Krugman’s Trade Policy History Course:

1. http://www.washingtonpost.com/blogs/wonkblog/wp/2013/01/17/manufacturing-jobs-used-to-pay-really-well-not-anymore-e/http://www.washingtonpost.com/blogs/wonkblog/wp/2013/01/17/manufacturing-jobs-used-to-pay-really-well-not-anymore-e/

2. Krugman’s Trade Policy History Course: • https://webspace.princeton.edu/users/pkrugman/WWS%20543_readings.pdf

3. Preview • Why do countries engage in international trade? • Opportunity costs and comparative advantage • A one-factor Ricardian model • Production possibilities • Gains from trade • Wages and trade • Misconceptions about comparative advantage • Transportation costs and non-traded goods • Empirical evidence

4. Introduction • Theories of why trade occurs: • Differences across countries in labor, labor skills, physical capital, natural resources, and technology  Countries can benefit from their own differences by reaching an arrangement in which each does the things it does relatively well. • Economies of scale: Countries might specialize in a limited range of goods and produce them at a large scale: (larger scale of production is more efficient) • Worth the 2008 Nobel Prize!

5. Worth the Nobel Prize! Press Release 13 October 2008 The Royal Swedish Academy of Sciences has decided to award The SverigesRiksbank Prize in Economic Sciences in Memory of Alfred Nobel 2008 to Paul KrugmanPrinceton University, NJ, USA"for his analysis of trade patterns and location of economic activity" International Trade and Economic Geography Patterns of trade and location have always been key issues in the economic debate. What are the effects of free trade and globalization? What are the driving forces behind worldwide urbanization? Paul Krugman has formulated a new theory to answer these questions. He has thereby integrated the previously disparate research fields of international trade and economic geography. Krugman’sapproach is based on the premise that many goods and services can be produced more cheaply in long series, a concept generally known as economies of scale. Meanwhile, consumers demand a varied supply of goods. As a result, small-scale production for a local market is replaced by large-scale production for the world market, where firms with similar products compete with one another. Traditional trade theory assumes that countries are different and explains why some countries export agricultural products whereas others export industrial goods. The new theory clarifies why worldwide trade is in fact dominated by countries which not only have similar conditions, but also trade in similar products – for instance, a country such as Sweden that both exports and imports cars. This kind of trade enables specialization and large-scale production, which result in lower prices and a greater diversity of commodities. Economies of scale combined with reduced transport costs also help to explain why an increasingly larger share of the world population lives in cities and why similar economic activities are concentrated in the same locations. Lower transport costs can trigger a self-reinforcing process whereby a growing metropolitan population gives rise to increased large-scale production, higher real wages and a more diversified supply of goods. This, in turn, stimulates further migration to cities. Krugman’stheories have shown that the outcome of these processes can well be that regions become divided into a high-technology urbanized core and a less developed “periphery”.

6. Introduction • Sources of differences across countries that lead to gains from trade: • The Ricardian model (Chapter 3) examines differences in the productivity of labor between countries. • Differences in Technology • The Heckscher-Ohlin model (Chapter 4) examines differences in labor, labor skills, physical capital, land, or other factors of production between countries. • Differences in Endowments

7. The Ricardian model • A domestic firm may lose out in international competition even if it is the lowest cost producer in the world. • Even if you have an “Absolute advantage” you can lose in international trade • Even though you donot have an absolute advantage in the production of some goods or trade you can win in the international trade, if you have a “comparative advantage”.

8. Comparative Advantage and Opportunity Cost • The Ricardian model uses the concepts of opportunity cost and comparative advantage. • The opportunity cost of producing somethingmeasures the cost of not being able to produce something else with the resources used. • Paul Samuelson: Comparative advantage is the best example I know of an economic principle that is undeniably true yet not obvious to intelligent people!

9. A One – Factor economy: Assumptions • Two countries (“Home” and “Foreign”) with a single factor of production (Labour). • Only two goods are produced: wine and cheese. Goods are homogeneous (they that are either physically identical or at least viewed as identical by buyers). • Labourproductivity in each country and industry is constant, but varies between countries and between industries (due o differences in technology). In other words we are assuming constant labour productivity. • The supply of labor in each country is constant.\ and fully employed.

