Gains from Trade

1. Gains from Trade John Ries Sauder School of Business, University of British Columbia

2. Gain from trade • Objectives of this session • Illustrate the gains from trade based on exploiting comparative advantage • Show how productivity, wages, competitive advantage, and exchange rates relate to each other. • Illustrate the gains from trade based on exploiting plant-level scale economies.

3. Your assignment: • Decide the number of workers in each of two factories (Korea & Thailand) to allocate to each of two activities (molding soles & stitching uppers). • Maximize corporate shoe output

4. Shoe terms Upper Sole

5. Assumptions • 300 workers in Thai factory • 300 workers in Korean factory • In the short run, you cannot add or subtract workers, or move them between plants. • One sole and one upper needed for each finished shoe. • Transport costs are negligible

6. Productivity MatrixOutput per worker

7. Compute total shoe output for four production plans • Plan A: (self-sufficient factories): Each country combines workers to produce completed shoes. There is no trade. • Plan B: Thailand produces only uppers, Korea produces only soles. • Plan B*: Thailand produces only uppers, Korea produces soles and uppers. • Plan C: Thailand produces only soles, Korea produces soles and uppers.

8. Plan B* increases shoe output by 9% • (60000-55000)/55000 = .0909 • Firm-level productivity rises • from 55000/600 = 92 shoes per worker per day • to 6000/600 = 100 shoes per worker per day • No new machinery, no new skills, no extra effort. • Trade is like a new technology!

9. Specialization is not enough • Plan C, involves specialization but it lowers output by 9% relative to Plan A. • Specialization based on comparative advantage yields gains from trade. • Comparative advantage = low opportunity costs.

10. Opportunity cost calculations • Opportunity cost of soles in foregone uppers • Thailand: 100 U/ 100 S = 1 U/S • Korea: 200U/400S = .5 U/S • Opportunity cost of uppers in foregone soles • Thailand: 100 S/ 100 U = 1 S/U • Korea: 400S/200U = 2 S/U • Korea has lower opportunity cost of seouls!

11. Long-run decisions • The level of employment is only fixed at 300 in each plant in the short run. • When employment is a decision variable, not a sunk cost, then wages and productivity matter.

12. Calculate the critical wages • If wages were equal, Korea’s factory with its absolute advantage both tasks (4:1 in soles, 2:1 in uppers) would be the low cost source for both uppers and soles. • How low would Thai wages have to be justify operating the plant? (doing what?) • How low would the wage in Thailand have to be to justify shutting the Korean plant?

13. Competitive advantage • A factory has a competitive advantage in a task when it can provide an equivalent product at a lower monetary cost than alternatives. • Competitive advantage here corresponds to lower unit labour costs. • Unit labour costs are given by wages divided by productivity.

14. Unit Labour Costs (in baht/unit) WK= wages in Korea (won/worker) WT = wages in Thailand (baht/worker) e = exchange rate (baht/won)

15. Thai plant gains competitive advantage • in uppers when Korea pays more than twice the Thai wage • eWK/200 > WT/100 • eWK/WT > 2 • in soles when Korea pays more than four times the Thai wage • eWK/400 > WT/100 • eWK/WT > 4

16. Relative wages and Competitive Advantage

17. Equilibrium relative wages: eWK/WT • Suppose wages are so high in Korea that unit labour costs are higher there than in Thailand for both goods, eWK/WT>4. • No firms would want to employ Korean workers and, hence, there would be no Korean products. Wages is Korea would fall and the won would depreciate (e=baht/won would fall). • Eventually, Korea would be low cost (have a competitive advantage) in one good (the comparative advantage good.)

18. Competitive Advantage and Equilibrium Exchange Rates • Suppose that unions or government fix the local currency values of wages at WK = 200 Won per day and WT = 100 Baht. • What values of e (in Baht/Won) would be consistent with production in both locations? • How would the e range change if Thai productivity doubled in all activities?

19. Lessons from the Shoe Story • Low wage countries do not “steal” all industries. • Define competitive advantage as the lowest unit labour costs. Exchange rates adjust so that a country that has a comparative advantage in a good will also have a competitive advantage in that good.

20. Shoe Story II: Returns to Scale • Comparative advantage is not the only way to obtain gains from trade. • Plant-level economies of scale (PLEoS) are important in many industries. • To illustrate the gains from exploiting PLEoS through trade, we revise the story to exclude comparative advantage and absolute advantage.

21. New Productivity Matrix

22. Indivisible Overhead • Factory workers are supported by services of non-production employees, also known as “overhead” • Accounting • Logistics and input procurement • Machinery maintenance • Some minimum number of overhead workers are required for any positive level of production.

23. New example • Let overhead be 30 workers per “product” (soles or uppers) per plant. • A factory that produces both products (that is, a factory that is not fully specialized) has overhead of 30+30=60, leaving 300-60=240 workers for production. • A factory that specializes has 300-30=270 workers for production.

24. Plan A vs Plan B revisited • Plan A (self-sufficiency): • Sole output in each factory: (240/2)*100 = 12000 • Upper output in each factory: (240/2)*100 = 12000 • Combined output = 2*12000=24000 shoes • Plan B (full specialization, KS,TU): • Sole output in Korea: 270*100 = 27000 • Upper output in Thailand: 270*100 =27000 • Combined output = 2700 shoes (11% gain!)

25. PLEoS gains are differentfrom CA gains • Plan C (full specialization KU and TS) is just as good (2700 shoes) as plan B • No such thing as specializing in the “wrong” thing in this case. • The key for PLEoS is to avoid duplicative overhead, rather than to “match” products with skills (as in the CA case)

26. Geometric PLEoS • Surface to volume ratios of three dimensional objects are a source of PLEoS. • The formula for the surface to volume ratio of a vat is decreasing in the volume (see EMS, p.35). Thus, as the vat size increases, the per volume cost of the material to make the vat (steel) is falling • Geometric PLEoS apply to vats, tanks, furnaces, and even buildings

28. Two-way trade and scale economies • Recall, Canada is both a big exporter and a big importer of cars, machinery, and industrial equipment • This can be explained by companies producing product varieties and concentrating individual varieties in single factories

29. Before Canada-US Autopact (1965) Minivans Sedans Local sales Canada US Minivans Sedans Local sales

30. After Canada-US Autopact (1965) Canada Minivans Local sales Canadian imports Canadian exports US Sedans Local sales

31. Benefits • Plant-level fixed costs are eliminated by concentrating individual varieties in single factories • Would a cost-minimizing firm prefer to locate both factories in the United States? • Yes, transport costs are minimized by locating in the large market.