ECO4703: CH3
Modern communications technology is making it possible to perform many services—e.g., reading X-rays or even doing legal research—from remote locations. How does this affect the potential gains from trade? With modern communications, gains from trade are
increasing as opportunities to benefit from comparative advantage increase
The overall cost of living is a lot less in China than it is in the United States or Europe. Why might this be? The cost of living is a lot less in China than in the U.S. or Europe because
labor productivity in China's service sector is high
In the multi-good, single-factor Ricardian model, any good produced by each country for itself is referred to as a *blank* good.
nontraded
This difference in opportunity costs offers the possibility
of a mutually beneficial rearrangement of world production
Economists use the term opportunity cost to refer to
the value of the next best alternative occurring as a result of making a particular choice.
Myth 3: Trade exploits a country and makes it worse off if its workers receive much lower wages than workers in other nations
to deny them the opportunity to export and trade might well be to condemn them to even deeper poverty
for any relative price of cheese between aLC/aLW and a∗LC/a∗LW, the relative supply of cheese is
(L/aLC)/(L∗/a∗LW).
Myth 2: Foreign competition is unfair and hurts other countries when it is based on low wages
(pauper labor argument)
equivalent of foreign
.5
Only when PC/PW is equal to aLC/aLW will both goods be produced
TRUE
wages in the wine sector will be higher if PC/PW<aLC/aLW
TRUE
If aLC < a∗LC,
Home labor is more efficient than Foreign in producing cheese
"It has been all downhill for the West since China entered the world market; we just can't compete with hundreds of millions of people willing to work for almost nothing." Assuming that the statement above fails to connect wages and productivity, which of the following statements is true?
It is cheaper to produce some goods in the U.S. because productivity is higher here.
the hourly wage in the cheese sector will equal the value of what a worker can produce in an hour (same for wine)
PC/aLC
This exercise applies the basic Ricardian model of one factor (labor) and two goods to the national economy of Home. Assume the following: aLS = number of labor hours needed to produce a unit of sugar in Home; aLC = number of labor hours needed to produce a unit of canvas in Home; PS = the price per ton of sugar; PC = the price per bolt of canvas. Which of the following conditions signifies that workers in Home will all want to work in the canvas sector?
Recall that everyone will wish to work where wages are highest. PC/PS > aLC/aLS
aLC = 2 hours aLW = 6 hours 240 total labor hours (L)
The production possibilities frontier is a straight line with vertical intercept 40 (240÷6) and horizontal intercept 120 (240÷2). The frontier is linear because the Ricardian model has only one factor of production (labor).
The reason that international trade produces this increase in world output is that it
allows each country to specialize in producing the good in which it has a comparative advantage Further, it increases the size of the world's economic pie. Because the world as a whole is producing more, it is possible in principle to raise everyone's standard of living
The potential for gains from the rearrangement of production among countries is due to
differing opportunity costs.
Trade between two countries can benefit both countries if
each country exports the goods in which it has a comparative advantage
Nontraded goods
goods that are neither imported nor exported due to high transportation costs
international production and trade are determined
in the marketplace, where supply and demand rule
Consider Home's production possibilities curve shown to the right. Which of the following does the absolute value of its slope convey?
production possibilities curve slope helps to understand the opportunity cost of one product with respect to others, As in this case the line shows that opportunity cost of producing 120 pound of cheese is 40 gallons of whiskey
partial equilibrium analysis
study of a single market
general equilibrium analysis
study of multiple markets and the linkages between them
This approach, in which international trade is solely due to international differences in the productivity of labor, is known as
the Ricardian model
In the multi-good, single-factor Ricardian model, the decisive factor in determining which country will produce a particular good is
the identification of the lowest cost producer.