10. A One – Factor economy: Assumptions (cont.) • Labour is freely and costlesslymobile between industries within a country, but it is completely immobile across countries • Production takes place under conditions of perfect competition: • many small firms in each industry • firms choose output to maximize profit • output is homogeneous • free entry and free exit of firms • perfect information • Consumptions takes place under conditions of utility maximization. • Countries indifferent curves are homothetic (if ratios of commodities of consumers are equal, with expansion of the budget constraint, then you are homothetic) • Competition allows workers to be paid a“competitive” wage equal to the value of what they produce • There are no transportation costs

11. A One-Factor Ricardian Model • Definitions: • Unit labour requirement: the number of hours required to produce a pound of cheese or a gallon of wine. Unit requirements is the inverse of productivity! (The more cheese and wine a worker can produce in an hour, the lower the unit labour requirement). • aLW: unit labour requirements in wine production in the Home country = 1/Marginal Product of Labour • aLC: unit labour requirements in cheese production in the Home country For example, aLC= 1 means that 1 hour of labourproduces one pound of cheese in the home country. For example, aLW = 2 means that 2 hours of labourproduces one gallon of wine in the home country.

12. A One-Factor Ricardian Model Definitions: • Labor supply L indicates the total number of hours worked in the home country (a constant number). • Cheese production QC indicates how many pounds of cheese are produced. • Wine production QW indicates how many gallons of wine are produced. • From now on “*” notates foreign country variables

13. Ricardian Production Functions Cheese Wine Qc, Q*c Qw, Q*w Qc Q*c Qw Q*w Lc, L*c Lw, L*w The slope of the production function is the marginal product of labour. This is why the production function is a straight line: the marginal product of labour is constant.

14. The Ricardian PPF in Home • These production functions will allow us to generate a PPF. Qw Production function PPF for wine in Home Max Qw Lw Max Qc Qc Production function for cheese in Home Labour constraint (slope -1) Lc

15. Total amount of labor resources (labour constraint) Total gallons of wine produced Labor required for each gallon of wine produced Total pounds of cheese produced Labor required for each pound of cheese produced Production Possibilities • The production possibility frontier (PPF) of an economy shows the maximum amount of a good that can be produced once the decision has been made to produce any given amount of the other good (and viceversa). • Remember: any economy has a fixed amount of resources there are limits on what it can produce (trade-offs)! • The production possibility frontier of the home economy is: aLCQC + aLWQW≤ L

16. Example: L= 1,000 hours aLW= 2 aLC= 1 1) The economy devotes all its labour (L) to cheese production: aLCQC= L 1*QC= 1000 QC = 1000 pounds of cheese 2) The economy devotes all its labour (L) to cheese production: aWCQC= W 2*QC= 1000 QC = 500 gallons of wine

17. Home’s Production Possibility Frontier The line PF shows the maximum amount of cheese Home can produce given any production of wine ad viceversa

18. Production Possibilities • The opportunity cost (trade- off) of cheese in terms of wine is how many gallons of wine Home must stop producing in order to make one more pound of cheese. QW= L/aLW– aLC/ aLW* QC • The opportunity cost of cheese appears as the absolute value of the slope of the PPF. (“marginal rate of transformation  how we can transform one good into an other) • aLC/aLWIn our example: 1/2 (The opportunity cost of producing 1 pound of cheese in terms of wine is half a gallon of wine) When the PPF is a straight line, the opportunity cost of a pound of cheese in terms of wine is constant

19. Autarky equilibrium • The production possibilities curve shows what the economy can produce • The country indifference curves show what the economy wants to consume. • Equilibrium exists where the economy maximizes its utility subject to its production possibility Qw MRT = - = Opportunity Cost MRS = - = Opportunity Cost PPF Dw =Sw A Dc=Sc Qc

20. Relative Prices, Wages, and Supply • So, what will be produced, and where? To answer we have to look at prices! • Let PCbe the price of cheese and PW be the price of wine. • Relative prices of the two goods the price of one good in terms of the other: PC /PW is the relative price of cheese (in terms of wine)

