Introductory Macroeconomics - Lecture 18: International Trade II PDF

Introductory Macroeconomics Lecture 18: International Trade II Jonathan Thong Daniel Minutillo 2nd Semester 2024 1  This Lecture International Trade II – production possibilities frontier – absolute vs. compa...

Introductory Macroeconomics Lecture 18: International Trade II Jonathan Thong Daniel Minutillo 2nd Semester 2024 1  This Lecture International Trade II – production possibilities frontier – absolute vs. comparative advantage – specialization and trade: the Ricardian model BOFAH Chapter 16 2  Reasons for Trade Why do countries trade with each other? Countries have different – technologies – endowments of capital and labour, natural resources etc – consumer tastes Will study the Ricardian model, based on differences in technologies 3 Production Possibilities Frontier 4  Production Possibilities Frontier (PPF) A fixed labour force can produce manufactures or services L = Lm + Ls Assume each good follows simple linear production functions Ym = Am Lm , Ys = As Ls Production possibilities frontier: (PPF) Can produce any combination of Ym , Ys satisfying Ym Ys As L = + ⇔ Ys = As L − Ym Am As Am 5  Production Possibilities Frontier (PPF) As Ys = As L − Ym Am Intercept. Services produced when all labour focuses on services As L (or, re-arrange to find Am L if labour focuses on manufactures) Slope. The marginal technical rate of substitution, the rate at which you can substitute production of services for production of manufactures, i.e. the opportunity cost dYs As = − dYm Am 6  A Numerical Example Assume the US labour force is L = 200 Suppose in the US one unit of labour produces Services Manufactures US (As =)8 (Am =)2 Implies a PPF: Ys = 8 × 200 − 82 Ym = 1600 − 4Ym The opportunity cost of one manufacture is 4 services Alternatively Ym = 2 × 200 − 82 Ys = 400 − 14 Ys 1 The opportunity cost of one service is 4 manufactures 7 Production Possibilities Frontier (PPF) 8  Consumption: Measuring Welfare We will measure welfare using levels of consumption Key simplifying assumption: Preferences are perfect complements Implies quantities consumed x = Ys = Ym As Am As x = As L − x ⇔ x= L Am Am + As Example 1600 x = 1600 − 4x ⇔ x= = 320 5 9 Consumption 10 Absolute vs. Comparative Advantage 11  Absolute Advantage Assume labour forces are LUS = 200 and LChina = 800 Suppose one unit of labour produces Services Manufactures US 8 2 China 1 4 US has absolute advantage in services China has absolute advantage in manufactures Adam Smith’s logic: specialise in absolute advantage 12  Problem? Problem: what if a country never has an absolute advantage? Now suppose one unit of labour produces Services Manufactures US 8 4 China 1 2 US has absolute advantage in both manufactures and services But China has absolute advantage in neither 13  Absolute vs. Comparative Advantage Ricardo’s insight is that only comparative advantage matters An economy has: – an absolute advantage in a good if it can produce more of that good (for a given amount of input) than any other country – an comparative advantage in a good if it can produce that good at lower opportunity cost than any other good (opportunity cost of an activity is what we give up to do it) Countries can benefit from trade even if no absolute advantage 14  Comparative advantage Services Manufactures US 8 4 China 1 2 United States has comparative advantage in services Ys,US = 1600 − 2Ym,US China has comparative advantage in manufactures 1 Ys,China = 800 − Ym,China 2 Generally, on the PPF, if As /Am is relatively – high (steep slope), comparative advantage in services – low (flat slope), comparative advantage in manufacturing 15 Specialization and Trade The Ricardian Model 16  Baseline Case: No Trade (Autarky) Still assume perfect complements For the US 1600 1 x = 1600 − 2x ⇒ x= = 533 3 3 For China 1 2 1 x = 800 − x ⇒ x= × 800 = 533 2 3 3 Both produce and consume 533 13 each of services and manufactures – Note: Global product of each is 2 × 533 13 = 1066 23 17 Consumption with No Trade (Autarky) 18  Specialisation If countries specialise, they will maximise global product (i.e., “grow the pie”) Starting point is the pattern of specialisation – US specialises in services Ys,US = As,US × LUS = 8 × 200 = 1600 – China specialises in manufactures Ym,China = Am,China × LChina = 2 × 800 = 1600 Global product of each after specialisation is 1600! – both countries will be better off if they trade 19  Trade: How it works Assume that the market price of one manufacture is one service If the US wants one manufacture, it could – produce it (forgoing 2 services); or – purchase it (selling 1 service) ⇒ US should produce services and buy manufactures from China If China wants one manufacture, it could – produce it (forgoing 1/2 services); or – purchase it (selling 1 service) ⇒ China should produce manufactures and buy services from US 20  Consumption: After Trade Since services and manufactures can be traded 1-for-1 – US trade line is Ys,US = As,US LUS − Ym,US , or Ys,US = 1600 − Ym,US – China trade line is same Ym,China = Am,China LChina − Ys,China , or Ys,China = 1600 − Ym,China – Consumption for both countries (assuming perfect complements) is 1600 x = 1600 − x ⇒ x= = 800 (of each good) 2 Both consume 800 each of services and manufactures – Up from 533 31 previously (slide 17) – Both countries are better off! 21 Consumption after Specialisation and Trade 22  Conditions for Trade to Occur Assume the market price of one manufacture is 1/4 services If the US wants one manufacture, it could – produce it (forgoing 2 services); or – purchase it (selling 1/4 services) ⇒ US should produce services and buy manufactures from China If China wants one manufacture, it could – produce it (forgoing 1/2 services); or – purchase it (selling 1/4 services) ⇒ China should also produce services! Price must be between opportunity costs for trade to occur! – i.e., manufactures is between 1/2 and 2 services 23  Learning Outcomes 1 Understand and explain the meaning of opportunity cost and marginal technical rate of substitution. Mathematically derive the PPF given a simple production technology in one input. 2 Understand and explain the differences between absolute and comparative advantage. Explain how a comparative advantage is sufficient to obtain gains from trade. 3 Mathematically solve the Ricardian model for two extreme cases: no trade and free trade. Demonstrate how the model illustrates key arguments in relation to trade, including the pattern of specialisation due to a difference in production technologies and the prices under which trade occurs. 24  New Formula(s) and Notation Production Possibility Frontier (assuming linear production functions of goods Yx and Yy , and perfectly mobile labour L) Ay Yy = Ay L − Yx Ax The following are all variations of variables you’ve already seen Yx , Yy quantities of goods x and y Ax , Ay productivity of labour to produce goods x and y L labour 25  Next Lecture Exchange Rates I – nominal vs. real exchange rates – fixed vs. floating rate regimes – exchange rates in the long run: purchasing power parity – exchange rates in the short run: supply & demand BOFAH Chapter 17 26