Learning unit 1: International trade theory.

Ricardian theory of comparative advantage.

Important concepts
Offer Curves:
 Offer curves (sometimes called reciprocal demand curves) introduced to international
economics by Marshall and Edgeworth.
 Shows how much of its import commodity a nation demands for it to be willing to
supply various amounts of its export commodity.
 Can be derived from production possibilities frontier, indifference map and various
hypothetical relative commodity prices at which trade could take place.

Terms of trade:
 It is the ratio of the price of a nation’s export commodity to the price of its import
commodity.
 In a two-nation world, the terms of trade of Nation 1 are equal to the reciprocal of the
terms of trade of Nation 2.
 In a world of many traded goods, the terms of trade is the ratio of the export price
index to the import price index, also called commodity or net barter terms of trade.
 If Nation 1 exports X and imports Y, its terms of trade are given by PX/PY, where P
= price index.

Ricardian theory of comparative advantage.

 This is an approach, in which international trade is solely due to international
differences in the productivity of labour.
 Production possibilities are determined by the allocation of a single resource, labour,
between sectors.
 Countries will export goods that their labour produces relatively efficiently and will
import goods that their labour produces relatively inefficiently.
 In other words, a country’s production pattern is determined by comparative
advantage.
Samuelson and Jones specific factors model;
 The specific factors model was developed by Paul Samuelson and Ronald Jones.
 Like the simple Ricardian model, it assumes an economy that produces two goods and
that can allocate its labour supply between the two sectors.
 Unlike the Ricardian model, however, the specific factors model allows for the
existence of factors of production besides labour.
 Whereas labour is a mobile factor that can move between sectors, these other factors
are assumed to be specific. That is, they can be used only in the production of
particular goods.
 Trade will:
o Have an ambiguous effect on a nation’s mobile factors,
 o Benefit the immobile factors specific to a nation’s export commodities or
sectors, and
o Harm the immobile factors specific to a nation’s import-competing
commodities or sectors.
NB: The specific factors model allows trade to affect income distribution.
Assumptions of the model:
 Two goods, cloth and food.
 Three factors of production: labor (L), capital (K) and land (T for terrain).
 Perfect competition prevails in all markets.
 Cloth produced using capital and labor (but not land).
 Food produced using land and labor (but not capital).
 Labor is a mobile factor that can move between sectors.
 Land and capital are both specific factors used only in the production of one good.
NB: These assumptions place the specific factor model squarely between an immobile factor
model and the Heckscher-Ohlin model. In an immobile factor model, all of the factors of
production are specific to an industry and cannot be moved. In a Heckscher-Ohlin model,
both factors are assumed to be freely mobile; that is, neither factor is specific to an industry.
Since the mobility of factors in response to any economic change is likely to rise over time,
we can interpret the immobile factor model results as short-run effects, the specific factor
model results as medium-run effects and the Heckscher-Ohlin model results as long-run
effects.
How much of each good does the economy produce?
 The production function for cloth gives the quantity of cloth that can be produced
given any input of capital and labour:

𝑸𝑪 = 𝑸𝑪 (𝑲,𝑳𝑪 ) -------------------------------------------equation 1

– Q is the output of cloth

C
– K is the capital stock
– L is the labor force employed in cloth.
C
Production Function for Clothing.
Figure 1

 The more labor employed in the production of cloth, the larger the output. As a result
of diminishing returns, however, each successive person-hour increases output by less
than the previous one; this is shown by the fact that the curve relating labor input to
output gets flatter at higher levels of employment.

 The production function for food gives the quantity of food that can be produced
given any input of land and labor:
𝑸𝑭 = 𝑸𝑭 (𝑻,𝑳𝑭 ) --------------------------------------------------------equation 1.
– Q is the output of food
F
– T is the supply of land
– L is the labor force employed in food
F
 The shape of the production function reflects the law of diminishing marginal
returns.
o Adding one worker to the production process (without increasing the amount
of capital) means that each worker has less capital to work with.
o Therefore, each additional unit of labor adds less output than the last.
 The marginal product of labour is the increase in output that corresponds to an extra
unit of labour. And in the clothing sector marginal product of labor is equal to the
slope of the production function.
 Is when the sector employs more labor.
Figure 2.

