Remember the reasons for trade:

Transcription

1 Ricardian model

2 Remember the reasons for trade: Differences between countries (climate, technology, productivity, resources, etc.) Comparative advantage Increasing returns to scale Imperfect competition 2

3 Comparative advantage Countries are different, and any difference between two countries in technology, climate, culture, factor proportions, consumer preferences, for example can lead to opportunities for mutual gain from trade. Theories based on this reasoning are called comparative advantage theories. We will first examine comparative advantage models in detail. 3

4 In order to formalize the comparative advantage argument, we will use the classic formulation by 19 th century British economist David Ricardo. 4

5 First: a brief history Mercantilism: was the dominant attitude towards international trade in the 17 th and 18 th centuries. Gold and silver served as money. Symbolized a nation s wealth. Nations encouraged exports and restricted imports as a method to improve inflow of gold and silver Mercantilists assumed trade was a zero-sum game (like a poker). Meaning: It could not be mutually beneficial to all parties. 5

6 Absolute advantage Definition: A country has an absolute advantage (AA) in a commodity if its workers are more productive in producing that commodity than workers in another country. Adam Smith (1776) The Wealth of Nations By assuming that each country could produce some commodities using less labor than its trading partners, he showed that all parties could benefit. Trade improved the allocation of labor, ensuring that each good would be produced in the country where the good s production required the least labor. Result would be a larger total quantity of goods produced in the world. Trade would be a positive-sum game. 6

7 Comparative advantage Definition: A country has a comparative advantage in a commodity if its opportunity cost of producing that commodity is lower than the other country s. David Ricardo (1817) Principles of Political Economy and Taxation Illustrated that trade s potential benefits to the world were more than even Adam Smith imagined Paul Samuelson: Comparative advantage is the best example of an economic principle that is undeniably true yet not obvious to intelligent people So, if you understand it by the end of the next few lectures you will have come a long way in your study of international trade! 7

8 Assumptions 2 countries: Home (H) and Foreign (F) 2 goods: Wheat (W) and Cloth (C) Perfect competition prevails Prices always determined by markets. All units of each good are identical (homogeneous). Buyers and sellers have perfect information about markets. Entry and exit are free in each market. Thus, price of each good will equal its marginal cost of production. Transportation costs are zero. Any barriers to global trade are ignored. 8

9 Preferences Assume that every consumer in each country has identical preferences and spends half of her income on wheat and half on cloth. Equivalently: Cobb-Douglas utility function with equal weights on the two goods: Hence: 1 2 U( W, C) W C 1 2 Q D W 2 I P W and Q D C I 2P C, where I is income. 9

10 Production technology Labor is the only factor of production. Each country has a fixed amount of labor available, which is fully employed and homogeneous within the country. Labor is completely mobile across industries within each country, but completely immobile across countries. Assume: Total labor supply available at home: L = 25 Total labor supply available at foreign: L * = 75 10

11 Production technology In Home: One worker can produce 4 bushels of wheat or 2 yards of cloth. Hence: MPL W = 4, MPL C = 2 In Foreign: One worker can produce one bushel of wheat or one yard of cloth. Hence: MPL * W = 1, MPL * C = 1 11

12 Opportunity cost Opportunity cost is the amount of one commodity that must be given up in order to obtain one additional unit of the other commodity. Hence: Opportunity cost of Wheat in Home is ½ yards of Cloth. Opportunity cost of Wheat in Foreign is 1 yard of Cloth. Opportunity cost of Cloth in Home is 2 bushels of Wheat. Opportunity cost of Cloth in Foreign is 1 bushel of Wheat. Important (though obvious) observation: In each country, the opportunity cost of one good is the reciprocal of the opportunity cost of the other good. 12

13 Comparative advantage The country with the lowest opportunity cost of producing a good has a comparative advantage in that good. Hence: Home has a comparative advantage in Wheat Foreign has a comparative advantage in Cloth. Crucially important (if obvious) observation: A country must have a comparative advantage in something. A country cannot have a comparative advantage in both goods. Why? Due to the reciprocal property of opportunity costs. 13

14 Contrast with absolute advantage A country has an absolute advantage (AA) in a good if its workers are more productive in producing it. Who has an AA here, in what? Home has an AA in both goods. Note: A country can have an AA in both goods, or an absolute disadvantage in both goods. 14

15 To anticipate: We ll see that comparative advantage is what determines the pattern of trade. AA has no importance at all for the pattern of trade. But AA is important for the international distribution of income. 15

16 An important notion: Autarky Autarky = No Trade. Comparing autarky with free trade allows us to analyze what trade does. First, we ll analyze autarky, then trade, and compare the two. 16

17 Relative supply and relative demand curves Relative supply curve for wheat: (quantity of wheat)/(quantity of cloth) as a function of (price of wheat)/(price of cloth). Similar for relative demand 17