21. Relative Prices, Wages, and Supply (cont.) • In a competitive economy, firms hire workers up to the point where the nominal wage exactly equals the value of the marginal product of labour. • hourly wages of cheese makers equal the value of the cheese produced in an hour: WC =PC /aLC= VMPLC • hourly wages of wine makers equal the value of the wine produced in an hour: WW =PW /aLW= VMPLW

22. Relative Prices, Wages, and Supply (cont.) • Before any trade occurs, the relative price of cheese to wine reflects the opportunity cost of cheese in terms of wine in each country. • For example, at Home: PLC/PLW = aLC/aLW • This is because workers will only work in the industry with the highest wage! • Wages must be equal for both goods to be produced.

23. Relative Prices, Wages, and Supply If the country wants to consume both wine and cheese then, in the absence of international trade, Home would have to produce both goods for itself. BUT: Home will produce both goods only if the relative price of cheese is just equal to its opportunity cost.  Relative prices must adjust so that wages are equal in the wine and cheese industries. Given that the opportunity cost is equal to aLC/aLW(the ratio of unit labor requirements in cheese and wine)  in absence of international trade, the relative prices of goods are equal to their relative unit labour requirements.

24. Relative Prices, Wages, and Supply If WC > WW, workers will only make cheese (the economy will specialize in the production of cheese). 1) PC /aLC > PW /aLW • PC / PW > aLC /aLWRelative price > opportunity cost 2) If WC < WW , workers will only make wine (the economy will specialize in the production of cheese). PC /aLC <PW /aLW • PC / PW < aLC/aLWRelative price < opportunity cost If PC / PW =aLC/aLWworkers will be indifferent to working in either wine or cheese. Relative price = opportunity cost

25. Example • Home: If PC / PW = aLC /aLW= 1/2, then suppose that PC = €7 and PW = €14 Then WC = PC /aLC= € 7/1 = €7 and WW= PW /aLW= € 14/2 = €7 • Foreign: If P*C / P*W = a*LC/a*LW = 6/3, then suppose that P*C = €14 and P*W = €7 Then W*C= P*C /a*LC = € 14/6 = €2.3 and W*W= P*W /a*LW = € 7/3 = €2.3

26. Trade in the Ricardian Model • In the absence of any trade, the relative price of cheese to wine will be higher in Foreign than in Home • It will be profitable to ship cheese from Home to Foreign (and wine from Foreign to Home) • This alters the relative price of cheese and wine • Where does the relative price of cheese to wine settle?

27. Trade in the Ricardian Model • Now let’s introduce trade. • Suppose the Home country is more efficient in wine and cheese production than the Foreign country. • It has an absolute advantagein all production: its unit labor requirements for wine and cheese production are lower than those in the foreign country: aLC < a*LC and aLW < a*LW 1< 6 2<3

28. Trade in the Ricardian Model Adam Smith: All countries would gain simultaneously if they practiced free trade and specialized in accordance with their absolute advantage. David Ricardo: Even if a country is the most (or least) efficient producer of all goods, it still can benefit from trade. We have to look at the comparative advantages!

29. Trade in the Ricardian Model • Suppose that the Homecountry has a comparative advantage in cheese production: its opportunity cost of producing cheese is lower than in the Foreign country. aLC/aLW < a*LC/a*LW 1/2 < 6/3 =2 When the home country increases cheese production, it reduces wine production less than the foreign country would. Foreign has a comparative advantage over Home in wine production because: a*LW/a*LC < aLW/aLC 3/6 = 1/2<2/1 =2

30. Trade in the Ricardian Model • N.B.: It is always the case, in a two countries two goods model, that if one country has a comparative advantage of one good, the other country MUST have a comparative advantage in the production of the other good!

