Econ 405 Topic1

Leah Marcal
Education:
B.A. in Economics UC Santa Cruz
M.S. and PhD in Economics UW Madison
Background:
Bass Lake
Teaching Experience:
ECON 160, 310, 406, and 500
Copyright2009PearsonAddisonWesley.
31
Leah Marcal (cont.)

Research:
College Assessment Director
Employer, alumni, and student satisfaction
surveys
Returns to college education
Interests:
Hiking
Texas Holdem
32
Your Introductions:
Name
Home
Employment
Favorite movie
33
Syllabus
Preparation:
Completion of ECON 309 and 310, and
passed UDWPE
Textbook:
Krugman and Obstfeld, International
Economics: Theory and Policy, 8th edition
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Syllabus (cont.)
Review:
Class website:
www.csun.edu/~lem50734/econ405index.html
PPT slides for each topic/lecture
Answers to selected questions at the end of each
chapter
35
Syllabus (cont.)
Presentation:
Teams of 4 or 5 students
50 min analysis of a current topic using
PPT slides
Preference form (with team members) due
next week!
36
Syllabus (cont.)
Assessment:
Presentation (20%)
Midterm (40%)
Final (40%)
Exams contain T/F, multiple choice, and essay
questions
No make-up presentations or exams
37
Syllabus (cont.)
Office Hours:
JH 4250 on Wednesday from 6:00 to 6:50;
or by appointment
Email your questions:
leah.marcal@csun.edu
Classes:
14 meetings: 10 lectures, 2 exams, and 2
student presentations
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Date
Topic
Chapters
01-20 to
02-17
International Trade
02-24
Student Presentations on
Trade Topics
---
03-03
Midterm Exam
---
03-10 to
04-28
International Finance
05-05
Student Presentations on
Finance Topics
---
05-12
Final Exam
---
3, 4, 5, 8, and 9
12 through 16
39
Topic 1
Labor Productivity
and Comparative
Advantage: The
Ricardian Model
Slides prepared by Thomas Bishop
Copyright 2009 Pearson Addison-Wesley. All rights reserved.
Preview
Opportunity costs and comparative advantage
A one factor Ricardian model
Production possibilities
Gains from trade
Wages and trade
Misconceptions about trade
Empirical evidence
311
Introduction
Why trade?
Differences in resources (e.g., L, K, T,
natural resources, and technology)
Economies of scale
312
Comparative Advantage
and Opportunity Cost
Ricardian model: differences in productivity of
L between countries cause productive
differences, leading to gains from trade.
Ricardian model uses the concepts of
opportunity cost and comparative advantage.
The opportunity cost of producing good X is
the cost of not being able to produce good Y
because resources have already been used to
produce good X.
313
and Opportunity Cost (cont.)
A country faces opportunity costs when it uses
resources to produce goods and services.
E.g., a limited number of workers could be
employed to produce roses or PCs.
Opportunity cost of producing PCs is the amount
of roses not produced
Opportunity cost of producing roses is the amount
of PCs not produced
How many PCs or roses should a country produce
with the limited resources it has?
314
Suppose U.S. can produce 10 million roses
with the same resources that could produce
100,000 PCs.
Ecuador can produce 10 million roses with the
same resources that could produce 30,000
PCs.
Workers in Ecuador are less productive than
those in U.S. in manufacturing PCs.
Question: what is the opportunity cost of roses
in Ecuador?
315
Ecuador has a lower opportunity cost of
producing roses.
U.S. has a lower opportunity cost of producing
PCs.
Ecuador: 10 million roses or 30,000 PCs
US: 10 million roses or 100,000 PCs
316
A country has a comparative advantage in
producing a good if the opportunity cost of
producing that good is lower in the country
than it is in other countries.
A country with a comparative advantage in
producing a good uses its resources most
efficiently when it produces that good
compared to producing other goods.
317
U.S. has a comparative advantage in the production
of PCs.
Ecuador has a comparative advantage in the
production of roses.
Suppose initially that Ecuador produces PCs and U.S.
produces roses, and that both countries want to
consume PCs and roses.
Can both countries be made better off?
318
Comparative Advantage and Trade

MillionsofRoses
Thousandsof
Computers
U.S.
10
+100
Ecuador
+10
30
Change
+70
319
Comparative Advantage and Trade (cont.)