unit labor requirements are inverse of productivity, meaning
the more products a worker can produce in an hour, the lower the unit labor requirement
equivalent of home
x2
Any good for which a∗Li/aLi > w/w∗ will be produced in Home
TRUE
In the absence of international trade, the relative prices of goods are equal to their relative unit labor requirements
TRUE
Wages in the cheese sector will be higher if PC/PW>aLC/aLW
TRUE
When there is only one factor of production, the production possibility frontier of an economy is simply a straight line
TRUE
any good for which a∗Li/aLi < w/w∗ will be produced in Foreign
TRUE
Suppose that the resource base in Country X can produce either 150 units of alpha or 400 units of beta. Similarly, suppose that Country Y's resource base is capable of producing 150 units of alpha or 300 betas. Clearly, the opportunity cost of 150 alphas is lower in *blank* Based on this result, it would be best for Country Y to concentrate on good *blank*
- Country Y - alpha - gain is 100 units of beta
Countries engage in international trade for two basic reasons, each of which contributes to their gains from trade:
- First, countries trade because they are different from each other - Second, countries trade to achieve economies of scale in production. That is, if each country produces only a limited range of goods, it can produce each of these goods at a larger scale and hence more efficiently than if it tried to produce everything
This exercise applies the basic Ricardian model of one factor and two goods. The table below contains the unit labor requirements in Foreign and Home for each of two goods. Home aLC = 6 hours per pound aLW = 5 hours per gallon Foreign a*LC = 2 hours per pound a*LW = 6 hours per gallon 1. In the absence of trade between Home and Foreign the unit labor requirements given above indicate that the relative price of candy (PC/PW) will be lower in *blank* 2. Once Home and Foreign engage in trade, the world equilibrium relative price of candy (PC/PW) will be determined by the 3. In the graphical portrayal of world equilibrium, the relative demand curve of candy is downward-sloping and the relative supply curve of candy is shaped as:
1. Before trade occurs candy's relative price in Foreign is 0.333 gallons of whiskey while in Home it is 1.200 gallons. (Answer: foreign) 2. relative supply and demand of candy. The world supply and demand of candy relative to whiskey are functions of the price of candy relative to that of whiskey. The world equilibrium relative price of candy will relate to the two domestic pre-trade prices as follows: 0.333≤(PC/PW)≤1.200 3. a step function.
Assume the U.S. currently grows 3.0 million tons of fresh winter fruit and that the resources absorbed in the production of this fruit could have produced 250,000 laptop computers. Therefore, the opportunity cost of those 3.0 million tons of fruit is *blank* computers.
250,000
relative wage
Amount workers are paid per hour compared with the amount workers in another country are paid per hour
TRANSPORTATION COSTS
At a relative wage of 3, 12 hours of Foreign labor costs only as much as 4 hours of Home labor; so in the absence of transport costs, Home imports dates. With a 100 percent transport cost, however, importing dates would cost the equivalent of 8 hours of Home labor (4 hours of labor plus the equivalent of 4 hours for the transportation costs), so Home will produce the good for itself instead
The figure to the right displays a scatterplot of hypothetical data for the US and the EU. More specifically, it compares the ratio of US to EU exports with the ratio of US to EU labor productivity for 24 industries. (The productivity ratio is measured on the horizontal axis, the export ratio on the vertical axis. And, both axes are given a logarithmic scale.) Which of the following statements does the graph most accurately support?
Countries will tend to export those goods in which their relative productivity is high.
This exercise applies the basic Ricardian model of one factor and two goods. The table below contains the unit labor requirements in Foreign and Home for each of two goods. C = Cheese, W = Wine Home aLC = 1 hour per pound aLW = 3 hours per gallon Foreign a*LC = 5 hours per pound a*LW = 4 hours per gallon In post-trade equilibrium with PC = PW = $20, the wage of workers in Home relative to the wage of workers in Foreign will be equal to:
In Home opportunity cost of producing 1 pound of candy is 1 hour which is worth 1/3 gallon of whisky. In Foreign opportunity cost of producing 1 pound of candy is 4 hours which are worth 5/4 gallon of whisky. Hence as opportunity cost of producing candy is lesser for home. Hence home has comparative advantage in producing Candy and hence Foreign has comparative advantage in producing whisky. $20/(1+4) = 4 (a ratio not dollar amount)
Myth 1: Free trade is beneficial only if your country is strong enough to stand up to foreign competition
Problem: failed to understand the essential point of Ricardo's model—that gains from trade depend on comparative rather than absolute advantage The competitive advantage of an industry depends not only on its productivity relative to the foreign industry, but also on the domestic wage rate relative to the foreign wage rate.
production possibilities frontier
a line on a production possibilities curve that shows the maximum possible output an economy can produce
Suppose that South America could have instead produced those 3.0 million tons of fruit at an opportunity cost of 150,000 laptops. Because of the difference in opportunity costs between the two regions, it can be shown that trade gives the possibility of
a mutually beneficial rearrangement of world production.
the labor used in producing cheese will be
aLC(QC)
Because the economy's total labor supply is L, the limits on production are defined by the inequality
aLC(QC)+aLW(QW)≤L
the opportunity cost of cheese in terms of wine is
aLC/aLW
Home's relative productivity in cheese is higher than it is in wine (Home has a comparative advantage in cheese):
aLC/aLW<a∗LC/a∗LW or, equivalently, that aLC/a∗LC<aLW/a∗LW.
then the labor used in producing wine will be
aLW(QW)
The Ricardian model of international trade makes predictions about actual international trade flows that
are supported with qualification by the empirical evidence. Although more recent evidence is less clear-cut than older research, it is nevertheless true that the model's two principle implications are supported by the evidence.
What is the opportunity cost of apples in terms of bananas? In the absence of trade, what would the price of apples in terms of bananas be?
bananas/apples # bananas per apple; without trade, the relative prices of the goods are equal to their relative unit labor requirements.
