Globalization
- Geographic: Compressed time and space due to more efficient transportation and
communication technology.
- Cultural: Homogenization of cultural values (e.g. spreading of ‘American culture’).
- Institutional: Spread of universal institutional arrangements.
- Political: Declining role of nation-states; growing importance of international
organization, multinational firms; growing international cooperation and
coordination.
Consumption effect: Welfare gain due to increase in quantity consumed.
Production effect: Welfare gain due to shifting to cheaper foreign producers.
Free trade makes everyone better off.
→ The country experiencing the larger price change gains more from trade.
With a steep import demand curve or steep export supply curve the price change is bigger.
Hence, the country with the less elastic (steeper) curve gains more from free trade.
Which products are traded depends on:
- Absolute advantages (Smith): Export what you can produce at lower costs than other
countries.
- Comparative advantage (Ricardo): Export what you can produce relatively cheaper
than other countries.
Opportunity costs: how much of another good has to be given up in order to produce this
good.
Absolute advantage:
U.S. is better at producing both goods → U.S. has an absolute advantage in the production
of both goods.
Adam Smith: Trade based on absolute advantages.
- Produce and export what you can produce relatively cheaper than any other country.
Import the rest.
Comparative advantage:
David Ricardo: Trade based on comparative advantages.
- Comparative advantage = what you can do relatively better than anybody else.
- Produce and export what you can produce at lower opportunity costs than other
countries. Import what involves higher opportunity costs.
Profits can be made from the fact that pre-trade (autarky) prices are different → arbitrage
opportunities.
Arbitrage:
“Buy low, sell high”
ROW has a comparative advantage in cloth production.
1. Go to ROW and buy 1 unit of cloth in exchange for 0.5 unit of wheat.
2. Go to U.S. and sell the unit of cloth in exchange for 1.5 units of wheat
3. Profit of 1 unit of wheat!
,What determines the world price
- Trade is worthwhile as long as the relative prices (OC) in the two countries differ.
- As countries trade, the relative prices converge wheat becomes relatively cheaper
(less scarce) in ROW and more expensive (scarcer) in U.S.
- Implies that the equilibrium international relative price must fall within the two
autarky price ratios.
Do absolute advantages matter?
- Yes! Absolute advantages, i.e. the absolute level of labor productivity, determine real
wages.
- Real wage = wage expressed in units of a good (rather than money):
o Nominal wage: w = P ⋅ labor productivity
o Real wage: ω = w/P = labor productivity
- Low productivity countries have low real wages and therefore lower living standards.
Limitations:
Ricardo’s theory of comparative advantages predicts complete specialization:
→ Problem: No country in the world is fully specialized.
Constant marginal costs are to blame.
- Production possibilities curve is a straight line.
- Relax this assumption→ More realistic predictions.
Increasing marginal cost:
Why are constant marginal costs unrealistic?
- Labor is not the only production factor:
Different activities require different combinations of production factors.
→ Leads to increasing marginal costs and “bowed out” production possibility curves.
How much wellbeing the derive from different combinations of different goods can be
visualized in the consumers’ indifference curves: The combinations of consumption
quantities that yield the same level of utility. → Indifference curves are ‘bowed inward’.
Why are indifference curves ‘bowed inward’?
- Due to decreasing marginal utility from each good.
- First unit of cloth gives lots of extra utility, so consumption of wheat has to fall a lot
to keep the utility level unchanged.
- Subsequent units of cloth generate less and less utility.
Optimal consumption:
- Consumers’ goal is to maximize their utility, given their income and the relative price
of the two goods.
o Budget constraint: Y = Pw x Qw + Pc x Qc
- The slope of the budget constraint equals the relative price, Pc/Pw:
- Utility is maximized where the consumer indifference curve is
tangent to the budget constraint.
, Equilibrium without trade:
- Maximize well-being (utility) given the production possibilities.
- Find the indifference curve that just touches the production possibilities curve.
o The highest utility given the production constraints.
o Autarky relative price is given by the slope in this point.
Equilibrium with trade:
- Before trade, wheat is cheap in U.S. relative to the rest of the world.
- International trade changes relative prices.
- Countries specializes in the product whose relative price increases and export the
surplus.
- Total production of each product increases, but no complete specialization: More
realistic than Ricardo.
- Countries reach a higher indifference curve (welfare gain!).
Gains from trade:
- Both countries move to higher indifference curves and gain welfare.
- What determines the size of the welfare gain?→ The terms of trade (= price of
exports/price of imports)
- The higher the price of exports the more imports you can buy: Larger gains from
trade.
- Similar result as in the Ricardo model: The larger the price change, the bigger the
welfare gain.
Heckscher-Ohlin theory:
- Assumes technology is identical across countries.
- Assumes different factor intensities of production, e.g.:
o Wheat is the land-intensive product.
o Cloth is the labor-intensive product.
- Assumes different factor endowments across countries, e.g.:
o U.S. is land-abundant.
o ROW is labor-abundant.
Differences in factor endowments across countries and factor intensities across industries
determine relative prices in the two countries:
- Land is cheap where it is abundant. Land-intensive goods can be produced relatively
more cheaply where land is abundant→ Lower relative price of wheat.
- Labor is cheap where it is abundant→ Relative price of cloth is lower in labor-
abundant countries.
Countries export the product that uses their abundant production factor intensively.
- U.S.: Exports the land-intensive product (wheat) because U.S. is land-abundant.
- ROW: Exports the labor-intensive product (cloths) because ROW is labor-abundant.
Countries are “exporting” their abundant production factor.
