onal Trede-Trede Comparative Advantag There are two countries, Home(H)and Foreign(F). There are two goods, units of wine(Qu)and cheese(Q. Suppose there is one factor of production, labour, which is available in amounts L and L'respectively Suppose both countries have 100 units of labour and the unit labour costs for producing the two goods are given in the table below. Notice home can produce both goods cheaper it has an absolute aduantage in both. Wine Cheese Home Foreign50 Before trade Home was producing Qe=3 and Qw=4. Foreign was producing Qw=l and Q= 2. Trade can make both countries better off. Consider Qe= l, Qu=8 and Q*= 4, Q*=0. If Home exports 3 units of wine in exchange for 2 imported units of cheese, both are strictly better off. Home has a comparative advantage in wine. Foreign has a comparatiue aduantage in cheese. International Trnde ade The Ricardian Model Trade can make both better off. This can be seen more generally in the Ricardian modeL There is still one factor of production and two goods. Unit labour costs are lw, le, l' and /: for Home and Foreign in wine and cheese respectively. Hence production possibilities are given by: lQ+l2Qe≤ L and Q+lQ≤L Q / The absolute value of the slopes are I/e and I'/.. They are the cost of wine in terms of cheese. Home has absolute advantage in wine when lw I and a comparative advantage when lyle< l/(assumed throughout) By definition, every country can produce a good in which it has a comparative advantage
International Trade — Trade 1 Comparative Advantage • There are two countries, Home (H) and Foreign (F). There are two goods, units of wine (Qw) and cheese (Qc). • Suppose there is one factor of production, labour, which is available in amounts L and L ∗ respectively. • Suppose both countries have 100 units of labour and the unit labour costs for producing the two goods are given in the table below. Notice home can produce both goods cheaper — it has an absolute advantage in both. Wine Cheese Home 10 20 Foreign 50 25 • Before trade Home was producing Qc = 3 and Qw = 4. Foreign was producing Q∗ w = 1 and Q∗ c = 2. Trade can make both countries better off. Consider Qc = 1, Qw = 8 and Q∗ c = 4, Q∗ w = 0. • If Home exports 3 units of wine in exchange for 2 imported units of cheese, both are strictly better off. • Home has a comparative advantage in wine. Foreign has a comparative advantage in cheese. International Trade — Trade 2 The Ricardian Model • Trade can make both better off. This can be seen more generally in the Ricardian model. • There is still one factor of production and two goods. Unit labour costs are lw, lc, l ∗ w and l ∗ c for Home and Foreign in wine and cheese respectively. Hence production possibilities are given by: lwQw + lcQc ≤ L and l ∗ wQ ∗ w + l ∗ cQ ∗ c ≤ L ∗ ................................................................................................................................................................................................................................................................................ .................................................................................................................................................................................................................................................................................. ................................................................................................................................................................................................................................................... . 0 Qw 0 Qc Q∗ w Q∗ c L/lw L/lc L ∗/l∗ w L ∗/l∗ c • The absolute value of the slopes are lw/lc and l ∗ w/l∗ c . They are the cost of wine in terms of cheese. Home has an absolute advantage in wine when lw < l ∗ w and a comparative advantage when lw/lc < l ∗ w/l∗ c (assumed throughout). • By definition, every country can produce a good in which it has a comparative advantage
Prices and Trade How is the world price(the exchange rate between goods) set? Plot relative prices against relative world production. Relative world demand (RD)will be downward sloping. Relative world supply(RS)will be a step function. The tersection of the two curves clearly yields the world equilibrium price ratio ee/le 8将 Consider RS. If relative price is below Lu/e both countries produce cheese. If relative price is above I+/ both countries produce wine. If relative prices are in between countries will specialise in their comparative advantage. In the first slide s example only abroad specialised. This can be illustrated with a different demand curv International Trnde The gains from trade Both countries can gain from trade. Consider the case where both countries specialise The below diagram shows the production possibility frontier along with the world price ratio(the dashed line)for both countries. Trade expands the consumption possibilities of both countries, beyond their frontier Exports In the diagram exports and imports can be illustrated. One countrys exports must equal the other's imports
