Ricardian Model -1 Updated Combined PDF

Chapter 3 Labor Productivity and Comparative Advantage: The Ricardian Model Why Nations Trade? Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-2 Explain How can countries gain from trade even if one country is more efficient in producing all goods? Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-3 Introduction Theories of why trade occurs: – Differences across countries in labor, labor skills, physical capital, natural resources, technology, and preferences – Economies of scale (larger scale of production is more efficient) Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-4 Introduction (cont.) Sources of differences across countries that lead to gains from trade: – The Ricardian model examines differences in the productivity of labor (due to differences in technology) between countries. – The Heckscher-Ohlin model Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-5 RICARDO’S MODEL: TRADE AND TECHNOLOGY Basics of Comparative Advantage Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-6 David Ricardo (1772-1823) An advocate of free trade Trade is mutual benefit between countries differing in the productivity of labor Comparative Advantage Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-7 Important Concepts Absolute advantage Comparative advantage Pattern of Trade Gains from Trade Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-8 Absolute vs. comparative advantage A country has an absolute advantage if it can produce a product more efficiently (cheaply) than other countries. A country has a comparative advantage if it can produce a product at a lower opportunity cost than other countries. 3-9 Comparative ≠ Absolute Can trade be mutual benefit between two countries one of which is more productive in every possible area than the other? How? 3-10 Opportunity Cost If scarce factors of production are used to produce two goods, producing more of one good always requires producing less of the other good. 3-11 Pizza and Cupcakes Party Lisa Cindy Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-12 How to prepare for the party Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-13 Lisa and Cindy’s Cooking Skills In 1 hour, Lisa can In 1 hour, Cindy can make 4 pizzas or 8 make 2 pizzas or 2 cupcakes. cupcakes Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-14 Absolute Advantage Because Lisa can make more pizzas and more cupcakes in the same amount of time, she has an absolute advantage in making both! She’s just faster all around. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-15 The Opportunity Costs for Lisa In 1 hour, Lisa can make 4 pizzas or 8 cupcakes. To make 1 pizza, she gives up making 2 cupcakes. To make 1 cupcake, she gives up making 0.5 pizzas Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-16 So… Lisa has a lower opportunity cost for making cupcakes (0.5 pizzas vs. 1 pizza for Cindy). Cindy has a lower opportunity cost for making pizza (1 cupcake vs. 2 cupcakes for Lisa). Even though Lisa has an absolute advantage in both tasks, Cindy still has a comparative advantage in making pizza. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-17 Roses vs. Computers 3-18 Roses vs. Computers For example, a limited number of workers could produce either roses or computers. ♦ The opportunity cost of producing computers is the amount of roses not produced. ♦ The opportunity cost of producing roses is the amount of computers not produced. Suppose that in the United States 10 million roses could be produced with the same resources as 100,000 computers. Suppose that in Colombia 10 million roses could be produced with the same resources as 30,000 computers. Who has a CA of producing roses? Colombia has a lower opportunity cost of producing roses: has to stop producing fewer computers. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-21 Comparative Advantage and Opportunity Cost (cont.) A country has a comparative advantage in producing a good if the opportunity cost of producing that good is lower in the country than in other countries. ♦The United States has a comparative advantage in computer production. ♦Colombia has a comparative advantage in rose production. Comparative Advantage and Opportunity Cost (cont.) Suppose initially that Colombia produces computers, and the United States produces roses, and that both countries want to consume computers and roses. Can both countries be made better off? Table 3-1: Hypothetical Changes in Production Comparative Advantage and Trade When countries specialize in production in which they have a comparative advantage, more goods and services can be produced and consumed. ♦ Have the United States stop growing roses and use those resources to make 100,000 computers instead. Have Colombia stop making 30,000 computers and grow roses instead. ♦ If produce goods in which have a comparative advantage (the United States produces computers and Colombia roses), they could still consume the same 10 million roses, but could consume 100,000 – 30,000 = 70,000 more computers. Understanding comparative advantage Nations trade for the same reasons people do. Why don’t pro football players mow their own lawns? Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-26 Answer He has better thing to do with his time. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-27 Exercise One: UK and India UK and India produce textiles and books Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-28 Output Textile Books UK 1 4 India 2 3 Total 3 7 For UK to produce 1 unit of textiles, it has an opportunity cost of __________ 4 books. For India to produce 1 unit of textiles it has an opportunity cost of _________ 1.5 books. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-29 Opportunity cost Please compute the opportunity cost of producing books for both countries. Who has a comparative advantage in producing books? Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-30 Output after specialization Textile Books UK 0 8 India 4 0 Total 4 8 UK exports books & India exports textile Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-31 Please download and install the Slido app on all computers you use If Country X can produce either 200 barrels of oil or 50 tons of grain, and Country Y can produce either 150 barrels of oil or 75 tons of grain, which country has a comparative advantage in producing grain? ⓘ Start presenting to display the poll results on this slide. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-32 Please download and install the Slido app on all computers you use Audience Q&A ⓘ Start presenting to display the audience questions on this slide. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-33 Please download and install the Slido app on all computers you use Country A can produce 15 units of tea or 30 units of coffee in a day. Country B can produce 10 units of tea or 40 units of coffee in a day. What is the opportunity cost of producing 1 unit of tea in Country A? ⓘ Start presenting to display the poll results on this slide. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-34 Pat Buchanan Ricardo’s theory...demands that more efficient producers in advanced countries give up industries to less efficient producers in less advanced nations...Are Chinese factories more efficient than U.S. factories? Of course not. (The Great Betrayal, p. 67.) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-35 Misinterpretation of Comparative Advantage Pat Buchanan's statement suggests that Ricardo's theory "demands that more efficient producers in advanced countries give up industries to less efficient producers in less advanced nations.“ This interpretation overlooks the core principle of comparative advantage. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-36 Comparative advantage does not require more efficient (or advanced) countries to "give up" industries to less efficient (or less advanced) ones. Instead, it suggests that each country should specialize in producing goods for which it has the lowest opportunity cost, even if one country is more efficient at producing all goods. In other words, countries benefit by focusing on what they do relatively best. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-37 Buchanan's critique focuses on the absolute efficiency of producers (i.e., being more or less efficient), whereas Ricardo’s theory centers on relative opportunity costs. A country may be less efficient in absolute terms in producing a good but still have a comparative advantage if it gives up less of another good to produce it. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-38 Please download and install the Slido app on all computers you use "Comparative advantage always leads to equal economic benefits for all trading partners." what are your comments to this statement? ⓘ Start presenting to display the poll results on this slide. