Absolute and comparative advantage The theory of comparative advantage Extensions and Limits Lecture 1: The Theory of Comparative Advantage Gregory Corcos Eco572: International Economics September 10, 2014
Absolute and comparative advantage The theory of comparative advantage Extensions and Limits
Lecture 1: The Theory of Comparative Advantage
Gregory Corcos
Eco572: International Economics
September 10, 2014
Absolute and comparative advantage The theory of comparative advantage Extensions and Limits
Theories of International Trade
Trade based on cross-country differences:in technologies: Ricardo
in factor endowments: Hecksher-Ohlin-Samuelson (HOS)
⇒ Inter-industry trade among “different” countries
Trade based on economies of scale and productdifferentiation:
Krugman and others
⇒ Intra-industry trade among “similar” countries
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Absolute and comparative advantage The theory of comparative advantage Extensions and Limits
Inter-Industry vs Intra-Industry Trade
Decomposition of trade (% total)
Source: Fontagne L., Freudenberg M., Gaulier G. (2006). Definitions:Intra-industry trade is identified as simultaneous exports and importswithin the same industry. Distinction of vertical and horizontal relieson price differences.
Around 40% of trade flows are intra-industry but growing3/24
Absolute and comparative advantage The theory of comparative advantage Extensions and Limits
Outline
Absolute versus comparative advantage
Ricardo’s model of international trade
Extensions and limitations
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Absolute and comparative advantage The theory of comparative advantage Extensions and Limits
David Ricardo (1772-1823)
39
English broker, political economist, member of Parliament
Promotes free trade against Corn Laws
On the Principles of Political Economy and Taxation (1817, 1819, 1821).
• Labor theory of value
• Differential rent (land)
• ‘Ricardian’ equivalence
• Theory of comparative advantage
David Ricardo (1772-1823)
Bénassy-Quéré & Coeuré – International Economics 2009-2010
English broker, political economist, memberof Parliament
Promotes free trade against Corn Laws
On the Principles of Political Economy andTaxation (1817, 1819, 1821).
Labor theory of value
Differential rent (land)
“Ricardian” equivalence
Theory of comparative advantage
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Absolute and comparative advantage The theory of comparative advantage Extensions and Limits
Ricardo’s simple example
On the Principles of Political Economy and Taxation, ch.7, 1817
With a given number of hours worked, Portugal can produce20 meters of cloth or 300 liters of wine, while England canproduce 10 meters of cloth or 100 liters of wine. England hasan absolute disadvantage in both productions.
Still, England should specialize in cloth, where it has acomparative advantage: with 10 meters of cloth, it can obtain150 liters of wine (10×300/20) in Portugal, instead of 100liters at home.
In turn, Portugal should specialize in wine: with 300 liters ofwine, it can get 30 meters of cloth in England (300×10/100),instead of only 20 meters at home.
England has a comparative advantage in the production ofcloth. Portugal has a comparative advantage in wine.
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Absolute and comparative advantage The theory of comparative advantage Extensions and Limits
Comparative advantage is related to opportunity cost.
To produce 10 meters of cloth, England must forego theproduction 100 liters of wine in autarky; to produce the same10 meters of cloth Portugal must forego the production of10 ∗ 300
20 = 150 liters of wine.
The opportunity cost of producing cloth in England ( 10010 ) is
lower than in Portugal ( 30020 = 150
10 ).
A country is said to have a comparative advantage in theproduction of one good if its opportunity cost is lower than inany other country.
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Absolute and comparative advantage The theory of comparative advantage Extensions and Limits
Additional Examples
Absolute advantageMonthly production per worker
(units of goods)
China Europe
Shirts 200 50Cars 5 10
China has an absolute advantage inshirts (200 > 50).Europe has an absolute advantage incars (10 > 5).China should specialize in shirts andimport carsEurope should specialize in cars andimport shirtsWorld output would then increasethanks to a more efficient use of labor
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Absolute and comparative advantage The theory of comparative advantage Extensions and Limits
Additional Examples
Absolute advantage Comparative advantageMonthly production per worker Monthly production per worker
(units of goods) (units of goods)
China Europe
Shirts 200 50Cars 5 10
China Europe
Shirts 400 50Cars 20 10
China has an absolute advantage inshirts (200 > 50).
China has an absolute advantage inboth industries (400 > 50, 20 > 10).
Europe has an absolute advantage incars (10 > 5).
Europe has a comparative advantagein cars ( 10
50> 20
400).
China should specialize in shirts andimport cars
China should specialize in shirts andimport cars
Europe should specialize in cars andimport shirts
Europe should specialize in cars andimport shirts
World output would then increasethanks to a more efficient use of labor
Specialization is efficient despite onecountry having absolute advantage.
