topic 1

Lecturer: Trung Vu

(Contact: Trung.Vu@lboro.ac.uk)

Loughborough Business School

1. Reasons for Trade

Have you ever wondered why countries bother trading with each other instead of just producing everything they need themselves? And how can a country like China, known for lower wages, compete with high-wage countries like the U.S.? These are the core questions this model explores.

  • Primary Questions

    • What are the fundamental reasons behind countries engaging in trade?

    • Is the most efficient producer of a good always the one to export it?

    • How do countries with relatively higher wages, like the United States, manage to compete against countries with significantly lower wages, such as China, in the global marketplace?

1.1 Overview

Trade between nations is driven by several key factors. Imagine two neighbors: one is great at baking, the other at gardening. It makes sense for them to specialize and trade. Similarly, countries trade because of:

  • Differences in Technology: Some countries are simply better at making certain things due to advanced production methods or machinery.

  • Differences in Resources: Countries have different natural resources (e.g., oil, fertile land) or different amounts of skilled labor.

  • Offshore Costs: It might be cheaper to produce goods in another country (offshoring) due to lower labor costs or specific expertise.

  • Proximity: It's often easier and cheaper to trade with close neighbors.

  • Example: In 2018, the U.S. imported snowboards from 19 different countries, totaling 28.5 million. China was the largest supplier, highlighting how even with varying production efficiencies, trade happens. This specific example demonstrates how a country like China, often associated with lower labor costs, can be a major exporter even to a high-income country like the U.S.

2. Ricardian Model

The Ricardian Model, named after economist David Ricardo, is one of the simplest yet most powerful tools for understanding international trade. It focuses on how differences in technology (or how efficiently countries use their labor) lead to trade patterns and the crucial concept of comparative advantage.

  • Assumptions of the Model: To simplify our understanding of trade, the Ricardian model operates under several key assumptions:

    • There are two countries and two goods.

    • Labor is the only factor of production.

    • Labor is perfectly mobile within a country but immobile between countries.

    • Technology is different across countries for different goods, leading to differences in unit labor requirements.

    • Returns to scale are constant, meaning unit labor requirements are fixed regardless of output level.

    • Markets are perfectly competitive.

    • There are no transportation costs or trade barriers.

  • The core idea: This model suggests that countries should identify what they are relatively best at producing and then specialize in those goods. By doing so, they can produce more overall and trade for other goods, leading to benefits for everyone involved.

2.1 Key Concepts in the Ricardian Model

Understanding trade requires distinguishing between being good at everything and being relatively good at something specific.

  • Absolute Advantage:

    • Definition (Layman's Terms): A country has an absolute advantage if it can simply produce more of a good than another country using the same amount of resources (e.g., the same number of workers or hours). Think of it as being generally better or more productive at making something.

    • Implication for Trade: While it might seem logical that the country with absolute advantage in everything would just produce everything, absolute advantage alone is not a solid explanation for why countries trade. If one country is better at producing everything, there's still a strong reason for both countries to trade, as we'll see with comparative advantage.

  • Comparative Advantage:

    • Definition (Layman's Terms): This is the true driver of trade. A country has a comparative advantage in producing a good if it can produce that good at a lower opportunity cost than another country. It's about what you have to give up to make something, not just how much you can make overall.

    • The Key to Trade: Understanding comparative advantage is fundamental to understanding why trade occurs and how both countries can benefit, even if one is less efficient in producing all goods. It dictates which goods a country should specialize in and export.

  • Opportunity Cost:

    • Definition (Layman's Terms): This is the value of the next best alternative that you give up when you choose to produce one good over another. It's the cost of a choice, measured in terms of what you didn't do or didn't get.

2.2 Unit Labor Requirements, Opportunity Cost, and the PPF in the Ricardian Model

To formalize the concepts of absolute and comparative advantage, the Ricardian model uses Unit Labor Requirements (ULRs), which represent the number of hours of labor required to produce one unit of a good.

  • Unit Labor Requirements (ULRs):

    • Let a_{LC} be the ULR for cloth (hours per unit of cloth).

    • Let a_{LW} be the ULR for wine (hours per unit of wine).

    • Absolute Advantage exists if a country has a lower ULR for a good than another country (e.g., if a{LC} < a^{LC} where denotes a foreign country).

  • Calculating Opportunity Cost (OC):

    • The opportunity cost of producing one unit of a good is the amount of the other good that must be given up.

    • For example, the opportunity cost of cloth (in terms of wine) in the home country is OC{CW} = a{LC}/a{LW}. This means to produce one more unit of cloth, you must divert enough labor that could have produced a{LC}/a_{LW} units of wine. The country with the lower ratio has the comparative advantage in that good.

  • Numerical Example for Calculations:

    • Consider two countries (Home and Foreign) and two goods (Cloth and Wine).

    • Home Country:

      • a_{LC} = 1 hour/unit of cloth

      • a_{LW} = 2 hours/unit of wine

      • Total Labor (L) = 100 hours

    • Foreign Country:

      • a^*_{LC} = 3 hours/unit of cloth

      • a^*_{LW} = 3 hours/unit of wine

      • Total Labor (L^*) = 100 hours

    • Step 1: Determine Absolute Advantage

    • Cloth: Home (1 hour) vs. Foreign (3 hours). Home has absolute advantage in cloth.

    • Wine: Home (2 hours) vs. Foreign (3 hours). Home has absolute advantage in wine.

    • Conclusion: Home has an absolute advantage in both goods.

