In our last class, we discussed

Comparative advantage;
Without trade, domestic relative prices equal the opportunity cost;
Pi/Pj = aLi/aLj
TEXTBOOK PROBLEMS Chapter 3

2
3
PRODUCTION POSSIBILITIES
The production possibility frontier (PPF) of an economy shows the maximum amount of
a goods that can be produced for a fixed amount of resources.
The production possibility frontier of the home economy is:

aLAQA + aLBQB ≤ L
Total amount of
labor resources

Total Labor required for

Labor required for Total pounds
pounds of each pound of
each pound of of bananas
apples banana produced
apples produced produced
produced
5
3/2=1.5

6
7
Home produces 400 apples and
Foreign produces 800 bananas
Qa/Qb=1/2

8
FIG. 3-3: WORLD RELATIVE SUPPLY
AND DEMAND
10
 PA/PB=2

RD=PB/PA
RS = ½
In equilibrium
PB/PA =2
PA/PB=1/2

11
12
13
2400/3=
800
R
S’

800/800=1

14
15
Relative Wages and relative productivity
• The relative wage lies between the ratio of the productivities in each industry.
• Therefore, both countries have a cost advantage in production.
• High wages can be offset by high productivity.
• Low productivity can be offset by low wages.
Productivity and Wages
Do Wages Reflect Productivity? (cont.)
• Other evidence shows that wages rise as productivity
rises.
• As recently as 1975, wages in South Korea were only 5% of
those of the United States.
• As South Korea’s labor productivity rose (to about half of
the U.S. level by 2007), so did its wages.
Eurozone
Misconceptions about Comparative Advantage
1. Free trade is beneficial only if a country is more productive
than foreign countries.
2. Free trade with countries that pay low wages hurts
high wage countries.
3. Free trade exploits less productive countries whose
workers make low wages.
Misconceptions about Comparative Advantage
1. Free trade is beneficial only if a country is more productive
than foreign countries.
• But even an unproductive country benefits from free trade by avoiding
the high costs for goods that it would otherwise have to produce
domestically.
• High costs derive from inefficient use of resources.
• The benefits of free trade do not depend on absolute advantage, rather
they depend on comparative advantage: specializing in industries that
use resources most efficiently.
 Misconceptions about Comparative Advantage
(cont.)
1. Free trade with countries that pay low wages hurts high wage countries.
• While trade may reduce wages for some workers, thereby affecting the distribution of
income within a country, trade benefits consumers and other workers.
• Consumers benefit because they can purchase goods more cheaply.
• Producers/workers benefit by earning a higher income in the industries that use resources
more efficiently, allowing them to earn higher prices and wages.
 Misconceptions about Comparative Advantage
(cont.)
1. Free trade exploits less productive countries whose workers make low wages.
• While labor standards in some countries are less than exemplary compared to Western
standards, they are so with or without trade.
• Are high wages and safe labor practices alternatives to trade? Deeper poverty and
exploitation may result without export production.
• Consumers benefit from free trade by having access to cheaply (efficiently) produced goods.
• Producers/workers benefit from having higher profits/wages—higher compared to the
alternative.
Comparative Advantage with Many Goods
• Suppose now there are N goods produced, indexed by i = 1,2,…N.
• The home country’s unit labor requirement for good i is aLi, and the
corresponding foreign unit labor requirement is a*Li .
• Goods will be produced wherever cheapest to produce them.
Comparative Advantage with Many Goods
(cont.)
• Let w represent the wage rate in the home country and w* represent the
wage rate in the foreign country.
• If waL1 < w*a*L1 then only the home country will produce good 1, since total
wage payments are less there.
• Or equivalently, if a*L1 /aL1 > w/w*, if the relative productivity of a country
in producing a good is higher than the relative wage, then the good will be
produced in that country.
Table 3-2: Home and Foreign Unit Labor
Requirements
Comparative Advantage with Many Goods
(cont.)
• Suppose there are 5 goods produced in the world: apples, bananas,
caviar, dates, and enchiladas.
• If w/w* = 3, the home country will produce apples, bananas, and
caviar, while the foreign country will produce dates and enchiladas.
• The relative productivities of the home country in producing apples, bananas,
and caviar are higher than the relative wage.
Comparative Advantage with Many Goods
(cont.)
• If each country specializes in goods that use resources productively and trades the
products for those that it wants to consume, then each benefits.
• If a country tries to produce all goods for itself, resources
are “wasted”.
• The home country has high productivity in apples, bananas, and caviar that give it
a cost advantage, despite its high wage.
• The foreign country has low wages that give it a cost advantage, despite its low
productivity in date production.
Comparative Advantage with Many Goods
(cont.)
• How is the relative wage determined?
• By the relative supply of and relative (derived) demand for labor
services.
• The relative (derived) demand for home labor services falls
when w/w* rises. As domestic labor services become more
expensive relative to foreign labor services,
• goods produced in the home country become more expensive, and
demand for these goods and the labor services to produce them falls.
• fewer goods will be produced in the home country, further reducing the
demand for domestic labor services.
Comparative Advantage with Many Goods
(cont.)
• Suppose w/w* increases from 3 to 3.99:
• The home country would produce apples, bananas, and caviar, but the demand for these goods
and the labor to produce them would fall as the relative wage rises.
• Suppose w/w* increases from 3.99 to 4.01:
• Caviar is now too expensive to produce in the home country, so the caviar industry moves to
the foreign country, causing a discrete (abrupt) drop in the demand for domestic labor services.
• Consider similar effects as w/w* rises from 0.75 to 10.
Fig. 3-5: Determination of Relative Wages
Comparative Advantage with Many Goods
(cont.)
• Finally, suppose that relative supply of labor is independent of w/w* and is fixed at
an amount determined by the populations in the home and foreign countries.
 Transportation Costs and Non-traded Goods
• The Ricardian model predicts that countries
completely specialize in production.
• But this rarely happens for three main reasons:
1. More than one factor of production reduces the tendency
of specialization (Econ/Trade Chapters 4-5).
2. Protectionism (Econ/Trade Chapters 9–12). ~ non-tradable
3. Transportation costs reduce or prevent trade, which may
cause each country to produce the same good or service.
· increasing return to scale (new trade policies