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-39 Please download and install the Slido app on all computers you use Audience Q&A ⓘ Start presenting to display the audience questions on this slide. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-40 The Model Two countries: Home country: H Foreign country: F Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-41 A one-factor world Each of the two countries has only one factor of production: LABOR The number of units of labor: H: L = 100 F: L* = 1000 Full employment Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-42 What they produce Each country can produce two goods. A: apple B: banana Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-43 All Markets are Perfectly Competitive Apple and banana producers take prices and wages as given. Profits are zero. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-44 What is opportunity cost The opportunity cost of producing something measures the cost of not being able to produce something else because resources have already been used. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-45 Opportunity cost in our case ♦The opportunity cost of producing A (apple) is the amount of B (banana) not produced. ♦The opportunity cost of producing B is the amount of A not produced. ♦A country faces a trade off: how many A or B should it produce with the limited number of workers that it has? Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-46 How to compute opportunity cost Labor productivities: unit labor requirement Unit labor requirement is defined as the amount of labor (number of workers) required to produce one unit of output. Unit labor requirement is constant. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-47 Unit labor requirement in the home country aLA is defined as the number of workers required to produce one bushel of apple in the home country. aLB is defined as the number of workers required to produce one bushel of banana in the home country. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-48 For example aLA = 2; aLB = 1 It takes 2 workers to produce one bushel of apple It takes 1 worker to produce one bushel of banana A high unit labor requirement means low labor productivity Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-49 Opportunity cost When the economy uses all of its resources, the opportunity cost of producing apple is the quantity of bushel of banana that is given up to produce one more bushel of apple. aLA /aLB =2 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-50 The national labor market The number of workers in a country is fixed. In a country, workers can move freely between industries. Wages are endogenously determined. Full employment. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-51 US unemployment rate over the last 10 years Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-52 Production Possibility frontier (PPF) The production possibility frontier (PPF) of an economy shows the maximum amount of a goods that can be produced for a fixed amount of resources (labor). Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-53 Production Possibilities QA: the quantity of Apple produced QB: the quantity of Banana produced The production possibility frontier of the Home country has the equation: aLAQA + aLBQB = L Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-54 Production Possibilities (cont.) In general, the amount of the domestic economy’s production is defined by aLAQA + aLBQB ≤ L Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-55 Prices &wages PA: the price of apple PB: the price of banana Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-56 Wages Because zero profits imply that revenues equal the wage bill, wages of apple makers are equal to the market value of the apple produced: PA /aLA Similarly, wages of banana producers are equal to the market value of the banana produced: PB /aLB. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-57 More is better Because workers like high wages, they will work in the industry that pays a higher wage. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-58 Autarky: Equilibrium prices and wages In a closed economy, prices of both goods must adjust so that wages are equal in both farms so that both apple and banana are produced. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-59 Absolute Advantage Home has an absolute advantage in apple production if … aLA < a*LA Home has an absolute advantage in banana production if… Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-60 Comparative Advantage 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. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-61 In our case Home has a comparative advantage in Apple production: it uses its resources more efficiently in producing A compared to producing B. Foreign has a comparative advantage in Banana production: it uses its resources more efficiently in producing B compared to producing A. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-62 Which means… aLA /aLB < a*LA /a*LB For example aLA = 2; aLB = 1 a*LA = 60; a*LB = 20 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-63 Free trade between H and F For example, H specializes in producing apple and F in producing banana. Who will gain from this type of free trade? Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-64 Perfect Competition Market PA be the price of one bushel of Apple. PA = $60 PB be the price of one bushel of Banana. PB = $30 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-65 Autarchic Equilibrium The relative price: the price of one good in terms of the other. In the autarchic equilibrium, the relative price of apple equals the opportunity cost of apple. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-66 Why? This is because relative price must adjust so that wages are equal in the two industries so that both apple and banana are produced. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-67 Two closed economies aLA /aLB < a*LA /a*LB PA /aLA = PB /aLB P*A /a*LA = P*B /a*LB PA /PB < P*A /P*B So that apple is relatively cheaper at Home before trade. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-68 Chapter 3 Labor Productivity and Comparative Advantage: The Ricardian Model Why Nations Trade? Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-2 Explain How can countries gain from trade even if one country is more efficient in producing all goods? Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-3 Introduction Theories of why trade occurs: – Differences across countries in labor, labor skills, physical capital, natural resources, technology, and preferences – Economies of scale (larger scale of production is more efficient) Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-4 Introduction (cont.) Sources of differences across countries that lead to gains from trade: – The Ricardian model examines differences in the productivity of labor (due to differences in technology) between countries. – The Heckscher-Ohlin model Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-5 RICARDO’S MODEL: TRADE AND TECHNOLOGY Basics of Comparative Advantage Copyright ©2015 Pearson Education, Inc. All rights reserved. 3-6 David Ricardo (1772-1823) An advocate of free trade Trade is mutual benefit between countries differing in the productivity of labor Comparative Advantage Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-7 Important Concepts Absolute advantage Comparative advantage Pattern of Trade Gains from Trade Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-8 Absolute vs. comparative advantage A country has an absolute advantage if it can produce a product more efficiently (cheaply) than other countries. A country has a comparative advantage if it can produce a product at a lower opportunity cost than other countries. 3-9 Comparative ≠ Absolute Can trade be mutual benefit between two countries one of which is more productive in every possible area than the other? How? 3-10 Opportunity Cost If scarce factors of production are used to produce two goods, producing more of one good always requires producing less of the other good. 3-11 Pizza and Cupcakes Party Lisa Cindy Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-12 How to prepare for the party Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-13 Lisa and Cindy’s Cooking Skills In 1 hour, Lisa can In 1 hour, Cindy can make 4 pizzas or 8 make 2 pizzas or 2 cupcakes. cupcakes Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-14 Absolute Advantage Because Lisa can make more pizzas and more cupcakes in the same amount of time, she has an absolute advantage in making both! She’s just faster all around. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-15 The Opportunity Costs for Lisa In 1 hour, Lisa can make 4 pizzas or 8 cupcakes. To make 1 pizza, she gives up making 2 cupcakes. To make 1 cupcake, she gives up making 0.5 pizzas Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-16 So… Lisa has a lower opportunity cost for making cupcakes (0.5 pizzas vs. 1 pizza for Cindy). Cindy has a lower opportunity cost for making pizza (1 cupcake vs. 2 cupcakes for Lisa). Even though Lisa has an absolute advantage in both tasks, Cindy still has a comparative advantage in making pizza. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-17 Roses vs. Computers 3-18 Roses vs. Computers For example, a limited number of workers could produce either roses or computers. ♦ The opportunity cost of producing computers is the amount of roses not produced. ♦ The opportunity cost of producing roses is the amount of computers not produced. Suppose that in the United States 10 million roses could be produced with the same resources as 100,000 computers. Suppose that in Colombia 10 million roses could be produced with the same resources as 30,000 computers. Who has a CA of producing roses? Colombia has a lower opportunity cost of producing roses: has to stop producing fewer computers. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-21 Comparative Advantage and Opportunity Cost (cont.) A country has a comparative advantage in producing a good if the opportunity cost of producing that good is lower in the country than in other countries. ♦The United States has a comparative advantage in computer production. ♦Colombia has a comparative advantage in rose production. Comparative Advantage and Opportunity Cost (cont.) Suppose initially that Colombia produces computers, and the United States produces roses, and that both countries want to consume computers and roses. Can both countries be made better off? Table 3-1: Hypothetical Changes in Production Comparative Advantage and Trade When countries specialize in production in which they have a comparative advantage, more goods and services can be produced and consumed. ♦ Have the United States stop growing roses and use those resources to make 100,000 computers instead. Have Colombia stop making 30,000 computers and grow roses instead. ♦ If produce goods in which have a comparative advantage (the United States produces computers and Colombia roses), they could still consume the same 10 million roses, but could consume 100,000 – 30,000 = 70,000 more computers. Understanding comparative advantage Nations trade for the same reasons people do. Why don’t pro football players mow their own lawns? Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-26 Answer He has better thing to do with his time. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-27 Exercise One: UK and India UK and India produce textiles and books Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-28 Output Textile Books UK 1 4 India 2 3 Total 3 7 For UK to produce 1 unit of textiles, it has an opportunity cost of __________ 4 books. For India to produce 1 unit of textiles it has an opportunity cost of _________ 1.5 books. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-29 Opportunity cost Please compute the opportunity cost of producing books for both countries. Who has a comparative advantage in producing books? Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-30 Output after specialization Textile Books UK 0 8 India 4 0 Total 4 8 UK exports books & India exports textile Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-31 Please download and install the Slido app on all computers you use If Country X can produce either 200 barrels of oil or 50 tons of grain, and Country Y can produce either 150 barrels of oil or 75 tons of grain, which country has a comparative advantage in producing grain? ⓘ Start presenting to display the poll results on this slide. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-32 Please download and install the Slido app on all computers you use Audience Q&A ⓘ Start presenting to display the audience questions on this slide. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-33 Please download and install the Slido app on all computers you use Country A can produce 15 units of tea or 30 units of coffee in a day. Country B can produce 10 units of tea or 40 units of coffee in a day. What is the opportunity cost of producing 1 unit of tea in Country A? ⓘ Start presenting to display the poll results on this slide. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-34 Pat Buchanan Ricardo’s theory...demands that more efficient producers in advanced countries give up industries to less efficient producers in less advanced nations...Are Chinese factories more efficient than U.S. factories? Of course not. (The Great Betrayal, p. 67.) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-35 Misinterpretation of Comparative Advantage Pat Buchanan's statement suggests that Ricardo's theory "demands that more efficient producers in advanced countries give up industries to less efficient producers in less advanced nations.“ This interpretation overlooks the core principle of comparative advantage. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-36 Comparative advantage does not require more efficient (or advanced) countries to "give up" industries to less efficient (or less advanced) ones. Instead, it suggests that each country should specialize in producing goods for which it has the lowest opportunity cost, even if one country is more efficient at producing all goods. In other words, countries benefit by focusing on what they do relatively best. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-37 Buchanan's critique focuses on the absolute efficiency of producers (i.e., being more or less efficient), whereas Ricardo’s theory centers on relative opportunity costs. A country may be less efficient in absolute terms in producing a good but still have a comparative advantage if it gives up less of another good to produce it. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-38 Please download and install the Slido app on all computers you use "Comparative advantage always leads to equal economic benefits for all trading partners." what are your comments to this statement? ⓘ Start presenting to display the poll results on this slide. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-39 Please download and install the Slido app on all computers you use Audience Q&A ⓘ Start presenting to display the audience questions on this slide. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-40 The Model Two countries: Home country: H Foreign country: F Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-41 A one-factor world Each of the two countries has only one factor of production: LABOR The number of units of labor: H: L = 100 F: L* = 1000 Full employment Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-42 What they produce Each country can produce two goods. A: apple B: banana Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-43 All Markets are Perfectly Competitive Apple and banana producers take prices and wages as given. Profits are zero. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-44 What is opportunity cost The opportunity cost of producing something measures the cost of not being able to produce something else because resources have already been used. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-45 Opportunity cost in our case ♦The opportunity cost of producing A (apple) is the amount of B (banana) not produced. ♦The opportunity cost of producing B is the amount of A not produced. ♦A country faces a trade off: how many A or B should it produce with the limited number of workers that it has? Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-46 How to compute opportunity cost Labor productivities: unit labor requirement Unit labor requirement is defined as the amount of labor (number of workers) required to produce one unit of output. Unit labor requirement is constant. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-47 Unit labor requirement in the home country aLA is defined as the number of workers required to produce one bushel of apple in the home country. aLB is defined as the number of workers required to produce one bushel of banana in the home country. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-48 For example aLA = 2; aLB = 1 It takes 2 workers to produce one bushel of apple It takes 1 worker to produce one bushel of banana A high unit labor requirement means low labor productivity Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-49 Opportunity cost When the economy uses all of its resources, the opportunity cost of producing apple is the quantity of bushel of banana that is given up to produce one more bushel of apple. aLA /aLB =2 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-50 The national labor market The number of workers in a country is fixed. In a country, workers can move freely between industries. Wages are endogenously determined. Full employment. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-51 US unemployment rate over the last 10 years Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-52 Production Possibility frontier (PPF) The production possibility frontier (PPF) of an economy shows the maximum amount of a goods that can be produced for a fixed amount of resources (labor). Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-53 Production Possibilities QA: the quantity of Apple produced QB: the quantity of Banana produced The production possibility frontier of the Home country has the equation: aLAQA + aLBQB = L Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-54 Production Possibilities (cont.) In general, the amount of the domestic economy’s production is defined by aLAQA + aLBQB ≤ L Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-55 Exercise 1 Two countries, Country A and Country B, produce two goods: wine and cheese. The production capabilities are as follows: Country A can produce 10 units of wine or 20 units of cheese using all its resources in a day. Country B can produce 15 units of wine or 10 units of cheese using all its resources in a day. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-56 Calculate the unit labor requirements Country A:𝑎𝑎𝐿𝐿𝑊𝑊=0.1; 𝑎𝑎𝐿𝐿𝐶𝐶=0.05 Country B:𝑎𝑎∗𝐿𝐿𝑊𝑊=0.0667; 𝑎𝑎∗𝐿𝐿𝐶𝐶=0.1 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-57 The only factor of production: Labor The number of units of labor: Country A: L = 100 Country B: L* = 1000 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-58 Drawing the Production Possibility Frontier (PPF): Country A's PPF: 𝐿𝐿 Maximum production of wine: 100x10= =1000units (x-axis 𝑎𝑎𝐿𝐿𝐿𝐿 intercept) Maximum production of cheese: 100x20=2000 units (y-axis intercept) Country B's PPF: Maximum production of wine: 1000x15=15,000 units (x-axis intercept) Maximum production of cheese: 1000x10=10,000 units (y-axis intercept) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-59 Prices &wages PA: the price of apple PB: the price of banana Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-60 Wages Because zero profits imply that revenues equal the wage bill, wages of apple makers are equal to the market value of the apple produced: PA /aLA Similarly, wages of banana producers are equal to the market value of the banana produced: PB /aLB. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-61 More is better Because workers like high wages, they will work in the industry that pays a higher wage. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-62 Autarky: Equilibrium prices and wages In a closed economy, prices of both goods must adjust so that wages are equal in both farms so that both apple and banana are produced. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-63 Absolute Advantage Home has an absolute advantage in apple production if … aLA < a*LA Home has an absolute advantage in banana production if… Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-64 Comparative Advantage 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. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-65 In our case Home has a comparative advantage in Apple production: it uses its resources more efficiently in producing A compared to producing B. Foreign has a comparative advantage in Banana production: it uses its resources more efficiently in producing B compared to producing A. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-66 Which means… aLA /aLB < a*LA /a*LB For example aLA = 2; aLB = 1 a*LA = 60; a*LB = 20 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-67 Free trade between H and F For example, H specializes in producing apple and F in producing banana. Who will gain from this type of free trade? Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-68 Perfect Competition Market PA be the price of one bushel of Apple. PA = $60 PB be the price of one bushel of Banana. PB = $30 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-69 Autarchic Equilibrium The relative price: the price of one good in terms of the other. In the autarchic equilibrium, the relative price of apple equals the opportunity cost of apple. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-70 Why? This is because relative price must adjust so that wages are equal in the two industries so that both apple and banana are produced. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-71 Two closed economies aLA /aLB < a*LA /a*LB PA /aLA = PB /aLB P*A /a*LA = P*B /a*LB PA /PB < P*A /P*B So that apple is relatively cheaper at Home before trade. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-72 Sir James Goldsmith Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-73 His book “The principal theoretician of free trade was David Ricardo, a British economist of the early nineteenth century. He believed in two interrelated concepts: specialization and comparative advantage. ……But these ideas are not valid in today's world." Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-74 His ideas There are all these countries out there that pay wages that are much lower than those in the West world. Free trade with these countries cannot be mutually beneficial. Therefore, Ricardian model is invalid in the modern world. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-75 The wages in Ricardian model Wage for apple producers at home country WA = PA /aLA = $60/2 =$30 Wage for foreign apple producers W*A = P*A /a*LA = $60/60 =$1 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-76 Please download and install the Slido app on all computers you use Sir Goldsmith believed that this approach could harm more efficient producers in developed countries by causing them to lose industries to less efficient producers in developing nations. He was concerned that this might lead to deindustrialization and job losses in advanced economies, as they abandon certain industries to focus on others where they have a comparative advantage. What are your comments on his idea? ⓘ Start presenting to display the poll results on this slide. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-77 Goldsmith's argument addresses concerns about the distributional effects of free trade rather than a direct refutation of Ricardo's principle of comparative advantage. His perspective highlights the potential socio-economic costs and imbalances that can result from adhering strictly to the theory without considering other economic, social, and political factors. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-78 Ricardo's theory suggests that countries should specialize in the production of goods for which they have the lowest opportunity cost, even if one country is more efficient in producing all goods. This specialization is supposed to increase overall economic welfare by making the most efficient use of resources globally. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-79 Relative price of apple The dollar price of apple, PA, is $60 per bushel The dollar price of banana, PB, is $30 per bushel The relative price of apple is 2 bushel of banana per bushel of apple: PA/PB Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-80 Barter Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-81 Now we open to trade! Home and Foreign can now trade apple and banana. Prices must now be equalized under free trade to rule out of arbitrage opportunities. PA /PB = P*A /P*B Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-82 Relative Prices, Wages, and Supply If the price of A relative to the price of B exceeds the opportunity cost of producing A: PA /PB > aLA /aLB , ♦Then the wage in A will exceed the wage in B: PA /aLA > PB/aLB ♦So workers will make only A (the economy specializes in A production). Relative Prices, Wages, and Supply (cont.) If the price of A relative to the price of B is less than the opportunity cost of producing APPLE PA /PB < aLA /aLB , ♦then the wage in A will be less than the wage in B PA /aLA < PB/aLB ♦so workers will make only B (the economy specializes in B production). Production, Prices, and Wages If the price of apple relative to the price of banana equals the opportunity cost of producing apple PA /PB = aLA /aLB , ♦then the wage in APPLE equals the wage in BANANA PA /aLA = PB/aLB ♦so workers will be willing to make both APPLE and BANANA. General Equilibrium Analysis It focus on the linkages between two markets. Relative prices and relative quantity Relative demand and relative supply Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-86 The Relative Quantities with Trade To calculate relative prices with trade, we first calculate relative quantities of world production: (QA + Q*A )/(QB + Q*B) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-87 Relative Supply and Relative Demand Next we consider relative supply of Apple: the quantity of apple supplied by all countries relative to the quantity of banana supplied by all countries at each relative price of apple, PA /PB. