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- 1. CHAPTER 3 THE RICARDIANMODEL Labor Productivity and Comparative Advantage
- 2. CHAPTER 3 THE RICARDIANMODEL Labor Productivity and Comparative Advantage
- 3. Chapter Organization ▰ Conceptof comparative advantage ▰ Production possibilities ▰ Relative prices and supply ▰ A one-factor economy ▰ Trade in a one-factor world ▰ Misconceptions about comparative advantage Slide 2
- 4. Why is freetrade beneficial? ▰ Free trade – a situation where a government does not attempt to influence through quotas or duties what its citizens can buy from another country or what they can produce and sell to another country ▰ Trade theories show why it is beneficial for a country to engage in international trade even for products it is able to produce for itself Slide 2
- 5. International trade theories ▰Classical trade theories ▻ Mercantilism (Pre-16th century) ▻ Absolute advantage (A. Smith, 1776) ▻ Comparative advantage (D. Ricardo, 1817) ▰ Neo-classical trade theory ▻ Factor-Endowment (Heckscher-Ohlin, 1919) ▰ New trade theories ▻ Economies of scale & Int’l trade (P. Krugman, 1908s) ▻ International product life cycle (R. Vernon, 1966) ▻ National competitive advantage (M. Porter, 1990) Slide 2 Chủ nghĩa trọng thương Lợi thế tuyệt đối Lợi thế so sánh
- 6. Historical development oftrade theory ▰ The mercantilist philosophy makes a crude case for government involvement in promoting exports and limiting import ▰ Smith, Ricardo, and Heckscher-Olin promote unrestricted free trade ▰ New trade theory and Porter’s theory of national competitive advantage justify limited and selective government intervention to support the development of certain export-oriented industries. Slide 6
- 7. Historical development oftrade theory ▰ Mercantilism: ▻ Regulation to ensure a positive trade balance ▻ Critics: possible only or short term; assumes static world economy ▰ Absolute advantage: ▻ Countries benefit from exporting what they produce more efficiently than anyone else ▻ But: Nations without absolute advantage do not gain from trade ▰ Comparative advantage: ▻ Nations can gain from specialization, even if they lack of absolute advantage Slide 7
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- 9. The Concept ofComparative Advantage Slide 9
- 10. 10 ADAM SMITH’S QUOTE •It is the maxim of every prudent master of a family never to attempt to makee at home what it will cost him more to make than to buy. The taylor does not attempt to make his own shoe. All of them find it for their interest to employ their whole industry in a way in which they have some advantage over their neighbours and to purchase with a part of its produce whatever else they have occasion for • What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom. Would it be a reasonable law to prohibit the importation of all foreign wines, merely to encourage the making of claret and burgundy in Scotland? - Smith, Adam An inquiry into the Nature and Causes of the Wealth of Nations
- 11. Review of Absoluteadvantage ▰ Adam Smith’s theory of Absolute advantage: Countries should specialize in the production of goods for which they have an absolute advantage and then trade these goods for goods produced by other countries. Slide 11
- 12. The Concept ofComparative Advantage ▰ David Ricardo asked what happens when one country has an absolute advantage in the production of all goods. ▰ The theory of comparative advantage (1817) – countries should specialize in the production of those goods they produce most efficiently and buy goods that they produce less efficiently from other countries ▻ Even if this means buying goods from other countries that they could produce more efficiently at home Slide 12
- 13. The Law ofComparative Advantage ▰ The less efficient nation should specialize in and export the good in which it is relatively less inefficient (where its absolute disadvantage is least). The more efficient nation should specialize in and export that good in which it is relatively more efficient (where absolute advantage is greatest) Slide 13
- 14. A One-Factor Economy ▰Assume that we are dealing with an economy (which we call Home). In this economy: ▻ Labor is the only factor of production. ▻ Only two goods (say rice and steel) are produced. ▻ The supply of labor is fixed in each country. ▻ The productivity of labor in each good is fixed. ▻ Perfect competition prevails in all markets. Slide 14
- 15. A One-Factor Economy ▰Before specialization ▰ Specialization and international trade ▰ If each country specializes in the production of the good in which it has a comparative advantage and trades for the other, both countries gain →Trade is a positive sum game Slide 15 Output/Labor unit Vietnam Japan World Rice 8 12 20 Steel 2 6 Output/Labor unit Vietnam Japan Gains Rice +8 -8 (1/3) 0 Steel -2 +4 (2/3) +2 (16) (4 =1/3 đv lđ) (6*2/3)
- 16. A One-Factor Economy ▰Comparative advantage model ▰ Comparative advantage of the two countries? ▰ Determining comparative advantage: 𝐿𝑎𝑏𝑜𝑟 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑟𝑖𝑐𝑒 𝑉𝑁 𝐿𝑎𝑏𝑜𝑟 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑟𝑖𝑐𝑒 𝐽𝑃 < 𝐿𝑎𝑏𝑜𝑟 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑠𝑡𝑒𝑒𝑙 𝑉𝑁 𝐿𝑎𝑏𝑜𝑟 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑠𝑡𝑒𝑒𝑙 𝐽𝑃 Slide 16 Output Vietnam Japan Rice 6 5 Steel 12 2 labor costs/output
- 17. Ricardo’s Theory ofComparative Advantage ▰ Comparative advantage theory provides a strong rationale for encouraging free trade ▻ Total output is higher ▻ Both countries benefit Trade is a positive sum game Slide 17
- 18. A One-Factor Economy ▰Suppose the Vietnam economy has only one factor of production: Labor ▰ It produces 2 products: rice and steel ▻ Denote with aLR the unit labor requirement for rice ▻ Denote with aLS the unit labor requirement for steel ▰ The economy’s total resources are defined as L, the total labor supply Slide 2-18