18 Autarky equilibrium in Home P P W C RD 1 RS H 2 Q Q W C Autarky Q Q W C 18

19 Autarky equilibrium in Foreign P P W C RD 1 RS F Q Q W C Autarky Q Q W C 19

20 Free trade Now, assume that there are no impediments to trade between the two countries. No tariffs or transport costs: One world price of wheat, one world price of cloth. Now, we need the world RS curve and RD curve. The RD curve is easy, since it s the same as before (since all consumers have identical preferences, within each country as well as across the two countries). For the RS curve, we combine the RS curves of the two countries 20

21 Free trade equilibrium P P W C RD RS World Q Q W C 21

22 Effect of trade on Home worker Cloth, Q C 3 Vertical intercept: Income (which is 4*P W ) divided by the price of cloth: 4PW 3 4* 3 P 4 C Wheat, Q W 22

23 Effect of trade on Foreign worker Cloth, Q C Horizontal intercept: Income (which is P C ) divided by the price of wheat: PC 4 P 3 W Wheat, Q W 23

24 Important: Utility of all consumers in both countries is higher under trade. Higher real incomes are due to efficiency gains of specialization along the lines of comparative advantage. Relative price of cloth has fallen in Home: This calls for a rise in cloth consumption (substitution effect) Budget line has shifted out in Home: Since cloth is a normal good, this also pushes for a rise in cloth consumption (income effect) 24

25 Additional insights: AA has NO ROLE AT ALL in determining the pattern of trade. On the other hand, AA determines the international distribution of income (= wage in this case). Home real wage is given by: 4 bushels of wheat or, Foreign real wage is given by: 1 yard of cloth or, P 3 4* 4* P 4 W 3 C PC 4 1* 1* P 3 W 4 3 yards bushels of of cloth wheat Hence, Home workers earn more than Foreign workers as measured by their ability to purchase either good. This reflects Home s AA in both goods. 25

26 Effect of size differences Suppose we increase the size of foreign work force from L * = 75 to L * = 80, and then to L * = 100. As we do so, the maximum amount of cloth that the foreign economy can produce increases. As a result, the world relative supply curve (and thus the free trade equilibrium) changes 26

27 P P W C RD RS World Q Q W C 27

28 P P W C RD RS World Q Q W C 28

29 Effect of size differences As the size of foreign workforce increases, the relative price of wheat (the good Home exports) increases and therefore the relative price of cloth (the good Home imports) decreases. In general, the cheaper are Home s imports, the better off it is. We call a reduction in the relative price of cloth (which is given by P C /P W ) as an improvement in Home s terms of trade, and a worsening in Foreign s terms of trade. Terms of Trade (ToT): The price of a country s exports divided by the price of its imports. 29

30 Effect of size differences If we keep increasing the size of foreign labor force, the price will be pushed to its maximum value of 1. At this point, Home is still producing only wheat, but Foreign is producing both goods. In other words, we now have an equilibrium with incomplete specialization. This is natural, since if Foreign is large enough compared to Home, the small Home economy will not be able to produce enough wheat to meet Foreign demand. If the difference in country sizes is large enough, the smaller country will capture all the gains from trade. 30

31 Possibilities for immigration So far, we have assumed that labor is immobile between countries. However, if we relax this assumption (so that we allow workers to move across borders to chase higher income), all of the labor movement will be in the direction of the country with the higher productivity (since income is higher). In our case, this implies: Workers will move from Foreign to Home. Therefore, although comparative advantage governs the direction of trade, in this model if immigration became possible, AA would govern the pattern of immigration. 31

32 Case study: Nigeria Most countries are net food importers. Particularly true for lower-income countries. That is, dependent on world market for food Many commentators view this as a problem per se: Leads to call for self-sufficiency in food. E.g., Nigeria Approximately 80% self-sufficiency ratio in cereals. Pres. Obasanjo ( ) outspoken booster of the idea. 32

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34 Case study: Nigeria Ways in which Nigeria has pushed toward food selfsufficiency: Loans to farmers. Subsidized inputs. Underwriting agricultural research -- new crop hybrids. Tightly restricting, even banning, cereals imports. E.g., rice and wheat import ban, Was it useful? What are your insights? 34

35 So what actually happened? Period of ban was Part of Nigeria s Structural Adjustment Program. One observation: Huge increase in consumer prices for food. Food consumption and nutrition: More complicated.

36 From FAO: State of Food Insecurity 1999

37 Does this mean the import ban improved nutrition? Note: danger of post-hoc reasoning. A happened; then B happened; therefore A caused B. Many other things were going on. Question of interest is the counterfactual: What would have happened to nutrition if everything else had happened as it did but the cereal ban had not occurred?

38 Bottom line for exercise: Macroeconomic recovery. Improvement in literacy. Government programs to help small farmers. Huge improvement in productivity in cassava. Note what happened in Ghana.

39 Bottom line for exercise: Comparative advantage provides huge argument for allowing countries to specialize in response trade. Strong argument against national selfsufficiency (in food or anything else).