International Trade CHAPTER 3: THE CLASSICAL WORL OF DAVID RICARDO AND COMPARATIVE ADVANTAGE

Transcription

1 International Trade CHAPTER 3: THE CLASSICAL WORL OF DAVID RICARDO AND COMPARATIVE ADVANTAGE

2 INTRODUCTION The Classical economist David Ricardo introduced the comparative advantage in The Principles of Political Economy and Taxation (1817). This is one of the most important and still unchallenged laws of economics. He stressed the potential gains from international trade that were not confined to Adam Smith s absolute advantage. Contrary to mercantilist thinking, trade is a positive-sum game ( i.e., all trading partners benefit from it)

3 The law of comparative advantage According to this law even if one nation is less efficient than (has an absolute disadvantage with respect to) the other nation in the production of both commodities, there is still a basis for mutually beneficial trade. The first nation should specialize in the production of and export the commodity in which its absolute disadvantage is smaller (this is the commodity of its comparative advantage) and import the commodity in which its absolute disadvantage is greater (this is the commodity of its comparative disadvantage). One has a comparative advantage over another in producing a particular good if he can produce that good at a lower relative opportunity cost or autarky price, i.e. at a lower relative marginal cost prior to trade.

4 Assumptions of the Basic Ricardian Model 1. Each country has a fixed endowment of resources, and all units of each particular resource is identical. 2. The factors of production are completely mobile between alternative uses within a country. This implies that the prices of factors of production also are the same among these alternative uses. 3. The factors of production are completely immobile externally, ie, they do not move between countries. 4. Labor theory of value is employed in the model. No other inputs are used in the production process, Any other input is measured in terms of labor embodied in the production process, The other input/labor ratio is the same in all industries.

5 Assumptions cont The level of technology is fixed for both countries. 6. Costs of production are constant, ie, the supply curve for any good is horizontal. 7. Ther e is full employment. 8. The economy is characterized by perfect competition. 9. There is no government intervention. 10. Transportation costs are zero. 11. Two-country, two-commodity model

6 Ricardian Comparative Advantage Wine Cloth Price ratios in Autarky Portugal 80 hrs/bbl 90 hrs/yd 1 W:8/9 C (or 1C:9/8W) England 120 hrs/bbl 100 hrs/yd 1 W:6/5 C (or 1C:5/6W) The labor requirements per unit of production reflect the technology in each country and imply relative value of each commodity. Above Portugal has an absolute advantage in production of both commodities. However, Portugal is relatively more efficient in production of wine than of cloth and that England s relative disadvantage is smaller in cloth.

7 Autarky price ratios Autarky (pretrade) price ratios show the price ratios when the country has no international trade. In England, 1barrel of wine should exchange for 6/5 yards of cloth, while in Portugal, 1 barrel would exchange for only 8/9 yard of cloth. Thus Portugal gains if it specialize in wine and acquire cloth from England at a ratio of 1 barrel for 6/5 yards. And England benefits by specializing in cloth production and exporting cloth to Portugal, and exchanges 1 yard for 9/8 barrels of wine (instead of 5/6 barrel at home)

8 Gains from trade Autarky price ratios: England 1 barrel of wine exchanges for 1.2 (6/5) yards of cloth Portugal 1 barrel of wine exchanges for 0.89 (8/9) yards of cloth So England gains if it buys wine at any price less than 1.2 C, and Portugal gains when it buys more than 0.89 C for 1W.

9 Terms of Trade Terms of trade is the international price ratios of commodities in international trade. After trade, there will be a common price for wine in terms of cloth in the two countries. because wine is coming into England (new supply from Portugal) and Portugal is now demanding English cloth (new demand), the relative price of English cloth in terms of wine will rise. In Portugal the relative price of wine will rise. Thus, the prices of both wine and cloth will change. There will be a new equilibrium depending on the demand in two countries. This new price will not be only determined by the labor content, why?

10 The equilibrium terms of trade This equilibrium will bring about a balanced trade, where exports = imports in total value, for each country. If one of the countries have a trade surplus, the pricespecie-flow mechanism starts and raises the prices and wages in the surplus country and depresses them in the deficit country. The surplus is eliminated and brings trade to equilibrium. The actual location of the equilibrium terms of trade between the two countries is determined by the comparative strength and elasticity of demand of each country for the other s product. This is referred to as reciprocal demand, a concept developed by John Stuart Mill in 1848.