- 19. A One-Factor Economy ▰Production Possibilities ▻ The production possibility frontier (PPF) of an economy shows the maximum amount of a good (say rice) that can be produced for any given amount of another (say steel), and vice versa. ▻ The PPF of Vietnam economy is given by the following equation: aLRQR + aLSQS = L ▻ For example, we have: aLR = 6; aLS = 12; L = 120 6QR + 12QS = 120 Slide 19
- 20. Slide 20 Figure 3-1:Vietnam’s Production Possibility Frontier L/aLR L/aLS A One-Factor Economy Absolute value of slope equals opportunity cost of rice in terms of steel F P Vietnam rice production, QR, in tons Vietnam steel production, QS, in tons aLr/aLS = 6/12 = 0.5 aLS/aLR = 12/6 = 2
- 21. A One-Factor Economy ▰Relative Prices and Supply ▻ The particular amounts of each good produced are determined by prices. ▻ If price of rice is $4 and the price of steel is $7, what will Vietnamese workers produce? Slide 21
- 22. A One-Factor Economy ▰The above relations imply that if the relative price of rice (PR / PS ) exceeds its opportunity cost (aLR / aLS), then the economy will specialize in the production of rice. 𝑃𝑅 𝑃𝑆 > 𝑎𝐿𝑅 𝑎𝐿𝑆 ⟹ 𝑠𝑝𝑒𝑐𝑖𝑎𝑙𝑖𝑧𝑒 𝑖𝑛 𝑟𝑖𝑐𝑒 ▰ In the absence of trade, both goods are produced, and therefore PR / PS = aLR /aLS. Slide 22
- 23. International Trade ▰ Absoluteadvantage concept can leave the impression that a country could lack an anything ▻ Therefore have nothing to export ▰ An absolute disadvantage in a product does not preclude having a comparative advantage in that product ▻ Vietnam could have absolute advantage in rice, but still export rice because of its comparative advantage ▰ Comparative advantage is a more powerful concept than absolute advantage ▻ Perhaps the most central concept in international economics Slide 23 loại trừ
- 24. International Trade ▰ Gainsfrom trade occur for the country as a whole ▻ Does not mean that every individual or group within the country benefits ▻ Good reasons to expect that there will be groups that lose from increased trade ▻ These groups will oppose increased trade despite the overall gains to their country ▰ Sometimes alleged international trade is almost always detrimental to the environment ▰ However, the situation is not straightforward ▻ Theoretical and empirical results demonstrate that increased trade can be either good or bad for the environment ▻ Need to approach the trade and environment issue on a case-by-case basis Slide 24
- 25. Comparative advantage andOpportunity cost ▰ Generalizes theory to include all factors, not just labor ▰ Shows combinations of products that can be made if all factors are used effectively ▰ Slope, or marginal rate of transformation, shows the opportunity cost of making more of one good (how much of one good must be given up to make more of another) Slide 25
- 26. Comparative advantage andOpportunity cost ▰ A country has a comparative advantage in producing a good if the opportunity cost of producing that good is lower in the country than it is in other countries. Slide 26
- 27. Summary of Ricardianmodel (Paul Krugman) 1. We examined the Ricardian model, the simplest model that shows how differences between countries give rise to trade and gains from trade. In this model, labor is the only factor of production, and countries differ only in the productivity of labor in different countries. Slide 27
- 28. Summary of Ricardianmodel (Paul Krugman) 2. In the Ricardian mode, countries will export goods that their labor produces relatively efficiently and will import goods that their labor produces inefficiently. In other words, a country’s production pattern is determined by comparative advantage. Slide 28
- 29. Summary of Ricardianmodel (Paul Krugman) 3. We can show that trade benefits a country in either of two ways. First, we can think of trade as an indirect method of production. Instead of producing a good for itself, a country can produce another good and trade it for the desired good. The simple model shows that whenever a good is imported, it must be true that this indirect “production” requires less labor than direct production. Second, we can show that trade enlarges a country’s consumption possibility, which implies gains from trade Slide 29
- 30. Summary of Ricardianmodel (Paul Krugman) 4. The distribution of the gains from trade depends on the relative prices of the goods countries produce. To determine these relative prices, necessary to look at the relative world supply and demand for goods. The relative price implies a relative wage as well. Slide 30
- 31. Summary of Ricardianmodel (Paul Krugman) 5. Extending the one-factor, two-good model to a world of many commodities does not alter these conclusions. The only difference is that it necessary to focus directly on the relative demand for labor to determine relative wages rather than to work via relative demand for goods. Also, a many-commodity model can be used to illustrate the important point that transportation costs can give rise to a situation in which some goods are nontraded. Slide 31
- 32. Revealed Comparative Advantage(RCA) – Bela Balassa (1965) ▰ RCA is an index used in international economics to measure the comparative advantage of a country in an industry (product cluster) 𝑹𝑪𝑨𝒊𝒋 = 𝒙𝒊𝒋 𝑿𝒊 𝒙𝒂𝒋 𝑿𝒂 Slide 32 x: export of an industry X: total exports i: a country j: an industry a: the world
- 33. Revealed Comparative Advantage(RCA) – Bela Balassa (1965) ▰ RCA < 1 ▰ RCA > 1 ▰ RCA > 2.5 Slide 33
- 34. Practice test (RCA) ▰Calculate RCA of Vietnam’s top 20 biggest export industries and Top-10 biggest import industries (4-digit HS) in the period of 10 years. ▰ Analyse RCA in the context of Vietnam’s economy (focusing on production factors and government policies) ▰ Source: Trade Map (intracen.org) Slide 34 code of products