International Economy Week 3

1. International Economy Week 3 Prepared by Shi Young Lee* (Chung-Ang University) syl1347@hanmail.net 2010-1

2. Contents: Global Trade Models • Trade Models Based on Comparative Advantage I. Labor Productivity and Trade: Ricardian Model II. Factor Endowments and Trade: Heckscher-Ohlin Model Keywords: Absolute vs comparative advantage, specialization, autarky, input-output coefficients, opportunity costs, gains from trade, & Ricardo, Heckscher-Ohlin, Dutch disease References: Krugman and Obstfeld Chs 2 and 4

3. On David Ricardo (1772-1823) David Ricardo was born in 1772. His parents were very successful and his father was a wealthy merchant banker. They lived at first in the Netherlands and then moved to London. David himself had little formal education (obviously not a modern role model!) and went to work for his father at the age of 14. However, when, at the age of 21, he married a Quaker (against his parents wishes) he was disinherited and so set up on his own as a stockbroker. He was phenomenally successful at this and was able to retire at 42 and concentrate on his writings and politics. He developed many important areas of economic theory and was great friends with other classical economists - Thomas Malthus and Jean-Baptiste Say. However, much of the theory he developed is still used and taught today.

4. Key Claims of Ricardian Model 1. Comparative rather than absolute advantage determines trade pattern & volume 2. International trade makes countries to specialize 3. Gains from trade may be larger for relatively small countries than large countries

5. Ricardian Model 2. Framework: (1) Basic Ingredients of Ricardian model: 2*2*1 2 Countries (North and South) world 2 Outputs (X and Y) 1 factor of production: labor (as a key determinant) Assumptions: identical (similar) taste perfect competition free mobility of labor

6. Input-Output Coefficients Table

7. Ricardian Model aLi input-output coefficient that describes production technology (labor productivity), i.e., no of hours/days to produce 1 unit of good i  labor efficiency

8. Ricardian Model 3. Production possibility frontiers for the North and South. - Describe the opportunity cost of producing Y in terms of X. - Compute the autarky relative prices for each region. - Describe autarky equilibrium. - Determine absolute and comparative advantages for the two regions.

9. Ricardian Model Both regions decide to open up. - Suppose that the international price can be determined as follows: PW=aP+(1-a)P* where “a” is the relative weight assigned to the South's autarky price. Assume further that =(3/4). - Compute the international price and determine pattern of trade and gains from trade for each region.

10. Applications 1. Suppose, due to famine, that the labor force of the North suddenly has contracted from 100 to 50. Determine new trade pattern. 2. Suppose that the South experiences technological progress. How does the input-output coefficient change? And why? Determine new trade pattern and gains from trade?

11. Problems associated with a simple Ricardian Model 1. Extreme specialization 2. Ignores the income distribution effects 3. No adjustment cost 4. No effect of labor force expansion 5. Ignores the role of institution & trade

12. On Competitiveness from Krugman (1994) "Countries do not compete with each other the way corporations do. Coke and Pepsi are almost pure rivals: only a negligible fraction of Coke's sales go to Pepsi workers and so on. So if Coke is successful, then it tends to be at Pepsi's expense. However, major industrial countries, while they sell products that compete with each other, are also each other's main export markets and each other's main suppliers of useful imports. If the EC does well, then EC is likely to help the U.S. economy by providing it with larger markets and selling it goods of superior quality at lower prices. International trade is not a zero-sum game. When productivity rises in Japan, the main result is a rise in Japanese real wage. At the same time, EC and U.S.'s wages are likely to rise if not stay the same."

13. Discussion Questions (1) How do we define competitiveness of nations? (2) Discuss the difference. Do you think that his claim is valid? Why? Or why not? (3) Can you think of any other difference?

14. Factor Endowments and Trade • Key Facts of Heckscher-Ohlin Model: 1. Countries tend to export goods that are intensive in factors with which they are abundantly supplied Comparative advantage determined by factor abundance 2. International trade changes relative prices of goods and thus brings about changes in the relative returns to capitalists and workers: income redistribution effects from trade 3. The empirical evidence on the H-O proposition may be weak : Leontief Paradox

15. Basic Ingredients of H-O proposition - 2 Countries (North and South) world - 2 Outputs (X and Y) - 2 factors of production: capital and labor Assumptions: - identical (similar) taste - perfect competition - free mobility of factors: labor and capital

16. Outline of Heckscher-Ohlin Model (1) Describe Autarky equilibrium (2) Trade equilibrium when Home country is a price-taker or partial price-taker - Suppose that (K/L)>(K/L)* - (K/L)x >(K/L)y Then Home country has comparative advantage in X and Foreign Y - Trade pattern determined (3) A Graphical description of Heckscher-Ohlin proposition

17. Stolper-Samuelson Result - Trade liberalization changes the relative prices faced by Home country - Suppose that X is a capital-intensive - Opening up increases the relative price of X in terms of Y in comparison to the autarky relative prices. This implies that the price of capital intensive good X increases – Then outflow of capital and labor out of Y  outflow of capital from Y < demand for capital in X and outflow of labor from Y > demand for labor in X - The returns to capitalist rise while the returns to workers fall: Stolper-Samuelson result Capitalists become better off while workers become worse off in Home country

18. Stolper-Samuelson result leads to political economy approach • Political Economy Approach – In this case, workers may oppose such trade liberalization policy – Trade liberalization policy almost always brings social frictions between classes and industries – Compensation schemes always discussed but may not be credible resistance level may be related to compensation

19. Ungenerous Endowments from Economist (1996) - Evidence of natural resource abundance and economic growth: abundance of natural resources often does not lead to high economic growth - Explain Dutch Disease via main symptom: discovery (or abundance) of natural resource often leads to a shrinkage of the traded sector (often manufacturing capacity) and dampens economic growth

20. Reasons - Natural resources do not come for free: considerable investment required to acquire natural resources and the investment diverts capital and labor away from productive investment (manufacturing sector) - Commodity price volatility: If an economy relies on one or two commodities, then due to volatility, the economy is unable to prosper due to huge adjustment cost - Discovery of natural resource (a commodity) often leads to the expansion of public sector (via nationalization) Once the public sector expands, it is hard to stop (related to habit formations) - The discovery fosters rent-seeking activities related to the industry and spread of corruption Distort work incentives

21. Business Strategy: Korea-US FTA • Suppose that you are the managing director for Hyundai Auto - Your job is to devise business strategy plan in response to the ratification of Korea-US FTA - Domestic market and US market