1 Lecture 3 Comparative Advantage and the Gains from Trade Econ 340 Lecture 3: Comp. Advantage 2 Outline: Comparative Advantage and the Gains from Trade • Why Countries Trade – Price Differences – Supply and Demand – Determinants of Prices • Ricardian Model of Trade – Examples – Wages and Prices in the Ricardian Model – Lessons from the Ricardian Model • Generality of the Gains from Trade • Identifying Comparative Advantage • Critiques of Comparative Advantage Lecture 3: Comp. Advantage 3 Why Countries Trade • Price differences – If prices differ by more than transport costs • Buyers in high-price country will import • Sellers in low-price country will export • Anybody in any country can profit by doing both – Buying in low-price country and – Selling in high-price country2 Lecture 3: Comp. Advantage 4 Why Countries Trade – Thus, in all cases: imports exports is,that trade: toleadmay BABAPPBA→< € PA< PBwill lead to : trade A → Bif PB− PA> tt = trade costLecture 3: Comp. Advantage 5 Why Countries Trade: Supply and Demand Country B P Q Country A P Q DA DB SB SA PA PB “Autarky” = No trade Autarky price in country A Autarky price in country B PB Lecture 3: Comp. Advantage 6 Country B P Q Country A P Q DA DB SB SA PA PB PF Exp Imp Why Countries Trade: Supply and Demand Free Trade = No barriers to trade PF is defined by these two distances being equal.3 Lecture 3: Comp. Advantage 7 Country B P Q Country A P Q DA DB SB SA PA PB PF Exp Imp a c b d Use areas to measure gains and losses. Lecture 3: Comp. Advantage 8 A’s demanders lose -a Gains and losses from trade: Country B PQCountry A PQDA DB SB SA PA PB PF Exp Imp acbdLoss of Consumer Surplus Lecture 3: Comp. Advantage 9 A’s demanders lose -a A’s suppliers gain +(a+b) Gains and losses from trade: Country B PQCountry A PQDA DB SB SA PA PB PF Exp Imp acbdGain of Producer Surplus4 Lecture 3: Comp. Advantage 10 A’s demanders lose -a A’s suppliers gain +(a+b) →Country A gains +b Gains and losses from trade: Country B PQCountry A PQDA DB SB SA PA PB PF Exp Imp acbdLecture 3: Comp. Advantage 11 A’s demanders lose -a A’s suppliers gain +(a+b) Country A gains +b B’s demanders gain +(c+d) Gains and losses from trade: Country B PQCountry A PQDA DB SB SA PA PB PF Exp Imp acbdGain of Consumer Surplus Lecture 3: Comp. Advantage 12 A’s demanders lose -a A’s suppliers gain +(a+b) Country A gains +b B’s demanders gain +(c+d) B’s suppliers lose -c Gains and losses from trade: Country B PQCountry A PQDA DB SB SA PA PB PF Exp Imp acbdLoss of Producer Surplus5 Lecture 3: Comp. Advantage 13 A’s demanders lose -a A’s suppliers gain +(a+b) Country A gains +b B’s demanders gain +(c+d) B’s suppliers lose -c →Country B gains +d Gains and losses from trade: Country B PQCountry A PQDA DB SB SA PA PB PF Exp Imp acbdLecture 3: Comp. Advantage 14 A’s demanders lose -a A’s suppliers gain +(a+b) Country A gains +b B’s demanders gain +(c+d) B’s suppliers lose -c Country B gains +d → World gains +(b+d) Gains and losses from trade: Country B PQCountry A PQDA DB SB SA PA PB PF Exp Imp cbdLecture 3: Comp. Advantage 15 What Determines Prices, and Thus Trade? • Prices determined by – Productivity of labor (and other factors) – Price of labor (w=wage) – Exchange rate (E) (i.e., prices of currencies) • Since w and E are largely common to all sectors – The main determinant of how individual sectors trade (i.e., whether they export or import) is Productivity in sectors – High (relative) productivity • Implies low (relative) price • And hence export6 Lecture 3: Comp. Advantage 16 Adjustment Mechanism • What if all of a country’s prices are too high for it to export at all? Then either: – Exchange rate (value of currency) will fall • Because otherwise nobody would buy its currency, Or: – Wages will fall • Because nobody would hire its labor èEither of these will lower the country’s prices Lecture 3: Comp. Advantage 17 Outline: Comparative Advantage and the Gains from Trade • Why Countries Trade – Price Differences – Supply and Demand – Determinants of Prices • Ricardian Model of Trade – Examples – Wages and Prices in the Ricardian Model – Lessons from the Ricardian Model • Generality of the Gains from Trade • Identifying Comparative Advantage • Critiques of Comparative Advantage Lecture 3: Comp. Advantage 18 Ricardian Model of Trade • Due to David Ricardo (1772-1823) Assumptions: • Production uses only labor • Technology: – Constant unit labor requirements (labor per unit of output) – Or equivalently, constant labor productivities (output per unit of labor) (“constant” means “doesn’t vary with output”)7 Lecture 3: Comp. Advantage 19 Ricardian Model of Trade • Example 1 (Absolute Advantage): 2 goods Food Cloth 2 countries A=US B=UK • Data: Labor requirements per unit US UK Food (hr/lb) .01 .02 Cloth (hr/yd) .02 .01 Labor endowment (workers) 10 10 Lecture 3: Comp. Advantage 20 Ricardian Model of Trade • Autarky Equilibrium (Example only) US UK Food @ .01 .02 Cloth @ .02 .01 Labor 10 10 Labor allocations Food 4 6 Cloth 6 4 Production = Consumption Food 400 300 Cloth 300 400 = 4/.01 = 6/.02 Lecture 3: Comp. Advantage 21 Ricardian Model of Trade • Trade – If countries had the same currency and same wage = $10/hr, then – Thus • US produces Food • UK produces Cloth – Suppose they both completely specialize • (i.e., US produces only food and UK only cloth) UKCLothUSClothUKFoodUSFoodPPPP=>==<=10.0$20.0$20.0$10.0$US UK Food .01 .02 Cloth .02 .018 Lecture 3: Comp. Advantage 22 Ricardian Model of Trade • Trade Equilibrium US UK Food @ .01 .02 Cloth @ .02 .01 Labor 10 10 Production Food 1000 0 Cloth 0 1000 Possible Consumption Food 500 500 Cloth 500 500 Lecture 3: Comp. Advantage 23 Ricardian Model of Trade • Compare consumption in autarky and trade: Consumption in Autarky Food 400 300 Cloth 300 400 Lecture 3: Comp. Advantage 24 Ricardian Model of Trade • Compare consumption in autarky and trade: • Trade permits consumption to be higher,
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