31. Home’s Production Possibility Frontier

32. Foreign’s Production Possibility Frontier

33. Trade in the Ricardian Model Since the slope of the PPF indicates the opportunity cost of cheese in terms of wine, Foreign’s PPF is steeper than Home’s. In other words: The PPF is relatively biased in the direction of cheese for the Home country. We can also say the Home has a comparative advantage over Foreign only in cheese production because: aLC/ a*LC < aLW/a*LW 1/6 < 2/3

34. Relative Supply and Relative Demand • We need to consider both supply and demand. • The (world) relative supply curve, RS, of cheese is the quantity of cheese supplied by all countries relative to the quantity of wine supplied by all countries RS = (QC + Q*C)/(QW + Q*W) At each relative price of cheese PC/PW • Relative demand of cheese is the quantity of cheese demanded in all countries relative to the quantity of wine demanded in all countries

35. The (World) Relative Supply Curve • Production decisions in both Home and Foreign are given by: • If PC/PW > aLC/aLW specialize in cheese • If PC/PW = aLC/aLW produce both goods according to demand • If PC/PW < aLC/aLWspecialize in wine

36. World Relative Supply and Demand

37. World Relative Supply and Demand • Study that chart, and read the textbook carefully!

38. Gains From Trade: specialization Each country specialize in the production of only one good: • Home only produces cheese and no wine • Foreign only produces wine and no cheese

39. Relative prices after trade • Generally, opening up to trade leads to the price of a good falling in between its pre-trade levels in the two countries. • World equilibrium is at point 1: • the relative price of cheese has risen in Home and fallen in Foreign. • the relative price of wine has risen in Foreign and fallen in Home • The relative prices of the traded goods will converge!

40. Home’s Gain From Trade Given that relative prices in Home increase from 1/2 to 1: Qw Pc/Pw=1 Pc/Pw=1/2 B Dw=Sw A Iw Dc=Sc Qc Ec

41. Home’s Gain From Trade Home has moved to a higher Country Indifference Curve (the red one): we have a higher level of the aggregate economic welfare. Trade has benefited Home at the aggregate level!

42. Trade Expands Consumption Possibilities

43. A Numerical Example Unit labor requirements for home and foreign countries • What is the home country’s opportunity cost of producing cheese? aLC /aLW = ½, to produce one pound of cheese, stop producing ½ gallon of wine.

44. A Numerical Example (cont.) • The home country is more efficient in both industries, but has a comparative advantage only in cheese production. 1/2 = aLC /aLW < a*LC /a*LW = 2 • The foreign country is less efficient in both industries, but has a comparative advantage in wine production.

45. A Numerical Example (cont.) • With trade, the equilibrium relative price of cheese to wine settles between the two opportunity costs of cheese. • Suppose that the intersection of RS and RD occurs at PC /PW= 1 so one pound of cheese trades for one gallon of wine. • Trade causes the relative price of cheese to rise in the home country and fall in foreign.

46. A Numerical Example (cont.) • With trade, the foreign country can buy one pound of cheese for PC /PW = one gallon of wine, • instead of stopping production of a*LC /a*LW = 2 gallons of wine to free up enough labor to produce one pound of cheese in the absence of trade.

47. A Numerical Example (cont.) • With trade, the home country can buy one gallon of wine for PW /PC = one pound of cheese, • instead of stopping production of aLW /aLC = two pounds of cheese to free up enough labor to produce one gallon of wine in the absence of trade.

48. Relative Wages after trade The Ricardian model predicts relative prices will equalize across countries after trade. What about relative wages? • Relative wages are the wages of the home country relative to the wages in the foreign country. • Productivity (technological) differences determine relative wage differences across countries. • Remember: these are reflected in the unit labor costs.

49. Relative wages after trade • Now PC /PW= 1. Let’s assume that PC = PW= € 12 Once countries have specialized: • All Home workers will produce cheese: WC= PC /aLC= € 12/1 = €12 > € 7 • Home workers are making more money with trade than in autarky! • All Foreign workers will produce wine: W*W= P*W /a*LW = € 12/3 = €4 > € 2.3 • Foreign workers are making more money with trade than in autarky!

50. Relative Wages (cont.) • Nominal wage has risen in both countries! • The ratio of wages (relative wages) between the two countries: W/ W *= 12/4=3 Relative productivities in the industries <W/ W *< 3/2 < 3< 6/1 • In the home economy, producing one pound of cheese costs $12 (one worker paid $12/hr) but would have cost $24 (six paid $4/hr) in Foreign. • In the foreign economy, producing one gallon of wine costs $12 (three workers paid $4/hr) but would have cost $24 (two paid $12/hr) in Home.