 For the economy as a whole, the total labour employed in cloth and food must equal
the total labour supply:
𝑳𝑪 + 𝑳𝑭 = L ----------------------------------------------------------equation 2.

Use above equations to derive the production possibilities frontier of the economy.
Figure 3.

 The production possibilities frontier exhibits increasing opportunity costs.

 This is because expansion of one industry is possible by transferring labour out of the
other industry, which must therefore contract.
 Due to the diminishing returns to labour, each additional unit of labour switched will
have a smaller effect on the expanding industry and a larger effect on the contracting
industry.
 This means that the graph of the PPF in the specific factor model will look similar to
the PPF in the variable proportion Heckscher-Ohlin model. However, in relation to a
model in which both factors were freely mobile, the specific factor model PPF will lie
on the interior. This is because the lack of mobility by one factor, inhibits firms from
taking full advantage of efficiency improvements that can arise when both factors can
be freely reallocated.

Prices, Wages, and Labour Allocation.

How much labour is employed in each sector?

 Need to look at supply and demand in the labour market.
Demand for labour:
 In each sector, employers will maximize profits by demanding labour up to the point
where the value produced by an additional hour equals the marginal cost of
employing a worker for that hour.

 The demand curve for labour in the cloth sector:𝑀𝑃𝐿𝐶 𝑥 𝑃𝐶 = 𝑊

o The wage equals the value of the marginal product of labor in manufacturing.
 The demand curve for labor in the food sector: 𝑀𝑃𝐿𝐹 𝑥 𝑃𝐹 = 𝑊
o The wage equals the value of the marginal product of labour in food.

NB:
• The two sectors must pay the same wage because labor can move between sectors.
• If the wage were higher in the cloth sector, workers would move from making food to
making cloth until the wages become equal.
– Or if the wage were higher in the food sector, workers would move in the
other direction.
• Where the labor demand curves intersect gives the equilibrium wage and allocation of
labor between the two sectors.
The Allocation of Labour.
Figure 4
  From the diagram labor is allocated so that the value of its marginal product (P ×
MPL) is the same in the cloth and food sectors. In equilibrium, the wage rate is equal
to the value of labor’s marginal product.
 At the production point, the production possibility frontier must be tangent to a line
whose slope is minus the price of cloth divided by that of food.
 Relationship between relative prices and output:

𝑀𝑃𝐿𝐹 𝑃𝐶
− =−
𝑀𝑃𝐿𝐶 𝑃𝐹
Production in the Specific Factors Model.
Figure 5.

 The economy produces at the point on its production possibility frontier (PP) where
the slope of that frontier equals minus the relative price of cloth.
What happens to the allocation of labour and the distribution of income when the prices
of food and cloth change?
Two cases:
o An equal proportional change in prices.
o A change in relative prices.
 When both prices change in the same proportion, no real changes occur.
 The wage rate (w) rises in the same proportion as the prices, so real wages (i.e., the
ratios of the wage rate to the prices of goods) are unaffected.
 The real incomes of capital owners and landowners also remain the same.
An Equal-Proportional Increase in the Prices of Cloth and Food.
Figure 5.

The labour demand curves in cloth and food shift up in proportion to the right 𝑃𝐶 from
𝑃𝐶1 to 𝑃𝐶2 and the rise in 𝑃𝐹 from 𝑃𝐹1 to 𝑃𝐹2 . The wage rate rises in the same proportion
from 𝑊 1 to 𝑊 2 but the allocation of labour between two sectors does not change.
When only 𝑃𝐶 rises, labour shifts from the food sector to the cloth sector and the
output of cloth rises while that of food falls.
The wage rate (w) does not rise as much as 𝑃𝐶 since in the cloth sector, employment
increases and thus the marginal product of labour in that sector falls.
 Rise in the Price of Cloth.
Figure 6.