Example shows that when countries
specialize in the good in which they have a
comparative advantage, more goods can be
produced and consumed.
Initially both countries could only consume 10
million roses and 30,000 PCs.
With specialization, they could still consume 10
million roses, but could consume 70,000 more
PCs.
320
A One Factor Ricardian Model
Example with roses and PCs explains the

intuition behind the Ricardian model.
Ricardian model assumes:

1. L is the only resource for production.
2. Supply of L in each country is fixed.
3. Only 2 goods are produced and consumed: wine
and cheese.
4. L is not specific to either industry.
5. Only 2 countries: home and foreign.
321
A One Factor Ricardian Model (cont.)

aLW and aLC are the unit labor requirements to
produce wine and cheese. Each reflects the
number of L hours required to produce 1 unit of
output.
E.g., if aLW = 2, then it takes 2 hours to produce 1
gallon of wine.
E.g., if aLC = 1, then it takes 1 hour to produce 1 lb
of cheese.
A high unit labor requirement means low labor
productivity.
322
Production Possibilities
PPF of a country shows the maximum amount of
goods that can be produced with a fixed amount of
resources.
PPF has the equation:
aLCQC + aLWQW = L
Total labor supply
Labor used in
cheese production
Labor used in
wine production
323
Fig. 1: Homes Production Possibility

Frontier
324
Production Possibilities (cont.)

aLCQC + aLWQW = L
QC = L/aLC when QW = 0
QW = L/aLW when QC = 0
Slope of the PPF = Qw / Qc = (aLC /aLW )
opportunity cost of cheese
Note: slope of any PPF reflects the opportunity cost of
the good that is graphed on the x-axis (in terms of the
good that is graphed on the y-axis).
325
Production Possibilities (cont.)

The amount of the economys production is
defined by:
aLCQC + aLWQW L
This equation describes what an economy
can produce, but to determine what the
economy does produce, we must determine
the price of goods.
326
Production, Prices and Wages

Let PC = price of cheese and PW = price
of wine.
Hourly wages reflect the value of what a
worker can produce in 1 hour.
Hourly wage in cheese industry = PC /aLC
Hourly wage in wine industry = PW /aLW
Workers will work in the industry that pays a

higher hourly wage.
327
Production, Prices and Wages (cont.)

If PC /aLC > PW/aLW (or PC /PW > aLC /aLW )
workers will make only cheese.
Economy specializes in cheese production if the
relative price of cheese > opportunity cost of
cheese.
If PC /aLC < PW /aLW (or PC /PW < aLC /aLW )

workers will make only wine.
Economy specializes in wine production if the
relative price of cheese < opportunity cost of
cheese.
328
Production, Prices and Wages (cont.)

If a country wants to consume both goods
(without trade), relative prices must adjust so
that wages are equal in both industries.
If PC /aLC = PW /aLW (or PC /PW = aLC /aLW ) workers
have no incentive to work solely in the cheese
industry or wine industry, so production of both
goods can occur.
Production (and consumption) of both goods
occurs when the relative price of a good = the
opportunity cost of producing that good.
329
Trade in the Ricardian Model

Suppose home has a comparative advantage
in cheese production. Its opportunity cost of
producing cheese is lower than in foreign.
aLC /aLW < a*LC /a*LW

where * indicates the foreign country
330
Trade in the Ricardian Model (cont.)

Suppose home is more efficient in wine and
cheese production.
It has an absolute advantage in both goods:
aLC < a*LC and aLW < a*LW
A country can be more efficient in producing

both goods, but it will have a comparative
advantage in only 1 goodthe good that uses
resources most efficiently.
331
Trade in the Ricardian Model (cont.)

Even if a country is the most (or least) efficient
producer of all goods, it still can benefit from
trade.
To see how all countries can benefit from trade,
we calculate relative prices when trade exists.
Without trade, the relative price of a good equals its
opportunity cost.
To calculate relative prices with trade, we must

use relative supply and relative demand curves.
332
Relative Supply
First we consider relative supply of cheese:
the Qc supplied by all countries relative to the
Qw supplied by all countries at each price of
cheese relative to the price of wine, Pc /PW.
333
Fig. 2: Relative Supply Curve

Relative price
of cheese, PC/PW
a*LC/a*LW
RS
aLC/aLW
L/aLC
L*/a*LW
Relative quantity
of cheese, QC + Q*C
QW + Q * W
334
Relative Supply (cont.)

There is no supply of cheese if its relative
price falls below its opportunity cost.
Why? because home will specialize in wine
whenever PC /PW < aLC /aLW
And we assumed that aLC /aLW < a*LC /a*LW so
foreign wont produce cheese either.
When PC /PW = aLC /aLW , home will produce

both goods, but foreign will produce only wine.
335
Relative Supply (cont.)