Despite major gains, Chinese manufacturing workers have much lower productivity than their U.S. counterparts. Chinese service workers are relatively more productive, but most services aren't tradable. So which matters for Chinese wages—manufacturing or service productivity? For Chinese wages,
both sectors matter because Chinese wages are a function of productivity and prices in all sectors.
We have focused on the case of trade involving only two countries. Suppose that there are many countries capable of producing two goods (apples and bananas), and that each country has only one factor of production, labor. The graph to the right shows the world relative supply and relative demand curves. As in the two country case, the flat sections of the RS curve are countries with different unit labor requirement ratios (aLA/aLB) Referring to the graph, countries to the left of the equilibrium relative price would *blank* apples to the countries to the right of the intersection.
export
The technology of Home's economy can be summarized by labor productivity in each industry
expressed in terms of the unit labor requirement, the number of hours of labor required to produce a pound of cheese or a gallon of wine
The Ricardian model unequivocally asserts that countries as a whole will always gain from trade because it
ignores the effects of trade on the distribution of income within countries In reality international trade has strong effects on the distribution of income within countries. These have the potential of at least clouding the national gains from trade.
The one-factor Ricardian model refutes the myth that free trade is beneficial only if a country is strong enough to stand up to foreign competition by
indicating that a country only needs a comparative advantage to benefit from trade.
Ricardian Model
international trade is solely due to international differences in the productivity of labor
The degree of specialization predicted by the basic Ricardian model
is much more extreme than is observed in the real world. The basic Ricardian model predicts that specialization will be complete. In other words, it predicts that only nontraded goods will be produced by more than one country. In the real world, specialization is incomplete.
According to the pauper labor argument, foreign competition is unfair and hurts other countries when it is based on
low wages Those who subscribe to this view contend that domestic industries should not have to compete with foreign industries that are less efficient but pay lower wages.
The claim that trade exploits a country and makes it worse off if its workers receive much lower wages than workers in other countries is shown by the Ricardian model to
miss the point because it fails to consider the alternative, which would be even lower wages.
comparative advantage
the ability to produce a good at a lower opportunity cost than another producer
opportunity cost
the most desirable alternative given up as the result of a decision The opportunity cost of roses in terms of computers is the number of computers that could have been produced with the resources used to produce a given number of roses
unit labor requirement
the number of hours of labor required to produce one unit of output
A country has a comparative advantage in producing a good if
the opportunity cost of producing that good in terms of other goods is lower in that country than it is in other countries
relative demand curve
the quantity demanded of one good divided by the quantity demanded of another good; how many units are demanded of a good for each unit demanded of another good
relative supply curve
the quantity supplied of one good divided by the quantity supplied of another good; how many units are supplied of a good for each unit supplied of another good
The economy will specialize in the production of cheese if
the relative price of cheese exceeds its opportunity cost in terms of wine
the economy will specialize in the production of wine if
the relative price of cheese is less than its opportunity cost in terms of wine
If aLi*/ aLi > w/w*
then it is cheaper to produce the good at home
In the basic Ricardian model of one factor and two goods, before any international trade occurs, the relative prices of goods in each country are determined by the relative
unit labor requirements
ratio of wage rates
w/w* Let w be the wage rate per hour in Home and w* be the wage rate in Foreign Goods will always be produced where it is cheapest to make them. The cost of making some good, say good i, is the unit labor requirement times the wage rate. To produce good i in Home will cost waLi. To produce the same good in Foreign will cost w∗a∗Li.
It will be cheaper to produce the good in Home if
waLi<w∗a∗Li, which can be rearranged to yield a∗Li/aLi>w/w∗
it will be cheaper to produce the good in Foreign if
waLi>w∗a∗Li, which can be rearranged to yield a∗Li/aLi<w/w∗
gains from trade
when countries engage in free trade, each country is better off than it would be in the complete absence of international trade; Free trade permits countries to afford better consumption bundles
absolute advantage
when one county can produce a unit of a good with less labor than another country, we say that the first country has an
This exercise applies the basic Ricardian model of one factor (labor) and two goods to the national economy of Home. Assume the following: aLS = number of labor hours needed to produce a unit of sugar in Home; aLC = number of labor hours needed to produce a unit of calico in Home; PS = the price per ton of sugar; PC = the price per bolt of calico. Which of the following represents the opportunity cost of calico? In the absence of international trade, Home will have to produce both calico and sugar for itself. However, it will do so only if
(aLC/aLS) gives the amount of sugar that is sacrificed when a unit of calico is produced. In otherwords, the opportunity cost of calico. PC/aLC=PS/aLS, PC/PS=aLC/aLS, AND Workers are indifferent as to where (Calico or Sugar) they work.
