Class 2 Outline PubPol 201 The Gains and Losses from Trade Module 3: International • Comparative advantage Trade Policy • Other sources of gain from trade • Who gains and who loses from trade Class 2 – In a single market The Gains and Losses – In the whole economy from Trade • How strong is the case for trade? Lecture 2: Gains 2 Class 2 Outline Comparative Advantage The Gains and Losses from Trade • Due to David Ricardo (1815) – Others (Adam Smith) recognized that the world could • Comparative advantage gain if production shifted • Other sources of gain from trade • From those who are worse at producing to • Those who are better at it. • Who gains and who loses from trade – So international trade would be beneficial if, say – In a single market • England was better at producing cloth – In the whole economy • Portugal was better at producing wine • And therefore England exported cloth to Portugal in • How strong is the case for trade? exchange for its wine. Lecture 2: Gains 3 Lecture 2: Gains 4 Comparative Advantage Comparative Advantage • Ricardo realized that each country did not need • Ricardo’s Example an “absolute advantage” in something for trade Hours of work necessary to produce 1000 units to be beneficial. Country Cloth Wine England 100 120 • Even if, say, Portugal 90 80 – England were absolutely worse at producing both cloth and wine • England needs more labor to produce both goods. So Portugal has absolute advantage in both – There would still be gains from trade if England’s relative (i.e., percentage) disadvantage were greater • But England needs about in one good (say wine) than the other. – About 10% more labor for Cloth – About 50% more for labor Wine • So England has a comparative advantage in cloth Lecture 2: Gains 5 Lecture 2: Gains 6 1
Hours of work necessary to produce 1000 units Hours of work necessary to produce 1000 units Comparative Advantage Comparative Advantage Country Cloth Wine Country Cloth Wine England 100 120 England 100 120 Portugal 90 80 Portugal 90 80 • Now suppose England uses all 220 to produce cloth • Without trade, the countries need the following amounts of labor to produce (and consume) – Since each hour produces 10 units (1000/100), it would produce 2200 units of cloth (and no wine). 1000 units each of cloth and wine • And suppose Portugal uses all 170 units to produce wine • England: 100 + 120 = 220 – Since each hour produces 12.5 units (1000/80), it would produce • Portugal: 90 + 80 = 170 2125 units of wine (12.5 � 170) (and no cloth). – And with that labor the world as a whole has • The world now has more of both cloth and wine than 2000 units of each good. before (2200>2000; 2125>2000). • Both countries would benefit if, say, each trades half its output with the other: – Each will consume 1100 units of cloth and 1062.5 units of wine Lecture 2: Gains 7 Lecture 2: Gains 8 Comparative Advantage Comparative Advantage • Ricardo’s Example • How markets generate trade • Shows the potential to gain from trade even if – Wages reflect productivity – Your trading partner is less productive than you in all activities, or – In Ricardo’s example, the wage per hour in England – Your trading partner is more productive than you in all activities must be lower than in Portugal • What actually happens depends on details of the example, including – It is this that makes England’s cloth cheaper than – All the productivities – Country sizes Portugal’s and makes trade happen. – Demands for the goods • The wage in England only has to be about 10% lower than • But economists have generalized this example into models that the wage in Portugal for English cloth to be cheaper than show that Portuguese cloth – The world must gain from trade, and • At that wage, Portuguese wine is still cheaper than English – No country will lose from trade wine Lecture 2: Gains 9 Lecture 2: Gains 10 Comparative Advantage Class 2 Outline • Why countries often fear trade The Gains and Losses from Trade – Low-productivity developing countries fear trade with • Comparative advantage high-productivity developed countries • Other sources of gain from trade • Fear: How can we compete with the US, whose technology, capital, education, etc. make it far more productive than we • Who gains and who loses from trade are? • Answer: You can compete, because your wage is lower. – In a single market – High-wage developed countries fear trade with low- – In the whole economy wage developing countries • How strong is the case for trade? • Fear: How can we compete with Mexico, whose wages are so much lower than ours? • Answer: Their wages are low because their productivity is low. Lecture 2: Gains 11 Lecture 2: Gains 12 2
Other Gains from trade Other Gains from trade • Scale economies • Comparative advantage is not the only reason that countries gain from trade – In many industries, costs per unit fall as output rises • Other sources of gain from trade – Examples: cars, computer software, – Scale economies pharmaceuticals – Greater competition • Assembly line lowers costs but only for producing many cars – Increased variety • Upfront cost of writing software, compared to – Increased productivity almost zero cost of making copies of it • Research cost for new drugs far larger than cost of making them Lecture 2: Gains 13 Lecture 2: Gains 14 Other Gains from trade Other Gains from trade • Scale economies and trade • Imperfect competition – Without trade, a small country produces – With few firms in an industry, firms have everything at small scale and high cost market power and charge prices well above cost – By specializing in fewer goods and exporting, cost of each goes down – These high prices reduce demand below what would be justified by their low cost – Society suffers lower welfare Lecture 2: Gains 15 Lecture 2: Gains 16 Other Gains from trade Other Gains from trade • Imperfect competition and trade • Variety – Without trade, a small country has few firms in – Buyers benefit when more varieties are each industry, which therefore use market available power to charge high prices • Consumers can choose what they most want – With trade, those firms must compete with • Firms buying inputs can get what works best for their particular needs imports and prices fall closer to costs – Economic welfare therefore rises with increases in variety of products available Lecture 2: Gains 17 Lecture 2: Gains 18 3
Other Gains from trade Other Gains from trade • Variety and trade • Firm productivity – Without trade, a small country cannot provide – Firms in the same industry differ in their many choices productivity for various reasons • Managerial ability – With trade consumers and firms have the world’s varieties to choose from • Location and availability of inputs • Product design – More productive firms produce and sell more than less productive firms and make more profit Lecture 2: Gains 19 Lecture 2: Gains 20 Other Gains from trade Discussion Question • Firm productivity and trade • Can you think of any down-sides to any of these? – When a country opens to international trade • Its most productive firms can expand and export – Scale economies • Its least productive firms compete with imports and – Increasing competition – Reduce output and sales, or – Variety – Shut down – Expansion of more productive firms • Thus average productivity of the industry rises – This means that the country and the world benefit from higher productivity and lower costs Lecture 2: Gains 21 Lecture 2: Gains 22 Class 2 Outline Who gains and loses from trade The Gains and Losses from Trade • Ricardo’s example already points to some losers from trade • Comparative advantage • Makers of wine in England • Other sources of gain from trade • Makers of cloth in Portugal • Who gains and who loses from trade – In the simple model, there is only labor, which – In a single market ends up earning a higher wage in the other industry – In the whole economy – But in fact those workers must first bear the • How strong is the case for trade? cost of moving to that other industry Lecture 2: Gains 23 Lecture 2: Gains 24 4
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