When a*LC /a*LW > Pc /PW > aLC /aLW , home
specializes in cheese and foreign specializes in
wine.
Here home produces L/aLC lbs of cheese and foreign produces
L* /a*LW gallons of wine. This, the relative supply of cheese =
L/aLC / L* /a*LW
When PC / PW = a*LC /a*LW, foreign produces both

goods, but home produces only cheese.
When Pc /PW > a*LC /a*LW , there is no supply of
wine.
336
Relative Demand
Relative demand for cheese is the Qc
demanded in all countries relative to the Qw
demanded at each PC /PW.
As PC /PW rises, consumers in all countries will
tend to purchase less cheese and more wine
so that the relative Qc demanded falls.
337
Fig. 3: World Relative Supply and

Demand
338
Determination of Prices After Trade

Equilibrium (PC /PW)t is determined by the
intersection of RS and RD.
In Fig. 3, point 1, each country specializes in
the production of the good in which it has a
comparative advantage. Home produces
cheese and foreign produces wine.
In Fig. 3, point 2, home produces both goods
and foreign produces wine.
339
Gains From Trade

Gains from trade come from specializing in
the type of production which uses resources
most efficiently, and using the income
generated from that production to buy the
goods and services that countries desire.
where using resources most efficiently means
producing the good in which a country has a
comparative advantage.
340
Gains From Trade (cont.)

Think of trade as an indirect method of
production or a means of converting cheese
into wine or vice versa.
Without trade, a country has to allocate
resources to produce all of the goods that it
wants to consume.
With trade, a country can specialize its
production and trade (convert) produced
goods for the goods that it wants to consume.
341
Gains From Trade (cont.)

Without trade, consumption is restricted to
what is produced.
With trade, consumption possibilities expand
beyond the PPF.
Easier to understand gains from trade by
using a numerical example.
342
A Numerical Example
Unit labor requirements for both countries
Cheese
Wine
Home
aLC = 1 hour/lb
aLW = 2 hours/gal
Foreign
a*LC = 6 hours/lb
a*LW = 3 hours/gal
aLC /aLW = 1/2 < a*LC /a*LW = 2

343
A Numerical Example (cont.)

Home has an absolute advantage in both
goods, but it has a comparative advantage in
cheese production.
Foreign is less efficient in both goods, but it
has a comparative advantage in wine
production.
Question: what is homes opportunity cost of
producing wine? What is its opportunity cost
of producing cheese?
344
A Numerical Example (cont.)

With trade, (PC /PW)t must be between aLC /aLW
= 1/2 and a*LC /a*LW = 2.
Why? What if (PC /PW)t = 3? Then foreign
would refuse to trade as it must give up 3 gal
of wine to purchase 1 lb of cheese.
Suppose that (PC /PW)t = 1.
In words, 1 lb of cheese trades for 1 gallon of wine.
345
Fig. 4: Equilibrium Price with Trade

Pc/Pw
aLC*/aLW* = 2
RS
(Pc/Pw)t = 1
aLC/aLW= 1/2
RD
(Qc + Qc*)/(Qw + Qw*)
Assumes L = L* = 30
346
Fig. 5: Gains from Trade Trade

Home
Qw
30
Foreign
Qw*
CPFt
PPF
CPFt*
L/aLW = 15
L*/a*LW = 10
10
20
L/aLC = 30
Qc
0 L*/a* = 5 10
LC
PPF*
Qc*
Note: Slope of the PPF in each country is the opportunity cost of cheese
in terms of wine (i.e., for home and 2 for foreign) and the slope of the
CPFt for both countries is the traded price (i.e., 1).
Assumes each country has 30 hours of labor available (i.e., L = L* = 30).
Gains from Trade (cont.)

Question: What drives the two countries to
specialize?
Home views (Pc/Pw)t = 1 which is greater than its
opportunity cost of cheese (1/2), so it increases its
production of cheese.
Foreign also views (Pc/Pw)t = 1 which is lower
than its opportunity cost of cheese (2), so it
decreases its production of cheese and increases
its production of wine.
348
Foreign
Home
Gains from Trade (cont.)

before trade in 1 hr could produce 1 C or W
after trade
in 1 hr produces 1 C and trades for 1 W
before trade in 1 hr could produce 1/6 C or 1/3 W

after trade
in 1 hr produces 1/3 W and trades for 1/3 C
Labor is used twice as effectively when trading for what it

needs instead of producing everything itself.
Wages
Although the Ricardian model predicts that
relative prices equalize across countries after
trade, it does not predict that relative wages
will equalize.
Productivity differences determine wage
differences in the Ricardian model.
350
Wages (cont.)
Before trade:
wage = 1 lb cheese/hr or gal of wine/hr
wage* = 1/6 lb of cheese/hr or 1/3 gal of wine/hr
After trade:
wage = 1 lb cheese/hr exchange for 1 gal of wine/hr
wage* = 1/3 gal of wine/hr exchange for 1/3 lb of cheese/hr
Before trade (in terms of cheese) wages are 6x higher at home. After
trade, wages are only 3x higher at home.
351
Wages (cont.)
Recall: home has an absolute advantage in
both goods as it is 6x more productive in
cheese and 1.5x more productive in wine.
Foreign wages are 1/3 of homes wages with
trade.
Foreign has a cost advantage in making wine
(even though home is 1.5x as productive in
wine) because of its low wages.
352
Wages (cont.)
Because foreign workers have a wage that is
only 1/3 the wage of domestic workers, they
are able to attain a cost advantage (in wine
production), despite low productivity.
Because domestic workers have a
productivity that is 6 times that of foreign
workers (in cheese production), they are
able to attain a cost advantage, despite
high wages.
353
Misconceptions About Trade