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Absolute and comparative advantage The theory of comparative advantage Extensions and Limits
Gains from Trade
Autarky Full SpecializationDenote by L the total volume of labor per month
Assume that the world relative price of shirts in termsof cars is 1/10
Each country produces and consumes its own goods: Countries specialize in one good and import the otherone:
- China produces and consumes S shirts andC cars, with:L = S/400 + C/20 hence C = 20L − S/20Maximum production: 400 L shirts or 20 Lcars; 1/20 = opportunity cost of producingone additional shirt in terms of forgone cars
- Europe produces and consumes S shirts andC cars, with:L = S/50 + C/10 hence C = 10L − S/5Maximum production: 50 L shirts or 10 Lcars; 1/5 = opportunity cost of producingone additional shirt in terms of forgone cars
15> 1
20: the opportunity cost of shirts is
higher in Europe than in China
- China specializes in shirts: produces 400 Lshirts, exchange part of the productionagainst cars at the world price 1/10, i.e. at ahigher price than the opportunity cost (1/20)
- Europe specializes in cars: produce 10 L carsand exchange part of the production againstshirts at the world price 10/1, i.e. at ahigher price than the opportunity cost (5/1)
Trade allows each country to consumemore of at least one good: utility is higher(Trade is Pareto-improving)
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Absolute and comparative advantage The theory of comparative advantage Extensions and Limits
Gains from Trade (2)
44
Gains from trade
400L
20L
Cars
Shirts 50L
10L China Europe
A
A
(1/10)
(1/20) (1/10) (1/5)
O
O
Y
Y
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Absolute and comparative advantage The theory of comparative advantage Extensions and Limits
Comparative Advantage
A country is said to have a comparative advantage in theproduction of one good if its opportunity cost is lower than inany other country
Trade between any two countries is Pareto-optimal if eachcountry exports the good in which it has a comparativeadvantage
In the Ricardian model, market mechanisms insure that eachcountry indeed specializes in its comparative advantage
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Absolute and comparative advantage The theory of comparative advantage Extensions and Limits
The Basic Ricardian Model
Assumptions Model
- 2 countries: Home and Foreign
- 2 goods X and Y
- 1 production factor L: perfectlymobile across industries, perfectyimmobile across countries
- Perfectly competitive goods andlabor markets
- No trade costs
- Constant returns to scale withdifferent labor requirements (=1/MPL): aX , a∗X , aY , a∗YOpportunity costs of X in terms
of Y: aXaY
,a∗Xa∗Y
- Assume w.l.o.g. aX /aY > a∗X /a∗Y
i.e. the foreign country has acomparative advantage in X
- PPF Home: L = aXX + aYY
- PPF Foreign:L∗ = a∗XX
∗ + a∗YY ∗
- aX /aY > a∗X /a∗Y : the opportunity
cost of X in terms of Y is higherin Home than in Foreign.
Home would specialize in Y ifpX /pY < aX /aY .
Foreign would specialize in X ifpX /pY > a∗X /a
∗Y .
This will happen ifaX /aY > pX /pY > a∗X /a
∗Y .
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Absolute and comparative advantage The theory of comparative advantage Extensions and Limits
Equilibrium in Autarky
46
Equilibrium in autarky
Y
X
A*
A
aX/aY
aX*/aY*
Perfect competition:
pX = aX w ; pY = aY w ; pa = pX/pY = aX/aY
pX* = aX*w*; pY
* = aY*w* ; pa*= pX*/pY
* =aX*/aY*
L/aY
L/aX
L*/aY*
L*/aX*
Bénassy-Quéré & Coeuré – International Economics 2009-2010
Both sectors compete for labor, so that pa = a∗X/a∗Y .
The relative price of X is higher in Home than in Foreign ⇒ Tradeopportunity.14/24
Absolute and comparative advantage The theory of comparative advantage Extensions and Limits
International Trade
A country specializes in one good if the relative price of thisgood is higher than its opportunity cost.
Since pX/pY > p∗X/p∗Y , Foreign gains by exporting X while
importing Y .
Since p∗Y /p∗X > pX/pY , Home gains by exporting Y while
importing X .
Those mutually advantageous exchanges imply a convergenceof prices: p∗X/p
∗Y ↑, pY /pX ↑ until pX/pY = p∗X/p
∗Y
The world price is (weakly) between the autarkic prices.