The cloth labor demand curve rises in proportion to the 7 percent increase in P , but the wage
C
rate rises less than proportionately. Labor moves from the food sector to the cloth sector.
Output of cloth rises; output of food falls.

The Response of Output to a Change in the Relative Price of Cloth.

Figure 7.
The economy always produces at the point on its production possibility frontier (PP) where
the slope of PP equals minus the relative price of cloth. Thus, an increase in 𝑃𝐶 > 𝑃𝐹 causes
production to move down and to the right along the production possibility frontier
corresponding to higher output of cloth and lower output of food.
Determination of Relative Prices.
Figure 8.

In the specific factors model, a higher relative price of cloth will lead to an increase in the
output of cloth relative to that of food. Thus, the relative supply curve RS is upward sloping.
Equilibrium relative quantities and prices are determined by the intersection of RS with the
relative demand curve RD.

Relative Prices and the Distribution of Income.

 Suppose that PC increases by 10%. Then, the wage would rise by less than 10%.
 What is the economic effect of this price increase on the incomes of the following
three groups?
 Workers, owners of capital, and owners of land.
o Owners of capital are definitely better off.
o Landowners are definitely worse off.
o Workers: cannot say whether workers are better or worse off: Depends on the
relative importance of cloth and food in workers’ consumption.
International Trade in the Specific Factors Model.
Trade and Relative Prices.

o The relative price of cloth prior to trade is determined by the intersection of

the economy’s relative supply of cloth and its relative demand.
 o Free trade relative price of cloth is determined by the intersection of world
relative supply of cloth and world relative demand.
o Opening up to trade increases the relative price of cloth in an economy whose
relative supply of cloth is larger than for the world as a whole.

Trade and Relative Prices.

Figure 9.

The figure shows the relative supply curve for the specific factors economy along with the
world relative supply curve. The differences between the two relative supply curves can be
due to either technology or resource differences across countries. There are no differences in
relative demand across countries. Opening up to trade induces an increase in the relative price
𝑃 𝑃
from (𝑃𝐶 )1 to (𝑃𝐶 )2.
𝐹 𝐹

International Trade in the Specific Factors Model.

Gains from trade.
 Without trade, the economy’s output of a good must equal its consumption.
 International trade allows the mix of cloth and food consumed to differ from the mix
produced.
 The country cannot spend more than it earns:

PC DC  PF DF  PCQC  PFQF
 The economy as a whole gains from trade. It imports an amount of food equal to the
relative price of cloth times the amount of cloth exported.

P 
DF  QF   C   QC  DC 
 PF 
 – It is able to afford amounts of cloth and food that the country is
not able to produce itself.
– The budget constraint with trade lies above the production
possibilities frontier.

Budget Constraint for a Trading Economy and Gains from Trade.

Figure 10.

Point 2 represents the economy’s production. The economy can choose its consumption point
along its budget constraint (a line that passes through point 2 and has a slope equal to minus
the relative price of cloth). Before trade, the economy must consume what it produces, such
as point 1 on the production possibility frontier (PP). The portion of the budget constraint in
the colored region consists of feasible post-trade consumption choices, with consumption of
both goods higher than at pre-trade point 1.

International Labour Mobility.

 Movements in factors of production include

o Labour migration
o The transfer of financial assets through international borrowing and lending
o Transactions of multinational corporations involving direct ownership of
foreign firms.
 Like movements of goods and services (trade), movements of factors of production
are politically sensitive and are often restricted.
 Why does labour migrate and what effects does labour migration cause?
 Workers migrate to wherever wages are highest.
 Consider movement of labour across countries instead of across sectors.
 Suppose two countries produce one non-traded good (food) using two factors of
production: Land cannot move across countries but labour can.

• Starting with 𝑂𝐿1 workers in the Home country earning a lower real wage at point C
than the 𝑂1 𝐿∗ in a Foreign (Point B).

– Lower wage due to less land per worker (lower productivity).

