International Trade, 31E00500

Transcription

1 International Trade, 31E00500 Lecture 1: Basic Facts in Need of Explanation, Introduction to Comparative Advantage Pertti Aalto University School of Business

2 Table of contents Facts to be explained 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality

3 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality Facts to be explained 1: Inter-industry specialization 1 Competitive general equilibrium theory, the backbone of the (classical) trade theories We ll use mostly the simplest two-industry versions of the theory. Production possibility frontier = possible combinations of output with full capacity Shape of the production possibility frontier affected by the availability of resources in the economy, technological knowledge (effectively used) and inter-sectoral differences in technologies. These can differ across countries and lead to the comparative advantage of nations.

4 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality Facts to be explained 1: Inter-industry specialization 2 Classical trade theories focus on the supply side determinants of inter-industry trade patters, e.g. factor endowments. Two countries: Country A has more capital and country B more labour. country A will export capital-intensive products and import labour-intensive product from country B. General equilibrium theory needed when one wants to discuss the determination of poverty, aggregate income and its distribution to factors and people, and especially how trade affects these. Classical trade theories also emphasize the structural changes implied by e.g. reductions of trade barriers and international transport costs.

5 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality Trade policies Old fashioned trade policy: tariffs, quantitative restrictions or import quotas, tariff-quota systems and anti-dumping policies (e.g. EU import restrictions for sugar) New trade policy: non-tariff measures (NTMs) and non-tariff barriers (NTBs) NTMs: all non-price and non-quantity restrictions on trade in goods, services and investment (e.g. technical standards and testing, licence requirements, IPR rules, differences in regulations from one state to another) NTBs: NTMs that can be considered protectionists restrictions and can be disputed in WTO (e.g. excessive custom delays, firm subsidies, embargoes) Trade disputes and WTO: Bananas, Steel, Shrimps, Meat (hormones), lately mostly NTB disputes (e.g. subsidies to Boeing and Airbus)

6 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality The classical trade theories to explain inter-industry specialization Lecture 2: Ricardian theory of Comparative advantage (from year 1817) Lecture 3: Factor intensity and the Heckscher-Ohlin model (from year 1933) + Stolper-Samuelson proposition and Rybczynski proposition Lecture 4: Trade policy: tariffs, quotas and NTMs (with perfect competition models)

7 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality Facts to be explained 2: Intra-industry trade and new trade theory Despite obvious inter-industry specialization various goods and services are both exported and imported. Exports of Nokia phones, import of iphones A growing share of world trade is intra-firm trade. About 60 percent of US imports from EU were trade within multinationals in (Lanz & Miroudot, 2011)

8 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality Abbildung : Finland, exports and imports of some product categories 2013 (million euro)

9 Facts to be explained 1: 2: 3: 4: Interindustry specialization Intra-industry trade Multinationals, services trade and labor markets Firm Heterogeneity, trade and income inequality Flows of sugar trade

10 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality Facts to be explained 2: Intra-industry trade 2 Several ways to understand intra-industry trade: 1. Product differentiation and consumer s love-of-variety: Competitive theory for a fixed number of goods: Eaton and Kortum model. Number of goods not fixed: Need for a theory of product differentiation. 2. Theory of monopolistic competition and increasing returns to scale. 3. Strategic behavior of large oligopolistic firms: incentive to enter each others markets even if they produce identical goods. 4. Global fragmentation of production processes

11 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality The new trade theories and applied models to explain intra-industry trade Lecture 5: Increasing returns to scale and imperfect competition (theories from year 1977 onwards) Lecture 6: Intra-industry trade (theories from 1970 s and 1980 s) and Gravity modelling (theories from 2002 & 2003 ) Lecture 7: Strategic (theories from 1980 s) & applied trade policy, including applied partial and general equilibrium models basics (developed especially after 1990 s)

12 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality Boeing 787 is produced in USA?