·
nebens que os paises preferem depender e produzem na mesma , mesmo
que não tennam comparative advantage (p e
.
:

comidal
Transportation Costs and Non-traded Goods
(cont.)
• Nontraded goods and services (ex., haircuts and auto repairs) exist due
to high transport costs.
• Countries tend to spend a large fraction of national income on nontraded goods
and services.
• This fact has implications for the gravity model and for models that consider
how income transfers across countries affect trade.
Empirical Evidence
• Do countries export those goods in which their productivity is
relatively high?

• The ratio of U.S. to British exports in 1951 compared to the ratio

of U.S. to British labor productivity in 26 manufacturing
industries suggests yes.

• At this time the U.S. had an absolute advantage in all 26

industries, yet the ratio of exports was low in the least
productive sectors of the U.S.
Fig. 3-6: Productivity and Exports
us has a comparative
advantage
-

USA expOrtS
more

Britain
eXDOrtS
~ more
Table 3-3: Bangladesh versus China, 2011
Empirical Evidence (cont.)
• A very poor country like Bangladesh can have comparative advantage in clothing
despite being less productive in clothing than other countries such as China
because it is even less productive compared to China in other sectors.
• Productivity (output per worker) in Bangladesh is only 28 percent of China’s
on average.
• In apparel, productivity in Bangladesh was about 77 percent of China’s,
creating strong comparative advantage in apparel for Bangladesh.
Empirical Evidence (cont.)
• The main implications of the Ricardian model are well supported by
empirical evidence:
• productivity differences play an important role in international trade
• comparative advantage (not absolute advantage) matters for trade
 Ricardian model - Summary
1. Differences in the productivity of labor across countries generate
comparative advantage.

2. A country has a comparative advantage in producing a good when

its opportunity cost of producing that good is lower than in other
countries.
 Summary (cont.)
1. Countries export goods in which they have a comparative
advantage - high productivity or low wages give countries a cost
advantage.
2. With trade, the relative price settles in between what the relative
prices were in each country before trade.
 Summary (cont.)
1. Trade benefits all countries due to the relative price of the
exported good rising: income for workers who produce exports
rises, and imported goods become less expensive.
2. Empirical evidence supports trade based on comparative
advantage, although transportation costs and other factors prevent
complete specialization in production.