SESSION_3_-_COMPARATIVE_ADVANTAGE

Comparative Advantage and the Ricardian Model

Session Overview

• Session 3 focuses on Comparative Advantage.

• Examines insights into trade, productivity, and economic isolation.

• Discusses the Ricardian Model and Spain's case study of comparative advantage in action.

What is Comparative Advantage?

• Definition: A country has a comparative advantage when it produces goods at a lower opportunity cost than others.

  • Opportunity Cost: Represents the potential benefits missed when choosing one alternative over another.

• Key Points:

  • Developed by David Ricardo in 1817.

  • Specialization: Lead to efficiency and mutual benefits.

  • Trade enables countries to consume beyond their Production Possibility Frontiers (PPFs).

Example of Comparative Advantage

• Country A: Specializes in producing motorbikes and trades for cars.

• Country B: Specializes in producing cars and trades for motorbikes.

Case Study: The Market for Winter Roses in the USA

Part I

• The USA imports roses from Colombia which grows them in heated greenhouses.

• Costs: High energy and capital costs are involved in domestic production of flowers, leading to fewer computers produced.

• Key Points:

  • Climate: Colombian workers have better efficiency in flower production compared to American workers.

Part II

• USA focuses on computers; Colombia focuses on growing roses.

• Mutual Benefits: Increased world production can occur when resources are reallocated effectively—USA stops producing roses, while Colombia increases flower production.

Comparative Advantage and Labor Productivity

• International trade increases world output by allowing specialization in goods where countries hold a comparative advantage.

• Trade benefits both exporting countries if each specializes in goods with lower opportunity costs.

• Ricardian Model Insight: International trade arises from differences in labor productivity between countries.

The Ricardian Model

• Framework: Involves two countries producing two different goods.

  • Labor as Sole Input: Homogeneous within countries but varies across them in productivity.

  • Constant Returns: Doubling labor inputs doubles output (returns to scale).

  • Perfect Competition: Goods traded freely in competitive markets.

  • No Transportation Costs: Assumes frictionless trade.

  • Technology Differences: Variability in labor productivity due to differing technologies.

A One-Factor Economy

• Unit Labor Requirement: Hours of labor required to produce a certain product.

  • Example: 1 hour of labor produces either 1 pound of cheese or 1 gallon of wine.

  • Constraints: Total resources (L) defined by the sum of labor inputs required for cheese (aLC) and wine (aLW).

Production Possibility Frontier (PPF)

• Definition: Maximum production amount of one product, given a set quantity of another.

  • Comparative advantage emerges when a country operates on the flatter segment of its PPF.

  • Example: UK wine and sweaters production.

Trade in a One-Factor World (I)

• Relative Price Dynamics:

  • Vertical: Price ratio between cheese (PC) and wine (PW).

    • High PC/PW: Countries specialize in cheese.

    • Average: Mix of specialization.

    • Low PC/PW: Both specialize in wine.

  • Horizontal: Relative quantity supplied/demanded globally denoting production adjustments.

Trade in a One-Factor World (II)

• Opportunity Cost Metrics:

  • Home's opportunity cost of cheese production: aLC/aLW.

  • Foreign’s opportunity cost of cheese: aLC/aLW.

  • World Equilibrium Price: Interaction of demand (RD) and supply (RS) ensures countries benefit from specialization based on comparative advantage.

Gains from Trade

• Trade enhances the global economy by enlarging the economic "pie".

• Increases global output and reallocates resources efficiently.

Relative Prices and Trade Patterns

• Price Influences: Relative prices determine specialization in goods.

  • High cheese prices lead to production specialization in wine and vice versa.

• Aligns goods produced with comparative advantages.

From One-Factor to Many Factors

• Model Expansion: From single-factor (labor) to multi-factors such as land and capital.

  • Productivity and wage differentials dictate trade patterns.

  • Example: High-productivity goods (apples) produced in Home, labor-intensive goods (bananas) in Foreign.

  • Small wage shifts can alter specialization patterns.

The Spanish Case: Economic Isolation and Autarky

• Spain's long-term economic isolation (Francoist policies) restricted foreign trade.

• Resulted in:

  • Inefficiency, high costs, and limited consumer options.

  • Technological stagnation and lack of economies of scale.

• Transition to trade liberalization and joining the EU enhanced productivity and market integration.

Trade and Global Gains

• Trade allows for indirect production of goods, enhancing output for both Home and Foreign through specialization and exchange.

• Example: Home produces cheese and trades for wine at a lower opportunity cost.

Misconceptions About Comparative Advantage

• Productivity Misunderstandings:

  • Countries can trade even with lower absolute productivity if they have relative efficiency in certain sectors.

• Wage Concerns: Lower wages in foreign countries reflect the comparative advantage in labor-intensive goods, not exploitation.

• Trade Benefits: Overall, trade can lead to improved worker welfare compared to autarky.

Challenges in Real-World Application

• Transport Costs: Unlike the Ricardo model, real trade incurs transportation costs.

• Multiple Production Factors: Incorporates factors beyond labor (land, capital).

• Income Distribution: Trade benefits are not evenly distributed across communities, potentially harming certain sectors.

• Modern Trade Policies: Trade dynamics are influenced by governmental regulations.

Key Aspects from Session

• Productivity Differences: Crucial for international trade.

• Exports and imports depend on labor efficiency.

• Implications of the Ricardian model: Countries specialize where they hold comparative advantages, enabling more efficient global consumption.

Test Questions Summary

1. Comparative Advantage is determined by lower opportunity costs.

2. Opportunity cost relates to the quantity of goods sacrificed for another.

3. Ricardian model shows trade benefits arise from productivity differences.

4. Wages correlate proportionally with productivity in international trade contexts.

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