    • Step 2: Calculate Opportunity Costs (Compare Ratios)

    • Home:

      • OC of Cloth (in terms of Wine): a{LC}/a{LW} = 1/2 = 0.5 units of wine

      • OC of Wine (in terms of Cloth): a{LW}/a{LC} = 2/1 = 2 units of cloth

    • Foreign:

      • OC of Cloth (in terms of Wine): a^{LC}/a^{LW} = 3/3 = 1 unit of wine

      • OC of Wine (in terms of Cloth): a^{LW}/a^{LC} = 3/3 = 1 unit of cloth

    • Step 3: Determine Comparative Advantage

    • Cloth: Home's OC (0.5 wine) < Foreign's OC (1 wine). Home has a comparative advantage in Cloth.

    • Wine: Home's OC (2 cloth) > Foreign's OC (1 cloth). Foreign has a comparative advantage in Wine. (Even though Home is absolutely better at wine, Foreign has a relatively lower opportunity cost).

  • Production Possibilities Frontier (PPF) in the Ricardian Model:

    • The PPF illustrates the maximum quantities of two goods a country can produce with its given labor force and technology.

    • In the Ricardian model, the PPF is a straight line because ULRs are constant, implying constant opportunity costs.

    • Equation for PPF: a{LC}QC + a{LW}QW \le L

    • Where QC is the quantity of cloth and QW is the quantity of wine.

    • Graphical Representation:

    • For the Home Country example (L=100):

      • If all labor produces cloth, max cloth = L/a_{LC} = 100/1 = 100 units.

      • If all labor produces wine, max wine = L/a_{LW} = 100/2 = 50 units.

      • The PPF is a straight line connecting (100 \text{ cloth}, 0 \text{ wine}) and (0 \text{ cloth}, 50 \text{ wine}).

      • The absolute value of the slope of the PPF is the opportunity cost of the good on the horizontal axis (e.g., if cloth is on the horizontal axis, slope = a{LC}/a{LW} = 0.5).

  • Trade and Changes in Graphs: Expanding Consumption Possibilities:

    • No-Trade Scenario: A country can only consume combinations of goods that lie on or inside its PPF.

    • With Trade (Changes in Graphs):

    1. Specialization: Each country specializes entirely in the production of the good in which it has a comparative advantage. For example, Home produces only cloth, Foreign only wine.

    2. Terms of Trade (Relative Prices): Trade occurs at an international relative price ratio (PC/PW) that lies between the domestic opportunity costs of the two countries. For trade to be mutually beneficial, this price must be: (\text{Home's } OCC) < (PC/PW) < (\text{Foreign's } OCC).

    3. Consumption Possibilities: Once trade occurs, a country can consume combinations of goods that lie outside its own PPF. Graphically, this means the Consumption Possibility Frontier (CPF) with trade will be a line that pivots outward from the production point (where the country specializes) along the international relative price line. This expands the range of goods available for consumption, leading to welfare gains for both countries. This is the main graphical change: the ability to consume beyond the domestic production limits.

3. Determining the Pattern of International Trade

The concepts of absolute and comparative advantage directly lead to how countries decide what to produce and trade.

3.1 No-Trade Equilibrium and Trade Equilibrium

  • Equilibrium Definitions:

    • No-trade equilibrium: This is a hypothetical situation where a country only consumes the goods it produces itself. It's self-sufficient but can't enjoy the benefits of specialization and trade.

    • Trade equilibrium: This occurs when countries engage in trade, allowing them to consume a wider variety of goods or a larger quantity of goods than they could produce on their own. By specializing and trading, countries can consume beyond their own production limits.

  • Indifference Curves are used by economists to represent different combinations of goods that provide a consumer with the same level of satisfaction or utility. In the context of no-trade equilibrium, these curves help visualize the consumption choices a country makes when it's limited to its own production.

    • Graph Representation: The Production Possibility Frontier (PPF) (which we'll define in detail next) shows all the possible combinations of two goods a country can produce. Points on the PPF represent efficient, attainable outputs. Points inside the PPF mean the country isn't using its resources effectively, and points outside the PPF are unattainable without trade or technological improvement.

3.2 Example of Comparative Advantage

  • David Ricardo’s Hypothetical (Portugal vs. England):

    • Let's say Portugal is better at producing both wine and cloth than England (Portugal has an absolute advantage in both). For instance, Portugal might take 80 hours to produce a unit of wine and 90 hours for a unit of cloth, while England takes 120 hours for wine and 100 hours for cloth. Clearly, Portugal uses less labor for both.

    • However, if Portugal can produce a unit of wine by giving up only 0.88 units of cloth (90/80) and England needs to give up 1.20 units of cloth (120/100) to produce a unit of wine, then Portugal has a comparative advantage in wine (lower opportunity cost).

    • Conversely, England has a comparative advantage in cloth. Even though England takes more labor to produce cloth (100 hours vs. Portugal's 90), its opportunity cost for cloth is lower. England gives up 0.83 units of wine (100/120) to make a unit of cloth, while Portugal gives up 1.125 units of wine (90/80).

    • The Outcome: Both countries benefit by specializing. Portugal focuses on wine where it has a relatively greater advantage (or lower opportunity cost), and England focuses on cloth. They then trade, enabling both to consume more than they could without trade. This demonstrates that trade is driven by comparative, not absolute, advantage.

4. Production Possibilities Frontier (PPF)

  • Definition (Layman's Terms): The PPF is a graph that illustrates the maximum possible output combinations of two goods that an economy can achieve when all its resources are fully and efficiently employed. It's a visual representation of the trade-offs a country faces. For example, if a country produces only two goods, say good X and good Y, the PPF shows all the combinations of X and Y that can be produced. Any point on the PPF represents efficient production, points inside represent inefficient production, and points outside are unattainable without trade or technological advancements.