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Chapter 3. Why Everybody Trades: Comparative Advantage and Factor Proportions. Mercantilism.
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Chapter 3 Why Everybody Trades: Comparative Advantage and Factor Proportions
Mercantilism • Mercantilists' view on Trade: The more gold and silver a nation had, the richer and more powerful it was. Thus, the government had to do all in its power to stimulate the nation's exports and discourage and restrict imports (particularly the import of luxury consumption goods).
Absolute Advantage • When one nation is more efficient (AA over) than another in the production of one good but is less efficient than (absolute disadvantage with respect to) the other nation in producing other goods, then both nations can gain by each specializing in the production of the good of its AA and exchanging part of its output with the other nation for the good of its absolute disadvantage (AD).
Comparative advantage • A country will export the goods and services that it can produce at a low opportunity cost and import the goods and services that it would otherwise produce at a high opportunity cost.
Comparative advantage • The opportunity cost of producing more of a product in a country is the amount of production of the other product that is given up. The opportunity cost exists because production resources must be shifted from the other product to this product.
Comparative advantage Ricardo focused on labor productivity (or resource productivity more generally) for different products in different countries. Basis for trade: Relative differences in labor (resource) productivity.
Comparative Advantage: The Ricardian Model • Assumptions : (1) One factor (2) Differences in labor productivity across countries (3) Two goods (4) Two countries (5) Constant returns to scale
Ricardo’s constant costs and the production-possibility curve Production possibility curve (PPC) shows all combinations of amounts of different products that an economy can produce with full employment of its resources and maximum feasible productivity of these resources.
Community Indifference Curves A curve that shows how the economic well-being of a whole group depends on the whole group’s consumption of products.
Production and consumption together • Trade triangle shows export and import quantities for each country.
The gains from trade • Trade allows each country to consume at a point that lies beyond its own ability to produce. • Trade allows each country to achieve a higher community indifference curve.
The gains from trade • Terms of trade shows a country’s export prices relative to its import prices. • For each country, the gains from trade depend on the country’s international terms of trade.
Trade affects production and consumption • The opening has two types of implications for production: First, within each country output expands for the product in which the country has a comparative advantage. Second, the shift from no trade to free trade results in more efficient world production as each country expands output of the product in which it is initially the lower-cost producer. • In each country, opening to trade also alters the quantities consumed of each product.
What determines the trade pattern • Production conditions differ---the relative shapes of the production-possibility curves differ between the countries. • Consumption conditions differ---the relative shapes and positions of the community indifference curves differ between the countries. • Some combination of these two differences.
The skewness of one country’s PPC could arise for two reasons: • Production technologies or resource productivities may differ between countries. • Differences in resource availability and resource use
Heckscher-Ohlin Theory of Trade A country will export products that use relatively intensively those production factors found relatively abundantly in the country, and import products that use relatively intensively those production factors that are relatively scarce in the country.
Heckscher-Ohlin Theory of Trade • A country is relatively labor-abundant if it has a higher ratio of labor to other factors than does the rest of the world. • A product is relatively labor-intensive if labor costs are a greater share of its value than they are of the value of other products.
Questions • Using standard Ricardian assumptions analyzes questions
Questions A has 30 million hours of labor in total per year. Bhas 20 million hours of labor per year. 1)Which country has an absolute advantage in wine? In cheese? 2)Which country has a comparative advantage in wine? In cheese?
Questions 3)Graph each country’s production-possibility curve. Using community indifference curves, show the no-trade equilibrium for each country (assuming that with no trade, A consumes 1.5 million kilos of cheese and B consumes 3 million kilos of cheese).
Questions 4)When trade is opened, which country exports which good? If the equilibrium international price ratio is ½ bottle of wine per kilo of cheese, what happens to production in each country?
Questions 5)In this free-trade equilibrium, 2 million kilos of cheese and 1 million bottles of wine are traded. What is the consumption point in each country with free trade? Show this graphically using community indifference curves. 6)Does each country gain from trade? Explain, referring to your graphs as is appropriate.
Questions • “According to Ricardo’s analysis, a country exports any good whose production requires fewer labor hours per unit than the labor hours per unit needed to produce the good in the foreign country. That is, the country exports any good in which its labor productivity is higher than the labor productivity for this good in the foreign country.” Do you agree or disagree? Why?
Comparative Advantage and Economic Growth • China's President Hu Jintao recently reported the strongest economic growth in three years, noting that his country's economy (or GDP) was 10.2 percent larger in the first quarter of 2006 than it was in the first quarter of 2005. This strong surge in economic activity--the strongest in three years--has many analysts wondering whether the Chinese government will take any action to prevent their economy from overheating.
The Chinese government tried to control similar rapid growth in 2002 by urging bankers to clean up bad loans and ensure that new loans are based on creditworthiness requirements. But many economists say that China's actions to stem the economic tide will not be nearly as noticeable this year. China is experiencing low inflation; domestic consumption is growing stronger, and economic growth is not as concentrated in large factory and public works projects as it has been in recent years. Add to these factors China's clear comparative advantage in its virtually inexhaustible labor resource and the strong growth rate could last for many years.
Economists speak of comparative advantage when a country--such as China--has a lower relative or comparative resource cost than do other countries. In this case, the comparative advantage over the U.S. and European countries consists of China's ability to produce labor-intensive goods like textiles, which can be produced cheaply in China where labor is abundant and inexpensive. One Chinese economist, Lu Zheng, says this comparative advantage in labor could last two decades and play an important part in promoting Chinese economic growth.
Many countries, including the U.S., would like to see China apply some economic restraints, but such intervention does not look likely in the near future. "I don't expect them to take any drastic action; they are comfortable with higher growth," said Frank Gong, the chief economist for greater China at J.P. Morgan Chase. "They will keep growth like this for a while."