11 Export concentration of selected countries Country X categories %of X China (2005) Ireland (2005) Japan (2005) Korea (2005) Nigeria (2003) Saudi Arabia (2005) United states (2005) Machinery & transport equipment Miscellaneous manufactured articles chemicals and related products Machinery & transport equipment Machinery & transport equipment Manufactured goods classified by materials Machinery & transport equipment Manufactured goods classified by materials minerals, fuels, etc. Machinery & transport equipment minerals, fuels, etc. chemicals and related products Machinery & transport equipment chemicals and related products 46.2%

12 Comparative advantage and total gains from trade Ricardian production characteristics Cloth Wine Price ratios in autarky Country A 1 hr/yd 3 hrs/bbl 1W:3C (1C:1/3W) Country B 2 hrs/yd 4 hrs/bbl 1W:2C (1C:1/2W) Country A has a comparative advantage in production of cloth and B has comparative advantage in wine. In the above example, Country B benefits when it can exchanges 1W with 3C. And Country A gains nothing because it pays the same relative price that it faces in autarky (exchanging 3C with 1W) Thus for both countries to gain, the international terms of trade must lie somewhere between the autarky price ratios.

13 Resource constraints Suppose Country A has 9,000 hrs of labor available, and Country B has 16,000 hrs of labor available. These constraints coupled with the production information given in the last table permits to establish the production possibilities. As given in table, Country A can produce 9,000 (9000/1) yards of cloth and no wine, or 3,000 (9000/3) barrels of wine and no cloth, or any combination in between absorbing 9,000 hrs of labor. Country B can produce 8,000 (16000/2) yds of cloth and no wine, 4,000 (16000/4) bbl of wine and no cloth, or any combination in between absorbing 16,000 hrs of labor.

14 Assume that country A produces 6000 yards of cloth and 1000 barrels of wine prior to trade, and country B produces 3000 yards of cloth and 2500 barrels of wine. Suppose the two countries exchange goods at the 1W:2.5C. Country A exchanges 2500 yards of cloth for 1000 barrels of wine from country B, but they do not alter their production. How will the post-trade and pre-trade scenarios compare? Country A has 9500 hrs (3500(1) + 2,000(3)), Country B has hrs (5500(2) (4)) Both countries better off after trade.

15 Complete specialization In the previous example, both countries gained from trade even though neither changed its production of wine or cloth (but incomplete picture!!!) In complete specialization, all resources are devoted to the production of one good, with no production of the other good. If Country A produces only cloth and Country B produces only wine, they exchange 2,000 bbl of wine with 5,000 yds of cloth. Country A has 10,000 hrs (4,000(1) + 2,000(3)), Country B has 18,000 hrs (5,000(2) + 2,000(4)) So both countries better off more than before specialization.

16 Maximum gains from trade Economic incentives cause production to move to the endpoint of the frontier, where the maximum gains from trade is realized. For country B the cost of producing one wine is two yards of cloth, but the return of producing 1 barrel of wine is 2.5 yards of cloth. So production of both goods in two countries expand to the endpoint at the PPF with specialization.

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18 Comparative advantage and concluding observations According to classical economists, participation in foreign trade could be a strong force for development. Adam Smith: export enables a country to use resources that otherwise would remain idle. Full employment increase the economic activity acquire foreign goods enhance consumption or investment growth Ricardo: the benefits from trade resulted not from the employment of underused resources but from the more effficient use of domestic resources which came about through specialization in production according to comparative advantage..

19 Comparative advantage and concluding observations, cont Stuart Mill: pointed out the dynamic effects of trade that were critical to development, such as acquiring foreign capital and technology, the impact of trade and resource allocation on the accumulation of saving. Also contacts with foreign countries and cultures could help break the binding chains of tradition, alter wants, and stimulate enterpreneurship, inventions, and innovations. There could be some undesirable consequences of trade, such as, specialization in the production of goods that have few links to the rest of the economycan lead to a lopsided pattern of growth.

20 Comparative advantage and concluding observations, cont Trade not only produces static gains but also can be positive vehicle for economic growth and development and that it should be encouraged. Any country can benefit from trade in which some foreign goods can be purchased at prices that are relatively lower than those at home, even if it is absolutely less efficient in the production of all goods compared to a more developed trading partner.

21 END OF CHAPTER 3