University of Cassino Economics and Business Academic Year 2018/2019 International Economics International Trade (Comparative advantage II) Maurizio Pugno University of Cassino 1
Comparative Productivity Advantage and the Gains from Trade Question: What happens if a country does not have an absolute productivity advantage in anything? Answer: Even if a country does not have any goods with an absolute productivity advantage, it can still benefit from trade - The idea that nations benefit from trade has nothing to do with whether a country has an absolute advantage in producing a particular good 2
Example Output per Hour Worked Chips Steel US 2 3 Malaysia 1.2 1 The US has an absolute advantage in both (2>1.2) and steel (3>1). Malaysia has a relative advantage (not absolute!) in producing Chips (1.2/1)>(2/3). 3
Prices for the US and for Malaysia 200 198 1.5. B.83 1.2 165 0.67 PPC(M): =198-1.2*steel P s US = 0. 67 tons P s Malaysia = 1. 2 tons PPC(Malaysia) PPC(US) 300 P c US = 1. 5 steel tons P c Malaysa = 0. 83 PPC(US): =200-0.67*steel tons If Malaysia has resources = 165 hours (and the US =100) 4
P s US Canada = 0. = 67 3 loaves tons Gains from trade For the US, it is convenient to buy in Malaysia because their price is lower: P c Malaysa = 0. 83 tons For Malaysia, it is convenient to buy steel in the US because its price is lower: P s US = 0. 67 tons P c US =1. 5 tons P s Malaysia =1. 2 tons Therefore, for both countries it is convenient to exchange steel for. Both gain from trade. 5
At what price the US trade with Malaysia? 1.5. B 110 Initial assumptions - Production at B (135,110) - The US can trade with Malaysia. - Prices are within the ranges: P s US P s s = 0.67 < P < P = 1.2 c Malaysia W eg: P s =1 and P b =1. Malaysia c c = 0.83 < P < P = 1.5 W US 135 US prices 1 300 steel 1.2 World prices Malaysia prices 6
Quantifying gains from trade 200 1.5. B By selling 1 ton of steel to Malaysia, the US gives up 0.67. The US can now trade 1 ton of steel for 1, thus (net) gaining 0.33 (1-0.67 = 0.33). 1.67 300 steel 7
Towards specialization It is convenient to trade steel for, up to produce only steel and no at B (300,0). The US can export (a portion of 300 of) steel at P s =1, and import at P b =1. But how much export? 200 Consumption Possibility Curve PPC. B 1 B (complete specialization) steel 8 300
Trade of the US with Malaysia net gain 200 165 110. B 135 prices in Malaysia exports of steel US-CPC US-PPC 1.2 1 300 imports of Assumption The US consume 135 and export 165(=300-135) of steel. Result The US would import 165(=165*1) of with a net gain of 55(=165-110) of steel 9
Trade of Malaysia with the US exports of chpis 198 33 0.83 imports of steel M-CPC. 1.2 137,5 prices in the US M-PPC 165 198 0.67 If Malaysia specializes in, if it consumes 33, then it exports 165(=198-33) of. Malaysia would import 165(=165*1) of steel with a net gain of 27.5(=165-137.5) of steel. steel 10
Less gains from trade with relative advantage Comparing the gains from complete specialization in the 2 examples. productivities bread/ steel US 2 3 Canada 3 1 Malaysia 1.2 1 import (gain) Canada export import (gain) Malaysia export import (gain) 330 (220) 165 (55) US export 165 16.5 (55) (27.5) 11
The Ricardian Law of Comparative Advantage If one nation has an absolute disadvantage with respect to the other nation in the production of both commodities, both still gain from trade. The first nation specializes in the production and export of the commodity in which its absolute disadvantage is smaller (this is the commodity of its comparative advantage) and import the commodity in which its absolute disadvantage is greater. The gain is usually greater if both nations have an absolute advantage in one commodity. 12
Example of Ricardian Comparative Advantage Relative unit labor costs and exports US and Japan 13
Comparative wages (US vs Canada) If competitive markets prevail in the US. w s = MPL s = 3 tons of steel where hourly wage = w Marginal Productivity of Labor = MPL. In case of international trade with Canada: w = MPL s *(p s / p b ) = 3 tons *2 = 6 loaves of bread Hourly wages in Canada: w b = MPL b = 3 loaves of bread w = MPL b *(p b / p s ) = 3 loaves *0.5 = 1.5 tons of st. The US is richer than Canada (the double). 14
Comparative wages (US vs Malaysia) Memo: If competitive markets prevail in the US. w s = MPL s = 3 tons of steel hourly wage = w Marginal Productivity of Labor = MPL. In case of international trade with Malaysia: w = MPL s *(p s / p c ) = 3 tons *1 = 3 Hourly wages in Malaysia: w c = MPL c = 1.2 w = MPL *(p / p ) = 1.2 *1 = 1.2 15
Unequal gains (and losses) from trade When two countries become open to trade, they move to specialization, so that: - sectors with comparative advantage grow, - sectors with comparative disadvantage shrink. This is the economic restructuring. Labor should move from the shrinking sectors to the growing ones. Losses from trade arise if: - this move takes time (frictional unemployment) - labor is sector specific (structural unemployment). all consumers gain from trade, some workers lose. 16
Job losses in high-import sectors in the US (1979-1999) 17
Problems with trade and politics Trade liberalization in the US with respect to China since 2000 is associated to: loss of income and employment in manufacturing rise of deaths due to suicides, alcohol abuse which are concentrated in some counties and among white and male population (Pierce and Schott 2016). In Trump s election, he performed best in counties with the highest drug, alcohol and suicide mortality with high job losses in manufacturing (Monnat 2016). 18
Deindustrialization International trade is usually accompanied by: - technological progress, - consumers move towards services. This implies deindustrialization, i.e. severe shrinkage of manufacturing, so that: - entire groups of workers lose jobs, - entire regions become poor. 19
Factors responsible for deindustrialization 20
Economic Restructuring and policy The problems due to international trade are NOT automatically solved by the theory of comparative advantage, but they need specific policies. Policy may: - seek to get the winners from trade and restructuring to compensate the losers; - or impose restrictions to international trade (see next lectures). 21
Conclusions on the Ricardian model It explains why economic development is accompanied by international trade, i.e. because countries thus gain from trade. It explains the pattern (export/import flows) of international trade. It explains why countries may trade by maintaining income inequality between them. However, it appeals to different countries productivities without explaining them. It does not remedy the problem of restructuring It s restrictive since it assumes constant marginal productivities, and constant returns to scale. 22
Appendix: the production function Y = F(L,K) where L,K production factors Y = production (flow variable) L = labor hours (or no. of workers with standard working time) (flow variable) K = real capital (stock variable) F = production function 23
Properties of the production function Y _ Y=F(L,K) _ Y Y=F(L,K) L K F L >0 Marginal Productivity of Labor (MPL) = w F K >0 Marginal Productivity of capital (MPK) = r MPL is decreasing (F LL <0) MPK is decreasing (F KK <0 ) 24
Returns to scale of the production function The returns to scale are constant if: ay = F(aL,aK) i.e. by multiplying each production factor by a positive constant a, production Y is multiplied by a. For example: if Y = L 0.6 K 0.4 and if a=2, then 2Y = (2L) 0.6 (2K) 0.4 although: 2Y > (2L) 0.6 (K) 0.4 and 2Y > (L) 0.6 (2K) 0.4 being MPL and MPK decreasing. 25