econ 405 topic1

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-1

Leah Marcal

• Education: B.A. in Economics –UC Santa Cruz

M.S. and PhD in Economics –UW Madison

• Background: Bass Lake

• Teaching Experience: ECON 160, 310, 406, and 500


Leah Marcal (cont.)

• Research: College Assessment Director

• Employer, alumni, and student satisfaction surveys

• Returns to college education

• Interests: Hiking

Texas Hold’em


Your Introductions:

• Name

• Home

• Employment

• Favorite movie


Syllabus

• Preparation: Completion of ECON 309 and 310, and

passed UDWPE

• Textbook: Krugman and Obstfeld, International

Economics: Theory and Policy, 8th edition


Syllabus (cont.)

• Review: Class website:

www.csun.edu/~lem50734/econ405index.html• PPT slides for each topic/lecture

• Answers to selected questions at the end of each chapter


Syllabus (cont.)

• Presentation: Teams of 4 or 5 students

50 min analysis of a current topic using PPT slides

Preference form (with team members) due next week!


Syllabus (cont.)

• Assessment: Presentation (20%)

Midterm (40%)

Final (40%)• Exams contain T/F, multiple choice, and essay

questions

• No make-up presentations or exams


Syllabus (cont.)

• Office Hours: JH 4250 on Wednesday from 6:00 to 6:50;

or by appointment

Email your questions: [email protected]

• Classes: 14 meetings: 10 lectures, 2 exams, and 2

student presentations


Date Topic Chapters

01-20 to02-17

International Trade 3, 4, 5, 8, and 9

02-24Student Presentations on Trade Topics

---

03-03 Midterm Exam ---

03-10 to 04-28

International Finance 12 through 16

05-05Student Presentations on Finance Topics

---

05-12 Final Exam ---

Slides prepared by Thomas Bishop Copyright © 2009 Pearson Addison-Wesley. All rights reserved.

Topic 1

Labor Productivity and Comparative Advantage: The Ricardian Model


Preview

• Opportunity costs and comparative advantage

• A one factor Ricardian model

• Production possibilities

• Gains from trade

• Wages and trade

• Misconceptions about trade

• Empirical evidence


Introduction

• Why trade?

Differences in resources (e.g., L, K, T, natural resources, and technology)

Economies of scale


Comparative Advantage and Opportunity Cost

• Ricardian model: differences in productivity of L between countries cause productive differences, leading to gains from trade.

• Ricardian model uses the concepts of opportunity cost and comparative advantage.

• The opportunity cost of producing good X is the cost of not being able to produce good Y because resources have already been used to produce good X.


Comparative Advantage and Opportunity Cost (cont.)

• A country faces opportunity costs when it uses resources to produce goods and services.

• E.g., a limited number of workers could be employed to produce roses or PCs. Opportunity cost of producing PCs is the amount

of roses not produced

Opportunity cost of producing roses is the amount of PCs not produced

How many PCs or roses should a country produce with the limited resources it has?



• Suppose U.S. can produce 10 million roses with the same resources that could produce 100,000 PCs.

• Ecuador can produce 10 million roses with the same resources that could produce 30,000 PCs.

• Workers in Ecuador are less productive than those in U.S. in manufacturing PCs.

• Question: what is the opportunity cost of roses in Ecuador?



• Ecuador has a lower opportunity cost of producing roses.

• U.S. has a lower opportunity cost of producing PCs.

Ecuador: 10 million roses or 30,000 PCs

US: 10 million roses or 100,000 PCs



• A country has a comparative advantage in producing a good if the opportunity cost of producing that good is lower in the country than it is in other countries.

• A country with a comparative advantage in producing a good uses its resources most efficiently when it produces that good compared to producing other goods.



• U.S. has a comparative advantage in the production of PCs.

• Ecuador has a comparative advantage in the production of roses.

• Suppose initially that Ecuador produces PCs and U.S. produces roses, and that both countries want to consume PCs and roses.

• Can both countries be made better off?


Comparative Advantage and Trade

Millions of Roses Thousands of

Computers

U.S. -10 +100

Ecuador +10 -30

Change 0 +70


Comparative Advantage and Trade (cont.)

