 6 1
CLOTH (yard/hr) 1 3
• Abs. Advantage and the course of trade:
– USA: wheat (6>1) → EX:W, IM: C
– GB: cloth (3>1) → EX:C, IM: W

• Gains from trade: let’s assume that USA and GB exchange 6W for 3 C → what
are the gains for both countries
• USA: EX=6W: the production takes 1 hour
IM=3C: own production would take 3 hours
gain: 2 hours of labour=12W/2C (hours of labour=1; consumption equals 3 hours of
own labour)

• GB: EX=3C: the production takes 1 hour


• IM=6W: own production would take 6 hours
gain: 5 hours of labour=5W/15C (hours of labour=1; consumption equals 6 hours of
own labour)
2
BOTH COUNTRIES GAIN BY SPECIALIZING AND TRADING
D. RICARDO: THEORY OF COMPARATIVE
ADVANTAGE
q=Q/hrs of labor USA GB
WHEAT (bushels/hr) 6 1
CLOTH (yard/hr) 3 2
• USA: absolute advantage in production of both goods
• Can trade still be beneficial for both countries?
– Smith: NO.
– Ricardo: YES: concept of COMPARATIVE (RELATIVE) ADVANTAGES
= in product in which country has greater absolute advantage or minor
absolute disadvantage
– USA: 6x more productive in W compared to GB
1,5x more productive in C compared to GB
– CA: USA: W (its abs. Advantage is greater in production of W)
GB: C (its abs. disadvantage is minor in production of C)
– Trade direction and gains form trade: A country will gain by specializing
in the production of good in which it has a comparative advantage, exporting
this good and importing other(s) (in which it has a com. disadvantage).
3
THEORY OF COMPARATIVE ADVANTAGE:
gains from INTERNATIONAL TRADE
q=Q/hrs of labor USA GB
WHEAT (bushels/hr) 6 1
CLOTH (yard/hr) 3 2

• Determine the “national relative prices” in case of no trade


• Let countries exchange 6 units of W for 6 units of C: show that such trade
is beneficial for both countries!
1. CA: USA: W, GB: C
2. Direction of IT:
– USA: EX 6W, IM 6C
– GB: EX 6C, IM 6W
3. Gains from IT:
• USA: EX=6W: the production takes 1 hour
IM=6C: own production would take 2 hours
gain: 1 hour of labour=6W/3C
• GB: EX=6C: the production takes 3 hours
IM=6W: own production would take 6 hours
gain: 3 hours of labour=3W/6C
– BOTH COUNTRIES HAVE GAIN FROM IT (=9W/9C) 4
T.CA-International price range
q=Q/hrs of labor USA GB
WHEAT (bushels/hr) 6 1
CLOTH (yard/hr) 3 2

1. Calculate unit production costs/price for W and C in each


country before IT: P=1/q
2. Calculate relative costs/prices (price ratio) for W and C
each country before IT (=autarky equilibrium price ratio)
→ relative costs/prices determine opportunity costs)
3. Determine once again the comparative advantages!
• This time by comparing relative prices of goods in both countries
4. International relative price range (price range which
ensures beneficial IT for both countries)
• Rel. price in exporting country < world rel. price < Rel. price in
importing country 5
Ricardo’s constant rel. costs and the
production-possibility curve (PPC)
• PPC shows all the combination of output of different
goods that an economy can produce with full
employment of resources (L) and maximum
productivity (best available technology)

• Ricardo: Constant relative (opportunity) costs → linear


PPC (straight line)

PX*QX+ PY*QY ≤ L or
QX/qx + QY/qy ≤ L

• Absolute value of the slope of PPC =


MRTYX=OCX=PX/PY=qY/qX 6
Gains from specialisation and trade
NO TRADE (AUTARKY)
• the consumption possibilities are bounded by the PPC
• production equilibrium point = consumption eq. point
• autarky relative price is equal to rel. costs (slope of PPC)
DETERMINATION OF CA
• country with the lower relative cost in production of a good has a CA
• comparison of the slopes of the PPCs!
FREE TRADE: each country can trade at Pw
• Production: complete specialisation according to CA (point A/A’)
• Consumption: above the PPC on the trade line
• (determination of consumption point → indifference curves)

QY Country 1 QY Country 2
A

A’
QX QX
7
• Changes in consumption and production equilibria as a
country moves from autarky to free trade

Country A Country B
y y
P2
C’2
C2
C1
C’1 P’2
x x

8
Example 1
Consider following example, using standard Ricardian assumptions:

L hours per bottle of L hours per kg of


WINE CHEESE
VINTLAND 15 10
MOONITED Rep. 10 4

Vintland has 30 million hours of labour in total per year.


Moonited Republic has 20 million hours of labour per year.

a) Which country has an absolute advantage in wine? In cheese?


b) Which country has a comparative advantage in wine? In cheese?
c) Graph each country’s production-possibility curve. Using community
indifference curves, show the no-trade equilibrium for each country
(assuming that with no trade, Vintland consumes 1.5 million kilos of cheese
and Moonited Republic consumes 3 million kilos of cheese.

