What Determines a Country’s Comparative Advantage?

• Exogenous factors are the most obvious

Climate (long growing season)

Natural Resources (petroleum reserves)

But there are also endogenous factors: education, skills,

capital,... • Implies that comparative advantage can

change over time:

• electronic goods to pharmaceutical goods to internet software to ….

Let’s take a closer look at how capital (K) and labor (L)

affect comparative advantage– Definitions:

• capital abundant country: has high K/L• labor abundant country: has low K/L• capital intensive production: uses high K/L• labor intensive production: uses low K/L

• Capital abundant countries: comparative advantage in capital intensive production

• Labor abundant countries: comparative advantage in labor intensive production

Factor Price Equalization

• Factor prices: – wage rate for labor– rental rate for capital

• Factor price equalization: even if factors are not mobile, factor prices will tend to equalize with trade

What causes factor price equalization? • suppose U.S. has high K/L• suppose Mexico has low K/L• then opening up trade will shift

– U.S. production toward capital intensive goods• thus demand for capital rises in U.S

– M. production toward labor intensive goods• thus demand for labor rises in Mexico

• U.S. wages fall and Mexican wages rise– that is a move toward factor price equalization– assumes ceteris paribus, productivity would rise

Gains from Expanded Markets

• Theory combines two features of production– economies of scale (declining ATC over the

relevant range of production)– product differentiation: leads to monopolistic

competition

• Focuses on intraindustry trade (same industry)– comparative advantage focuses on interindustry

trade (different industries)

Getting a sense of the gains from expanded markets

17_03

Production: 1,000 MRI units Cost: $300,000 per unit

Production: 1,000 ultrasound units Cost: $200,000 per unit

United States

Production: 1,000 MRI units Cost: $300,000 per unit

Production: 1,000 ultrasound units Cost: $200,000 per unit

Germany

Production: 2,000 MRI units Cost: $150,000 per unit

U.S. exports 1,000 MRI units to Germany.

No Trade

Germany exports 1,000 ultra- sound units to U.S.

United States

Production: 2,000 ultrasound units Cost: $150,000 per unit

Germany

Now let’s develop a model to show the gains from expanded markets

• First derive a relationship between – the number of firms, – the size of the market– costs per unit (ATC)

• Second, derive a relationship between the number of firms and the price

• Third, combine the two relationships

17_04D

Cost per unit Cost per unit

1 of 4 1 of 4

DOLLARS35

30

25

20

15

10

5

0

DOLLARS35

30

25

20

15

10

5

0QUANTITY QUANTITY

Smaller Market Larger Market

17_04C

Cost per unit Cost per unit

1 of 4 1 of 4 1 of 31 of 3

DOLLARS

35

30

25

20

15

10

5

0

DOLLARS

35

30

25

20

15

10

5

0QUANTITY QUANTITY

Smaller Market Larger Market

17_04B

Cost per unit Cost per unit

1 of 4 1 of 4 1 of 3 1 of 21 of 3 1 of 2

DOLLARS

35

30

25

20

15

10

5

0

DOLLARS

35

30

25

20

15

10

5

0QUANTITY QUANTITY

Smaller Market Larger Market

17_04A

DOLLARS

35

30

25

20

15

10

5

0

Cost per unit Cost per unit

Numberof

firms

1 102 203 25

4 30

Costper unit($)

Numberof

firms

Costper unit($)

1 52 153 20

4 25

1 of 4 1 of 4 1 of 3 1 of 2

1 of 1

1 of 3 1 of 2 1 of 1

DOLLARS

35

30

25

20

15

10

5

0

Smaller Market Larger Market

QUANTITY QUANTITY

Now, summarize the results using a new curve

17_05

DOLLARS

50

45

40

35

30

25

20

15

10

5

NUMBER OF FIRMSIN THE MARKET

1 102 3 4 5 6 7 8 9

Cost per unitwith largermarket

Cost per unitwith smallermarket

Curve shifts downas market gets larger.

0

Recall results from monopolistic competition model

• Product differentiation

• Firms face downward sloping demand curve

• With more firms in the industry, the demand curve shifts– and gets flatter (a point we did not emphasize

earlier), so the price falls– sketch this by hand:

Now, summarize the result that more firms lead to a lower price

in another new curve17_06DOLLARS

50

45

40

35

30

25

20

15

10

5

NUMBER OF FIRMS IN THE MARKET

1 102 3 4 5 6 7 8 9

Price in the market

0

Put the two new curves in the same diagram; look at the long run equilibrium

17_07

DOLLARS

50

45

40

35

30

25

20

15

10

5

NUMBER OF FIRMS

IN THE MARKET

1 102 3 4 5 6 7 8 9

.... but the price each firmwill charge falls with thenumber of firms.

Cost per unit at each firmincreases as more firms entera market of a fixed size...

0

Equilibriumnumber of firms

Long-runequilibriumprice

The condition of long-runequilibrium is where priceequals cost per unit.

Price (P) inthe market

Cost per unit

Finally, open up the economy; curve shifts showing effect of a larger market

17_08

DOLLARS

50

45

40

35

30

25

20

15

10

5

NUMBER OF FIRMS

IN THE MARKET

1 102 3 4 5 6 7 8 9

Price

Cost per unit with smaller market

Cost per unit with larger market

Increase in numberof firms and variety

Reductionin price

0

Cost per unitat eachfirm falls as market sizeincreases.

End of Lecture