• Example shows that when countries specialize in the good in which they have a comparative advantage, more goods can be produced and consumed. Initially both countries could only consume 10

million roses and 30,000 PCs.

With specialization, they could still consume 10 million roses, but could consume 70,000 more PCs.


A One Factor Ricardian Model

• Example with roses and PCs explains the intuition behind the Ricardian model.

• Ricardian model assumes:

1. L is the only resource for production.

2. Supply of L in each country is fixed.

3. Only 2 goods are produced and consumed: wine and cheese.

4. L is not specific to either industry.

5. Only 2 countries: home and foreign.


A One Factor Ricardian Model (cont.)

• aLW and aLC are the unit labor requirements to produce wine and cheese. Each reflects the number of L hours required to produce 1 unit of output.

E.g., if aLW = 2, then it takes 2 hours to produce 1 gallon of wine.

E.g., if aLC = 1, then it takes 1 hour to produce 1 lb of cheese.

A high unit labor requirement means low labor productivity.


Production Possibilities

• PPF of a country shows the maximum amount of goods that can be produced with a fixed amount of resources.

• PPF has the equation:

aLCQC + aLWQW = L

Labor used in cheese production

Labor used in wine production

Total labor supply


Fig. 1: Home’s Production Possibility Frontier


Production Possibilities (cont.)

aLCQC + aLWQW = L

• QC = L/aLC when QW = 0

• QW = L/aLW when QC = 0

• Slope of the PPF = ∆Qw / ∆Qc = – (aLC /aLW ) → opportunity cost of cheese

• Note: slope of any PPF reflects the opportunity cost of the good that is graphed on the x-axis (in terms of the good that is graphed on the y-axis).


Production Possibilities (cont.)

• The amount of the economy’s production is defined by: aLCQC + aLWQW ≤ L

• This equation describes what an economy can produce, but to determine what the economy does produce, we must determine the price of goods.


Production, Prices and Wages

• Let PC = price of cheese and PW = price of wine.

• Hourly wages reflect the value of what a worker can produce in 1 hour.

Hourly wage in cheese industry = PC /aLC

Hourly wage in wine industry = PW /aLW

• Workers will work in the industry that pays a higher hourly wage.


Production, Prices and Wages (cont.)

• If PC /aLC > PW/aLW (or PC /PW > aLC /aLW ) workers will make only cheese.

Economy specializes in cheese production if the relative price of cheese > opportunity cost of cheese.

• If PC /aLC < PW /aLW (or PC /PW < aLC /aLW ) workers will make only wine.

Economy specializes in wine production if the relative price of cheese < opportunity cost of cheese.


Production, Prices and Wages (cont.)

• If a country wants to consume both goods (without trade), relative prices must adjust so that wages are equal in both industries.

If PC /aLC = PW /aLW (or PC /PW = aLC /aLW ) workers have no incentive to work solely in the cheese industry or wine industry, so production of both goods can occur.

Production (and consumption) of both goods occurs when the relative price of a good = the opportunity cost of producing that good.


Trade in the Ricardian Model

• Suppose home has a comparative advantage in cheese production. Its opportunity cost of producing cheese is lower than in foreign.

aLC /aLW < a*LC /a*

LW

• where * indicates the foreign country


Trade in the Ricardian Model (cont.)

• Suppose home is more efficient in wine and cheese production.

• It has an absolute advantage in both goods:

aLC < a*LC and aLW < a*

LW

• A country can be more efficient in producing both goods, but it will have a comparative advantage in only 1 good—the good that uses resources most efficiently.


Trade in the Ricardian Model (cont.)

• Even if a country is the most (or least) efficient producer of all goods, it still can benefit from trade.

• To see how all countries can benefit from trade, we calculate relative prices when trade exists. Without trade, the relative price of a good equals its

opportunity cost.

• To calculate relative prices with trade, we must use relative supply and relative demand curves.


Relative Supply

• First we consider relative supply of cheese: the Qc supplied by all countries relative to the Qw supplied by all countries at each price of cheese relative to the price of wine, Pc /PW.


