Chapter 3

• Reasons for Trade:

o Countries trade because they are different (comparative advantage).

o Countries trade to achieve economies of scale.

• Comparative Advantage:
o A country has a comparative advantage in producing a good if its opportunity
cost of producing that good is lower than in other countries.

o This concept is central to understanding why trade is beneficial.

o Trade between two countries can benefit both countries if each country exports
the goods in which it has a comparative advantage.

• Ricardian Model:
o A model of international trade where trade is solely due to international
differences in labor productivity.

o Developed by David Ricardo.

One-Factor Economy:

• Assumptions:

o One factor of production (labor).

o Two goods (wine and cheese).

o Unit labor requirement (aLC, aLW): the number of hours of labor required to
produce one unit of a good.

o Total labor supply (L).

• Production Possibilities Frontier (PPF):

o Shows the maximum amount of one good that can be produced given the
production of another good.

o In a one-factor economy, the PPF is a straight line.

o Equation: aLCQC + aLWQW ≤ L.
o The slope of the PPF represents the opportunity cost of one good in terms of the
other.

• Relative Prices and Supply:

 o Supply decisions are based on maximizing earnings.

o Labor moves to the sector with the higher wage.

o The economy specializes in the production of the good with the higher relative
price compared to its opportunity cost.
o In the absence of trade, relative prices equal relative unit labor requirements
(labor theory of value).

Trade in a One-Factor World:

• Assumptions:

o Two countries (Home and Foreign).

o One factor of production (labor) in each country.

o Two goods (wine and cheese).

o Home has a comparative advantage in cheese: aLC/aLW < aLC*/aLW*.

• Absolute Advantage vs. Comparative Advantage:

o Absolute advantage: A country can produce a good with less labor than another
country.

o Comparative advantage determines trade patterns, not absolute advantage.

• Determining Relative Prices After Trade:

o Prices are determined by relative supply and demand.

o General equilibrium analysis is crucial (considering both markets).

o Relative supply curve (RS) is a "step" function.

o World relative price is determined by the intersection of relative supply and
demand curves.

• Gains from Trade:

o Trade allows countries to "produce" goods indirectly, which can be more
efficient.
o Trade expands consumption possibilities beyond production possibilities.

o Both countries are better off with trade.

• Relative Wages:

o Relative wage: the ratio of wages between two countries.

 o Relative wage lies between the ratios of the two countries' productivities in the
two industries.
o Comparative advantage allows countries to have a cost advantage even with
different wage rates.

Misconceptions about Comparative Advantage:

• Productivity and Competitiveness (Myth 1):
o Free trade is beneficial even if a country does not have an absolute advantage in
any good.

o Gains from trade depend on comparative, not absolute, advantage.

o Competitive advantage depends on relative productivity and relative wages.

• The Pauper Labor Argument (Myth 2):
o Foreign competition is not inherently unfair or harmful when based on low
wages.

o Low wages in foreign countries are often due to lower overall productivity.
o The argument that industries shouldn't compete with those paying lower wages
is flawed.
o Example: Ross Perot's warning about the "giant sucking sound" of U.S. industry
moving to Mexico.
o The key point is that trade benefits a country if it's cheaper to produce goods
domestically and trade them than to produce everything.

o Foreign countries benefit from trade, even with low wages.

• Exploitation (Myth 3):

o The belief that trade exploits a country if its workers receive much lower wages is
a misconception.
o Focus should be on whether workers and their country are better off with trade
than without it.
o Example: Contrast between high CEO salaries and low wages of Central American
garment workers.
o Denying low-wage countries the opportunity to export can lead to even deeper
poverty.

o The alternative to "exploitation" might be worse.

 o One must know the alternative situation before declaring that a low wage
represents exploitation.

Comparative Advantage with Many Goods:

• Model Setup:
o Two countries (Home and Foreign).

o One factor of production (labor).

o Many goods (N).

o Unit labor requirements: aLi (Home), aLi* (Foreign).

o Goods are ordered by increasing ratio of Home to Foreign unit labor
requirements (aLi/aLi*).

• Relative Wages and Specialization:

o The pattern of trade depends on the ratio of Home to Foreign wages (w/w*).

o Goods are produced where it is cheapest.

o Home produces goods where aLi*/aLi > w/w*.

o Foreign produces goods where aLi*/aLi < w/w*.

o There is a "cut" in the lineup of goods based on the wage ratio.

o Numerical example: Apples, bananas, caviar, dates, enchiladas.

• Benefits of Specialization:

o Both countries gain from specialization and trade.

o It is cheaper to "produce" goods indirectly through trade.

o Example: Home imports dates and enchiladas because it's cheaper than domestic
production.
• Determining Relative Wages:

o Relative wages are determined by the relative derived demand for labor.

o Relative demand for Home labor falls when Home wages rise.
o Two effects: Goods produced in Home become more expensive; fewer goods are
produced in Home.
o Relative demand curve (RD) is "stepped."
 o Relative supply curve (RS) is vertical.

o Equilibrium relative wage is determined by the intersection of RD and RS.

Adding Transport Costs and Nontraded Goods:

• Effects of Transport Costs:

o Transport costs do not change the fundamental principles of comparative
advantage.

o They reduce the extent of specialization.

o Some goods become nontraded.

o Example: Caviar and dates become nontraded with 100% transport costs.
o Reasons for less than complete specialisation are: multiple factors of production,
protectionism, and transport costs.

• Nontraded Goods:

o Services (haircuts, auto repair) are generally nontraded.

o Goods with high weight-to-value ratios (cement) are often nontraded.

o Many goods are nontraded due to low cost advantages or high transport costs.

o Nations spend a large portion of their income on non-traded goods.

Empirical Evidence on the Ricardian Model:

• Model's Limitations:

o Predicts extreme specialization.

o Ignores income distribution effects.

o Neglects differences in resources.

o Does not account for economies of scale.

• Model's Strengths:

o Predicts that countries export goods with relatively high productivity.

o Confirmed by studies comparing British and American productivity and trade.

o Bela Balassa's 1963 study: Higher relative productivity leads to higher relative
exports.

o Trade depends on comparative, not absolute, advantage.

 o Example: Bangladesh's clothing exports, despite low overall productivity.
o Evidence shows that differences in labour productivity play an important role in
determining world trade patterns.

Important Definitions:
• Comparative Advantage: The ability of a country to produce a good or service at a lower
opportunity cost than another country.
• Opportunity Cost: The value of the next best alternative that is given up when a choice
is made.
• Ricardian Model: A model of international trade that demonstrates how comparative
advantage leads to gains from trade.

• Unit Labor Requirement: The amount of labor required to produce one unit of a good.
• Production Possibilities Frontier (PPF): A graph that shows the maximum amount of one
good that can be produced for every possible level of production of the other good.
• Absolute Advantage: The ability of a country to produce more of a good or service
than another country using the same amount of resources.
• Relative Wage: The wage rate of one country relative to the wage rate of another
country.

• General Equilibrium Analysis: The simultaneous analysis of all markets in an economy.

• • Pauper Labor Argument: The misconception that foreign competition based on low
wages is unfair.

• • Derived Demand: Demand for a factor of production that results from the demand for
goods produced with that factor.

• • Nontraded Goods: Goods and services that are not traded internationally due to high
transport costs or other factors.

• • Relative Derived Demand for Labor: The demand for home labor relative to foreign
labor, derived from the demand for the goods those laborers produce.