Economics 1535: Lecture 6

Transcription

1 Economics 1535: Lecture 6 The Ricardian Model (II): Free Trade Equilibrium and Gains from Trade Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 1

2 Plan for Today Describe world equilibrium in the Ricardian model Provide a numerical example of a world equilibrium in the Ricardian model Illustrate and discuss the gains from trade in the Ricardian model Discuss how relative wages are determined Provide some preliminary empirical evidence Preliminary lessons from the model Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 2

3 Trade in the Ricardian Model Consider now a situation where Home and Foreign are allowed to trade clothing and wine with each other Assume that the Foreign labor force is equal to L * and that unit labor requirements in both countries satisfy a LC /a LW < a * LC /a * LW This implies that under autarky: 1. The opportunity cost of cloth in terms of wine is lower at Home than in Foreign 2. The relative price of cloth in terms of wine is lower at Home than in Foreign This implies that we are assuming that Home has comparative advantage in cloth Satisfies both relative price and opportunity cost definitions of comparative advantage Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 3

4 World Equilibrium In the free trade equilibrium, we will have that: 1. consumers choose their demand of cloth and wine to maximize their utility; 2. firms choose their production levels to maximize profits; 3. world demand and supply of each good are equated; 4. each country s demand and supply of labor are equated Main difference with autarky equilibrium is part (3), where under autarky we imposed equilibrium in each country Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 4

5 Profit Maximization Firm behavior is essentially identical to that in the autarkic equilibrium If P C /P W < a LC /a LW < a * LC /a * LW then no firm or worker in either country would want to produce clothing If P C /P W > a * LC /a * LW > a LC /a LW then no firm or worker in either country would want to produce wine What happens when P C /P W = a * LC /a * LW or P C /P W = a LC /a LW? Firms/workers in 1 country are indifferent between producing either good What happens when a * LC /a * LW > P C /P W > a LC /a LW? Home only wants to produce cloth: Q C = L/a LC, Q W = 0 Foreign only wants to produce wine: Q C = 0, Q * W =L * /a * LW Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 5

6 World Relative Supply P C /P W a * LC /a * LW RS a LC /a LW L/a LC * * L /a LW Q C /Q W Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 6

7 Demand Side of the Model Up to now we have ignored the demand side of the model It did not play any role in determining relative prices under autarky Workers receive their wage w or w * and they spend it on clothing and food Assume that workers in both countries have identical homothetic preferences This implies that their relative demand of the two goods is independent of wages Hence, the relative demand schedule is identical in both countries And since consumers in both countries face the same relative prices, they will also have a common relative demand Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 7

8 World Equilibrium Three possible types of equilibria P C /P W incomplete specialization a * LC /a * LW RS RD 1 a LC /a LW RD 2 complete specialization incomplete specialization RD 3 L/a LC * * L /a LW Q C /Q W Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 8

9 A Numerical Example Consider our Lecture 2 example with England and Portugal, where L = L * =100 We can represent the technology matrix as follows Note that England has absolute advantage in both goods, but comparative advantage in cloth: 5/10 < 4/6 On the demand side, assume U(D C,D W ) = (D C ) 3/5 (D W ) 2/5 Unit labor requirements Cloth England a LC = 1/10 workers/unit Portugal a * LC = 1/6 workers/unit Wine a LW = 1/5 workers/bottle a * LW = 1/4 workers/bottle Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 9

10 A Numerical Example (cont.) From Lecture 3, relative demand is given by DC 3 1 = D 2 P /P W C W P C /P W 2/3 RS The relative supply curve is plotted on the right L/aLC 100 /(1/10) = = 2.5 * * L /a 100 /(1/ 4) LW RD The equilibrium is: P C /P W = 0.6 D C /D W =Q C /Q W = Q C /Q W Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 10

