Summary International Economics: Theory and Policy, Global Edition, ISBN: 9781292214870 International Economics
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Module
International Economics
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Erasmus Universiteit Rotterdam (EUR)
Book
International Economics
This summary includes all relevant theory for the International Economics course. This is an elaborate summary and could be used as a substitute for reading the course material.
Main book: Summary International Economics: Theory and Policy, Global Edition, ISBN: 4870 International Economics. A...
Summary International Trade Theory Lectures ('21 - '22)
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Chapter 3 Labor Productivity and Comparative
Advantage: The Ricardian Model
Countries trade due to two reasons: (1) they are different from each other, (2) to achieve economies
of scale in production.
The Concept of Comparative Advantage
A country has a comparative advantage in producing a good if the opportunity cost of producing that
good in terms of other goods is lower in that country than it is in other countries. Trade between two
countries can benefit both countries if each country exports the goods in which it has a comparative
advantage. The question is if it will also be realized in the market place.
Ricardian model: International trade is solely due to international differences in the productivity of
labor.
Assumptions of the model:
1. Two countries: home and foreign
2. Two goods: wine and cheese
3. Labor is the only factor of production
4. The supply of labor in each country is
constant
5. Labor productivity varies across countries
due to differences in technology, but is
constant (over time) in each country =>
productivity determines opportunity costs/comparative advantages.
6. Competition:
a. In the goods market: workers are paid a wage equal to the value of what they produce.
i. Profits = 0, as revenues = costs = wages.
ii. Hourly wages in each industry equal the value of what is produced in an hour w C =
PC/aLC
b. In the factors market: workers work in the industry that pays the highest wage.
i. This depends on the relative price: PC/PW
ii. And determines what a country produces.
A One-Factor Economy
Unit labor requirement -> the number of hours of labor required to produce something (a L) -> the
inverse of productivity. L, total labor supply.
- A high unit labor requirement means low labor productivity.
Production possibility frontier -> illustrate trade-offs between producing goods. If there is only one
factor of production, this is a straight line.
,- When it is a straight line, the opportunity cost of a pound of cheese in terms of wine is constant.
The opportunity cost of cheese in terms of wine is a LC/aLW = slope of frontier (x/y).
Relative Prices and Supply
The production possibility frontier (PPF) illustrates the
different mixes of goods the economy can produce. To
determine what the economy will actually produce, however,
we need to look at prices. Specifically, we need to know the
relative price of the economy’s two goods, that is, the price
of one good in terms of the other. In a competitive economy,
supply decisions are determined by the attempts of
individuals to maximize their earnings. In our simplified
economy, since labor is the only factor of production, the supply of cheese and wine will be
determined by the movement of labor to whichever sector pays the higher wage. No profits in this
model.
- Hourly wage = PC / aLC -> determines what people will make. Only when the hourly wage is equal,
both goods will be produced.
- The economy will specialize in the production of cheese if the relative price of cheese exceeds its
opportunity cost in terms of wine; it will specialize in the production of wine if the relative price of
cheese is less than its opportunity cost in terms of wine.
- In the absence of international trade, Home would have to produce both goods for itself. But it
will produce both goods only if the relative price of cheese is just equal to its opportunity cost. In
the absence of international trade, the relative prices of goods are equal to their relative unit
labor requirements.
Trade in a One-Factor World
-> Home has a comparative advantage in cheese -> have
to compare all 4 unit labor requirements, not just that
one on cheese.
Absolute advantage -> when one country can produce a
unit of a good with less labor than another country.
Once we allow for the possibility of international trade,
however, prices will no longer be determined purely by
domestic considerations. If the relative price of cheese is
,higher in Foreign than in Home, it will be profitable to ship cheese from Home to Foreign and to ship
wine from Foreign to Home. This cannot go on indefinitely, however. Eventually, Home will export
enough cheese and Foreign enough wine to equalize the relative price.
Determining the Relative Price after Trade
Determined by supply and demand.
Partial equilibrium analysis -> to study a single market (e.g. the sugar market).
When studying comparative advantage, it is
crucial, however, to keep track of the
relationship between markets (e.g. wine and
cheese) -> need general equilibrium
analysis, which takes account of the linkages
between the two markets.