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-88 Relative Supply and Relative Demand (cont.) Relative price of apple, PA/PB a*LA/a*LB RS aLA/aLB L/aLA Relative quantity L*/a*LB of apple QA + Q*A Q B + Q *B Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-89 Relative Supply and Relative Demand (cont.) There is no supply of apple if the relative price of apple falls below aLA /aLB. ♦ Why? because the domestic country will specialize in banana production whenever PA /PB < aLA /aLB ♦ And we assumed that aLA /aLB < a*LA /a*LB so foreign workers won’t find it desirable to produce apple either. When PA /PB = aLA /aLB, domestic workers will be indifferent between producing apple or banana, but foreign workers will still produce only banana. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-90 Relative Supply and Relative Demand (cont.) Relative demand of apple is the quantity of apple demanded in all countries relative to the quantity of banana demanded in all countries at each relative price of apple, PA /PB. As the relative price of apple rises, consumers in all countries will tend to purchase less apple and more banana so that the relative quantity of apple demanded falls. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-91 Relative Supply and Relative Demand (cont.) Relative price of apple, PA/PB 3 RS RD 2 1 Relative quantity of apple Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-92 Trade: the pattern of trade Notice that the free trade relative price lies between both countries’ autarky relative prices. Home specializes fully in apple production and Foreign specializes fully in banana production. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-93 What determines the pattern of trade? Notice that it is the comparative advantage and not absolute advantage determines the pattern of trade. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-94 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 a good in which a country has a comparative advantage. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-95 Gains From Trade (cont.) Think of trade as an indirect method of production or a new technology that converts apple into banana or vice versa. Without the technology, a country has to allocate resources to produce all of the goods that it wants to consume. With the technology, a country can specialize its production and trade (“convert”) the products for the goods that it wants to consume. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-96 Gains From Trade (cont.) We show how consumption possibilities expand beyond the production possibility frontier when trade is allowed. Without trade, consumption is restricted to what is produced. With trade, consumption in each country is expanded because world production is expanded when each country specializes in producing the good in which it has a comparative advantage. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-97 Common misconceptions Trade is beneficial only if your country is strong enough to stand up to foreign competition. Trade cannot be beneficial if it leads to job losses in some industries. Trade with countries that pay low wages hurts high wage countries and is unfair. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-98 Common misconceptions Trade exploits a country and makes it worse off if its workers receive much lower wages than workers in other nations. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-99 Fig. 3-4: Trade Expands Consumption Possibilities Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-100 Misconceptions About Comparative Advantage 1. Free trade is beneficial only if a country is more productive than foreign countries. ♦ But even an unproductive country benefits from free trade by avoiding the high costs for goods that it would otherwise have to produce domestically. ♦ High costs derive from inefficient use of resources. ♦ The benefits of free trade do not depend on absolute advantage, rather they depend on comparative advantage: specializing in industries that use resources most efficiently. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-101 Misconceptions About Comparative Advantage (cont.) 2. Free trade with countries that pay low wages hurts high wage countries. ♦ While trade may reduce wages for some workers, thereby affecting the distribution of income within a country, trade benefits consumers and other workers. ♦ Consumers benefit because they can purchase goods more cheaply. ♦ Producers/workers benefit by earning a higher income in the industries that use resources more efficiently, allowing them to earn higher prices and wages. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-102 Misconceptions About Comparative Advantage (cont.) 3. Free trade exploits less productive countries. ♦ While labor standards in some countries are less than exemplary compared to Western standards, they are so with or without trade. ♦ Are high wages and safe labor practices alternatives to trade? Deeper poverty and exploitation (ex., involuntary prostitution) may result without export production. ♦ Consumers benefit from free trade by having access to cheaply (efficiently) produced goods. ♦ Producers/workers benefit from having higher profits/wages—higher compared to the alternative. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-103 Transportation Costs and Non-traded Goods The Ricardian model predicts that countries should completely specialize in production. But this rarely happens for primarily three reasons: 1. More than one factor of production reduces the tendency of specialization (chapter 4) 2. Protectionism (chapters 8–11) 3. Transportation costs reduce or prevent trade, which may cause each country to produce the same good or service Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-104 Transportation Costs and Non-traded Goods (cont.) Non-traded goods and services (ex., haircuts and auto repairs) exist due to high transportation costs. ♦ Countries tend to spend a large fraction of national income on non-traded goods and services. ♦ This fact has implications for the gravity model and for models that consider how income transfers across countries affect trade. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-105 Empirical Evidence Do countries export those goods in which their productivity is relatively high? The ratio of U.S. to British exports in 1951 compared to the ratio of U.S. to British labor productivity in 26 manufacturing industries suggests yes. At this time the U.S. had an absolute advantage in all 26 industries, yet the ratio of exports was low in the least productive sectors of the U.S. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-106 Fig. 3-6: Productivity and Exports Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-107 Case Study: Canada's Free Trade Agreement with Mexico and Application of Trade Theorems Stolper-Samuelson Theorem Rybczynski Theorem H-O trade Theorem NAFTA (USMCA) Canada’s Free Trade Agreement with Mexico, as part of NAFTA (now updated as USMCA), provides a practical example to illustrate three central trade theorems: the Stolper-Samuelson Theorem, the Rybczynski Theorem, and the Heckscher-Ohlin (H-O) Theorem. Heckscher-Ohlin (H-O) Theorem Canada is relatively natural resources-abandant,compared to Mexico, its exports to Mexico and other countries often include resource-intensive goods such as oil, gas, and minerals. Mexico is relatively labor-abundant, especially in lower-skilled labor, meaning it is more efficient in producing labor-intensive goods (such as textiles, apparel, etc.). Heckscher-Ohlin (H-O) Theorem Mexico’s Exports: Canada’s Exports: Labor-intensive Oil, gas, and other goods, such as natural resources- textiles and intensive goods. agricultural products. Stolper-Samuelson Theorem The Stolper-Samuelson Theorem suggests that trade benefits the owners of the abundant factors of production (natural resources in Canada) and harms the owners of the scarce factor (lower-skilled labor). Outcome: The real incomes of resource owners rise, while wages for lower- skilled workers in labor-intensive sectors decline, increasing wage inequality. Rybczynski Theorem The Rybczynski Theorem explains that as the supply of one factor increases, output of the goods using that factor intensively will increase, while output of other goods may decrease. Outcome: Canada’s natural resource sector (oil and gas) grows due to increased foreign investment and export opportunities. As more resources are allocated to this sector, other sectors (such as labor- intensive manufacturing) shrink. In long run… Over time, Canada becomes more specialized in resource extraction and capital-intensive industries, reducing the role of labor-intensive manufacturing. Relative Wages and Labor Productivity in Canada In this case, trade leads to an increase in labor productivity in capital- and resource-intensive sectors, but lower relative wages for lower- skilled workers in labor-intensive sectors. Wage Disparity: The expanding natural resource and capital- intensive industries in Canada lead to higher wages for skilled workers, while lower-skilled workers in industries like manufacturing see their relative wages decline due to increased competition from labor-abundant countries like Mexico. International Economics: Theory and Policy Twelfth Edition Chapter 5 Resources and Trade: The Heckscher-Ohlin Model Copyright © 2022, 2018, 2015 Pearson Education, Inc. All Rights Reserved Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-1 Preview Production possibilities Changing the mix of inputs Relationships among factor prices and goods prices, and resources and output Trade in the Heckscher-Ohlin model Factor price equalization Trade and income distribution Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-2 Trade and income distribution While there will still be overall gains from trade, there will now be individual winners and losers from trade! Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-3 Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-4 Answer? Remember that countries trade because they are different from one another in terms of technology, endowments, or preferences. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-5 What are the patterns of trade? Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-6 Ricardian model It is the comparative advantage and not absolute advantage determines the pattern of trade. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-7 Gains from trade? Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-8 Ricardian model Free trade is mutually beneficial. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-9 Can Ricardian model tells all? The Ricardian model emphasized technological differences but abstracted from endowment differences. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-10 Technology Technological advantage may be eroded over time by – Technology transfer to other countries – Multinational companies – Technical progress Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-11 Source of comparative advantage What determines comparative advantage? Answer: – Technological differences – And many other things! – Such as factor endowments of countries together with factor intensities of industries. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-12 For example The U.S. exports orange juice to Canada – Not because its Orange farmers are more productive – But because it is endowed with good weather in Florida. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-13 Factor endowment Labor Capital Land Skilled worker (human capital) Resources Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-14 Factor intensities Agriculture uses lots of land Textiles & apparel use lots of unskilled workers Autos use lots of capital Computers use lots of human capital Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-15 The Heckscher-Ohlin Theorem Countries have comparative advantage in, and therefore export, goods that use relatively intensively their relatively abundant factors. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-16 Intuition Abundant factors are cheap (in autarky) Cheap factors produce cheap goods Hence comparative advantage! Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-17 The model Setup of the model Autarky equilibrium Free trade equilibrium Gains from trade Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-18 Introduction In addition to differences in labor productivity, trade occurs due to differences in resources across countries. The Heckscher-Ohlin theory argues that trade occurs due to differences in labor, labor skills, physical capital, capital, or other factors of production across countries. – Countries have different relative abundance of factors of production. – Production processes use factors of production with different relative intensity. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-19 Exercise 1 1) In the Heckscher-Ohlin model, comparative advantage is influenced by the interaction between nations' resources, called ________, and the technology of production, called ________, used in the production of different goods. A) factor abundance; factor intensity B) factor resources; factor technology C) relative abundance; relative intensity D) interactive resource; interactive technology Answer A Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-20 Exercise 2 4) According to the Heckscher-Ohlin model, the source of comparative advantage is a country's A) factor endowments. B) technology. C) advertising. D) human capital. E) political system Answer A Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-21 Eli Heckscher (1879-1952) A Swedish political economist Published 1148 books and articles. Best known for the H-O model Copyright ©2015 Pearson Education, Inc. All rights reserved. 4-22 5-22 Bertil Ohlin (1899-1979) A Swedish economist and politician. Was awarded the Nobel Prize in 1977 together with James Meade. Copyright ©2015 Pearson Education, Inc. All rights reserved. 4-23 5-23 Heckscher-Ohlin Model So-called “2x2x2” model: Two countries: H and F Two goods: cloth and food Two factors of production: labor “L” and capital “K”(land) Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-24 The H-O vs. the Ricardian In the H-O model, the per-capita productivity is the same in both countries. Two countries share the same technology! Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-25 Production Possibilities – aLC = hours of labor used to produce one yard of cloth – aLF = hours of labor used to produce one calorie of food – aKF = units of capital used to produce one calorie of food – aKC = units of capital used to produce one yard of cloth – L = total amount of labor services available for production – K= total amount of capital available for production Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-26 Two-Factor Heckscher-Ohlin Model Countries differ in their factor endowments. Home is labor abundant relative to Foreign. – In the sense that Home is endowed with relatively more labor: L/K > L*/K* Cloth production is labor intensive relative to food production. – In the sense that cloth production uses relatively more labor for all factor prices: aLC/aKC > aLF/aKF Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-27 Setup If the production of one good is labor intensive relative to the production of another good in one country, we also assume the same to be the case in the other country. However, this assumption does not always hold in practice. For example, shoe production is capital intensive relative to call center service production in the U.S. while the opposite is true in India. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-28 Setup Technology features constant returns to scale. All markets are perfectly competitive. As one consequence, food and cloth producers take prices and wages as given. As another consequence workers are paid a competitive wage and capital-owners are paid a competitive rent. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-29 Production Possibilities With more than one factor of production, the opportunity cost in production is no longer constant and the PPF is no longer a straight line. Why? Numerical example: K = 3000, total amount of capital available for production L = 2000, total amount of labor available for production Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-30 Production Possibilities (cont.) Suppose use a fixed mix of capital and labor in each sector. aKC = 2, capital used to produce one yard of cloth aLC = 2, labor used to produce one yard of cloth aKF = 3, capital used to produce one calorie of food aLF = 1, labor used to produce one calorie of food Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-31 Production Possibilities (cont.) Production possibilities are influenced by both capital and labor: aKCQC + aKFQF ≤ K Total amount of capital resources Capital used for Capital used for Total calories of each yard of cloth Total yards of each calorie of food production production cloth production food production aLCQC + aLFQF ≤ L Total amount of labor resources Labor used for Labor required for each yard of cloth each calorie of production food production Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-32 Production Possibilities (cont.) Constraint on capital that capital used cannot exceed supply: 2QC + 3QF ≤ 3000 Constraint on labor that labor used cannot exceed labor supply: 2QC + QF ≤ 2000 Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-33 Production Possibilities (cont.) Economy must produce subject to both constraints – i.e., it must have enough capital and labor. Without factor substitution, the production possibilities frontier is the interior of the two factor constraints. