Chapter 3 Comparative Advantage and the Gains from

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Lecture Objectives n n n Introduce theory of comparative advantage Discuss the difference between comparative and absolute advantages Analyze the causes and consequences of economic restructuring Copyright © 2002 Pearson Education, Inc. 2

Mercantilism: Economic Theory for an Absolutist State n Historical Context: State Construction n The Political Agenda of Mercantilism n n Domestically, the sovereign needed to establish hegemony over feudal lords and, perhaps more importantly, over cities and towns. Internationally, the sovereign sought to extend state power and, given that other sovereigns sought to do the same, to defend against the incursions of other sovereigns. Copyright © 2002 Pearson Education, Inc. 3

Mercantilism (continued) n Pursuit of these goals required new institutions n n n A centralized bureaucracy A professional military Economically this meant n n A need for increased revenues A need for national industry Copyright © 2002 Pearson Education, Inc. 4

Mercantilist Theory n Core Propositions of Mercantilist Theory n n Wealth is an absolutely essential means to power, whether for security or for aggression; Power is essential or valuable as a means to the acquisition or retention of wealth; Wealth and power are each proper ultimate ends of national policy; and There is a long-run harmony between these ends. Copyright © 2002 Pearson Education, Inc. 5

Adam Smith (1723 -1790) and the Attack on Mercantilism n n Historical context: Emerging merchant capitalism and early notions of democracy Note that Smith was making a political argument, not an economic one. n n n Part of the argument was for new economic policy, but An essential part of the argument was for new social and political arrangements. In Particular, Smith was arguing that the basic unit for social analysis should be the nation not the state. Copyright © 2002 Pearson Education, Inc. 6

Adam Smith and the Attack on Mercantilism n In 1776, Adam Smith published An Inquiry into the Nature and Causes of the Wealth of Nations. n n n Smith argued against the belief that trade was a zero sum game – that the gain of one nation from trade was the loss of another. Trade is a positive sum game – both nations gain. But note that this argument rested on a redefinition of social goals—toward those consistent with merchant capitalism and democracy. Copyright © 2002 Pearson Education, Inc. 7

Adam Smith and the Role of Absolute Advantage in Trade n It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. The taylor does not attempt to make his own shoes, but buys them from the shoemaker. The shoemaker does not attempt to make his own clothes, but employs a taylor. . . What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage. The general industry of the country, being always in proportion to the capital that employs it, will not thereby be diminished, no more than that of the above mentioned artificers; but employed to the greatest advantage. It is not employed to the greatest advantage when it is thus directed toward an object which it can buy cheaper than it can make. (Wealth of Nations; book 4, chapter 2). Copyright © 2002 Pearson Education, Inc. 8

Implications of Smith’s Theory n Access to foreign markets helps create wealth n n If no nation imports, every company will be limited by the size of its home country market More importantly, the macro division of labor will be limited by the extent of the market Imports enable a country to obtain goods that it cannot make itself or can make only at very high costs Trade barriers decrease the size of the potential market, hampering the prospects of specialization, technological progress, mutually beneficial exchange, and, ultimately, wealth creation. Copyright © 2002 Pearson Education, Inc. 9

Ricardian Model of Production and Trade n n Named after David Ricardo (1772 -1823) Assumptions: n n There are two countries producing two goods and using one input (labor) Markets are competitive: firms are price takers Static world: technology is constant and there are no learning effects Labor is perfectly mobile: it can easily move back and forth between industries Copyright © 2002 Pearson Education, Inc. 10

Ricardian Model: Absolute Productivity Advantage n n n Productivity – the amount of output obtained from a unit of input Labor productivity– (output)/(hours worked) n If two loaves of bread can be produced in 1 hour, productivity = (2 loaves) / (1 hour) n Similarly, suppose productivity in steel is given as (3 tons) / (1 hour). Absolute productivity advantage – held by a country that produces more of a certain good per hour worked than another Copyright © 2002 Pearson Education, Inc. 11