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Absolute and comparative advantage The theory of comparative advantage Extensions and Limits
World Equilibrium with Full Specialization
48
World equilibrium with full specialization
p = pX/pY
X/Y
Relative world supply
E
pa* = aX*/aY
*
pa = aX/aY
Relative world demand
pE
For p < pa*, no country produces X
For p > pa, no country produces Y
Bénassy-Quéré & Coeuré – International Economics 2009-2010
Full specialization if a∗X/a∗Y < p < aX/aY
Relative quantity: X/Y = L∗/aXL/aY
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Absolute and comparative advantage The theory of comparative advantage Extensions and Limits
World Equilibrium with Incomplete Specialization
49
World equilibrium with incomplete specialization
p = pX/pY
X/Y
World relative supply
E pE=pa* =pX*/aY
*
pa = aX/aY
World relative demand
Foreign country produces both goods
Home country only produces Y
Bénassy-Quéré & Coeuré – International Economics 2009-2010
Partial specialization if p = a∗X/a∗Y or p = aX/aY
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Absolute and comparative advantage The theory of comparative advantage Extensions and Limits
Welfare Gains under Full Specialization
47
Full specialization
Y
X
aX/aY
aX*/aY
*
pX/pY
aX*/aY
* < pX/pY < aX/aY
pX/pY
Bénassy-Quéré & Coeuré – International Economics 2009-2010
If pX/pY < aX/aY, then the home country only produces Y (profit per unit pY/aYw > pX/aXw).
If pX/pY > aX*/aY*, then the foreign country only produces X (profit per unit pX
*/aX* w* > pY*/aY* w*).
In autarky, production possibility frontier = consumption possibilityfrontier
Under free trade, additional consumption possibilities: Rather thanproducing one unit of X, Home saves aX units of labor, produces with thisaX/aY units of good Y, sells it to Foreign and buys pY
pX
aXaY
> 1 units of X
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Absolute and comparative advantage The theory of comparative advantage Extensions and Limits
Wages
Gains from trade do not depend on wages in both countriesbecause wages are assumed the same in both sectors (labormobility) ⇒ No impact on comparative advantage
Autarky: paX = waX , paY = waY , p∗aX = w∗a∗X , p∗aY = w∗a∗Y
Full specialization: w = pY /aY , w∗ = pX/a∗X
Since the relative price of the product in which each countryspecializes increases, real wages increase in terms of the importgood and are unchanged in terms of the export good.
Wage differences between countries: w/w∗ = (pY /pX )(a∗X/aY )
- Because a∗X/a∗Y < pX/pY < aX/aY
- We have aY /aX < pY /pX < a∗Y /a∗X
- Replace pY /pX by (w/w∗)(aY /a∗X )
- So that: a∗X/aX < w/w∗ < a∗Y /aY
⇒ Wage differences w/w∗ depend on absolute advantage.
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Absolute and comparative advantage The theory of comparative advantage Extensions and Limits
Wages and productivity
51
Wages and productivity
Source Eurostat.
Hourly labor cost in Europe
Bénassy-Quéré & Coeuré – International Economics 2009-2010
Source: Eurostat
Wages in Eastern European countries are lower because of a lowerproductivity of labor.
The model predicts that trade is mutually beneficial despite wagedifferences.
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Absolute and comparative advantage The theory of comparative advantage Extensions and Limits
Conclusion
Trade patterns depend on comparative advantage, notabsolute advantage
Gains from trade come from a more efficient use ofresources, increasing consumption possibilities
Relative wages between countries only depend on absoluteadvantages: a low-productivity country will have lower wages
The theory contradicts the following views of free trade:
trade only benefits highly productive (absolute advantage)countriestrade with low-wage countries reduces wages in high-wagecountriestrade increases poverty in low-wage countries
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Absolute and comparative advantage The theory of comparative advantage Extensions and Limits
Extensions
More than two goods Transport costs
- Rank all goods based onrelative productivity
a∗1/a1 < a∗2/a2 < ... < a∗n/an
- Locate w/w∗ in this chain
- Those products such asa∗i /ai > w/w∗ are exportedby the home countrybecause the disadvantage interms of wages is more thancompensated by anadvantage in terms ofproductivity
- Assume a proportionaltransport cost τ
- If wai < w∗a∗i < wai (1 + τ),then good i is not traded
- Non-traded goods representaround 50% of GDP inadvanced economies (e.g.services).
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Absolute and comparative advantage The theory of comparative advantage Extensions and Limits
Empirical tests
52
Conclusion
• Gains from trade only depend on comparative advantages
• Relative wages between countries only depend on absolute advantages: a low-productive country will pay less
Bénassy-Quéré & Coeuré – International Economics 2009-2010
MacDougall (1951) and Balassa (1963): Compare sectoral productivitydata for the US and UK. In 1950, the US have an absolute advantage inalmost all sectors but, thanks to lower wages, the UK produces at lowercost in some sector (comparative advantage). Trade patterns are indeedconsistent with those comparative advantage
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Absolute and comparative advantage The theory of comparative advantage Extensions and Limits
Limits
Where does comparative advantage come from?
Only one production factor→ All citizens of a country gains from trade
Constant opportunity cost→ Full specialization
Does not explain intra-industry trade
No impact of market size on trade patterns
No impact of non-price competitiveness on trade patterns
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