13 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality Facts to be explained 3: Off-shoring (outsourcing abroad) 1 Lot of research in the last 15 years on analysing the fragmentation of production processes (outsourcing of some stages of production to other firms located possibly in foreign countries). One measure of international outsourcing is the share of imported intermediates in production. An increase in the share may be an indication of off-shoring Factories of Nokia and Kone abroad increased imported intermediate input use

14 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality Facts to be explained 3: Off-shoring 2 Especially small countries such as Denmark, Finland, Netherlands and Sweden have a high share of imported intermediates. The increases have been highest in Denmark, Finland, Germany and Sweden (largest percent increase in Japan). What explains the increasing fragmentation and off-shoring of production? Liberalisation of world trade, communication technologies, integration of Eastern Europe and China in the world economy, increasing international competition. The other side: increasing exports of services.

15 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality Facts to be explained 3: Services exports Services exports, different modes: Mode 1: Cross-border supply; Mode 2: Consumption abroad; Mode 3: Commercial presence; and Mode 4: Presence of natural persons. (Mode 5: Domestic indirect services value added embodied in goods trade, Cernat 2014) Note: Services exports vs. service sectors exports

16 Facts to be explained 1: 2: 3: 4: Interindustry specialization Intra-industry trade Multinationals, services trade and labor markets Firm Heterogeneity, trade and income inequality Abbildung : Examples of services trade

17 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality Abbildung : Extent of serviceseconomics trade Dept and recent trends

18 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality Trade and labor markets How does trade affect our job markets? Does off-shoring shift our jobs to China? Global fragmentation of production processes and trade in tasks What statistics should be look when we want to analyse the effects of trade on labor markets? Gross exports vs. domestic value added of exports? Does general decrease in salary costs help Finnish exports competitiveness and increase our employment?

19 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality Abbildung : Domestic value added (VA) in exports, %, by country and foreign VA by industry in Finland (OECD, Economics TiVA Dept indicators)

20 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality

21 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality

22 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality Share of exports value added from services Abbildung : Share of export s domestic value added originating from service sectors (OECD, TiVA indicators)

23 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality Models on multinationals and trade in tasks to explain these phenomena Lecture 8: Multinational Firms and Fragmentation of Production (theories from 2004 onwards) Lecture 9: Offshoring and labor markets (theories developed during the last 10 years)

24 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality Abbildung : The long term view on trade Economics developments, Dept (Source:

25 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality Trade & Income inequality Income inequality has decreased between many country pairs, but has increased within-countries in the majority of countries during last 30 years (Anand & Segal, 2008)(Galbraith & Kum, 2005)

26 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality Trade & Income inequality Income inequality has decreased between many country pairs, but has increased within-countries in the majority of countries during last 30 years (Anand & Segal, 2008)(Galbraith & Kum, 2005) Helsingin Sanomat, : 85 richest persons own as much wealth as the the poorest half of the world s population in total.

27 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality Trade & Income inequality Income inequality has decreased between many country pairs, but has increased within-countries in the majority of countries during last 30 years (Anand & Segal, 2008)(Galbraith & Kum, 2005) Helsingin Sanomat, : 85 richest persons own as much wealth as the the poorest half of the world s population in total. Helsingin Sanomat, : World Economic Forum in Davos warned about the political instabilities caused by income inequality. In the streets of Bangkok, in the barricades of Kiova and even in the war in Syria this threat is already a reality.

28 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality Trade & Income inequality Income inequality has decreased between many country pairs, but has increased within-countries in the majority of countries during last 30 years (Anand & Segal, 2008)(Galbraith & Kum, 2005) Helsingin Sanomat, : 85 richest persons own as much wealth as the the poorest half of the world s population in total. Helsingin Sanomat, : World Economic Forum in Davos warned about the political instabilities caused by income inequality. In the streets of Bangkok, in the barricades of Kiova and even in the war in Syria this threat is already a reality. The Washington Post, : Income inequality hurts economic growth, researchers say.

29 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality Global and National Inequality Trade can have different impacts on inequality within a single country and on global inequality. Global inequality = Income inequality between all the people in the world = Inequality within nations + inequality between nations. Branko Milanovic ( Global Inequality 2015) has compiled evidence on both. The next figure (Figure 1.3. in Milanovic) gives the income gains of individuals all over the world in different income classes (vintiles), the second the development of global income inequality as measured by the global Gini-coefficient. Trade vs technological change? Or both, mutually reinforcing?

