CH02 Labor productivity comparative advantage the Ricardian model

Copyright 2003PearsonEducation Inc Slide1 1 CHAPTER2 LABORPRODUCTIVITYCOMPARATIVEADVANTAGETHERICARDIANMODEL Copyright 2003PearsonEducation Inc Slide1 2 ChapterOrganization IntroductionTheConceptofComparativeAdvantageAOne FactorEconomyTradeinaOne FactorWorldComparativeAdvantagewithManyGoodsAddingTransportCostsandNontradedGoodsSummary Copyright 2003PearsonEducation Inc Slide1 3 Countriesengageininternationaltradefortwobasicreasons Theyaredifferentfromeachotherintermsofclimate land capital labor andtechnology Theytrytoachievescaleeconomiesinproduction TheRicardianmodelisbasedontechnologicaldifferencesacrosscountries Thesetechnologicaldifferencesarereflectedindifferencesintheproductivityoflabor Introduction Copyright 2003PearsonEducation Inc Slide1 4 OnValentine sDaytheU S demandforrosesisabout10millionroses GrowingrosesintheU S inthewinterisdifficult Heatedgreenhousesshouldbeused Thecostsforenergy capital andlaboraresubstantial Resourcesfortheproductionofrosescouldbeusedtoproduceothergoods saycomputers TheConceptofComparativeAdvantage Copyright 2003PearsonEducation Inc Slide1 5 OpportunityCostTheopportunitycostofrosesintermsofcomputersisthenumberofcomputersthatcouldbeproducedwiththesameresourcesasagivennumberofroses ComparativeAdvantageAcountryhasacomparativeadvantageinproducingagoodsiftheopportunitycostofproducingthatgoodsintermsofothergoodsislowerinthatcountrythanitisinothercountries TheConceptofComparativeAdvantage Copyright 2003PearsonEducation Inc Slide1 6 SupposethatintheU S 10millionrosescanbeproducedwiththesameresourcesas100 000computers SupposealsothatinSouthAmerica10millionrosescanbeproducedwiththesameresourcesas30 000computers ThisexampleassumesthatSouthAmericanworkersarelessproductivethanU S workers TheConceptofComparativeAdvantage Copyright 2003PearsonEducation Inc Slide1 7 Ifeachcountryspecializesintheproductionofthegoodswithloweropportunitycosts tradecanbebeneficialforbothcountries RoseshaveloweropportunitycostsinSouthAmerica ComputershaveloweropportunitycostsintheU S Thebenefitsfromtradecanbeseenbyconsideringthechangesinproductionofrosesandcomputersinbothcountries TheConceptofComparativeAdvantage Copyright 2003PearsonEducation Inc Slide1 8 Table2 1 HypotheticalChangesinProduction TheConceptofComparativeAdvantage Copyright 2003PearsonEducation Inc Slide1 9 TheexampleinTable2 1illustratestheprincipleofcomparativeadvantage Ifeachcountryexportsthegoodsinwhichithascomparativeadvantage loweropportunitycosts thenallcountriescaninprinciplegainfromtrade Whatdeterminescomparativeadvantage Answeringthisquestionwouldhelpusunderstandhowcountrydifferencesdeterminethepatternoftrade whichgoodsacountryexports TheConceptofComparativeAdvantage Copyright 2003PearsonEducation Inc Slide1 10 AOne FactorEconomy Assumethatwearedealingwithaneconomy whichwecallHome Inthiseconomy Laboristheonlyfactorofproduction Onlytwogoods saywineandcheese areproduced Thesupplyoflaborisfixedineachcountry Theproductivityoflaborineachgoodsisfixed Perfectcompetitionprevailsinallmarkets Copyright 2003PearsonEducation Inc Slide1 11 ThetechnologyofHome seconomycanbesummarizedbylaborproductivityineachindustry expressedintermsofunitlaborrequirements Theunitlaborrequirementisthenumberofhoursoflaborrequiredtoproduceoneunitofoutput DenotewithaLWtheunitlaborrequirementforwine e g ifaLW 2 thenoneneeds2hoursoflabortoproduceonegallonofwine DenotewithaLCtheunitlaborrequirementforcheese e g ifaLC 1 thenoneneeds1houroflabortoproduceapoundofcheese Theeconomy stotalresourcesaredefinedasL thetotallaborsupply e g ifL 120 