Chapter 3: Labor Productivity and Comparative Advantage: The Richardson Model

Reasons for Trade

  • Countries trade because they are different form each other – they have a mutual benefit
  • To achieve economies of scale in production… if countries only produce what they are good at, they can produce at a larger scale, meaning more efficiently

Comparative Advantage

  • Example of winter roses, US must sacrifice other production to be able to produce winter roses for valentine’s day
  • This idea is called opportunity cost, say its roses and computers, this cost refers to the number of computers that could have been produced with the resources to produce a given number of roses
  • The difference in opportunity cost refers to the possibility of a mutually beneficial rearrangement of world production
  • A company has comparative advantage in producing a good if the opportunity cost of producing that good in terms of other goods is lower in that country than it is in other countries
  • Which evidently means that trade between two countries can be beneficial to both countries if a country exports the goods in which it has comparative advantage

One-Factor Economy

  • Say your country “home” is producing wine and cheese
  • say it will take 1 hour of labour to make cheese and 2 hours of labour to produce wine
  • Note: we are defining unit labour requirements as the inverse of productivity the more goods produced in an hour the lower the unit labour requirement
  • Notation: “aLW” and “aLC” where total resources are notes as “L”

Production Possibilities

  • Since an economy has limited resources, there are limits on what the economy can produce so there has to be trade-offs
  • The trade-offs are shows in a graph usually as PPF’s which shows the max amount of good a given a fixed production of product b and vice versa:
  • When there is only one factor of production, the PPF is a straight line
  • Equation: aLCQC + aLWQC <= L

Relative Prices and Supply

  • The PPF shoes different mixes of goods an economy can produce but to know how much they WILL actually produce; we have to consider relative prices (how much one good is in terms of the other)
  • Now take the wine and cheese example, say cheese sells for $4 while wine sells for $7 (we don’t consider profits since labour if the only input into production here)
  • So that means if they make cheese they can earn $4 but if they make wine they can earn only $7/2
  • So in the case above, the economy will specialize in making cheese
  • IF the price falls of cheese drops to $3 then will specialize in wine
  • Note: if both prices are equal then both will be produced
  • The economy will specialize in cheese if the relative price of cheese exceed its opportunity cost in terms of wine, and specialize in wine if relative price of cheese is less than OPC in terms of wine
  • In the absence of international trade, the relative prices of goods are equal to their relative unit labour requirements

Trade in a One-Factor World

  • Absolute advantage is when a country can have produced a unit of goof with less labour than another country
  • We cannot determine a pattern of trade from absolute advantage alone
  • Below is the home and foreign country productions of wine and cheese:

/Users/m_onelove8/Desktop/Screen Shot 2018-05-08 at 6.42.21 PM.png/Users/m_onelove8/Desktop/Screen Shot 2018-05-08 at 6.22.21 PM.png

  • So as you can see it is better to produce cheese at home and wine foreign
  • But you can’t do this forever, eventually home will export enough cheese and same for foreign wine that they will equalize the relative price… but at what price?

Determining Relative Price After Trade

  • Partial equilibrium analysis is to study a single market – but that’s not effective so use general equilibrium analysis which takes into account both markets
  • The graph below shows the Relative Demand Curve “RD” and Relative Supply Curve “RS”
  • /Users/m_onelove8/Desktop/Screen Shot 2018-05-08 at 6.53.12 PM.png
  • We made the assumption that aLW/aLC < a*LW/a*LC so we know that the relative price of cheese cannot fall below aLW/aLC or there would be no production
  • If relative price of cheese = aLC/aLW then home is indifferent in making wine/cheese since they will earn the same flat part of RS
  • When relative price of cheese is above aLC/aLW then home will produce cheese
  • The height of the supply graph between two flat lines is determined by the relative price of cheese between aLC/aLW and a*LC/a*LW

** So the relative supply of cheese is ((L/aLC)/(L*/a*LW))

  • When relative price of cheese is equal to a*LC/a*LW then home and foreign is indifferent between producing wine or cheese
  • And finally for relative price of cheese greater than a*LC/a*LW both home and foreign will specialize in cheese production and no wine production and so the line will be infinite
  • International trade allows Home and Foreign to consume anywhere within the colored lines which lie outside the PPF, meaning they can only consume out of it with trade

/Users/m_onelove8/Desktop/Screen Shot 2018-05-08 at 7.31.25 PM.png

Gains from Trade

  • Free trade permits countries to afford better consumption bundles
  • This can be shown in two ways
  • Trade is an indirect method of production
  • Like consider two alternative ways to use one hour of labour like say we have one hour we can produce 1 cheese and trade it for 2 G of wine rather than spending that one hour on making 0.5 G of wine (because it takes 2 Hrs to make 1 G of wine)
  • Relative wage is the amount of money they are paid per hours compared with the amount workers in another country are paid per hour
  • The wage rate lies between the ratios of the two countries productiveness in the two industried (cheese = 6 times more productive, wine = ½ times more)
  • It is this way because each country ends up with a cost advantage in one good… so even is cheese has higher wages, it has cost advantage and same with wine, even though its lower wage its cost advantage

Misconceptions About Comparative Advantage

Productivity and Competitiveness

  • Free trade is beneficial only if your country is strong enough to stand up to foreign competition – MYTH
  • Gains from trade depend on comparative advantage not absolute advantage
  • The competitive advantage of an industry depends not only on its productivity but also the wage rate
  • A country’s wage rate depends on relative productivity in its other industries
  • Example: Portugal has low productivity in clothing compared to USA but since it has a productivity disadvantage that is greater in other industries… it pays low enough wages to have a competitive advantage in clothing
  • Do wages reflect productivity?
  • in the real world national wage rates reflect differences in productivity
  • the orthodox economist’s view that national wage reflects national productivity is verifies by the data below at a point in time
  • in the past rising relative productivity led to rising wages
  • If wage rates were exactly proportional to productivity the graph points would all be along the line
  • in short, productivity increases are reflected in wage increases

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The Pauper Labor Argument

  • myth # 2 = foreign competition is unfair and hurts other countries when it is based on low wages
  • people who believe this argument argue that industries should not have to cope with foreign industries that are less efficient but pay lower wages

Exploitation

  • myth #3 – trade exploits a country and makes it worse off if its workers receive much lower wages than workers in other nations – this is often expressed in emotional terms

Empirical Evidence on the Ricardian Model

  • this model makes misleading predictions:
  • because it predicts an extreme degree of specialization that isn’t true in the real world
  • assumes away effects on international trade on the distribution of income within countries therefore predicts that countries as a whole always gain from trade
  • allows no role for differences in resources among courtiers as a cause of trade
  • neglects the possible role of economies of scale as a cause of trade
  • In spite of its failings, basic prediction of the model – that countries should tend to export those goods in which their productivity is relatively high../../../../../Desktop/Screen%20Shot%202018-05-13%20at%205.39.45%2
  • this theory leads us to expect that the higher the relative productivity in the US industry, the more likely US rather than UK firms would export in that industry
  • having high productivity compared with foreigners is not enough to export that product, they must also have the highest relative productivity relative to its other sectors

Bangladesh (clothing) – it has low productivity even in the production of clothing, but its productivity disadvantage there is much smaller than in other industries so the country has comparative advantage in clothing

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