Opportunity Cost Calculation n n The U. S. opportunity cost of steel is 2/3 loaf of bread: each unit of steel produced requires the U. S. economy to forfeit the production of 2/3 loaf of bread. Thus, the bread price of steel in the US is: Copyright © 2002 Pearson Education, Inc. 13

Opportunity Cost Calculation n n By the same logic, The Canadian opportunity cost of steel is 3 loaves of bread. That is, the bread price of steel in Canada is: Copyright © 2002 Pearson Education, Inc. 14

Absolute Advantage and Trade (cont) n n Trade between the US and Canada, in this example, will occur at a price between these limits: Note that the steel price of bread is just the inverse of the bread price of steel. Copyright © 2002 Pearson Education, Inc. 15

Ricardo’s Great Insight: Comparative Advantage n Suppose, relative to our previous example that Canada experiences technological advance: US Canada Bread 2 loaves 12 loaves Steel 3 tons 4 tons Copyright © 2002 Pearson Education, Inc. 16

Comparative Advantage (the easy way) n Note that nothing has changed in the opportunity cost ratios. n n n Thus, the relative (i. e. bread) prices of steel remain the same, so Canada will still import steel and export bread. Although the US has an absolute disadvantage in everything, it has a comparative advantage in steel. Copyright © 2002 Pearson Education, Inc. 17

The Law of Comparative Advantage n n Comparative Advantage: A country has a comparative advantage in the production of a good if its autarky relative price is lower than that in the other country. Law of Comparative Advantage: A country will export the good in which it has a comparative advantage. Copyright © 2002 Pearson Education, Inc. 18

The Law of Comparative Advantage (continued) n The Law of Comparative Advantage is a powerful positive prediction n In the Ricardian context it holds with as many goods and countries as we care to contemplate. It holds generally in competitive contexts. Empirical work suggests that comparative advantage is a major element in the explanation of trade patterns. Copyright © 2002 Pearson Education, Inc. 19

Comparative Advantage and the Gains from Trade n Gains from Trade: If countries trade on the basis of comparative advantage, for the country as a whole: n n Free trade is better than autarky; For a small economy, free trade is better than protection; These are important results, we now consider the logic in a bit more detail Copyright © 2002 Pearson Education, Inc. 20

A Bit More Detail: Production Functions n A Production Function: A rule giving the efficient level of output for good j (yj) that can be derived from a bundle of inputs (zj): n n yj = f j(zj) A Ricardian production function has only one input (Lj) and constant returns to scale, so it is a linear function: n yj = αLj Lj, where αLj is output of good j per unit input. Copyright © 2002 Pearson Education, Inc. 21

Deriving the Ricardian Production Frontier n The Production Frontier shows all the feasible output combinations an economy can produce given: n n Technology, and Endowment of inputs (“factors of production”) n n n Recall the only input is labor in the Ricardian case Since labor can be used in either sector, but not both, the labor constraint is just a line with a slope of -1. That is, to use a unit of labor in one sector, it must be removed from the other. Copyright © 2002 Pearson Education, Inc. 23

Marginal Rate of Transformation n The marginal rate of transformation gives the technologically determined rate at which one good (bread) can be transformed into another (steel). n n This is obviously the opportunity cost of steel in terms of bread. The slope of the production frontier gives the marginal rate of transformation. Copyright © 2002 Pearson Education, Inc. 28

Deriving the Marginal Rate of Transformation n Our graphical analysis suggests that the slope of the production frontier should be a function of the αLj’s (i. e. output per unit input) and the labor constraint. n n n Consider any two points on the production frontier: (y. S′ , y. B′) and (y. S″, y. B″). Let change be: Δyj = yj″ - yj′. As usual, the slope is rise-over-run, or in the case of our diagram Δy. B /Δy. S. Copyright © 2002 Pearson Education, Inc. 29

Deriving the Marginal Rate of Transformation (continued) n We can complete the analysis by noting: n n Full employment implies: ΔLS = -ΔLB; so That is, the slope is negative and equal to the ratio of the sectoral output/unit inputs Copyright © 2002 Pearson Education, Inc. 34