thenthiseconomyisendowedwith120hoursoflaboror120workers AOne FactorEconomy Copyright 2003PearsonEducation Inc Slide1 12 ProductionPossibilitiesTheproductionpossibilityfrontier PPF ofaneconomyshowsthemaximumamountofagoods saywine thatcanbeproducedforanygivenamountofanother saycheese andviceversa Orillustratesthedifferentmixesofgoodstheeconomycanproduce ThePPFofoureconomyisgivenbythefollowingequation aLCQC aLWQW L 2 1 Fromourpreviousexample weget QC 2QW 120 AOne FactorEconomy Copyright 2003PearsonEducation Inc Slide1 13 L aLW L aLC Figure2 1 Home sProductionPossibilityFrontier AOne FactorEconomy o Copyright 2003PearsonEducation Inc Slide1 14 RelativePricesandSupplyTheparticularamountsofeachgoodsproducedaredeterminedbyprices TherelativepriceofgoodsX cheese intermsofgoodsY wine istheamountofgoodsY wine thatcanbeexchangedforoneunitofgoodsX cheese Examplesofrelativeprices IfapriceofacanofCokeis 0 5 thentherelativepriceofCokeistheamountof thatcanbeexchangedforoneunitofCoke whichis0 5 Therelativepriceofa intermsofCokeis2cansofCokeperdollar AOne FactorEconomy Copyright 2003PearsonEducation Inc Slide1 15 DenotewithPCthedollarpriceofcheeseandwithPWthedollarpriceofwine DenotewithwWthedollarwageinthewineindustryandwithwCthedollarwageinthecheeseindustry Therearenoprofitsinourone factormodel thehourlywagerateinthecheesesectorwillequalthevalueofwhataworkercanproduceinanhour PC aLC ThehourlywagerateinthewinesectorwillbePW aLW AOne FactorEconomy Copyright 2003PearsonEducation Inc Slide1 16 Theaboverelationsimplythatiftherelativepriceofcheese PC PW exceedsitsopportunitycost aLC aLW thentheeconomywillspecializeintheproductionofcheese OrPC aLC PW aLW Intheabsenceoftrade bothgoodsareproduced andthereforePC PW aLC aLW AOne FactorEconomy Copyright 2003PearsonEducation Inc Slide1 17 TradeinaOne FactorWorld Assumptionsofthemodel Therearetwocountriesintheworld HomeandForeign Eachofthetwocountriesproducestwogoods saywineandcheese Laboristheonlyfactorofproduction Thesupplyoflaborisfixedineachcountry Theproductivityoflaborineachgoodsisfixed Laborisnotmobileacrossthetwocountries Perfectcompetitionprevailsinallmarkets AllvariableswithanasteriskrefertotheForeigncountry Copyright 2003PearsonEducation Inc Slide1 18 AbsoluteAdvantageAcountryhasanabsoluteadvantageinaproductionofagoodsifithasalowerunitlaborrequirementthantheforeigncountryinthisgoods AssumethataLC a LCandaLW a LWThisassumptionimpliesthatHomehasanabsoluteadvantageintheproductionofbothgoods AnotherwaytoseethisistonoticethatHomeismoreproductiveintheproductionofbothgoodsthanForeign EvenifHomehasanabsoluteadvantageinbothgoods beneficialtradeispossible Thepatternoftradewillbedeterminedbytheconceptofcomparativeadvantage TradeinaOne FactorWorld Copyright 2003PearsonEducation Inc Slide1 19 ComparativeAdvantageAssumethataLC aLW a LC a LW 2 2 ThisassumptionimpliesthattheopportunitycostofcheeseintermsofwineislowerinHomethanitisinForeign Inotherwords intheabsenceoftrade therelativepriceofcheeseatHomeislowerthantherelativepriceofcheeseatForeign HomehasacomparativeadvantageincheeseandwillexportittoForeigninexchangeforwine TradeinaOne FactorWorld Copyright 2003PearsonEducation Inc Slide1 20 L a LW L a LC 1 Figure2 2 Foreign sProductionPossibilityFrontier TradeinaOne FactorWorld Copyright 2003PearsonEducation Inc Slide1 21 DeterminingtheRelativePriceAfterTradeWhatdeterminestherelativeprice e g PC PW aftertrade Toanswerthisquestionwehavetodefinetherelativesupplyandrelativedemandforcheeseintheworldasawhole Therelativesupplyofcheeseequalsthetotalquantityofcheesesuppliedbybothcountriesateachgivenrelativepricedividedbythetotalquantityofwinesupplied QC Q C QW Q W