Chapter 3 -- Classical Model

1. Chapter 3 -- Classical Model • INTERNATIONAL ECONOMICS,ECO 486 • Display your name card

2. Learning Objectives • Understand five more assumptions • Determine and understand comparative and absolute advantage • Find international trade equilibrium • Explain gains from trade • Derive range of wages that will permit trade

3. Learning Objectives • Understand five more assumptions • Determine and understand comparative and absolute advantage • Find international trade equilibrium • Explain gains from trade • Derive range of wages that will permit trade

4. Assumption #8 • Factors of production cannot move between countries

5. Assumption #9 • There are no barriers to trade in goods.

6. Assumption #10 • Exports must pay for imports • Assumptions 8-10 apply to both the Classical and HO Models • Assumptions 11 & 12 apply only to Classical Model

7. Assumption #11 • Labor is the only relevant factor of production in terms of productivity analysis or costs of production.

8. Assumption #12 • Production exhibits constant returns to scale, CRS, between labor and output.

9. CRS Implies Linear PPF • See Figure 3.1, page 68

10. Autarky • See Figure 3.2, page 69 • Given perfect competition,

11. Autarky • See Figure 3.2, page 69 • Given perfect competition, • P = MC • Autarky price of S equals slope of PPF • Resource payments correspond to their productivity

12. Learning Objectives • Understand five more assumptions • Determine and understand comparative and absolute advantage • Find international trade equilibrium • Explain gains from trade • Derive range of wages that will permit trade

13. Absolute Advantage • Compare one good across countries. • Country with lower labor input has an absolute advantage in that good.

14. Comparative Advantage • Calculate opportunity costs. • Compare one good across countries. • Country with lower opportunity cost has a comparative advantage in that good.

15. Which Advantage? • Absolute advantage is a special case. • Comparative advantage is the general case.

16. Learning Objectives • Understand five more assumptions • Determine and understand comparative and absolute advantage • Find international trade equilibrium • Explain gains from trade • Derive range of wages that will permit trade

17. Terms of Trade • Once trade begins, an international equilibrium results • Results in one world price for a good

18. Terms of Trade • Once trade begins, an international equilibrium results • Results in one world price for a good • called the terms of trade • between the two autarky prices • determined by reciprocal demand

19. International Trade Equilibrium • See Figure 3.3, page 71 • Complete specialization in Comparative Advantage good • CIC & ToT tangent at consumption point • Congruent trade triangles imply balanced trade

20. Learning Objectives • Understand five more assumptions • Determine and understand comparative and absolute advantage • Find international trade equilibrium • Explain gains from trade • Derive range of wages that will permit trade

21. Gains From Trade • Higher CIC shows a gain • Measure gains from trade using GDP • Sources of gain:

22. Gains From Trade • Higher CIC shows a gain • Measure gains from trade using GDP • Sources of gain: • production (gains from specialization) • consumption (ToT price lower than autarky)

23. Learning Objectives • Understand five more assumptions • Determine and understand comparative and absolute advantage • Find international trade equilibrium • Explain gains from trade • Derive range of wages that will permit trade

24. Perfect Competition Review(Product & Resource Markets) • PXC = MC for a good, X, in a country, C • MC = w/MPPL (Labor, L, is only var. input) • w=MRPL =(MR) MPPL=(P) MPPL=VMPL

25. Perfect Competition Review(Product & Resource Markets) • PXC = MC for a good, X, in a country, C • MC = w/MPPL (Labor, L, is only var. input) • w=MRPL =(MR) MPPL=(P) MPPL=VMPL • MRPL = Marginal Revenue Product MR = Marginal Revenue;MPPL = Marginal Physical Product of LVMPL = Value Marginal Product of L

26. Prices & Wages • PXC = MC = w/MPPL • MPPL is measured as units of X per hour • hoursXC is stated as hours per unit of X • PXC = wC (hoursXC)

27. Exchange Rates • State exchange rate, E, in US dollars per UK pound • say $2/£ • A good will be imported if its foreign pre-trade price (x E) is less than the domestic price • PSA < E x PSB

28. Buy Low . . . • Trade requires • PSA < E x PSB • PTA > E x PTB • autarky prices • A has comparative advantage in S • B has comparative advantage in T

29. Trade & Wages • Substitute PXC = wC (hoursXC) • wA (hoursSA) < E x wB (hoursSB) • wA (hoursTA) > E x wB (hoursTB) • To solve • divide both sides by (E x wB) • divide both sides by (hoursXA)

30. Trade & Wages (Cont.)

31. Trade & Wages (Cont.) • Trade will occur if the wage ratio does not exceed the productivity ratio

32. Trade & Wages (Cont.) • If one country is technologically advanced, it must have a higher wage rate.

33. Losing Comparative Advantage • If the wage ratio exceeds the productivity ratio, trade will not occur • If a currency is overvalued (say $1/£ instead of $2/£), both goods may be cheaper in one country

34. Review Homework

35. Q#8: Degree of Specialization X = COMPLETE SPECIALIZATION, P = PARTIAL SPECIALIZATION X 10 Autarky Equilibrium 8 P C = COMPLETE SPECIALIZATION, ALLOWS GREATER CONSUMPTION G TEXTILES, T (millions of yards per year) 6 C D 4 CIC2 2 CIC1 CIC0 PPF 0 2 4 6 8 10 SOYBEANS, S (millions of bushels per year)

36. Quantity of Soybeans Demanded PS/PT = 2.5 yd.T/bu.S 10 H Autarky General Equilibrium|slope PPF| = PS/PT =2 yd.T/bu.S 8 G TEXTILES, T (millions of yards per year) 6 L PS/PT = 1 yd.T/bu.S 4 CIC2 2 CIC1 CIC0 PPF 1.8 0 2 4 6 8 10 4.7 SOYBEANS, S (millions of bushels per year)