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-34 Production Possibilities (cont.) Max food production 1000 (point 1) fully uses capital, with excess labor. Max cloth 1000 (point 2) fully uses labor, with excess capital. Intersection of labor and capital constraints occurs at 500 calories of food and 750 yards of cloth (point 3). Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-35 Fig. 5-1: The Production Possibility Frontier without Factor Substitution Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-36 Production Possibilities (cont.) The opportunity cost of producing one more yard of cloth, in terms of food, is not constant: – low (2/3 in example) when the economy produces a low amount of cloth and a high amount of food – high (2 in example) when the economy produces a high amount of cloth and a low amount of food Why? Because when the economy devotes more resources towards production of one good, the marginal productivity of those resources tends to be low so that the opportunity cost is high. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-37 Production Possibilities (cont.) The above PPF equations do not allow substitution of capital for labor in production. – Unit factor requirements are constant along each line segment of the PPF. If producers can substitute one input for another in the production process, then the PPF is curved (bowed). – Opportunity cost of cloth increases as producers make more cloth. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-38 Fig. 5-2: The Production Possibility Frontier with Factor Substitution Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-39 Production Possibilities (cont.) What does the country produce? The economy produces at the point that maximizes the value of production, V. An isovalue line is a line representing a constant value of production, V: V = PC QC + PF QF – where PC and PF are the prices of cloth and food. – slope of isovalue line is – (PC /PF) Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-40 Fig. 5-3: Prices and Production Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-41 Production Possibilities (cont.) Given the relative price of cloth, the economy produces at the point Q that touches the highest possible isovalue line. At that point, the relative price of cloth equals the slope of the PPF, which equals the opportunity cost of producing cloth. – The trade-off in production equals the trade-off according to market prices. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-42 Choosing the Mix of Inputs Producers may choose different amounts of factors of production used to make cloth or food. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-43 Factor prices: wage &rent The choice of factors of production depends on the wage, w, paid to labor and the rental rate, r, paid when renting capital. As the wage w increases relative to the rental rate r, producers use less labor and more capital in the production of both food and cloth. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-44 Fig. 5-4: Input Possibilities in Food Production Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-45 Factor intensities of industries Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-46 Factor intensity It measures the input ratio of production factors in the production. It is not the absolute amount of capital and labor used in the production, but the amount of labor per unit of capital L/K Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-47 Choosing the Mix of Inputs (cont.) Assume that at any given factor prices, cloth production uses more labor relative to capital than food production uses: aLC /aKC > aLF /aKF or LC /KC > LF /KF Production of cloth is relatively labor intensive, while production of food is relatively land intensive. Relative factor demand curve for cloth CC lies outside that for food FF. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-48 FACTOR INTENSITY LABOR INTENSIVE capital INTENSIVE Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-49 The Stolper-Samuelson Theorem The Stolper-Samuelson Theorem is an economic concept that helps us understand how changes in international trade can affect the wages and incomes of workers and owners of resources, like land and capital, in a country. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-50 Fig. 5-5: Factor Prices and Input Choices Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-51 Factor Prices and Goods Prices In competitive markets, the price of a good should equal its cost of production, which depends on the factor prices. How changes in the wage and rent affect the cost of producing a good depends on the mix of factors used. – An increase in the rental rate of capital should affect the price of food more than the price of cloth since food is the capital intensive industry. Changes in w/r are tied to changes in PC /PW. Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-52 Fig. 5-6: Factor Prices and Goods Prices Copyright ©2015 Pearson Education, Inc. All rights reserved. 5-53 International Economics: Theory and Policy Twelfth Edition Chapter 7 External Economies of Scale and the International Location of Production Copyright © 2022, 2018, 2015 Pearson Education, Inc. All Rights Reserved International Economics: Theory and Policy Twelfth Edition Chapter 8 Firms in the Global Economy: Export and Foreign Sourcing Decisions and Multinational Enterprises Copyright © 2022, 2018, 2015 Pearson Education, Inc. All Rights Reserved Debates Why are there only a few firms in some industries globally (e.g., airliners)? Why do countries trade similar products (e.g., cars)? Should infant industries be protected? Is anti-dumping protectionism? 6-3 Increasing Returns In the Ricardian and Heckscher-Ohlin models, we assume that production processes have constant returns to scale:  When factors of production change at a certain rate, output increases at the same rate. But a firm or industry may have increasing returns to scale or economies of scale:  When factors of production change at a certain rate, output increases at a faster rate.  A larger scale is more efficient: the cost per unit of output falls as a firm or industry increases output. 6-4 Imperfect Competition The Ricardian and Heckscher-Ohlin models also rely on competition to predict that all income from production is paid to owners of factors of production: no “excess” or monopoly profits exist. But when economies of scale exist, large firms may be more efficient than small firms, and the industry may consist of a monopoly or a few large firms. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-5 Types of Economies of Scale Economies of scale could mean either that larger firms or a larger industry is more efficient. External economies of scale occur when cost per unit of output depends on the size of the industry. Internal economies of scale occur when the cost per unit of output depends on the size of a firm. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-6 Examples of external economies of scale Transportation Research and experiment Banking facility Skilled workers Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-7 6-8 Types of Economies of Scale (cont.) External economies of scale may result if a larger industry allows for more efficient provision of services or equipment to firms in the industry.  Many small firms that are competitive may comprise a large industry and benefit when services or equipment can be efficiently provided to all firms in the industry. Internal economies of scale result when large firms have a cost advantage over small firms, causing the industry to become uncompetitive. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-9 Another reason to trade Economies of scale! In some industries there are likely to be only a few profitable firms. It does not contradict the theory of comparative advantage, but instead identifies another source of comparative advantage. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-10 First mover advantages Firms with first mover advantages will develop economies of scale and create barriers to entry for other firms. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-11 Economies of scale Typically, requires industries with high, fixed costs. World demand will support few competitors. Competitors may emerge because “they got there first”  first-mover advantage. Some argue that it generates government intervention and strategic trade policy (e.g. the need to nurture and protect “first movers”) 6-12 Case study: The commercial aircraft industry The commercial aircraft industry is an excellent example. Boeing Airbus Bombardier Embraer COMAC 6-13 New markets and new players Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-14 6-15 6-16 6-17 6-18 Commercial Aircraft Corporation of China, Ltd. 6-19 The classic duopoly The competition between Airbus and Boeing has been characterized as a duopoly in the large jet airline market since the 1990s. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-20 Background Airbus began as a European consortium while the American Boeing absorbed its former arch-rival, McDonnell Douglas in a 1997 merger. Over the years, competition has been intense; each company regularly accuses the other of receiving unfair state aid from their respective governments. 6-21 Background Manufacturers like Lockheed Martin, Convair and Fairchild Aircraft in the United States and British Aerospace and Fokker in Europe withdrew from the market as they were no longer in a position to compete effectively. 6-22 Tragic pioneer Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-23 Door dilemma Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-24 Reasons for duopoly Barriers to Entry Barriers to entry exist for a number of reasons, but the end result is that there is limited entry into a market or industry because the hurdles that must be overcome are great, and therefore firms that are already part of the industry or market have an advantage and are insulated from competition from new entrants. 6-25 Barriers to entry Financing Engineering Technology Production Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-26 Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-27 Airbus-Boeing subsides case The largest legal case in WTO history US argues that the EU government subsidies to Airbus is illegal. 6-28 WTO agreements The legal ground-rules for international commerce. These rules are transparent and predictable To settle trade disputes between nations The Most Favoured Nation Rule It requires that a WTO member must apply the same conditions on all trade with other WTO members. On October 6, 2004, the US complained to the WTO that the European governments have broken trade rules with its government loans to Airbus, including $ 3.2 Billions for the super jumbo A 380. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-31 The Airbus subsides Europeans have justified subsidies to Airbus as necessary to an infant industry. Boeing has long asserted that Airbus has an unfair advantage because it gets government money and now that it does not need money because it took the lead in the commercial aerospace business in 2003 delivering 305 commercial planes while Boeing delivered 281,whereas Boeing in 1999 had delivered more than 600 planes. 6-32 A Review of Monopoly A monopoly is an industry with only one firm. An oligopoly is an industry with only a few firms. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-33 Price taker vs. Price setter In a perfectly competitive market, firms are price takers. With imperfect competition, firms are price setters. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-34 Marginal Revenue MR is the extra or marginal revenue the firm gains from selling an additional unit. In a perfectly competitive market, the MR curve is the Demand curve. In a monopoly market, MR curve lies below the demand curve. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-35 Fig. 8-1: Monopolistic Pricing and Production Decisions A Review of Monopoly (cont.) Average cost is the cost of production (C) divided by the total quantity of production (Q).  AC = C/Q Marginal cost is the cost of producing an additional unit of output. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-37 A Review of Monopoly (cont.) A larger firm is more efficient because average cost decreases as output Q increases: internal economies of scale. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-38 Fig. 8-2: Average Versus Marginal Cost Monopoly examples 6-40 6-41 Monopolistic competition examples 6-42 6-43 Monopolistic Competition Monopolistic competition is a model of an imperfectly competitive industry which assumes that 1. Each firm can differentiate its product from the product of competitors (e.g., auto industry). 2. Each firm ignores the impact that changes in its price will have on the prices that competitors set: even though each firm faces competition it behaves as if it were a monopolist. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-44 A Model A number of firms: n. Each firm produces a particular good. All goods produced in this industry are similar and substitutes for one another. The demand function each firm is facing: Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-45 The Demand Function The total demand Its own price The prices charged by its rivals The total number of firms in the industry Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-46 The Demand Function (cont.) Q = S[1/n – b(P – P)]  Q is an individual firm’s sales  S is the total sales of the industry  n is the number of firms in the industry  b is a constant term representing the responsiveness of a firm’s sales to its price  P is the price charged by the firm itself  P is the average price charged by its competitors Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-47 The Cost Function C=F+cxQ where C is the total cost of production of the firm; F is a fixed cost; c is the firm’s marginal cost; Q is the firm’s output. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-48 One Big Assumption We assume that all firms face the same demand functions and have the same cost functions: Thus in equilibrium, all firms should charge the same price: P = P In equilibrium, Q = S/n + 0 AC = C/Q = F/Q + c = F(n/S) + c Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-49 Monopolistic Competition (cont.) AC = F(n/S) + c As the number of firms n in the industry increases, the average cost increases for each firm because each produces less. As total sales S of the industry increase, the average cost decreases for each firm because each produces more. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-50 Fig. 8-3: Equilibrium in a Monopolistically Competitive Market Monopolistic Competition (cont.) As the number of firms n in the industry increases, the price that each firm charges decreases because of increased competition. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-52 Monopolistic Competition (cont.) At some number of firms, the price that firms charge (which decreases in n) matches the average cost that firms pay (which increases in n). When the industry has this number of firms, each firm will earn revenue that exactly offsets all costs: price will match average cost.  This number is the equilibrium number of firms in the industry because firms have no incentive or tendency to enter or exit the industry. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-53 Monopolistic Competition (cont.) If the number of firms is greater than or less than the equilibrium number, then firms have an incentive to exit or enter the industry.  Firms have an incentive to enter the industry when revenues exceed all costs (price > average cost).  Firms have an incentive to exit the industry when revenues are less all costs (price < average cost). Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-54 Monopolistic Competition and Trade Because trade increases market size, trade is predicted to decrease average cost in an industry described by monopolistic competition.  Industry sales increase with trade leading to decreased average costs: AC = F(n/S) + c Because trade increases the variety of goods that consumers can buy under monopolistic competition, it increases the welfare of consumers.  And because average costs decrease, consumers can also benefit from a decreased price. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-55 Fig. 8-4: Effects of a Larger Market Monopolistic Competition and Trade (cont.) As a result of trade, the number of firms in a new international industry is predicted to increase relative to each national market.  But it is unclear if firms will locate in the domestic country or foreign countries. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 6-57 Gains from an Integrated Market: A Numerical Example Suppose that b = 1/30,000, fixed cost F = $750,000,000 and a marginal cost of c = $5,000 per automobile. The total cost is C = 750,000,000 + (5,000*Q). The average cost is therefore AC = (750,000,000/Q) + 5,000. Gains from an Integrated Market: A Numerical Example (cont.) Suppose there are two countries, Home and Foreign. Home has annual sales of 900,000 automobiles; Foreign has annual sales of 1.6 million. The two countries are assumed (for now) to have the same costs of production. Gains from an Integrated Market: A Numerical Example (cont.) The integrated market supports more firms, each producing at a larger scale and selling at a lower price than either national market does on its own. Everyone is better off as a resul

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