Therelativedemandofcheeseintheworldisasimilarconcept TradeinaOne FactorWorld Copyright 2003PearsonEducation Inc Slide1 22 2 1 aLC aLW a LC a LW Figure2 3 WorldRelativeSupplyandDemand TradeinaOne FactorWorld Copyright 2003PearsonEducation Inc Slide1 23 TradeinaOne FactorWorld First theRScurveshowsthatthereisnosupplyofcheeseiftheworldpricedropsbelowaLC aLW AssumeaLC aLW a LC a LW Homewillspecializeintheproductionofcheese HomewillspecializeintheproductionofwinewheneverPC PW aLC aLW orPC aLC PW aLW Similarly ForeignwillspecializeinwineproductionwheneverPC PW a LC a LW Second whentherelativepriceofcheese PC PW aLC aLW Homeworkersareindifferentbetweenproducingcheeseandwine Wehaveaflatsectionofthesupplycurve Copyright 2003PearsonEducation Inc Slide1 24 TradeinaOne FactorWorld Third forPC PW a LC a LW bothHomeandForeignwillspecializeincheeseproduction Therewillbenowineproduction sothattherelativesupplyofcheesewillbecomeinfinite Fourth AtPC PW a LC a LW Foreignworkersareindifferentbetweenproducingcheeseandwine Weagainhaveaflatsectionofthesupplycurve Fifth aLC aLW PC PW a LC a LW therelativesupplyofcheeseis L aLC L a LW Copyright 2003PearsonEducation Inc Slide1 25 TheGainsfromTradeIfcountriesspecializeaccordingtotheircomparativeadvantage theyallgainfromthisspecializationandtrade Wewilldemonstratethesegainsfromtradeintwoways First wecanthinkoftradeasanewwayofproducinggoodsandservices thatis anewtechnology TradeinaOne FactorWorld Copyright 2003PearsonEducation Inc Slide1 26 Anotherwaytoseethegainsfromtradeistoconsiderhowtradeaffectstheconsumptionineachofthetwocountries Theconsumptionpossibilityfrontierstatesthemaximumamountofconsumptionofagoodsacountrycanobtainforanygivenamountoftheothercommodity Intheabsenceoftrade theconsumptionpossibilitycurveisthesameastheproductionpossibilitycurve Tradeenlargestheconsumptionpossibilityforeachofthetwocountries TradeinaOne FactorWorld Copyright 2003PearsonEducation Inc Slide1 27 TradeinaOne FactorWorld Figure2 4 TradeExpandsConsumptionPossibilities a Home b Foreign Copyright 2003PearsonEducation Inc Slide1 28 SettingUptheModelBothcountriesconsumeandareabletoproducealargenumber N ofdifferentgoods RelativeWagesandSpecializationThepatternoftradewilldependontheratioofHometoForeignwages Goodswillalwaysbeproducedwhereitischeapesttomakethem Forexample itwillbecheapertoproducegoodsiinHomeifwaLiw w ComparativeAdvantagewithManyGoods Copyright 2003PearsonEducation Inc Slide1 29 ComparativeAdvantagewithManyGoods Table2 4 HomeandForeignUnitLaborRequirements Copyright 2003PearsonEducation Inc Slide1 30 Whichcountryproduceswhichgoods Acountryhasacostadvantageinanygoodforwhichitsrelativeproductivityishigherthanitsrelativewage If forexample w w 3 Homewillproduceapples bananas andcaviar whileForeignwillproduceonlydatesandenchiladas Bothcountrieswillgainfromthisspecialization ComparativeAdvantagewithManyGoods Copyright 2003PearsonEducation Inc Slide1 31 DeterminingtheRelativeWageintheMultigoodModelTodeterminerelativewagesinamultigoodeconomywemustlookbehindtherelativedemandforgoods i e therelativederiveddemand TherelativedemandforHomelabordependsnegativelyontheratioofHometoForeignwages ComparativeAdvantagewithManyGoods Copyright 2003PearsonEducation Inc Slide1 32 ComparativeAdvantagewithManyGoods Figure2 5 DeterminationofRelativeWages Copyright 2003PearsonEducation Inc Slide1 33 AddingTransportCostsandNontradedGoods Therearethreemainreasonswhyspecializationintherealinternationaleconomyisnotextreme Theexistenceofmorethanonefactorofproduction Countriessometimesprotectindustriesfromforeigncompetition Itiscostlytotransportgoodsandservices Theresultofintroducingtransportcostsmakessom