 Workers in the home country want to migrate to the foreign country where they can
earn more.
 If no obstacles to labor migration, workers move from Home to Foreign until the
purchasing power of wages is equal across countries (point A), with 𝑂𝐿2 in Home and
𝑂2 𝐿∗ workers in Foreign.

 Emigration from Home decreases the supply of labor and raises real wage of the
workers who remain there.

 Workers who start in the Home country earn more due to emigration regardless if they
are among those who leave.
– Immigration into Foreign increases the supply of labor and
decreases the real wage there.
 Wages do not actually equalize, due to barriers to migration such as policies
restricting immigration and natural reluctance to move.
Causes and Effects of International Labor Mobility.

Figure 11

Initially 𝑂𝐿1 workers are employed in Home 𝑂1 𝐿∗ workers are employed in a Foreign.
Labor migrates from Home to Foreign until 𝑂𝐿2 workers are employed in Home.
𝑂2 𝐿∗ in Foreign and wages are equalized.

• Workers initially in Home benefit while workers in Foreign are hurt by inflows of
other workers.
– Landowners in Foreign gain from the inflow of workers
decreasing real wages and increasing output.
– Landowners in Home are hurt by the outflow of workers
increasing real wages and decreasing output.

QUESTIONS AND SOLUTIONS.

QUESTION: Assume a hypothetical economy, Namibia, producing 2 goods, computers
and maize. Assume cars are capital specific and maize is land specific. Further, labour
should be assumed to be the mobile factor. Using a well-drawn diagram, explain how
trade affects the relative prices of cars and maize and how Namibia responds to the
changes in the relative prices because of trade.
 Trade has substantial effects on the income distribution within each trading nation.
 There are two main reasons why international trade has strong effects on the
distribution of income:
 Resources cannot move immediately or costlessly from one industry to another.
 Industries differ in the factors of production they demand.
 The specific factors model allows trade to affect income distribution.

Assumptions of the Model.

 Assume that we are dealing with Namibia that can produce two goods, cars and
maize.
 There are three factors of production; labour (L), capital (K) and
land (La).
 Cars are produced using capital and labour (but not
land).
 Maize is produced using land and labour (but not capital).
– Labour is therefore a mobile factor that can be used in either sector.
– Land and capital are both specific factors that can be used
only in the production of one good.
 Perfect Competition prevails in all markets.
 How much of each good does the economy produce? – The economy’s output of cars
depends on how much capital and labour are used in that sector. Note that such a
relationship is summarized by a production function.
 The full employment of labour condition requires that the economy-wide supply of
labour must equal the labour employed in computers plus the labour employed in
maize: then we can derive the production possibilities frontier of the Namibia’s
economy and shape of the production function reflects the law of diminishing
marginal returns.

Trade and Relative Prices.

 The effect of international trade on relative prices for specific factors is given by
diagram
  In the absence of trade, Namibia’s relative price is determined by RDworld and
domestic relative supply (RS) at the level of (Pc/Pm)1.
 When Namibia opens up to trade, the relative price of cars is determined by the
relative supply and demand for the world.
 Therefore, the relative price is (Pc/Pm)2, which is higher than (Pc/Pm)1.

 On how will Namibia responds to the changes in the relative prices because of trade,
the increase in relative price from (Pc/Pm)1 to (Pc/Pm)2 induces Namibia to produce
more cars. At the same time, consumers will respond to the higher relative price of
cars by demanding more maize (because maize is relatively cheaper).At this new
relative price, the economy exports cars and imports maize.

Why would a country opt for free trade when some workers remain unemployed in the
importing-competing sector? Given the real wage in Thailand is higher than that in
Bangladesh, how would international trade affect real wages between them under a
perfectly mobile labour movement.
 A country would opt for international trade even though the workers in the import
competitive sector face the risk of losing their jobs. This is mainly because of the
gains that the consumer realizes if more imports were allowed and the associated
increase in employment in the export sectors. Under perfect labour mobility, if the
real wage in Thailand is higher than Bangladesh, then labour movement from
Bangladesh to Thailand takes place. This reduces the labour force and raises the wage
rates in Bangladesh. Similarly, a movement in labour to Thailand increases the labour
force and reduces the real wage rate in Thailand. The movement between two
countries will continue until the wages in these two countries are equalized.