Marginal Rate of Transformation and the Autarky Price Ratio n Under perfect competition firms earn zero profits: n n n Let a. Lj = 1/αLj be the input required to produce one unit of output We can write zero profits as: pj = wa. Lj. But this means we can write the price ratio as: Copyright © 2002 Pearson Education, Inc. 35

Opportunity Cost and Relative Prices n Note, as in our informal development, that the relative price is equal to the opportunity cost. n n Why relative price? Because the price is not in monetary units but in units of the other good. In fact, none of the models we consider in the first half of the course actually have money. They are barter models. Copyright © 2002 Pearson Education, Inc. 36

Gains from Trade for a Small Economy: Autarky versus Trade n n n Autarky – complete absence of trade; the feasible consumption set is equal to the production set. A small economy has no effect on world prices. Gains from Free Trade: n n Trade at world prices permits a consumption set that lies strictly outside the autarky consumption set at all points except the specialization point. As long as consumers prefer to consume some positive amount of both goods, trade must raise aggregate welfare. Copyright © 2002 Pearson Education, Inc. 37

Illustrating the Gains from Trade n How the illustration will work n n Consider autarky equilibrium at an interior equilibrium (i. e. both goods are consumed, so both must be produced). Then consider the option of trading at a world price which is different from the autarky price. n n For concreteness we will assume that the world relative price of steel, p* = PS*/PB* > p = MRT. Show that consumption opportunities are greater in the free trade equilibrium than in the autarky equilibrium. Copyright © 2002 Pearson Education, Inc. 38

Gains from Trade n n So, for the small economy, free trade welfaredominates any other policy. What have we ignored: n n n Large countries Market imperfections Adjustment costs Copyright © 2002 Pearson Education, Inc. 45

Large Country Gains from Trade n Free trade cannot be worse than autarky for the large country. n n As long as the autarky price and the post trade prices are different, the logic is as above. However, some level of protection will generally be welfare superior to free trade. n n Straightforward if trading partner is small. Trade war possible if trading partner is large. Copyright © 2002 Pearson Education, Inc. 46

Market Imperfections and the Gains from Trade n There a variety of ways in which real economies deviate from perfect competition n n Product Market Imperfection: Monopoly, Oligopoly, Monopolistic Competition Factor Market Imperfection: Unions, Long-term contracts Externalities: Positive and Negative Increasing Returns to Scale Copyright © 2002 Pearson Education, Inc. 47

Market Imperfections (continued) n Market imperfections may justify policy intervention n Trade policy is usually not the preferred intervention; but In theory, correctly applied trade policy might be welfare increasing. We return to these issues later. Copyright © 2002 Pearson Education, Inc. 48

Adjustment Costs and the Gains from Trade n n The argument we have made to this point considers only the long-run. People that must shift jobs will generally experience costs n n n Direct relocation costs Spells of unemployment and reduced wages These costs must be considered n n This will reduce the total gains; Redistribution must be made for a Pareto improvement. Copyright © 2002 Pearson Education, Inc. 49

Response to Adjustment Costs n Given that some lose due to economic restructuring, the government can seek to get winners from trade and restructuring to compensate the losers n n Trade adjustment assistance (TAA) helps losers by providing extended unemployment benefits, worker retraining, and temporary tax on imports For example, the U. S. government created a special program for workers laid off because of NAFTA; in 1994, 17, 000 workers qualified for the program Copyright © 2002 Pearson Education, Inc. 50

The Future of the Tensions n Two views about the tension between civic and social groups on the one hand, and governments in international institutions, on the other: n n Pessimistic: the tension will roll back the international integration achieved over the past several decades Optimistic: the tension will lead to increasing participation by civic and social groups in decision-making in international institutions, which will produce better policies and allow more people enjoy the benefits of globalization Copyright © 2002 Pearson Education, Inc. 51