Comparative Advantage

International Trade Session 1 Daniel TRAA

Globalization I: Increased trade in goods and services

Trade has grown faster than GDP

40 Trade (% GDP) 35 30 25 20 15 10 1980 World 1985 1990 High income 1995 Low & middle income
Exports (% GDP)

mostly for East Asia; it has fallen for Africa

45 30 15 0 E-Asia & Pac. Lat. Am. & Mid East, N South Asia Carib. Af
1960 1970 1980 1990 1998

Sub-S. Africa

International Trade involves mostly exchanges among high income countries. Developing countries have increased their relevance, particularly East Asia, but are still a small part.

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Trade in services and merchandise

Most of world trade is in goods (merchandise) 82%. Services trail behind, but are the fastest growing component.
Outsourcing is the latest trend
World North America Latin America Western Europe Africa Egypt Nigeria Asia India Indonesia Japan

Share of goods and commercial services in total trade

(Percentages, based on balance of payments data)
Export Shares Import Shares

Goods

Commercial Services

Goods

Commercial Services

81.4 77.2 86.0 78.8 81.5 42.5 93.8 85.7 71.4 92.8 87.1

18.6 22.8 14.0 21.2 18.5 57.8 6.2 14.3 28.6 7.2 12.9

81.4 85.9 84.1 79.4 76.8 68.2 71.1 81.3 73.4 72.3 74.8

18.6 14.1 15.9 20.6 23.2 31.8 28.9 18.7 26.6 27.7 25.2

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Globalization II: Foreign Investment - complex strategies of multinationals

FDI FDI FDI FDI Global FDI Flows 2000 1995 1990 1985 1980 1975 1970 in millions of dollars 1,270,764 331,068 202,297 56,583 54,725 25,850 12,542 per capita (dollars) 210.3 58.8 41.4 12.8 13.6 9.8 5.3 as percentage of GDP 3.12 1.13 0.96 0.48 0.52 0.49 0.48 as percentage of exports 19.99 6.45 6.05 3.10 2.95 3.33 4.56

Gross foreign direct investment (% of GDP) 8 6 4

50% 100%

Share of FDI flows, by group

75%

2
25%

Low income Middle income High income

0 1976 World 1981 1986 1991 1996

0%

High incom e

Low & m iddle incom e

1980

1985

1990

1995

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Drivers of Modern Globalization

Lower transport and communication costs Development of international institutions

The WTO Regional Trade Agreements

Political decisions toward deregulation and liberalization of trade and FDI regulations

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Theory and practice of international trade and foreign investment WHAT WE WILL LEARN
Why do countries export certain goods and imports others? What do countries and populations gain and loose from trade? Why do multinationals exist and what are their effects? Why do governments protect their industries and what are the costs and benefits? What are the effects of different protectionist instruments? How do the institutions that regulate global trade work? What have been the economic and social consequences of the rise in trade and foreign investment with developing nations? What has globalization brought to developing countries?

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Organization of the course

Theories of international trade

Comparative advantage Gains from trade: static and dynamic Losers and winners

The effects of modern globalization

Trade and the developing countries Multinationals and FDI The effects in industrialized countries

Trade policy
Policy Instruments The case for free-trade and exceptions Policies for Strategic sectors Political economy and the realist view

Institutions of global trade

The W.T.O Regional agreements

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Materials and exams

course website: www.danieltraca.com
Download class slides before class from website
Also available at GES

Practice exams and answer keys available at website.

List of required sections available from website

Recommended textbook
International Economics, 7th edby Krugman P. and Obstfeld M., AddisonWesley
Available in French

Additional readings available at website

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The theory of Comparative Advantage

Absolute Advantage

It is the maxim of every prudent master of the family, never attempt to make at home what it will cost him more to make than buy What is prudent in the conduct of every family can scarce be folly in that of a great kingdom If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them
Adam Smith 1776

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Absolute Advantage

Output per worker (productivity)

Manufacturing (pieces) Food (bushels)

NORTH SOUTH

10 3

9
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Gains from specialization

Output
before
1 northerner (FOOD to MANUF)

after

North specializes in Manufacturing and South in Food There is more of both goods, if specialization follows absolute advantage

Food 10 Manuf

1 southerner (MANUF to FOOD)

3 Manuf 9

Food

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Comparative Advantage

"A country enabled to manufacture commodities with much less labour that her neighbours may, in return for such commodities, import a fraction of the corn required for its consumption, even if corn could be grown with much less labour than in the country from which it was imported."
David Ricardo

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Comparative Advantage
North is MORE productive in both goods

Output per worker (Productivity)

Manuf (pieces) Food (bushels)

NORTH SOUTH

10 3

10

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Even so, there are gains from specialization Output

before after

1 northerner (Food to Manuf)

10 Food

10 Manuf

A country has Comparative Advantage in a given good if its relative productivity in that good is higher than in other goods

2 southerners (Manuf to Food)

2x3 6 Manuf

2x9 18 Food

Specialization according to Comparative Advantage creates value, by increasing output.

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How does the market work?

