ECON 2181, PROF. BUTT, WEEK 2 NOTES
ECON 2181, PROF. BUTT, WEEK 2 NOTES ECON 2181
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This 7 page Class Notes was uploaded by skenan on Friday September 23, 2016. The Class Notes belongs to ECON 2181 at George Washington University taught by Ahsan Butt in Fall 2016. Since its upload, it has received 8 views. For similar materials see International Trade Theory and Policy in Economics at George Washington University.
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Date Created: 09/23/16
ECON 2181 WEEK 2 CHAPTER 2: THE RICARDIAN MODEL KEY TERMS IMPORTANT PEOPLE IMPORTANT CONCEPT IMPORTANT FORMULAS Reasons countries trade with each other: • Technology: ∆ in tech used (differences a country’s ability to manufacture) • Resources: ∆ in the total amount of resources found in each country (including land, labor, and capital) o Geography: Natural resources, labor resources, and capital o Factors of Production: land, labor, capital • Offshoring: ∆ in the costs of offshoring (producing the various parts of a good in different countries and then assembling it in a final location) • Proximity: the proximity of countries to each other. The closer countries are lower the costs of transportation. Ex; European countries. Absolute Advantage: the ability to produce more of a good than competitors, using the same resources/time. Comparative Advantage: the ability to produce a good/service at a lower opportunity cost. • Primary explanation for trade among countries. • A country has comparative advantage in producing those goods that it produces best compared with how well it produces other goods. • In some cases, like “icewine”, which is a type of wine invented in Germany but is now produced in the Niagara Falls region of Canada and the U.S. Therefore; a country can export a good without having any advantage in the natural resources needed to produce it. David Ricardo and Mercantilism: Mercantilists believed that exporting was good b/c it generated gold, importing was bad b/c it drained gold from the national treasury. • In favor of high tariffs to ensure high exports and low imports. Ricardo showed that countries could benefit from international trade w/out having to use tariffs. Today, it is accepted that international trade brings gains to all trading partners. Ricardian Model: start up point of the new classical international trade theory. It explains how the level of a country’s tech. affects its trade pattern. Ex; if the U.S. has the capacity to produce its own snowboards, why is it importing instead? • Because of absolute and comparative advantage ????????????????∗???????????????? Trade= ???????????????????????????????? (????,????) Developing a Ricardian Model of Trade: • 2 goods; wheat and cloth • For simplicity; assume that labor is the only resource used to produce goods. Marginal Product of Labor (MPL) is the extra output obtained by using one more unit of labor. • We can graph Home’s PPF using MPL. Production Possibilities Frontier (PPF) is a curve showing the maximum attainable combinations of two products that may b produced with available resources and current technology. The slope of the PPF is the opportunity cost of Good A, (the amount of Good B must be given.) Home Country: Foreign Country: 50 workers available: if employed in 100 workers available: if all employed in wheat, Home could produce 100 bushels. wheat, they could produce 100 bushels. If If all were employed in cloth they could all were employed in cloth, they could produce 50 yards. produce 100 yards. • In home, one worker produces 2 yards of cloth OR 4 bushels of wheat, so • Foreign one worker can produce 1 MPL =C2, MPL =W4 bushel of wheat OR 1 yard of cloth. MPL *W = 1, MPL*C= 1 This PPF is based on the following assumptions: This PPF is based on the following Labor = 25 assumptions: MPL W 4, MPL = C Labor = 100 Q W MPL (LW*= 25*4 = 100 MPL W 1, MPL =C1 Q C MPL (C* = 25*2 = 50 QW= MPL (W* = 100*1 = 100 The linear shape of the PPF is a unique QC= MPL (C* = 100*1 = 100 feature of the Ricardian model. Without The opp. cost is the amount of cloth that trade, the PPF acts as a budget constraint must be given up (1 yard) to obtain 1 more for the country. bushel of wheat. M PPF - opportunity cost of wheat, that is, The magnitude of the slope can be the amount of cloth that must be given up expressed as the ratio of the marginal (1/2 yard) to obtain 1 more bushel of products of labor for the two goods wheat. Pm MPLa = Pa MPLm Indifference Curves: All points on an indifference curve have the same level of utility. Points on higher indifference curves have higher utility. • UA= U B The highest level of Home utility on the PPF is obtained at point A, which is the no-trade equilibrium. • U > U , but point B is off C A of the PPF, so it is not attainable in the absence of international trade. With perfectly competitive markets, the country will produce at its highest level of utility within the limits of the PPF. Under perfect competition the opportunity cost of wheat should also equal the relative price of wheat. Price reflects the opportunity cost of a good. M = Opp. cost of wheat (comparative advantage) = Relative Price PPF In competitive markets firms hire workers up to the point at which the hourly wage equals the value of one more hour of production. The value of one more hour of labor equals the amount of goods produced in that hour (MPL) times the price of the good. Labor will be hired up to the point where wage equals P • MPL for each industry. P W MPL = PW• MPL C C PW• MPL =Wrelative price of wheat PC• MPL =CM PPF(the opp. cost of wheat) P WP =CMPL /MPL C