Gains from Trade

John RiesSauder School of Business, University of British Columbia

Gain from trade

• Objectives of this session– Illustrate the gains from trade based on

exploiting comparative advantage– Show how productivity, wages, competitive

advantage, and exchange rates relate to each other.

– Illustrate the gains from trade based on exploiting plant-level scale economies.

Your assignment:

• Decide the number of workers in each of two factories (Korea & Thailand) to allocate to each of two activities (molding soles & stitching uppers).

• Maximize corporate shoe output

Shoe terms

Sole

Upper

Assumptions

• 300 workers in Thai factory

• 300 workers in Korean factory

• In the short run, you cannot add or subtract workers, or move them between plants.

• One sole and one upper needed for each finished shoe.

• Transport costs are negligible

Productivity MatrixOutput per worker

Factory:

Activity:

Uppers Soles

Korea 200 400

Thailand 100 100

Compute total shoe output for four production plans

• Plan A: (self-sufficient factories): Each country combines workers to produce completed shoes. There is no trade.

• Plan B: Thailand produces only uppers, Korea produces only soles.

• Plan B*: Thailand produces only uppers, Korea produces soles and uppers.

• Plan C: Thailand produces only soles, Korea produces soles and uppers.

Plan B* increases shoe output by 9%

• (60000-55000)/55000 = .0909

• Firm-level productivity rises– from 55000/600 = 92 shoes per worker per

day– to 6000/600 = 100 shoes per worker per day

• No new machinery, no new skills, no extra effort.

• Trade is like a new technology!

Specialization is not enough

• Plan C, involves specialization but it lowers output by 9% relative to Plan A.

• Specialization based on comparative advantage yields gains from trade.

• Comparative advantage = low opportunity costs.

Opportunity cost calculations

• Opportunity cost of soles in foregone uppers– Thailand: 100 U/ 100 S = 1 U/S

– Korea: 200U/400S = .5 U/S

• Opportunity cost of uppers in foregone soles– Thailand: 100 S/ 100 U = 1 S/U

– Korea: 400S/200U = 2 S/U

• Korea has lower opportunity cost of seouls!

Long-run decisions

• The level of employment is only fixed at 300 in each plant in the short run.

• When employment is a decision variable, not a sunk cost, then wages and productivity matter.

Calculate the critical wages

• If wages were equal, Korea’s factory with its absolute advantage both tasks (4:1 in soles, 2:1 in uppers) would be the low cost source for both uppers and soles.

• How low would Thai wages have to be justify operating the plant? (doing what?)

• How low would the wage in Thailand have to be to justify shutting the Korean plant?

Competitive advantage

• A factory has a competitive advantage in a task when it can provide an equivalent product at a lower monetary cost than alternatives.

• Competitive advantage here corresponds to lower unit labour costs.

• Unit labour costs are given by wages divided by productivity.

Unit Labour Costs (in baht/unit)

Factory:

Activity:

Uppers Soles

KoreaeWK/200 eWK/400

ThailandWT/100 WT/100

WK= wages in Korea (won/worker)WT = wages in Thailand (baht/worker) e = exchange rate (baht/won)

Thai plant gains competitive advantage

• in uppers when Korea pays more than twice the Thai wageeWK/200 > WT/100

eWK/WT > 2

• in soles when Korea pays more than four times the Thai wageeWK/400 > WT/100

eWK/WT > 4

Relative wages and Competitive Advantage

Equilibrium relative wages: eWK/WT

• Suppose wages are so high in Korea that unit labour costs are higher there than in Thailand for both goods, eWK/WT>4. – No firms would want to employ Korean workers and,

hence, there would be no Korean products. Wages is Korea would fall and the won would depreciate (e=baht/won would fall).

– Eventually, Korea would be low cost (have a competitive advantage) in one good (the comparative advantage good.)

Competitive Advantage and Equilibrium Exchange Rates

• Suppose that unions or government fix the local currency values of wages at WK = 200 Won per day and WT = 100 Baht.

– What values of e (in Baht/Won) would be consistent with production in both locations?

– How would the e range change if Thai productivity doubled in all activities?

Lessons from the Shoe Story

• Low wage countries do not “steal” all industries.

• Define competitive advantage as the lowest unit labour costs. Exchange rates adjust so that a country that has a comparative advantage in a good will also have a competitive advantage in that good.

Shoe Story II: Returns to Scale

• Comparative advantage is not the only way to obtain gains from trade.

• Plant-level economies of scale (PLEoS) are important in many industries.

• To illustrate the gains from exploiting PLEoS through trade, we revise the story to exclude comparative advantage and absolute advantage.

New Productivity Matrix

Factory:

Activity:

Uppers Soles

Korea 100 100

Thailand 100 100

Indivisible Overhead

• Factory workers are supported by services of non-production employees, also known as “overhead”– Accounting– Logistics and input procurement– Machinery maintenance

• Some minimum number of overhead workers are required for any positive level of production.

New example

• Let overhead be 30 workers per “product” (soles or uppers) per plant.

• A factory that produces both products (that is, a factory that is not fully specialized) has overhead of 30+30=60, leaving 300-60=240 workers for production.

• A factory that specializes has 300-30=270 workers for production.

Plan A vs Plan B revisited

• Plan A (self-sufficiency): – Sole output in each factory: (240/2)*100 = 12000– Upper output in each factory: (240/2)*100 = 12000– Combined output = 2*12000=24000 shoes

• Plan B (full specialization, KS,TU):– Sole output in Korea: 270*100 = 27000– Upper output in Thailand: 270*100 =27000– Combined output = 2700 shoes (11% gain!)

PLEoS gains are differentfrom CA gains

1. Plan C (full specialization KU and TS) is just as good (2700 shoes) as plan B No such thing as specializing in the

“wrong” thing in this case. The key for PLEoS is to avoid duplicative

overhead, rather than to “match” products with skills (as in the CA case)

Geometric PLEoS

• Surface to volume ratios of three dimensional objects are a source of PLEoS.– The formula for the surface to volume ratio of

a vat is decreasing in the volume (see EMS, p.35). Thus, as the vat size increases, the per volume cost of the material to make the vat (steel) is falling

• Geometric PLEoS apply to vats, tanks, furnaces, and even buildings

Two-way trade and scale economies

• Recall, Canada is both a big exporter and a big importer of cars, machinery, and industrial equipment

• This can be explained by companies producing product varieties and concentrating individual varieties in single factories

Before Canada-US Autopact (1965)

Minivans

Sedans

Local sales

Minivans

Local sales

Sedans

Canada

US

After Canada-US Autopact (1965)

Minivans

SedansLocal sales

Local salesCanada

US

Canadian exports

Canadian imports

Benefits

• Plant-level fixed costs are eliminated by concentrating individual varieties in single factories

• Would a cost-minimizing firm prefer to locate both factories in the United States?– Yes, transport costs are minimized by locating

in the large market.