Consider two countries (Home and Foreign) that produce goods 1 (with labour and
capital) and 2 (with labour and land) according to the production functions described in
problems 2 and 3. Initially, both countries have the same supply of labour (100 units
each), capital and land. The capital stock in Home then grows. This change shifts out
both the production curve for good 1 as a function of labour employed (described in
problem 2) and the associated marginal product of labour curve (described in problem
3). Nothing happens to the production and marginal product curve for good 2.
a. Show how the increase in the supply of capital for Home affects its production
possibility frontier.
The increase in the capital stock in Home will increase the possible production of good 1, but
have no effect on the production of good 2 because good 2 does not use capital in production.
As a result, the PPF shifts out to the right, representing the greater quantity of good 1 that
Home can now produce.
b. On the same graph, draw the relative supply curve for both the Home and the
Foreign economy.

Given the increased production possibility for Home, the relative supply of home (defined as
Q1/Q2) is further to the right than the relative supply for Foreign. As a result, the relative
price of good 1 is lower in Home than it is in Foreign.

c. If those two economies open up to trade, what will be the pattern of trade (i.e.
which country exports which good)?
If both countries open to trade, Home will export good 1, and Foreign will export good 2.
d. Describe how opening up to trade affect all three factors (labour, capital, land) in
both countries.
Owners of capital in Home and owners of land in Foreign will benefit from trade, while
owners of land in Home and owners of capital in Foreign will be hurt. The effects on labour
will be ambiguous because the real wage in terms of good 1 will fall (rise) in Home (Foreign)
and the real wage in terms of good 2 will rise (fall) in Home (Foreign). The net welfare effect
for labour will depend on preferences in each country. For example, if labour in Home
consumes relatively more of good 2, they will gain from trade. If labour in Home consumes
relatively more of good 1, they will lose from trade.

In Home and Foreign, there are two factors each of production, land, and labour used
to produce only one good. The land supply in each country and the technology of
production are exactly the same. The marginal product of labour in each country
depends on employment as follows:

Initially there are 11 workers employed in Home, but only 5 workers in Foreign. Find the
effects of free movement of labour from Home to Foreign in employment, production,
real wages, and the income of landowners in each country.
The real wage in Home is 10, while real wage in Foreign is 18. If there is free movement
of labour, then workers will migrate from Home to Foreign until the real wage is equal in
each country. If 3 workers move from Home to Foreign, then there will be 8 workers
employed in each country, earning a real wage of 14 in each country.
We can find total production by adding up the marginal product of each worker. After
trade, total production is 30 + 29 + 28 + 27 + 26 + 25 + 24 + 23 = 212 in each country for
total world production of 424. Before trade, production in Home was 30 + 29 + 28 = 87
 and production in Foreign was 30 + 29 + ⋯ + 10 = 265. Total world production before
trade was 87 + 265 = 352. Thus, trade increased output by 72.
Workers in Home benefit from migration, while workers in Foreign are hurt. Landowners
in Home are hurt by migration (their costs rise), while Landowners in Foreign benefit.
Production increases in Foreign, but decreases in Home.

Using the numerical example in problem 5, assume now that Foreign limits
immigration, so that only three workers can move there from Home. Calculate how the
movement of these three workers affect the income of five different groups:
a. Workers who were originally in Foreign.
Workers in Foreign are hurt as their wage falls from 14 to 11.
b. Foreign landowners.
Landowners in Foreign benefit as their costs fall by 3 for each worker employed.
c. Workers who stay in Home.
Workers who stay at Home benefit as their wages rise from 10 to 13.
d. Home landowners
Landowners in Home are hurt as their costs rise by 3 for each worker employed.
e. The workers who do move.

The workers who do move benefit by seeing their wages rise from 10 to 18.

End