30 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality SugarSync/Luennot/International Trade 2017/Lecture 1/IntTrL1Fa.pdf Global income gains in different income classes

31 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality SugarSync/Luennot/International Trade 2017/Lecture 1/IntTrL1Fb.pdf Global income inequality

32 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality Only a fraction of firms export Finland has around firms (excluding self-employed) Around 10% of all firms are exporting in Finland But around 21% of firms in ëxport sectorsäre exporting Among medium and large firms these share are significantly higher, but vary from sector to sector

33 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality Abbildung : Exporting firms vs. export value by number of products and destinations (Marrewijk, 2012, figure 17.3) Comparison: 18 firms created 50% of Finland s gross exports in % of export firms (0.35% of all firms) accounted for 89% of Finland s

34 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality Facts to be explained 4: Firm Heterogeneity and new new trade theory Exporting firms are more productive, larger, pay better wages and do more R&D than domestically oriented firms in the same sector. (Figure 4: Mayer & Ottaviano, 2008) Learning-by-exporting or self-selection? What is the effect of this firm heterogeneity on economic structures?

35 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality Trade policy: The Banana trade war The Banana War in 1990 s and the structure of banana trade Who won and who lost in the deal?

36 1: Interindustry specialization 2: Intra-industry trade 3: Multinationals, services trade and labor markets 4: Firm Heterogeneity, trade and income inequality Melitz model and its extensions to explain the effects of trade on economic structures Lecture 10: Firm heterogeneity and the Melitz model (empirics from 1995 onwards and Melitz model from 2003) Lecture 11: Trade and income inequality (theoretical explanations developed from 2008 onwards)

37 Trade and Technology 1 The oldest modern theory is based on the assumption that production technologies in the form of (labor) productivity differ across countries, the theory is known (for good reasons) as the Ricardian theory of international trade. Despite being the oldest theory it has experienced a revival as international and interfirm differences in productivity have become transparent with new data. The sources of productivity differentials are usually left unexplained, but there many possible explanations: slow international dissemination of information on new technologies (also due e.g. to institution like patent protection), economic and social history (learning).

38 Trade and Technology 2 One striking and tragic example of the impacts of history on economic and social development is analyzed in Grosfeld, Rodnyansky and Zhuravskaya Persistent Antimarket Culture: A Legacy of the Pale of Settlement after the Holocaust, American Economic Journal: Economic Policy 2013, the working paper version is here sol3/papers.cfm?abstract_id= In the Russian Empire Jews were forced to live in the Pale Settlement (incl. Byelorussia, Ukraine), those living outside of it were forced to move in the Pale. Grosfeld et. al. argue that this created among non-jews in Pale antimarket and anti-entrepreneurship attitudes. They test whether these have persisted to this day, and it turns they do, although there was a dramatic change in the composition of population in the Pale area dueeconomics to thedept Holocaust:

39 SugarSync/Luennot/International Trade 2017/Lecture 1/IntTrL1F1.pdf History and attitudes

40 Trade and Technology 3 Let us start with the simplest model: two countries (EU, K), two goods (f,c), one factor of production, labor. Given this and assuming that markets (exchange) are perfectly competitive the production technologies are fully characterized by labor productivities, or equivalently, by unit labor requirements. Let e.g. af EU denote the unit labor requirement (e.g. in terms hours worked) in EU for production of f = the hours of work required to produce one unit of f. Obviously one hour of work produces then 1 units of good f af EU in EU = EU labor productivity in f.

41 Trade and Technology 4 The existence of international productivity differences means that unit labor requirements cannot be the same in all countries in all industries. What kind of differences matter for trade? The sine qua non for international trade trade are international differences in relative labor requirements/labor productivities, the comparative advantage. This is because they determine the production possibilities and thereby the trading opportunities as they determine the domestic opportunity costs of expanding production of one good in terms of the reduction of the other. If the opportunity costs differ internationally mutual trade is beneficial for both.

