Lecture 1: The Theory of Comparative Advantagegregory.corcos.free.fr/epp/M1EPP_lect1_CompAdv.pdfAbsolute and comparative advantageThe theory of comparative advantageExtensions and

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

mailto:[email protected]

http://gregory.corcos.free.fr/epp/EPP.html


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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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


Outline

Absolute versus comparative advantage

Ricardo’s model of international trade

Extensions and limitations

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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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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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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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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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Additional Examples

Absolute advantage Comparative advantageMonthly production per worker Monthly production per worker

(units of goods) (units of goods)

China Europe


China Europe


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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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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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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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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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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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*


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


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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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


Full specialization if a∗X/a∗Y < p < aX/aY

Relative quantity: X/Y = L∗/aXL/aY

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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


Partial specialization if p = a∗X/a∗Y or p = aX/aY

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Welfare Gains under Full Specialization

47

Full specialization

Y

X

aX/aY

aX*/aY

*

pX/pY

aX*/aY

* < pX/pY < aX/aY

pX/pY


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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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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Wages and productivity

51

Wages and productivity

Source Eurostat.

Hourly labor cost in Europe


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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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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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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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


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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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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Documents

Lecture 1: The Theory of Comparative Advantagegregory.corcos.free.fr/epp/M1EPP_lect1_CompAdv.pdfAbsolute and comparative advantageThe theory of comparative advantageExtensions and