- Geographic: Compressed time and space due to more efficient transportation and
communication technology.
- Cultural: Homogenization of cultural values (e.g. spreading of ‘American culture’).
- Institutional: Spread of universal institutional arrangements.
- Political: Declining role of nation-states; growing importance of international
organization, multinational firms; growing international cooperation and
coordination.
Consumption effect: Welfare gain due to increase in quantity consumed.
Production effect: Welfare gain due to shifting to cheaper foreign producers.
Free trade makes everyone better off.
→ The country experiencing the larger price change gains more from trade.
With a steep import demand curve or steep export supply curve the price change is bigger.
Hence, the country with the less elastic (steeper) curve gains more from free trade.
Which products are traded depends on:
- Absolute advantages (Smith): Export what you can produce at lower costs than other
countries.
- Comparative advantage (Ricardo): Export what you can produce relatively cheaper
than other countries.
Opportunity costs: how much of another good has to be given up in order to produce this
good.
Absolute advantage:
U.S. is better at producing both goods → U.S. has an absolute advantage in the production
of both goods.
Adam Smith: Trade based on absolute advantages.
- Produce and export what you can produce relatively cheaper than any other country.
Import the rest.
Comparative advantage:
David Ricardo: Trade based on comparative advantages.
- Comparative advantage = what you can do relatively better than anybody else.
- Produce and export what you can produce at lower opportunity costs than other
countries. Import what involves higher opportunity costs.
Profits can be made from the fact that pre-trade (autarky) prices are different → arbitrage
opportunities.
Arbitrage:
“Buy low, sell high”
ROW has a comparative advantage in cloth production.
1. Go to ROW and buy 1 unit of cloth in exchange for 0.5 unit of wheat.
2. Go to U.S. and sell the unit of cloth in exchange for 1.5 units of wheat
3. Profit of 1 unit of wheat!
,What determines the world price
- Trade is worthwhile as long as the relative prices (OC) in the two countries differ.
- As countries trade, the relative prices converge wheat becomes relatively cheaper
(less scarce) in ROW and more expensive (scarcer) in U.S.
- Implies that the equilibrium international relative price must fall within the two
autarky price ratios.
Do absolute advantages matter?
- Yes! Absolute advantages, i.e. the absolute level of labor productivity, determine real
wages.
- Real wage = wage expressed in units of a good (rather than money):
o Nominal wage: w = P ⋅ labor productivity
o Real wage: ω = w/P = labor productivity
- Low productivity countries have low real wages and therefore lower living standards.
Limitations:
Ricardo’s theory of comparative advantages predicts complete specialization:
→ Problem: No country in the world is fully specialized.
Constant marginal costs are to blame.
- Production possibilities curve is a straight line.
- Relax this assumption→ More realistic predictions.
Increasing marginal cost:
Why are constant marginal costs unrealistic?
- Labor is not the only production factor:
Different activities require different combinations of production factors.
→ Leads to increasing marginal costs and “bowed out” production possibility curves.
How much wellbeing the derive from different combinations of different goods can be
visualized in the consumers’ indifference curves: The combinations of consumption
quantities that yield the same level of utility. → Indifference curves are ‘bowed inward’.
Why are indifference curves ‘bowed inward’?
- Due to decreasing marginal utility from each good.
- First unit of cloth gives lots of extra utility, so consumption of wheat has to fall a lot
to keep the utility level unchanged.
- Subsequent units of cloth generate less and less utility.
Optimal consumption:
- Consumers’ goal is to maximize their utility, given their income and the relative price
of the two goods.
o Budget constraint: Y = Pw x Qw + Pc x Qc
- The slope of the budget constraint equals the relative price, Pc/Pw:
- Utility is maximized where the consumer indifference curve is
tangent to the budget constraint.
, Equilibrium without trade:
- Maximize well-being (utility) given the production possibilities.
- Find the indifference curve that just touches the production possibilities curve.
o The highest utility given the production constraints.
o Autarky relative price is given by the slope in this point.
Equilibrium with trade:
- Before trade, wheat is cheap in U.S. relative to the rest of the world.
- International trade changes relative prices.
- Countries specializes in the product whose relative price increases and export the
surplus.
- Total production of each product increases, but no complete specialization: More
realistic than Ricardo.
- Countries reach a higher indifference curve (welfare gain!).
Gains from trade:
- Both countries move to higher indifference curves and gain welfare.
- What determines the size of the welfare gain?→ The terms of trade (= price of
exports/price of imports)
- The higher the price of exports the more imports you can buy: Larger gains from
trade.
- Similar result as in the Ricardo model: The larger the price change, the bigger the
welfare gain.
Heckscher-Ohlin theory:
- Assumes technology is identical across countries.
- Assumes different factor intensities of production, e.g.:
o Wheat is the land-intensive product.
o Cloth is the labor-intensive product.
- Assumes different factor endowments across countries, e.g.:
o U.S. is land-abundant.
o ROW is labor-abundant.
Differences in factor endowments across countries and factor intensities across industries
determine relative prices in the two countries:
- Land is cheap where it is abundant. Land-intensive goods can be produced relatively
more cheaply where land is abundant→ Lower relative price of wheat.
- Labor is cheap where it is abundant→ Relative price of cloth is lower in labor-
abundant countries.
Countries export the product that uses their abundant production factor intensively.
- U.S.: Exports the land-intensive product (wheat) because U.S. is land-abundant.
- ROW: Exports the labor-intensive product (cloths) because ROW is labor-abundant.
Countries are “exporting” their abundant production factor.