42 Trade and Technology 5 To understand this, assume that the EU labor supply is L EU. If all of it is allocated to production of c production of c is LEU. ac EU If the production of c is cut by one unit, the amount of labor released for production is a EU c. With this amount of labor aeu c af EU units of f can be produced in EU. This is the opportunity cost of expanding the production of f in EU. At the same time it also equals the (minus) of the slope of the production possibility frontier, see the next figure. Obviously, if all labor eventually is in production of the other good, its production is LEU a EU f Why can we assume that production is on the production possibility frontier, not inside it?

43 SugarSync/Luennot/International Trade 2017/Lecture 1/IntTrL1F2.pdf f Production possibilities slope = -

44 Trade and Technology 6 Intuitively, in perfectly competitive markets wages and prices adjust to equilibrate all markets. Were labor supply to exceed labor demand wage rate would equal 0. More formally. it can be shown that with perfect competition factors of production are allocated to sectors so that the value of production is maximized for given prices. Let the prices of the goods be p c, p f and let L be the labor input allocated to production of c. Then the value of production is Y = Y = p c [ L p c ac EU L a EU c p f + p f LEU L L af EU ] af EU + p f LEU af EU (1)

45 Trade and Technology 7 So, what allocation of labor, what value of L, maximizes the value of production Y? Look at (1). If p c L a EU c p f L a EU f > 0 then clearly all labor should be allocated to production of c, L = L EU. But this is equivalent to having p c p f > aeu c af EU The opportunity cost of expanding production of good c is smaller than the opportunity cost the markets give. (2)

46 Trade and Technology 8 You can convince yourself that when pc p f be allocated to production of f. What happens if pc p f = aeu c af EU? < aeu c af EU all labor will Obviously, income is maximized by any allocation of labor. In this case allocation of labor will be determined by demand. At the same time prices would be determined by technology,the previous formula tells that relative prices pc p f determined by the unit labor requirements/labor productivities. This is the labor theory of value developed and used by classical economists. are

47 Trade and Technology 9 The labor theory of value holds if a) all goods are always demanded (as then complete specialization = allocation of all labor to one sector only) would not be an equilibrium, there would be excess supply of one commodity and excess demand of the other), and b) the economy is closed. Those interested in history of economic thought would benefit from this account of the labor theory of value by Branko Milanovic: labor-theory-of-value-primer.html. It is more about Karl Marx s version of it, who along with Ricardo realized that the classical theory does not hold exactly, in Ricardo s case because of the possibility to international trade, in Marx case because of the heterogeneity of labor.

48 Trade and Technology 10 How can we understand the results on labor allocation from the perspective of individual agents, through their actions and choices? In this simple model with just one factor of production, labor, resources would with given prices obviously flow to the sector with highest return = highest wage (people are self-employed). As with perfect competition no pure profits can exist prices have to equal unit costs. We have already implicitly assumed that labor is fully mobile across sectors. With this, wages have to be equal in both sectors if both goods are produced, otherwise the economy will be completely specialized.

49 Trade and Technology 11 The unit costs of production = costs of producing one unit of the commodity are a EU c w c, a EU f w f (3) Here w c (w f ) = the wage that can be earned in producing good c (f ). Since unit costs must equal the price the wage rates are p c = a EU c w c, p f = a EU f w f (4) w c = pc a EU c w f = pf af EU (5) (6)

50 Trade and Technology 12 People switch producing in sector c if the returns there are higher than in sector f, w c > w f. This happens, using (5) and (6), when p c p f > aeu c af EU This is exactly the same condition as derived above (see (2)) for the complete specialization of production on c. You can go yourself through the other cases. Thus, with both goods produced the labor theory of value holds also from the point of view of maximizing the returns to labor. (7)

51 Trade and Technology 13 The final item to notice before going to international trade case is that, as shown by equation (2) and our discussion after this, the resource allocation depends only on relative prices, p c p f, and not on absolute price levels, the exact values of p c and p f, but only their ratios. This is a reflection of the fact that we do not have any money in the model. But even with money we would reach the same result by assuming that there is not money illusion in the economy (or alternatively, money neutrality). The result on the competitive economy maximizing the value of production for given prices is used actually in large Computable General Equilibrium models in solving the model. These models are extensively used in trade policy analysis.