International Trade — Trade 3 Prices and Trade • How is the world price (the exchange rate between goods) set? Plot relative prices against relative world production. • Relative world demand (RD) will be downward sloping. Relative world supply (RS) will be a step function. The intersection of the two curves clearly yields the world equilibrium price ratio. ................................................................................................................................................................................................................................................................................ ............................................................................................................. ............................................................................................................ . ............. ............. ............. ............. ......... . . . 0 Qw+Q∗ w Qc+Q∗ c Pw/Pc l ∗ w/l∗ c lw/lc • RS RD L/lw L∗/l∗ c • Consider RS. If relative price is below lw/lc both countries produce cheese. If relative price is above l ∗ w/l∗ c both countries produce wine. If relative prices are in between countries will specialise in their comparative advantage. • In the first slide’s example only abroad specialised. This can be illustrated with a different demand curve. International Trade — Trade 4 The Gains from Trade • Both countries can gain from trade. Consider the case where both countries specialise. • The below diagram shows the production possibility frontier along with the world price ratio (the dashed line) for both countries. Trade expands the consumption possibilities of both countries, beyond their frontier. ................................................................................................................................................................................................................................................................................ .................................................................................................................................................................................................................................................................................. .................................................................................................................................... . . . . ..................................................................................... ...... ...... ... ...... ...... ...... ... ..................................................................................... ............... ..................... . . . ..................................................................................... ...... ...... ... ...... ...... ...... ... ..................................................................................... ............... ..................... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 0 • • Qw Qc Q∗ w Q∗ c Imports Exports Imports Exports • In the diagram exports and imports can be illustrated. One country’s exports must equal the other’s imports
The Heckscher- Ohlin model A more general analysis involves two factors of production, labour and capital. Suppose wine is labour intensive it uses relatively more labour to capital than the production of cheese Suppose Home has more labour(hence the comparative advantage in wine production). The above diagram shows the production possibility frontier (which is now concave as there are two factors of ction). The straight line is the world price ratio. Home produces at r but consumes(after trade)at y. They are better off. Notice that specialisation is not complete. Countries tend to export goods whose production is intensive in factors in which they are abundant. Home still exports wine. International Trnde ade Trade and Goods prices Home is relatively good at producing wine. For a given price it can produce more. Foreign is relatively good at producing cheese. Therefore the relative supply curves are positioned as in the below picture. Notice that both countries now produce positive amounts of both goods. There is no complete specialisation. Pu/Pe Foreign is relatively bad at producing wine. From Homes point of view relative supply of wine falls under trade and prices rise. From Foreigns point of view relative supply of wine rises under trade and prices fall. World price will be somewhere in between RSF and RSH
International Trade — Trade 5 The Heckscher-Ohlin Model • A more general analysis involves two factors of production, labour and capital. Suppose wine is labour intensive — it uses relatively more labour to capital than the production of cheese. • Suppose Home has more labour (hence the comparative advantage in wine production). ............. ............. ............. ............. ............. ............. ............. . . . . . ............. ............. ............. .......... . . . . . . . . ............................................................................................................................................................................................................................................................................................. . . . . .......................................................................... ...... ...... ... ...... ...... ...... ... .......................................................................... ............... ..................... . ... ... ... ... ... ... ... .... .... ....... ........ ......... .......... ............ ................... ..................................... • • Qw Qc Exports Imports 0 x y • The above diagram shows the production possibility frontier (which is now concave as there are two factors of production). The straight line is the world price ratio. Home produces at x but consumes (after trade) at y. • They are better off. Notice that specialisation is not complete. Countries tend to export goods whose production is intensive in factors in which they are abundant. Home still exports wine. International Trade — Trade 6 Trade and Goods Prices • Home is relatively good at producing wine. For a given price it can produce more. Foreign is relatively good at producing cheese. Therefore the relative supply curves are positioned as in the below picture. • Notice that both countries now produce positive amounts of both goods. There is no complete specialisation. ................................................................................................................................................................................................................................................................................ . . . . . . . . . . . . . . . . . . . . . . . . . 0 Qw+Q∗ w Qc+Q∗ c Pw/Pc • • • RD RSF RSH • Foreign is relatively bad at producing wine. • From Home’s point of view relative supply of wine falls under trade and prices rise. From Foreign’s point of view relative supply of wine rises under trade and prices fall. World price will be somewhere in between RSF and RSH