Fig. 2: Relative Supply Curve

aLC/aLW

a*LC/a*

LW RS

Relative priceof cheese, PC/PW

Relative quantityof cheese, QC + Q*

C

QW + Q*W

L/aLC

L*/a*LW


Relative Supply (cont.)

• There is no supply of cheese if its relative price falls below its opportunity cost. Why? because home will specialize in wine

whenever PC /PW < aLC /aLW

And we assumed that aLC /aLW < a*LC /a*

LW so foreign won’t produce cheese either.

• When PC /PW = aLC /aLW , home will produce both goods, but foreign will produce only wine.


Relative Supply (cont.)

• When a*LC /a*

LW > Pc /PW > aLC /aLW , home specializes in cheese and foreign specializes in wine. Here home produces L/aLC lbs of cheese and foreign produces

L* /a*LW gallons of wine. This, the relative supply of cheese =

L/aLC / L* /a*LW

• When PC / PW = a*LC /a*

LW, foreign produces both goods, but home produces only cheese.

• When Pc /PW > a*LC /a*

LW , there is no supply of wine.


Relative Demand

• Relative demand for cheese is the Qc demanded in all countries relative to the Qw demanded at each PC /PW.

• As PC /PW rises, consumers in all countries will tend to purchase less cheese and more wine so that the relative Qc demanded falls.


Fig. 3: World Relative Supply and Demand


Determination of Prices After Trade

• Equilibrium (PC /PW)t is determined by the intersection of RS and RD.

• In Fig. 3, point 1, each country specializes in the production of the good in which it has a comparative advantage. Home produces cheese and foreign produces wine.

• In Fig. 3, point 2, home produces both goods and foreign produces wine.


Gains From Trade

• Gains from trade come from specializing in the type of production which uses resources most efficiently, and using the income generated from that production to buy the goods and services that countries desire. where “using resources most efficiently” means

producing the good in which a country has a comparative advantage.


Gains From Trade (cont.)

• Think of trade as an indirect method of production or a means of converting cheese into wine or vice versa.

• Without trade, a country has to allocate resources to produce all of the goods that it wants to consume.

• With trade, a country can specialize its production and trade (“convert”) produced goods for the goods that it wants to consume.


Gains From Trade (cont.)

• Without trade, consumption is restricted to what is produced.

• With trade, consumption possibilities expand beyond the PPF.

• Easier to understand gains from trade by using a numerical example.


A Numerical Example

• aLC /aLW = 1/2 < a*LC /a*

LW = 2

Unit labor requirements for both countries

Cheese Wine

Home aLC = 1 hour/lb aLW = 2 hours/gal

Foreign a*LC = 6 hours/lb a*

LW = 3 hours/gal


A Numerical Example (cont.)

• Home has an absolute advantage in both goods, but it has a comparative advantage in cheese production.

• Foreign is less efficient in both goods, but it has a comparative advantage in wine production.

• Question: what is home’s opportunity cost of producing wine? What is its opportunity cost of producing cheese?


A Numerical Example (cont.)

• With trade, (PC /PW)t must be between aLC /aLW = 1/2 and a*

LC /a*LW = 2.

• Why? What if (PC /PW)t = 3? Then foreign would refuse to trade as it must give up 3 gal of wine to purchase 1 lb of cheese.

• Suppose that (PC /PW)t = 1.

In words, 1 lb of cheese trades for 1 gallon of wine.


Fig. 4: Equilibrium Price with Trade

RS

RD

3

(Pc/Pw)t = 1

aLC/aLW= 1/2

0

aLC*/aLW* = 2

(Qc + Qc*)/(Qw + Qw*)

Pc/Pw

Assumes L = L* = 30

Fig. 5: Gains from Trade Trade

L/aLW = 15

Qc

QwHome

L/aLC = 30

CPFt

PPF

20

10

30

0 Qc*

Qw* Foreign

L*/a*LC = 5

CPFt*

PPF*

100

L*/a*LW = 10

Note: Slope of the PPF in each country is the opportunity cost of cheese in terms of wine (i.e., ½ for home and 2 for foreign) and the slope of the CPFt for both countries is the traded price (i.e., 1).

