From observation so far:

Countries with
lower pre-trade price
are potential exporters.

Factors contributing to low price of production:

• High labour productivity due to natural or acquired advantage

• Low wages
• Low raw material costs etc.
• More competitive markets

Our focus in this session is on LABOUR PRODUCTIVITY difference as a determinant of trade.

1
 ‘conditions are favourable’ for production
Trade on the basis of natural advantage
Leaders in world exports (2020) • Climate / Natural resource
Selected commodities • Acquired skill
commodities 3 Leading exporters Combined
Share of world
exports
(approx)
Coffee Brazil, Switzerland, Germany 35%
Tea China, Sri Lanka, Kenya 58%
Cinnamon China, Vietnam, Sri Lanka 72%
Perfumes France, Spain, Germany 47%
Pepper India, Vietnam, China 61%
Clocks and Switzerland, Hong Kong, China 67%
watches
Wine from France, Italy, Spain 59%
fresh grapes

2
A shift from a regime of self sufficiency to one of free trade is
associated with
- more competition for domestic firms
- close down of some domestic industries
- price adjustments
- old skills becoming irrelevant to the market
- workers trying to acquire of new skills
- market being flooded with varieties of imported goods

So, should free trade necessarily be welcome?

3
• A policy shift from protected market (autarky) to free trade is a
political decision.
• It benefits some, while others incur costs.

But one argument in favour of ‘free trade’ that all agree to is

It raises
consumption possibilities
beyond
production possibilities.

Let us try and understand what that means….

4
 Absolute advantage:

Absolute Country A has an absolute advantage in a product if price for that

product in A is lower compared to that in other countries

advantage Adam smith used higher labour productivity to represent lower

price.

• Argument:
If free trade is allowed between countries with natural or acquired
advantage,
(1) world’s productive efficiency will increase.
Due to Adam Smith • Through honing of existing skills
• Development of more effective work methods
• Most importantly, through a better allocation of resources
between sectors (industries)
(2) Consumption possibilities increase

5
 Absolute advantage : lower price.

lower price may be due to higher

coffee Pepper productivity, lower wages, lower raw
India 20 5 material costs.

• India has an ab. adv. in pepper

Brazil 10 25 • Brazil has ab. adv. in coffee

The numbers in the matrix represent price.

7
Say, the cost difference is solely due to productivity differences.
• Let the countries be identical in all respect except labour productivity
• Let the total number of labour available in each country = 100
• Market structure – perfectly competitive (P = MC)
• Production subject to Constant returns to scale (AC = MC)
• Identical wages in both countries

• This implies higher labour productivity

→ lower labour requirement coffee Pepper
(and identical wages)
→ lower AC India 20 5
→ lower MC
→ lower price
Brazil 10 25
Price is proportional to labour requirement

The numbers in the matrix represent

labour requirement for unit production

8
 coffee Pepper
India 20 5
Brazil 10 25

9
 coffee Pepper Production possibility frontiers
India 20 5 India’s PPF equation: L(i) = Lci.Qc + Lpi.Qp
Brazil 10 25 => Qp = L(i)/Lpi - Lci/Lpi . Qc
Labour available in each => Qp = 100/5 – 20/5.Qc
country: 100

Brazil’s PPF equation: L(b) = Lcb.Qc + Lpb.Qp

=> Qp = L(b)/Lpb – Lcb/Lpb. Qc
=> Qp = 100/25 – 10/25. Qc

L(i) = total availability of labour in India

L(b) = total availability of labour in Brazil
Lci = labour required to produce one unit of coffee in India
Lpi = labour required to produce one unit of pepper in India
Lcb = labour required to produce one unit of coffee in Brazil
Lpb = labour required to produce one unit of pepper in Brazil
Qc and Qp are variable quantities of coffee and pepper production
10
 Maximum production possible in
India using the entire labour resource
In absence of trade:

coffee Pepper coffee Pepper

India 20 5 India 5 0
or
Brazil 10 25 0 20
India

Maximum
coffee Pepper
production
possible in Brazil Brazil 10 0 Labour available in
using the entire each country: 100
labour resource or

Brazil 0 4

11
 Production possibility frontiers
pepper
India’s PPF equation:
20
Qp = 100/5 – 20/5.Qc

Brazil’s PPF equation:

Qp = 100/25 – 10/25. Qc

5 10
coffee
12
Relative prices and what do they signify….