onal Trede-Trede Trade and Factor Prices Recall that wine was labour intensive and cheese capital intensive. How does trade affect the income distribution? Home- abundant ur and relatively good at producing wine. Re There is a relationship between goods prices and factor prices. Competition ensures goods prices are equal to marginal cost, costs depend on factor prices. Higher factor prices push up goods prices which involve that factor. Pe/pe Autarky Trade meant a rise in the relative price P/Pe for Home. Hence there will be an associated rise in ar/ Owners of a country's abundant factor will gain from trade, whilst owners of a country's scarce factor will lose International Trnde ade The terms of trade The price of the export good divided by the price of the import good is a countrys terms of trade. For Home this is Pu/ Pe since they export wine. The terms of trade are determined by relative world supply and demand. Suppose initially, supply is given by Rs and demand by RD. Which factors affect the terms of trade? Pu /Pe RD Economic growth(an increase in productivity) will shift the relative supply 1. Import biased growth: Relative supply moves to RS1. Terms of trade"improve 2. Export biased growth: Relative supply moves to RSz. Terms of trade "get worse Better products will result in higher relative demand (RDi)which improves the terms of trade
International Trade — Trade 7 Trade and Factor Prices • Recall that wine was labour intensive and cheese capital intensive. How does trade affect the income distribution? • Consider Home — abundant in labour and relatively good at producing wine. Relative prices rise after trade. • There is a relationship between goods prices and factor prices. Competition ensures goods prices are equal to marginal cost, costs depend on factor prices. Higher factor prices push up goods prices which involve that factor. . ................................................................................................................. ................................................................................................................................................................................................................................................................................ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 w/r Pw/Pc • • Autarky Trade • Trade meant a rise in the relative price Pw/Pc for Home. Hence there will be an associated rise in w/r. • Owners of a country’s abundant factor will gain from trade, whilst owners of a country’s scarce factor will lose. International Trade — Trade 8 The Terms of Trade • The price of the export good divided by the price of the import good is a country’s terms of trade. • For Home this is Pw/Pc since they export wine. The terms of trade are determined by relative world supply and demand. Suppose initially, supply is given by RS and demand by RD. Which factors affect the terms of trade? ................................................................................................................................................................................................................................................................................ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Qw+Q∗ w Qc+Q∗ c Pw/Pc • RS RD RD1 RS1 RS2 • Economic growth (an increase in productivity) will shift the relative supply curve. 1. Import biased growth: Relative supply moves to RS1. Terms of trade “improve”. 2. Export biased growth: Relative supply moves to RS2. Terms of trade “get worse”. • Better products will result in higher relative demand (RD1) which improves the terms of trade
Tariffs in a Small Country How does a tariff affect a small country? Suppose Homes demand and supply for cheese are given by D and S respectively. The world price is Pe. The government adds a tariff on imports of t. The price now paid by the country is Pe +t. More is supplied at Home. Less is imported. P P+ The consumer loses area a+6+c+d since they purchase less and pay more. higher price. The government raise of area e(imports times tariff), and so the total loss to the country is b+d International Trnde ade ge In a large country however, world price is affected by the tariff. In the same way that taxes affected a market, a tariff will lower the world supply price and raise the world demand price The supply price is initially Pl. It falls to P2 after the introduction of a tariff which means Home now faces a price of P2 +t. How is welfare affected? S and D are Home s supply and demand. D The consumer loses a+6+c+d. The firm gains a. The government now raises Total loss is therefore b+d-e. This could be negative -that is, a benefit. Does revenue outweight loss? It might