Does the decentralized international market achieve this pattern of specialization? How? Who benefits and who looses from international trade in the freemarket?
Among individuals within a country? Among countries?

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In Autarky...
North Northern worker
They work in both sectors, and trade among them at the autarky relative price

The relative price

P=p
Manuf

Mn f au

/pFood

In equilibrium, workers must be indifferent between the two sectors. They must get the same wage
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South

Food

The prices in autarky (closed economy)

The relative price of Manuf (P) denotes how many bushels of Food for one piece of Manuf. Manuf (pieces) Food (bushels)

NORTH SOUTH

10 3

10

10/10 = 1

9/3 = 3

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Relative prices, relative supply, relative demand

P

PS = 3

Relative Supply (RSs) South

PN = 1

Relative Supply(RSN) North Relative demand (RDW) It is the same in both countries if preferences are the same
[Manuf/Agro]S [Manuf/Agro]N

Manuf/Agro
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In Autarky...
Northern worker North Food
The Northerners trade among them at the autarky price PN =1

Southern worker South Food

The Southerners trade among them at the autarky price PS= 3

Manuf

Manuf

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Wages and productivity

Are the wages the same in both sectors? Why?

If not, where are they higher? Why?

Are they the same in both countries? Why?

If not, where are they higher? Why?

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The Production Possibility Frontier and Welfare

North
Manuf 10
+1

Production Possibility Frontier

Northern Workers in Manuf

Slope = -1 -ProdF / ProdM

The choice of consumers determines the allocation of labor

MRS =MUFood / MUManuf = 1/P =1

UN

Equilibrium P=1, So that both goods are produced

-1/PN = -1

10

Northern Workers in Agro

Agro
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The beginnings of Trade

Manuf is relatively cheaper in the North.

An enterprising Northerner takes 1 Manuf to the South and exchange it for 3 Foods. Back in the North, she could sell 1 Foods for 1 Manuf with a net gain of 1 Food.

There are gains from exchange because prices are different: Trade occurs!
What happens to the relative price of Manuf in North? And in the South?

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Openness in the Short Run...

North Food
PN >10/10

2 . Prices adjust to new scarcity

P rises in the North and falls in the South

South
PS < 9/3

Food

Manuf

1 . Trade starts due to arbitrage

Manuf

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In the Long-Run, there is reallocation

North
PN >10/10

South
Each country specializes completely in, and exports, the good in which it has comparative advantage

PS < 9/3

Food

Food

Manuf
There is one world price, which is between the initial prices
10/10 < PW <9/3

Manuf

3 . Factors (workers) respond to new prices and profitability -- specialization

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In the Long-Run, there is reallocation

North
PN >10/10

South
Each country specializes completely in, and exports, the good in which it has comparative advantage

PS < 9/3

Food

Food

Manuf
There is one world price, which is between the initial prices
10/10 < PW <9/3

Manuf

3 . Factors (workers) respond to new prices and profitability -- specialization

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How to determine the world price?

P
North and South produce only Manuf

3
North and South specialize completely
North produces Manuf only South produces both

Relative Supply (RSW) World

1<PW <3 1
North and South produce only Food

South produces Food only North produces both

Relative Demand (RDW) World

Manuf/Food
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The Gains from Trade according to Comparative Advantage

Manuf 10
-1/PW -1/PN

North

Manuf

South

UN(Manuf)

1< PW

3
PN =1

PS

<3

=3

UN

1< PW

<3

US(Food)
-1/PW -1/PS

US 9
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10

Food

Food

The Gains from Trade according to Comparative Advantage

Manuf 10
-1/PW -1/PN

North

Manuf

South

UN(Manuf)

1< PW

3
PN =1

PS

<3

=3

UN

1< PW

<3

US(Food)
-1/PW -1/PS

US 9
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10

Food

Food

Some unrealistic features of the model, so far

What if there are transport costs? What if there are more than two goods? What if factors cannot adjust to other sectors? What if there are more than one factor? Why is there always complete specialization?

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Transport Costs and Non-traded goods

If there are transport costs, the competitiveness edge of a country must more than make up for this transport cost. Otherwise, the good will not be traded, even if it is cheaper to produce in one country. This good is called non-tradable.
In reality, economies spend large proportions of their income in these type of goods.

It can become tradable, if transport costs fall or the productivity advantages widen (globalization).

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Global markets vs. local markets TRADABLES and NONTRADABLES

Tradable goods can travel across borders and have international markets that set prices. Non-tradable goods have their prices set by supply and demand in local markets.
Often, the same good exists in different countries because it is produced locally.
Nontradables
Cement Housing McDonalds Hamburger

Tradables

Goods

Textiles Machinery Almost all goods

With globalization, many goods and services have become tradable.

Services

Hairdressers Government services Auto-repair Almost all services

Consulting Banking Telecoms Tourism

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Summary

Comparative advantage:
Consumers react to price differences and buy from lower price foreign producers the goods in which their country does not have comparative advantage (gains from exchange). Producers react to price differences and allocate resources to industries where relative productivity is higher, exporting those goods (gains from specialization).

Every country always has an industry in which it has Comparative Advantage and it is competitive in world markets for that industry.
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