Say, Price of pepper = Rs. 5 per unit

And Price of coffee = Rs. 20 per unit
Relative price of coffee = Pc / Pp = 20/5 = 4
If a pepper producer wants to buy 1 unit of coffee, he will have to sell 4
units of pepper.
So in this economy exchange ratio of pepper to coffee = 4

In autarky,
Relative price ratio
= Pc/Pp = relative labour requirement
= L used in 1 unit of Coffee/ L used in 1 unit of Pepper
= slope of PPF

13
 Production possibility frontiers
pepper

20

India’s consumption ,
production in absence
of trade Coffee: Pepper = 60L: 40L
Brazil’s consumption ,
production in absence
4 of trade Coffee: Pepper = 50L: 50L

5 10
coffee
14
 In absence of trade:
Say, India uses 60L in coffee and 40L in
pepper
coffee Pepper coffee Pepper

India 20 5 India 3 8

Say, Brazil uses 50L in coffee and 50L in

Brazil 10 25 pepper
coffee Pepper
Brazil 5 2
Each country produces according to the
domestic demand. Maximum possible Total world production
production – on the PPF.
There is enough demand to produce on
the PPF, i.e., exhaust all resources. coffee Pepper
world 8 10

15
 coffee Pepper

India 20 5
Brazil 10 25 • Once trade is allowed, consumers buy products from the cheaper source
Post trade prices
Price of Pepper rises in India due to increased demand from Brazil
falls in Brazil due to increased supply from India
Price for coffee should increase for Brazil and decrease for India and settle
between 5 and 25 say at 20

Price of Coffee rises in Brazil due to increased demand from India

falls in India due to increased supply from Brazil
• Price for pepper should increase for India and decrease for Brazil and settle
between 10 and 20 say at 15

16
Workers’ pre trade wage
Wage for Coffee workers in Brazil = price / number of workers = 10 / 10 = 1
Wage for Pepper workers in Brazil = 25 / 25 = 1

Wage for Coffee workers in India = price / workers = 20 / 20 = 1

Wage for Pepper workers in India = 5 / 5 = 1

Workers’ post trade wage

Wage for Coffee workers in Brazil = price / number of workers = 15 / 10 = 1.5
Wage for Pepper workers in Brazil = 20 / 25 = 0.8
So in Brazil workers shift from Pepper to Coffee.

Wage for Coffee workers in India = price / workers = 15 / 20 = 0.75

Wage for Pepper workers in India = 20 / 5 = 4
So in India workers shift from Coffee to Pepper.

This makes the two countries completely specialise in the two products.
Wage in both countries rise.
In Brazil it rises to 1.5 from 1. In India it rises to 4 from 1. 17
Under free trade:
Indian specialises in pepper and uses 100L
in pepper
coffee Pepper
coffee Pepper

India 20 5 India 0 20

Brazil specialises in coffee and uses 100L in

Brazil 10 25
coffee coffee Pepper

Brazil 10 0

Total world production

coffee Pepper

world 10 20

18
Gains from trade:

coffee Pepper
Total world production world 10 20
after trade
Total world production world 8 10
before trade

• Total world supply increases – for both goods (Production gain)

• Consumers gain due to price fall, in some commodities
• Producers or workers gain duo to wage rises.

• Unemployment:
Note the assumption that all that is produces is sold. There is enough
demand. Rather a questionable assumption.

19
 Prices and possibility of consumption gain

Pre-trade prices Pre-trade Post trade prices Post-trade

Pc/Pp Pc/Pp
coffee Pepper coffee Pepper

India 20 5 20/5 = 4 15 20 15/20 = 0.75

Brazil 10 25 15 20 15/20 = 0.75

2/5 = 0.4

Relative prices
Pc/Pp fall in India, rise in Brazil relative to the autarky level.

Absolute prices equalise across countries for each product.

Relative prices also equalize across countries.

20
 Production and consumption possibility frontiers
pepper Pre-trade Post-trade
Pc/Pp Pc/Pp
20 India 4 0.75

Possibility of
consumption
gain

5 10
coffee
21
 Production and consumption possibility frontiers
pepper Pre-trade Post-trade
Pc/Pp Pc/Pp
20 Brazil 0.4 0.75

Possibility of
consumption
gain
4

5 10
coffee
22
Terms of Trade

For any country

TOT = Price of export good/ price of import good

For India,
TOT = price of pepper / price of coffee
TOT rises from 5/20 to 20/15
Or from 0.25 to 1.33

For Brazil,
TOT = price of coffee / price of pepper
TOT rises from 10/25 to 15/20
Or from 0.4 to 0.75

23
Possible Consumption Gain due to

selling goods (exports) at a higher price (than in autarky)

and buying goods (imports) cheaper (than in autarky)

24
So, is trade all beneficial? Is there no problem?

Yes there are

• There is short term unemployment.
But how short is the short term?

• Increasing consumption ‘possibility’ may not mean that actual

consumption rises for all.
Consumption may increase for some and decrease for others.

25
Implicit assumptions:

1. Only labour productivity matters

2. Labour requirements do not change with scale of operation (CRF or CRS)
3. Competitive factor and product markets (low price comes from low cost)
4. No transportation costs
5. Advantage is based on productivity
6. Size of market, labour force is identical.
7. Demand is always large enough to maintain full employment
8. No labour migration, no capital inflows or outflows
9. Goods trade only, no services trade, buyers and produces may remain
separated
10. Each nation has an advantage in production.

26
Reading

Most relevant – slides and class notes

You may also refer to

“Trade and Technology – The Ricardian Model ”

27