52 Trade and Technology 14 We are now ready to introduce the second country K. As in EU resource allocation depends on the ratio of market prices relative to unit labor requirements there. Thus, if pc p f > ak c a K f, K produces only c, if pc p f = ak c a K f < ak c a K f only good f and if pc p f determined by demand, it can produce both goods. it produces its resource allocation will be Notice that I have assumed the goods prices to be equal in both countries. This is the standard assumption, I come later to issues which arise if there are trading costs (trade policies are among them).

53 Trade and Technology 15 Now we know that if ak c a K f = aeu c af EU, there will not be any trade between the two countries (or more precisely, trade would be indeterminate, the pattern of trade, which would exporting what, would be indeterminate, and it would not have any impact). Why? Assume now that ak c = aeu af K c af EU Let us define comparative advantage, CA, as follows: EU has a comparative advantage in producing good c if and only if aeu c < ak a f EU c a f K Obviously K has comparative advantage in producing f.

54 Trade and Technology 16 The other way to put this is to say that country has a CA in producing c if its relative unit costs of producing it are lower than in the other country. CA implies a precise pattern of trade: If there is any trade between the countries the country will be exporting the good in the production of which it has comparative advantage. Take the case in which aeu c af EU pc p f ak c a K f The prices here are now the world market prices. By the analysis above, in this case at least one of the countries would be completely specialized. EU would produce always c, K always f. Thus, if in both countries there is some demand for the good produced in the other, EU would be exporting c and importing f, K exporting f and importing c..

55 Trade and Technology 17 With all other price ratios both countries would be specialized in producing the same good, and there would not be any trade. But this cannot be an equilibrium if there is demand for both of the goods in the global economy at all prices. So we assume that holds. a EU c a EU f pc p f ak c a K f Using (8) one can show that there are gains from international trade. (8)

56 Trade and Technology 18 One way of doing this is to look at real wages (wages deflated by prices), if they increase then welfare increases. Let us look at EU. We know then that EU produces (and exports) good c. In this case ac EU w EU = p c which implies that the real wage in terms of good c is w EU p = 1. c ac EU This is the same as without trade, so the purchasing power of domestic wages over the export good does not change. So, look at the other real wage: w EU p f = w EU /p c p f /p c w EU /p c af EU /ac EU = 1 a EU f

57 Trade and Technology 19 The inequality comes from (8). Now 1 is the real wage prevailing in EU without trade. Thus, af EU this real wage increases with trade and does strictly so when EU is completely specialized (strict inequality holds in (8)). With trade based on comparative advantage citizens possible choices are not bound by the production possibility set but by the market value of production. The EU-citizens budget constraint (assume EU is completely specialized) is p c C EU c + p f C EU f C EU f p c Q EU c = p c LEU a EU c pc L EU p f ac EU pc p f C c EU

58 Trade and Technology 20 Here the C s and Q s are consumption and production volumes. Next figure shows the difference between production possibilities and consumption volumes:

59 SugarSync/Luennot/International Trade 2017/Lecture 1/IntTrL1F3.pdf Trade and welfare Consumption possibilities slope = slope = - Production possib.

60 Trade and Technology 21 If in both countries have larger consumption opportunities than production opportunities, then international trade must increase global production of both goods. How? The logic: Start by assuming that all labor in the world is allocated to the production of c. Assume then that the production of c is reduced by one unit. Will this reduction take place in EU or in K? Here it must take place in K as it has comparative advantage in producing f, it is relatively more productive in production of f. This continues until all labor in K has been transferred to production of f. Further increases in production of f must come at the expense of production in EU. Next Figure repeats this and shows the resulting global production possibilities.

61 SugarSync/Luennot/International Trade 2017/Lecture 1/IntTrL1F4.pdf International division of labor and production possibilities slope = - slope = -

62 Trade and Technology 22 With trade changes in global structures of production can always be made by using technology with the smallest opportunity costs even when the most efficient technologies cannot be used in individual countries. This is equivalent to saying that trade increases global productivity even with the given technologies. These gains are one source of growth impacts trade creates. Empirics of trade and growth? The results give quite a rosy picture from gains of trade. But in a sense this is a lousy model of trade. Why? We ll get back to this.