1. Free trade is beneficial only if a country is
more productive than foreign countries.
The least efficient country can still gain from trade
by specializing in its least inefficient (i.e.,
comparative advantage) industry.
Our example shows home has an AA in both goods. Yet,

foreign still gains by producing wine (its least inefficient
good).
The benefits of free trade do not depend on

absolute advantage. They depend on comparative
advantage: specializing in industries that use
resources most efficiently.
354
Misconceptions About Trade (cont.)

2. Free trade with countries that pay low wages
hurts high wage countries.
Our example shows home is more productive in
both goods and therefore has higher wages than
foreign.
Foreigns lower wages are irrelevant to the
question of whether home gains from trade.
Home gains from trade because it is cheaper in
terms of its own labor for home to produce
cheese and trade for wine rather than produce
wine itself.
355
Misconceptions About Trade (cont.)

3. Free trade exploits less productive countries.
Bob Herbert in NY Times (1995): wages CEO of

Gap = $2 million/year vs. wages of its workers in
Central America = $0.56/hr.
Free trade does not make poor workers worse

off. What are their alternatives?
Our example shows (with trade) foreign workers

are paid 1/3 of what home workers are paid, Yet,
without trade, foreign workers earn only 1/6 of
homes workers.
356
Empirical Evidence
Ricardian model predicts that countries tend to export
goods in which their productivity is relatively high.
World trade in textiles/apparel illustrates the principles
of comparative advantage.
By any measure, the U.S. has a higher labor productivity in
manufacturing than that of newly industrialized countries
(e.g., China or Mexico).
Technology of manufacturing clothing is relatively simple, so
the productivity advantage of advanced countries in textiles
is less than their advantage in many other industries.
In 1992, average U.S. worker was 5x as productive as a
Mexican worker but only 1.5x as productive in textiles.
Thus, textiles/apparel are a major export from low-wage to
high-wage countries.
357

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Leah Marcal

Leah Marcal (cont.)

Slides prepared by Thomas Bishop

Copyright 2009 Pearson Addison-Wesley. All rights reserved.

US: 10 million roses or 100,000 PCs

Comparative Advantage and Trade

Comparative Advantage and Trade (cont.)

A One Factor Ricardian Model

Example with roses and PCs explains the

Ricardian model assumes:

A One Factor Ricardian Model (cont.)

Fig. 1: Homes Production Possibility

Production Possibilities (cont.)

Production Possibilities (cont.)

Production, Prices and Wages

Workers will work in the industry that pays a

Production, Prices and Wages (cont.)

If PC /aLC < PW /aLW (or PC /PW < aLC /aLW )

Production, Prices and Wages (cont.)

Trade in the Ricardian Model

aLC /aLW < a*LC /a*LW

Trade in the Ricardian Model (cont.)

A country can be more efficient in producing

Trade in the Ricardian Model (cont.)

To calculate relative prices with trade, we must

Fig. 2: Relative Supply Curve

Relative Supply (cont.)

When PC /PW = aLC /aLW , home will produce

Relative Supply (cont.)

When PC / PW = a*LC /a*LW, foreign produces both

Fig. 3: World Relative Supply and

Determination of Prices After Trade

Gains From Trade

Gains From Trade (cont.)

Gains From Trade (cont.)

aLC /aLW = 1/2 < a*LC /a*LW = 2

A Numerical Example (cont.)

A Numerical Example (cont.)

Fig. 4: Equilibrium Price with Trade

(Qc + Qc*)/(Qw + Qw*)

Fig. 5: Gains from Trade Trade

Gains from Trade (cont.)

Gains from Trade (cont.)

in 1 hr produces 1 C and trades for 1 W

before trade in 1 hr could produce 1/6 C or 1/3 W

in 1 hr produces 1/3 W and trades for 1/3 C

Labor is used twice as effectively when trading for what it

Misconceptions About Trade

Our example shows home has an AA in both goods. Yet,

The benefits of free trade do not depend on

Misconceptions About Trade (cont.)

Misconceptions About Trade (cont.)

Bob Herbert in NY Times (1995): wages CEO of

Free trade does not make poor workers worse

Our example shows (with trade) foreign workers

S-ar putea să vă placă și

aLC /aLW < aLC /aLW

When PC / PW = aLC /aLW, foreign produces both

aLC /aLW = 1/2 < aLC /aLW = 2

(Qc + Qc)/(Qw + Qw)