9
Example 1
L hours per bottle of L hours per kg of
WINE CHEESE
VINTLAND 15 10
MOONITED Rep. 10 4

d) When trade is allowed, which country exports which good? If


the equilibrium international price ratio is 0.5 bottle of vine
per kilo of cheese, what happens to production in each
country?
e) In this free-trade equilibrium, 2 million kilos of cheese and 1
million bottles of wine are traded. What is the consumption
point in each country with free trade? Show this graphically
using community indifference curves.
f) Does each country gain from trade? Explain why, referring to
your graphs. 10
Example 2

Quantity per unit of Slovenia Croatia


labor
peas 10 6
apples 2 4
a) Where do absolute advantages lie? Would trade have
happened according to A.Smith? What about comparative
advantages?
b) What if Slovenia has 20 units of labor at its disposal and
Croatia has 30 units. Draw the production possibility frontiers
and explain how the graph indicates comparative advantage.
c) Assume that free trade happens as 1 unit of apples get traded
for 3 units of peas. Show the autarky and free-trade equilibria
on the graph.
11
Example 3

Quantity per Country A Country B


unit of labor
Food 10 6
Manufactures 8 4

• Determine the exchange ratio within which mutually


beneficial trade can take place.
• Assume that in free-trade equilibrium 8 units of food are
exchanged for 6 units of manufacturing products. What is
the gain from free trade in country A and B in terms of
food?

12
Introduction of money/currency
• Up to this point all prices were measured in terms of the
labor employed in their production
• If wages are allowed to differ between the two countries,
they become an important determinants of the costs of
production and the price competitiveness

P = Lw/Q

• In order to compare prices, we will have to rely on the use


of exchange rates of the two countries’ currencies

13
Example 4
costs in L units per costs in L units
unit of wool per unit of steel
United States 3 2
Great Britain 4 4

• Determine the span of exchange rates that ensure


that trade will take place in line with the
predictions of classical trade theory, if you know
that a unit of labor costs 2$ in the US and 1£ in
GB.

14
Solution of example 4
• For the comparative advantage to “work”, GB has to
export wool and the US steel. This will not happen if
the exchange rates are either too high or too low.
condition 1 (wool): PGB < PUS
L*wGB < L*wUS
4*1£*t ($/ £) < 3*2$
t ($/ £) < 3/2 $/ £
Determines the upper limit of the exchange rate range.

15
Solution of example 4 (cont.)

condition 2 (steel): PGB > PUS


L*wGB > L*wUS
4*1£*t ($/ £) > 2*2$
t ($/ £) > 1/2 $/ £
Determines the lower limit of the exchange rate
range. The range of exchange rates that allows
trade between the two countries to take place
according to their comparative advantage:

1/2 $/ £ < t($/ £) < 3/2 $/ £


16
Example 5
costs in L units per costs in L units
unit of steel per unit of cheese
France 6 2
Japan 4 3

• Assume that the ¥/€ exchange rate is 1€=100¥.


Determine the range of relative wages that would
make comparative-advantage based trade possible.

17
Neoclassical trade theory

Heckscher-Ohlin
Heckscher-Ohlin-Samuelson model
Increasing marginal costs
• More than one factor of production (neoclassical
theory):
– Increasing marginal costs: Different products use factor
inputs in different proportions therefore the proportion in
which resources are released from one industry is different
from the prevailing factor proportion in the other industry
to which released resources are shifted (similar to the law
of diminishing returns) ➩ increasing opportunity costs
(OCX=-ΔY/ΔX)↑ : as one industry expands, increasing
amounts of the other good must be given up to produce
extra unit of expanding output.
– Increasing opportunity costs + constant returns to scale ➩
concave PPC ➩incomplete specialization in production
19
Community indifference curves
Adding the demand conditions:
• Preferences of consumers are presented by community indifference
curve: shows the various consumption combinations of good X and
Y that yield equivalent satisfaction for the community or country.
• Different preferences (tastes) among countries → different
indifference curve
• Adding the indifference curves allows us to determine:
– Autarky equilibrium in production and consumption and
autarky eq. Price
– Consumption point in free trade
– World price (TOT)
• “usual” assumptions for preferences of an individual (more is
preferred to less, transitivity of preferences) + community indif.
Curve must not intersect (income redistribution effect).

20
Slope of the indifference curve =
marginal rate of substitution
• community indiff. curves are downward-sloping: if
consumers reduce the level of consumption of one
good they have to increase consumption of the other
good to maintain the same satisfaction level
• The slope (in absolute value) reflects marginal rate of
substitution: MRSYX= - ΔY/ΔX = MUX/MUY : amount
of good Y the consumers are willing to give up for
consumption of additional unit of X (unchanged
utility)
• MRSYX is diminishing as we move toward
consumption of a greater number of units of good X
along any given indifference curve → law of
diminishing marginal utility → Indifference curves
are convex to the origin.
21
Autarky equilibrium in neoclassical trade
Y

I3
I2
I1
I4

Px/Py

22

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