- One useful way to keep track of two
markets at once is to focus not just on
the quantities of cheese and wine
supplied and demanded but also on the
relative supply and demand, that is, on
the number of pounds of cheese
supplied or demanded divided by the number of gallons of wine supplied or demanded.
- The relative demand curve & relative supply curve. World general equilibrium requires that
relative supply equal relative demand, and thus the world relative price is determined by the
intersection of RD and RS.
- The RS curve shows that there would be no supply of cheese if the world price dropped below
aLC/aLW. Recall that if PC/PW < aLC/aLW and same for the foreign market, they will prefer wine. Then
there is the assumption aLC/aLW < a*LC/a*LW. So at relative prices of cheese below aLC/aLW, there
would be no world cheese production.
- When the relative price of cheese PC/PW is exactly aLC/aLW, Home is willing to supply any relative
amount of the two goods, producing a flat section to the supply curve.
- We have already seen that if PC>PW is above aLC>aLW, Home will specialize in the production of
cheese. As long as PC>PW 6 aLC* >aLW* , however, Foreign will continue to specialize in producing
wine.
- The relative demand curve RD does not require such exhaustive analysis. The downward slope of
RD reflects substitution effects. As the relative price of cheese rises, consumers will tend to
purchase less cheese and more wine, so the relative demand for cheese falls.
- The equilibrium relative price of cheese is determined by the intersection of the relative supply
and relative demand curves. Figure 3-3 shows a relative demand curve RD that intersects the RS
, curve at point 1, where the relative price of cheese is between the two countries’ pre-trade
prices. In this case, each country specializes in the production of the good in which it has a
comparative advantage: Home produces only cheese, while Foreign produces only wine. This is
not, however, the only possible outcome. If the relevant RD curve were RD ′, for example, relative
supply and relative demand would intersect on one of the horizontal sections of RS. At point 2,
the world relative price of cheese after trade is a LC/aLW, the same as the opportunity cost of
cheese in terms of wine in Home. What is the significance of this outcome? If the relative price of
cheese is equal to its opportunity cost in Home, the Home economy need not specialize in
producing either cheese or wine. In fact, at point 2 Home must be producing both some wine and
some cheese; we can infer this from the fact that the relative supply of cheese (point Q ′ on the
horizontal axis) is less than it would be if Home were in fact completely specialized. Since P C/PW is
below the opportunity cost of cheese in terms of wine
in Foreign, however, Foreign does specialize
completely in producing wine. It therefore remains
true that if a country does specialize, it will do so in the
good in which it has a comparative advantage.
- For the moment, let’s leave aside the possibility that
one of the two countries does not completely
specialize. Except in this case, the normal result of
trade is that the price of a traded good (e.g., cheese)
relative to that of another good (wine) ends up
somewhere in between its pre-trade levels in the two
countries.
The Gains from Trade
Both countries derive gains from trade from this
specialization. This can be demonstrated in 2 ways:
- The first way to show that specialization and trade are beneficial is to think of trade as an indirect
method of production. Home could produce wine directly, but trade with Foreign allows it to
“produce” wine by producing cheese and then trading the cheese for wine. This indirect method
of “producing” a gallon of wine is a more efficient method than direct production. More
generally, consider two alternative ways of using an hour of labor. On one side, Home could use
the hour directly to produce 1/aLW gallons of wine. Alternatively, Home could use the hour to
produce 1/aLC pounds of cheese. This cheese could then be traded for wine, with each pound
trading for PC/PW gallons, so our original hour of labor yields (1/a LC)(PC/PW)
gallons of wine. This will be more wine than the hour could have produced
directly as long as (see condition). And the latter holds because otherwise
countries would produce both goods.
- Another way to see mutual gains from trade is to examine how trade affects
each country’s possibility for consumption. In the absence of trade,
consumption possibilities are the dame as production possibilities. However, not when trade is
allowed (See 3-4).
A Note on Relative Wages
Our discussion of international trade up to this point has not explicitly compared wages in the two
countries, but it is possible in the context of our numerical example to determine how the wage rates
in the two countries compare. In our example, once the countries have specialized, all Home workers
are employed producing cheese. Since it takes one hour of labor to produce one pound of cheese,
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