11 A Numerical Example (cont.) We thus see that in equilibrium, England exports cloth and Portugal exports wine, just as we hypothesized in Lecture 2 Furthermore, consistent with our suggested numbers: England fully specializes in cloth and produces 1000 pieces of cloth Portugal fully specializes in wine and produces 400 bottles of wine This implies that income in England is 1000 P C, which is spent on cloth (P C D C ) and wine (P W D W ) Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 11

12 A Numerical Example (cont.) From the demand side we also know that 2 P C D C =3 P W D W We thus have (1+2/3) P C D C = 1000 P C D C = 600 Using P C /P W = 0.6, we also have D W = 240 Exercise: show that D * C = 400 and D * W = 160 Looks familiar? Exercise: show that in autarky, D C = 600 and D W = 200 and D * C = 360 and D * W = 160 (looks familiar?) Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 12

13 Gains From Trade in the Example Hence, in our example, both countries are better off Still, how general is this result? Does it depend on Cobb-Douglas preferences? Does it depend on the specific Cobb-Douglas function we assumed? Does it depend on equal population sizes? Do both countries generally gain? Can a country lose? Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 13

14 Gains From Trade: Autarky We can represent the autarkic equilibrium in each country as follows Q W Q * W L/a LW L * / a * LW a a LC LW a a * LC * LW L/a LC Q C L * /a * LC Q * C Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 14

15 Gains From Trade: Graph Free trade has an effect analogous to an expansion of the PPF Q W Q * W L/a LW C L * / a * LW A A C P C /P W P C /P W L/a LC Q C L * /a * LC Q * C Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 15

16 Gains from Trade Gains from trade come from specializing in production that uses resources most efficiently and using the income generated from that production to buy the goods and services that the country desires Using resources most efficiently means producing a good in which a country has a comparative advantage Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 16

17 Production vs. Consumption Gains There are actually two forces at play in shift from A to C Consumption gains from trade (A to B), as in Lecture 4 Production gains from trade (B to C) Q W L/a LW B C A P C /P W L/a LC Q C Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 17

18 Gains from Trade: Caveat Caveat: for both countries to gain from trade, we need an equilibrium with complete specialization Whenever we have an equilibrium in which one country produces both goods, then we know that relative prices have to be identical to the autarky ones, and welfare will not be affected by trade in that country Free trade may not be strictly Pareto superior but we will see it generally is Pareto superior with many goods Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 18

19 Trade as Indirect Method of Production One can think of trade as an indirect and more efficient method of production For instance, when Home produces wine under autarky, each worker produces 1/a LW bottles of wine With trade, a worker can: 1. produce 1/a LC pieces of cloth; 2. sell them in the world market for an amount P C (1/a LC ) 3. use this income to buy P C (1/a LC ) / P W bottles of wine But P C (1/a LC ) / P W 1/a LW, with strict inequality in an equilibrium in which Home is completely specialized Hence, Home can procure wine for itself more efficiently by trading with Foreign than by producing wine itself Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 19

20 Trade as Indirect Method of Production Similarly, when Foreign produces wine under autarky, each worker produces 1/a * LC units of cloth With trade, a worker can: 1. produce 1/a * LW bottles of wine; 2. sell them in the world market for an amount P W (1/a * LW ) 3. use this income to buy P W (1/a * LW ) / P C units of cloth But P W (1/a * LW ) / P C 1/a * LC, with strict inequality in an equilibrium in which Foreign is completely specialized Hence, Foreign can procure cloth for itself more efficiently by trading with Home than by producing cloth itself Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 20

21 Distributional Effects (or lack thereof) The Ricardian model is extremely simple in that: 1. All workers are identical (or units of skill are perfect subst.) 2. Workers can costlessly transition between sectors 3. All markets are perfectly competitive and all markets clear (hence, no unemployment) As a result, all workers gain from trade and there is no need for redistribution The next two models we will present will feature distributional effects Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 21

