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ECONOMICS 3150M

ECONOMICS 3150M. Winter 2014 Professor Lazar Office: N205J, Schulich flazar@yorku.ca 736-5068. Lecture 16: March 10 Ch. 2, 3, 4, 5. Comparative Advantage Models. 1. Single Factor, Ricardian Model Assumptions: One factor of production: X1 Two goods: Y1, Y2

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ECONOMICS 3150M

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  1. ECONOMICS 3150M Winter 2014 Professor Lazar Office: N205J, Schulich flazar@yorku.ca 736-5068

  2. Lecture 16: March 10Ch. 2, 3, 4, 5

  3. Comparative Advantage Models 1. Single Factor, Ricardian Model • Assumptions: • One factor of production: X1 • Two goods: Y1, Y2 • Constant returns to scale [Y = F(X1), δ=1] • PF: Yi = i1 X1 [i1: units of product i per unit of factor of production 1] • Resulting PPF: • Y1/ i1 + Y2/ 21  0X1 • Opportunity cost of Y1 in terms of Y2: 21/ 11 • No adjustment problems since sole factor of production can move costlessly and instantaneously between products

  4. Single Factor Ricardian Model • Utility maximization  optimal production and consumption point, P1, P2 • Slope of straight line PFF: • P2/P1 • 11/ 21 • Relationship between relative prices and opportunity costs

  5. Single Factor Ricardian Model • Two countries, two products, one factor of production • Conditions for pre-trade relative prices to differ [i.e. {P1/P2}A  {P1/P2}B] • Different production functions: i1(A)  i1(B) • Different tastes will not produce different relative prices • Absolute advantage vs. comparative advantage • Implications for productivity, incomes per capita, migration • Comparative advantage • Country has comparative advantage in product with lower relative opportunity cost • Country A has comparative advantage in product 1 if • [21/ 11 ]A < [21/ 11]B • {P1/P2}A < {P1/P2}B

  6. Single Factor Ricardian Model • Trade between A and B will equalize relative prices  {P1/P2}A = {P1/P2}B • Equilibrium relative prices post-trade between original pre-trade ratios • If A is large country and B a small country, equilibrium relative prices post-trade closer to pre-trade ratio in A • Specialization – small country, not necessarily for large country • Transportation costs • Protection of industries • Terms of trade: price of exported product relative to price of imported product • For country: P1/P2

  7. Single Factor Ricardian Model • Gains from trade • Consumption, production – pre-trade and post-trade • Exports, imports • Higher level of utility, higher level of real income/GDP • Equilibrium in currency market will result in current account balance = 0 • Total value of exports = total value of imports • D/S of country’s currency depend upon current account transactions only • For Country A: P1AEX(Y1) = P2BIM(Y2)E* • With no trade costs: P1A = P1BE* and P2A = P2BE*

  8. Single Factor Ricardian Model • Conclusions: • Extreme degree of specialization • No impact on distribution of income within each country – no losers (full employment, one factor of production) • Gains from trade • No explanation of differences in production functions and relative and absolute productivities • Volumes of exports and imports not determined

  9. Extension of Ricardian Model • Many products (i = 1, N), one factor of production • Assumptions: • Constant returns to scale • Perfect competition: Pi = MCi • MCi = P(X1)/i1 • Allocation of production in two country world (A, B) • Product i produced in country with lower MC • Produced in A: {P(X1)E/ i1}A < {P(X1)/ i1}B  {[P(X1)]AE /[P(X1)]B} < {i1}A / {i1}B • Produced in B: {[P(X1)]AE /[P(X1)]B} >{i1}A / {i1}B

  10. Extension of Ricardian Model • Order the products 1 to N so that {11}A / {11}B < {21}A / {21}B < …….. < {N1}A / {N1}B • All products 1 through K are produced in B and exported by B: {[P(X1)]AE /[P(X1)]B} > {K1}A / {K1}B and {[P(X1)]AE /[P(X1)]B} < {K+11}A / {K+11}B