Assumes each country has 30 hours of labor available (i.e., L = L* = 30).


Gains from Trade (cont.)

• Question: What drives the two countries to specialize? Home views (Pc/Pw)t = 1 which is greater than its

opportunity cost of cheese (1/2), so it increases its production of cheese.

Foreign also views (Pc/Pw)t = 1 which is lower than its opportunity cost of cheese (2), so it decreases its production of cheese and increases its production of wine.

Gains from Trade (cont.)H

ome before trade

after trade

in 1 hr could produce 1 C or ½ W

in 1 hr produces 1 C and trades for 1 W

before trade

after trade

in 1 hr could produce 1/6 C or 1/3 W

in 1 hr produces 1/3 W and trades for 1/3 CFor

eign

Labor is used twice as effectively when trading for what it needs instead of producing everything itself.


Wages

• Although the Ricardian model predicts that relative prices equalize across countries after trade, it does not predict that relative wages will equalize.

• Productivity differences determine wage differences in the Ricardian model.


Wages (cont.)

wage = 1 lb cheese/hr or ½ gal of wine/hr

wage* = 1/6 lb of cheese/hr or 1/3 gal of wine/hr

Before trade:

wage = 1 lb cheese/hr exchange for 1 gal of wine/hr

wage* = 1/3 gal of wine/hr exchange for 1/3 lb of cheese/hr

After trade:

Before trade (in terms of cheese) wages are 6x higher at home. After trade, wages are only 3x higher at home.


Wages (cont.)

• Recall: home has an absolute advantage in both goods as it is 6x more productive in cheese and 1.5x more productive in wine.

• Foreign wages are 1/3 of home’s wages with trade.

• Foreign has a cost advantage in making wine (even though home is 1.5x as productive in wine) because of its low wages.


Wages (cont.)

• Because foreign workers have a wage that is only 1/3 the wage of domestic workers, they are able to attain a cost advantage (in wine production), despite low productivity.

• Because domestic workers have a productivity that is 6 times that of foreign workers (in cheese production), they are able to attain a cost advantage, despite high wages.


Misconceptions About Trade

1. Free trade is beneficial only if a country is more productive than foreign countries.

The least efficient country can still gain from trade by specializing in its least inefficient (i.e., comparative advantage) industry.

• Our example shows home has an AA in both goods. Yet, foreign still gains by producing wine (its least inefficient good).

The benefits of free trade do not depend on absolute advantage. They depend on comparative advantage: specializing in industries that use resources most efficiently.


Misconceptions About Trade (cont.)

2. Free trade with countries that pay low wages hurts high wage countries.

Our example shows home is more productive in both goods and therefore has higher wages than foreign.

Foreign’s lower wages are irrelevant to the question of whether home gains from trade.

Home gains from trade because it is cheaper in terms of its own labor for home to produce cheese and trade for wine rather than produce wine itself.


Misconceptions About Trade (cont.)

3. Free trade exploits less productive countries.

• Bob Herbert in NY Times (1995): wages CEO of Gap = $2 million/year vs. wages of its workers in Central America = $0.56/hr.

• Free trade does not make poor workers worse off. What are their alternatives?

• Our example shows (with trade) foreign workers are paid 1/3 of what home workers are paid, Yet, without trade, foreign workers earn only 1/6 of home’s workers.


Empirical Evidence• Ricardian model predicts that countries tend to export

goods in which their productivity is relatively high.

• World trade in textiles/apparel illustrates the principles of comparative advantage. By any measure, the U.S. has a higher labor productivity in

manufacturing than that of newly industrialized countries (e.g., China or Mexico).

Technology of manufacturing clothing is relatively simple, so the productivity advantage of advanced countries in textiles is less than their advantage in many other industries.

In 1992, average U.S. worker was 5x as productive as a Mexican worker but only 1.5x as productive in textiles.

Thus, textiles/apparel are a major export from low-wage to high-wage countries.

econ 405 topic1

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