22 Relative Wages Relative wages are the wages of the domestic country relative to the wages in the foreign country Although the Ricardian model predicts that goods prices equalize across countries after trade, it does not predict that wages will do the same Productivity (technological) differences determine wage differences in the Ricardian model A country with absolute advantage in producing a good will enjoy a higher wage in that industry after trade Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 22

23 Relative Wages (cont.) Notice that regardless of the type of equilibrium, Home workers produce cloth and Foreign workers produce wine The wage at Home is thus equal to revenue per worker in cloth (remember zero profits), and hence w = P C (1/a LC ) The wage in Foreign equals revenue per worker in wine, so w * = P W (1/a * LW) The relative wage of domestic workers is therefore w * = w P P C W a a * LW LC Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 23

24 Relative Wages (cont.) Remember that P C /P W a LC /a LW, and hence w/w * a * LW/a LW Similarly, P C /P W a * LC/a * LW implies that w/w * a * LC/a LC Putting the pieces together we have that the relative wage lies between the ratios of the two countries productivities in the two industries: a * LC/a LC w/w * a * LW/a LW Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 24

25 Relative Wages (cont.) a * LC/a LC w/w * a * LW/a LW If Home has absolute advantage in both industries, then w > w * In our recurrent example, we have that w/w * = 1.5 With complete specialization, w/w * will fall strictly between the bounds (each countries has a cost advantage in one good) When both countries produce the same good, relative wages are given by the ratio of productivities in that good (absolute advantage determines wages) Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 25

26 Comparative Advantage and Wages Consider a situation in which Home has absolute advantage in both industries Naïve intuition suggests it should be producing both goods Absolute advantage seems to govern competition between firms What the Ricardian model formalizes is that the more productive Home is (and thus the more we would want it to produce), the larger will labor demand be at Home and this will translate into a larger relative wage and a cost advantage for Foreign Bottom line: A firm can expand production without affecting (much) wages; a country cannot Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 26

27 Preliminary Empirical Evidence In the Ricardian model, relative wages reflect the relative productivities of the two countries Some argue that lowwage countries pay low wages despite growing productivity, putting high-wage countries at a cost disadvantage What does the evidence suggest? Estimates for 2007 Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 27

28 Misconceptions We have dispelled the following misconceptions 1. Free trade can be beneficial only if a country is strong enough to stand up to foreign competition gains from trade are related to comparative advantage 2. Free trade with countries that pay low wages hurts high-wage countries and is unfair Free trade will lead to the dislocation of some workers, but these workers can (in principle) transition to another sector that leaves them with higher real income, due to lower relative price of imported good Bastiat s Petition of the Candle Makers 3. Free trade exploits less productive countries On welfare grounds they are better off What about labor standards and so on? Key question: what is the counterfactual? Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 28

29 Frédéric Bastiat ( ) Economic Sophisms, 1845 Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 29

30 Petition of the Candle Makers We are suffering from the ruinous competition of a rival who apparently works under conditions so far superior to our own for the production of light that he is flooding the domestic market with it at an incredibly low price [ ] This rival, which is none other than the sun, is waging war on us so mercilessly we suspect he is being stirred up against us by perfidious Albion (excellent diplomacy nowadays!), particularly because he has for that haughty island a respect that he does not show for us. Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 30

31 Petition of the Candle Makers We ask you to be so good as to pass a law requiring the closing of all windows, dormers, skylights, inside and outside shutters, curtains, casements, bull's-eyes, deadlights, and blinds in short, all openings, holes, chinks, and fissures through which the light of the sun is wont to enter houses, to the detriment of the fair industries with which, we are proud to say, we have endowed the country, a country that cannot, without betraying ingratitude, abandon us today to so unequal a combat. Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 31

32 Plan for Next Time Introduce non-traded goods into the model Sketch a multi-good extension of the model Discuss some comparative statics and relate them to recent debates Provide further empirical evidence Pol Antràs (Harvard) Fall 2015 Economics 1535: Lecture 6 32