  11. Extension of Ricardian Model • Products K+1 through N are produced and exported by A • Not all products may be traded – depends upon trade costs  non-traded products • Specialization, but if B is a large country, B also may produce, but not export some or all of the products 1 through K • Assumes that E is at equilibrium level so that value of A’s exports = value of B’s imports • If value of E changes so too does cut-off point “K”

  12. Services • 2010 • World merchandise exports: US$15.2 T • World commercial services exports: US$3.7T (20%) • P. 21: “”current dominance of world trade by manufactures…may be only temporary. In the long run, trade in services, delivered electronically, may become the most important component of world trade.” • Measurement problem with services • Unit of financial service; consulting service, legal service, call center service, etc.

  13. Heckscher-Ohlin Model • 2X2X2 model • Two countries • 2 factors of production • 2 products – different factor intensities • Identical production technologies and state of technology • Different relative resource availabilities: {X1/X2}A {X1/X2}B • Basis for trade: different resource availabilities which give rise to different pre-trade relative prices • Comparative advantage: interaction between relative abundance (supply) of resources (factors of production) and technology of production (relative intensity with which different factors of production used in production of different goods) • Counties export goods whose production is intensive in factors with which the countries are abundantly endowed

  14. Heckscher-Ohlin Model • Factor intensity:{X1/X2}i • Min TC = P(X1)X1 + P(X2)X2 s.t. 0Y1 = F1(X1, X2, T) • Factor intensity determined by intersection of isoquant and budget line • Constant returns to scale and factor intensity • Factor intensity {X1/X2}1depends upon {P(X2)/P(X1)} • If {P(X2)/P(X1)}  {X1/X2}1 • Relative prices of factors of production depend upon relative availabilities of factors of production • If {X1/X2}A  {P(X2)/P(X1)}A

  15. Heckscher-Ohlin Model • Relative prices of products {P1/P2} depend upon relative prices of factors of production [P=MC] {P(X1)/P(X2)}and relative factor intensities • Assume Y1 uses X1 relatively more intensively than Y2  {X1/X2}1 > {X1/X2}2 • As {P(X1)/P(X2)}  so too does P1/P2

  16. Heckscher-Ohlin Model • If {X1/X2}A > {X1/X2}Bthen {P(X1)/P(X2)}A < {P(X1)/P(X2)}B and {P1/P2}A < {P1/P2}B • A has comparative advantage in Y1 (Y1 uses X1 relatively more intensively and A has relative abundance of X1) • A will export Y1 and import Y2 • Specialization not necessary outcome even if one of the countries is a small country and the other is a large country • Trade will tend to equalize relative prices of products and factors of production

  17. Heckscher-Ohlin Model • Winners and losers • Net utility/income gains • Full employment and no transition costs •  D for Y1 post-trade   D for X1 in A  P(X1) in A •  S of Y2 post-trade   D for X2 in A   P(X2) in A • Welfare effects of changes in terms of trade: {P1/P2} for A • Assume improvement in terms of trade for A • Leads to improvement in aggregate welfare in A and increase in trade volumes • Owners of a country’s abundant factors gain from trade; owners of country’s scarce factors lose relatively and may lose in absolute values as well • Implications for income distribution between X1 and X2 •  D for X1 in A •  D for X2 in A

  18. Heckscher-Ohlin Model Increase in availability of factors of production in country A • Proportionate increase in both factors of production  no change in relative availabilities • Increase in volume of trade • Change in terms of trade  deterioration because of  S of Y1 from country A and  D for Y2 from country A • Increase in X1 (or disproportionate increase in X1) • Biased growth • Change in shape of PPF for country A  change in relative prices, change in terms of trade • Larger impacts on volume of trade and terms of trade • Growth leads to more trade

  19. Heckscher-Ohlin Model Determinants of relative abundance of factors of production • Natural resources including climate • Exploration/development • Climate change • Labor • Skill level • Education, training • Population growth, demographics • Capital • Types • Investment • Technology • R&D • Production, products

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