63 Trade and Technology 23 Up until now we have not specified the demand side at all except for assuming demand structure where all goods are demanded and assuming that consumer welfare is increasing in her real income (real wage). The backside of this is that we have not been able to pin down the equilibrium prices but in the closed economies. By augmenting the model with an explicit demand side it becomes a rudimentary example of a general equilibrium model of the world economy. These type of models are among the main tools used in analyzing the impacts of changes in trade (and other) policies. The are usually hard to solve analytically, that is why they are called C(omputable)G(eneral)E(quilibrium) models.

64 Trade and Technology 24 An particularly easy way to model the demand side is to assume that spending on each good is a constant proportion of income. This type of structure comes from assuming Cobb-Douglas-preferences U = C α c C 1 α f, 0 < α < 1 (9) The consumer maximizes this by choosing consumption levels from her budget set p c C c + p f C f Y (10)

65 Trade and Technology 25 Here Y is the nominal income. The optimal choices are C c = α Y p c (11) C f = (1 α) Y p f (12) Assuming both countries are completely specialized Y EU = p c LEU and Y K = p f LK. ac EU af K

66 Trade and Technology 26 For EU the demands are C EU c = α LEU ac EU, Cf EU = (1 α) pc L EU p f ac EU (13) Analogous expressions hold for K. Notice that demands depend, in both countries, only on the relative price pc p f. Thus, there is only one variable for which the model can be solved, the relative price. But there are two equilibrium conditions, one for each good, is not this a problem, as we need then two variables (prices) to get a solution?

67 Trade and Technology 27 No, the equilibrium conditions are not independent, the Walras Law holds: If one of the markets is in equilibrium then the other market is also in equilibrium. The budget constraints are p c C EU c + p f C EU f = p c LEU a EU c p c C K c + p f C K f = p f LK a K f Sum these side by side and reorganize the expression to get the equation [ ] [ p c Cc EU + Cc K LEU L ac EU = p f K af K C EU f C K f ] (14)

68 Trade and Technology 28 The equilibrium condition for the market of c is C EU c + C K c = LEU a EU c If this holds then also, by (14), also the market for f is in equilibrium: C EU f + C K f = LK a K f Thus, we have only one equilibrium condition and it can be used to solve for the equilibrium price-ratio.

69 Trade and Technology 29 Since only relative prices can be solved, a standard practice is to choose some good (or basket of goods, or some nominal aggregate) as the numeraire in terms of which all other prices are expressed. In our case one could e.g. choose good f as the numeraire and set p f = 1. All other prices and incomes would then be measured in terms of good f. The standard practice in deflating GDP s or aggregate expenditures or wages by CPI or GDP deflator are examples of this. We are now ready to solve the model just built.

70 Trade and Technology 30 The equilibrium condition for the market of good c is α LEU a EU c This can be solved for pf p c : + α pf p c L K a K f = LEU a EU c (15) giving p f p c = 1 α α p c p f = α 1 α L EU a EU c L K a K f L K a K f L EU a EU c (16) (17)

71 Trade and Technology 31 Recall that we have assumed, in calculating this equilibrium, that both countries are completely specialized, that a EU c a EU f < pc p f < ak c a K f holds. We must then look the conditions under which this is true: a EU c a EU f < α 1 α L K a K f L EU a EU c < ak c a K f Thus: differences in expenditure shares cannot be two different, countries size differences (in terms of labor force) cannot be too large, and countries productivity differentials cannot be too large. (18) (19)

72 Trade and Technology 32 The last point is important: This is the first time in this lecture when absolute advantage, the absolute level of productivity is mentioned. Before Ricardo (and unfortunately also after him) absolute advantage was thought to be crucial for trade, Ricardo pointed out that also a country with absolute disadvantage (with lowest productivity in all activities) can successfully enter in beneficial trade with other countries. But: absolute (dis)advantage can play a role in global structural change.