W Relative price of wheat and opp. cost of wheat must be equal in the no-trade equilibrium at Wage= P*MPL point A. WITH TRADE: • A country’s no-trade relative price determines which product it will export and which it will import. • No-trade relative price = opp. cost of production = comparative advantage values of goods • The pattern of exports and imports will be determined by the opportunity costs of production in each country—their comparative advantage. How to determine which good a country will export? By looking at relative prices. Both countries export the good for which they have the comparative advantage. • The relative price of cloth in ForeiCn Ws P /P = 1. • The relative price of cloth in HomeCisWP /P = 2. Production Opportunity Cost Cloth Wheat Cloth (W/C) Wheat (C/W) Home 2 bushels of w. 4 yard of c. 2 bushel of w. ½ yards of c. Foreign 1 bushel of w. 1 yard of c. 1 bushel of w. 1 yard of c. • Therefore, Foreign would want to export cloth to Home—they can make it for $1 and export it for more than $1. Home will export wheat. • The two countries are in international trade equilibrium when the relative price of wheat is the same in the two countries. • The relative price of wheat in the trade equilibrium will be between the no-trade price in the two countries. • Assume the free-trade price of P /W isC2/3 (between the price of ½ in Home and 1 in Foreign). World price line shows the range of consumption possibilities that a country can achieve by specializing in one good and engaging in international trade. With a world rel. price of 2 wheat of / 3 Home production will occur at point B. Through international trade, Home is able to export each bushel of wheat it produces in exchange for / 3ard of cloth. • Home profit from trade > opp. cost of production of wheat. Home will therefore shift labor resources toward the production of wheat and increase its production. With the given information, we can calculate the ratio of wages in the two industries. W=P*MPL As wheat is exported, Home moves up the world price line BC. Home consumption occurs at point C, at the tangent intersection with indifference curve U 2 since this is the highest possible utility curve on the world price line. (U2> U 1. Given these levels of production and consumption, we can see that total exports are 60 bushels of wheat in exchange for imports of 40 yards of cloth and also that Home consumes 10 fewer bushels of wheat and 15 more yards of cloth relative to its pre-trade levels. Home’s exports and imports are equal when valued in the same units. Home’s utility increase with trade is a demonstration of the gains from trade. There are gains from trade for both countries. (as seen in foreign’s post-trade graph) Each country is exporting the good for which it has the comparative advantage, by which the pattern of trade is determined. The utility of an importing or exporting country is at least as high as it would be in the absence of international trade. Wages: Contrary to pattern of trade, wages are determined by absolute advantage. In competitive labor markets, firms will pay workers the value of their marginal product. Home produces and exports wheat, therefore they will be paid in terms of that good. The real wage is MPL = W bushels of wheat. The relative price of wheat is PW/P C 2/3. The real wage in terms of cloth: (P WP )CMPL = (W/3)*4 = 8/3 yards. Foreign workers earn less than Home workers as measured by their ability to purchase either good. This reflects Home’s absolute advantage in the production of both goods. • Labor productivity is measured by value-added per hour of work and can be compared with the wages paid in manufacturing in various countries. Countries with higher labor productivity pay higher wages. Export Supply Curve: When the relative price of wheat is 1/2, Home will export any amount of wheat between 0 and 50 bushels, along the segment Aʹ Bʹ of the Home export supply curve. For relative prices above /2, Home exports more than 50 bushels, along the segment Bʹ Cʹ. 2 For example, at the relative price of 3 , Home exports 60 bushels of wheat. For relative prices below 1, Foreign imports more than 50 bushels, along the segment B*ʹC*ʹ. For example, at the relative price of / ,3Foreign imports 60 bushels of wheat. World Market for Wheat: Putting together the Home export supply curve and the Foreign import demand curve for wheat, the world equilibrium is established at point Cʹ, where the relative price of wheat is 2 /3. The equilibrium price of a good on the world market is determined at the point where the export supply of one country equals the import demand of the other country. Terms of Trade: The price of a country’s exports divided by the price of its imports. • Home terms of trade is (P WP ),Cb/c Home exports wheat. • Foreign terms of trade is (Pc/P w b/c Foreign exports cloth. • In this case, having a higher price for cloth (Foreign’s export) or a lower price for wheat (Foreign’s import) would make the Foreign country better off. T. of T. for Primary Commodities: Economists Raúl Prebisch and Hans Singer argued that the price of primary commodities would decline over time relative to the price of manufactured goods. any developing countries export primary commodities (that is, agricultural products and minerals), whereas industrial countries export manufactured products. Shown here are the prices of various primary commodities relative to an overall manufacturing price, from 1900 to 1998. The relative prices of some primary commodities have fallen over time whereas other commodities have had rising relative prices.
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