International Trade — Trade 9 Tariffs in a Small Country • How does a tariff affect a small country? Suppose Home’s demand and supply for cheese are given by D and S respectively. The world price is Pc. The government adds a tariff on imports of t. • The price now paid by the country is Pc + t. More is supplied at Home. Less is imported. ................................................................................................................................................................................................................................................................................ . . .......................................................................................................................................................... ...... ...... ... ...... ...... ...... ... ........................................................................................................................................................... ............... ..................... .................................................... ...... ...... ... ...... ...... ...... ... .................................................... ............... ..................... ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Qc Pc S D Pc Pc + t Imports a b c d • The consumer loses area a + b + c + d since they purchase less and pay more. • The producer gains area a since they produce more at a higher price. • The government raises revenue of area c (imports times tariff), and so the total loss to the country is b + d. International Trade — Trade 10 Tariffs in a Large Country • In a large country however, world price is affected by the tariff. In the same way that taxes affected a market, a tariff will lower the world supply price and raise the world demand price. • The supply price is initially P 1 c . It falls to P 2 c after the introduction of a tariff which means Home now faces a price of P 2 c + t. How is welfare affected? S and D are Home’s supply and demand. ........................................................................................................................................................................................................................................................................................................... . . ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. ............. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Qc Pc S D P 1 c P 2 c + t P 2 c a b c d e • The consumer loses a + b + c + d. The firm gains a. The government now raises a revenue of c + e. • Total loss is therefore b + d − e. This could be negative — that is, a benefit. Does revenue outweight loss? It might
Tariffs and the terms of trade How does a tariff affect the terms of trade? Consider a tariff on the imported good(cheese) The lower relative price of wine at Home will result in more demand from Home's The lower relative price of wine will result in Home's firm producing less wine(producers will substitute into the import good- cheese, which is now more profitable). Notice it is only Home's prices that have changed. P/P RDI The first effect results in a rise in relative demand (RD, to RDz)and the second in a fall in relative supply (RSi to RSa). Hence world prices also change. The terms of trade improve given a tariff. Hence a tariff at Home can be beneficial to Home - see earlier slide, but always damages foreign by worsening their terms of trade(improwing Homes terms of trade worsens Foreigns) International Trnde ade How does an export subsidy affect the terms of trade? Can it ever benefit Home? Export subsidies raise supply of the export good (wine)at Home. Relative supply rises from RS to RS2 They lower Homes demand for the export good. Relative demand falls from RDi to RD2 The terms of trade fall as illustrated below. Home is worse off due to this fall DI Home is also worse off due to the distortionary effect of the subsidy. An export subsidy always reduces welfare. On the other hand. export subsidies benefit Foreign by improving their terms of trade. Not a sensible policy
International Trade — Trade 11 Tariffs and the Terms of Trade • How does a tariff affect the terms of trade? Consider a tariff on the imported good (cheese). • The lower relative price of wine at Home will result in more demand from Home’s consumer for wine. • The lower relative price of wine will result in Home’s firm producing less wine (producers will substitute into the import good — cheese, which is now more profitable). Notice it is only Home’s prices that have changed. ................................................................................................................................................................................................................................................................................ . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Qw+Q∗ w Qc+Q∗ c Pw/Pc • • RD2 RD1 RS2 RS1 • The first effect results in a rise in relative demand (RD1 to RD2) and the second in a fall in relative supply (RS1 to RS2). Hence world prices also change. The terms of trade improve given a tariff. • Hence a tariff at Home can be beneficial to Home — see earlier slide, but always damages Foreign by worsening their terms of trade (improving Home’s terms of trade worsens Foreign’s). International Trade — Trade 12 Export Subsidies • How does an export subsidy affect the terms of trade? Can it ever benefit Home? • Export subsidies raise supply of the export good (wine) at Home. Relative supply rises from RS1 to RS2. • They lower Home’s demand for the export good. Relative demand falls from RD1 to RD2. • The terms of trade fall as illustrated below. Home is worse off due to this fall. ................................................................................................................................................................................................................................................................................ . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 Qw+Q∗ w Qc+Q∗ c Pw/Pc • • RD1 RD2 RS1 RS2 • Home is also worse off due to the distortionary effect of the subsidy. An export subsidy always reduces welfare. • On the other hand, export subsidies benefit Foreign by improving their terms of trade. Not a sensible policy