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Comparative Advantage

International Trade – Session 1 Daniel TRAÇA


Globalization I: Increased trade in goods and services

Trade has grown faster than GDP

…mostly for East Asia; it has fallen for Africa
45 30 15 0

Trade (% GDP)

35 30 25 20 15 10 1980 World 1985 1990 High income 1995 Low & middle income

Exports (% GDP)

E-Asia & Pac.

Lat. Am. & Mid East, N South Asia Carib. Af
1960 1970 1980 1990 1998

Sub-S. Africa

International Trade involves mostly exchanges among high income countries.

Developing countries have increased their relevance, particularly East Asia,
but are still a small part.


Trade in services and merchandise

• Most of world trade is in goods (merchandise) – 82%. • Services trail behind, but are the fastest growing component.
– Outsourcing is the latest trend

Share of goods and commercial services in total trade
(Percentages, based on balance of payments data)

Export Shares Commercial Services

Import Shares Commercial Services



World North America

81.4 77.2

18.6 22.8

81.4 85.9

18.6 14.1

Latin America
Western Europe Africa Egypt Nigeria Asia India Indonesia Japan

78.8 81.5 42.5 93.8 85.7 71.4 92.8 87.1

21.2 18.5 57.8 6.2 14.3 28.6 7.2 12.9

79.4 76.8 68.2 71.1 81.3 73.4 72.3 74.8

20.6 23.2 31.8 28.9 18.7 26.6 27.7 25.2


by group 75% 2 25% Low income Middle income High income 0 1976 World 1981 1986 High income 1991 1996 0% Low & middle income 1980 1985 1990 1995 |4 .725 25.297 56.8 13.48 19.4 12.542 210.33 4.05 3.49 0.95 3.068 202.52 0.6 9.48 0.850 12.12 1.3 58.8 5.8 41.Globalization II: Foreign Investment .13 0.10 2.complex strategies of multinationals Global FDI Flows FDI in millions of dollars FDI per capita (dollars) FDI as percentage of GDP FDI as percentage of exports 2000 1995 1990 1985 1980 1975 1970 1.96 0.270.764 331.56 Gross foreign direct investment (% of GDP) 8 6 4 50% 100% Share of FDI flows.45 6.3 3.583 54.99 6.

Drivers of Modern Globalization • Lower transport and communication costs • Development of international institutions – The WTO – Regional Trade Agreements • Political decisions toward de- regulation and liberalization of trade and FDI regulations |5 .

Theory and practice of international trade and foreign investment WHAT WE WILL LEARN… • • • • • • • • Why do countries export certain goods and imports others? What do countries and populations gain and loose from trade? Why do multinationals exist and what are their effects? Why do governments protect their industries and what are the costs and benefits? What are the effects of different protectionist instruments? How do the institutions that regulate global trade work? What have been the economic and social consequences of the rise in trade and foreign investment with developing nations? What has globalization brought to developing countries? |6 .

T.O – Regional agreements |7 .Organization of the course • Theories of international trade – Comparative advantage – Gains from trade: static and dynamic – Losers and winners • The effects of modern globalization – Trade and the developing countries – Multinationals and FDI – The effects in industrialized countries • Trade policy – Policy Instruments – The case for free-trade and exceptions – Policies for Strategic sectors – Political economy and the realist view • Institutions of global trade – The W.

Addison-Wesley • Available in French – Additional readings available at website |8 . and Obstfeld M.danieltraca. 7th ed”by Krugman • Download class slides before class from website – Also available at GES • Practice exams and answer keys available at website. List of required sections available from website • Recommended textbook – “International Economics.Materials and exams course website: www.

The theory of Comparative Advantage 9 .

better buy it of them …” – Adam Smith 1776 |10 . never attempt to make at home what it will cost him more to make than buy … What is prudent in the conduct of every family can scarce be folly in that of a great kingdom If a foreign country can supply us with a commodity cheaper than we ourselves can make it.Absolute Advantage • “It is the maxim of every prudent master of the family.

Absolute Advantage Output per worker (productivity) Manufacturing (pieces) Food (bushels) NORTH SOUTH 10 3 8 9 |11 .

if specialization follows absolute advantage 1 northerner (FOOD to MANUF) 8 Food 10 Manuf 1 southerner (MANUF to FOOD) 3 Manuf 9 Food |12 .Gains from specialization Output before after • North specializes in Manufacturing and South in Food • There is more of both goods.

in return for such commodities. import a fraction of the corn required for its consumption. even if … corn could be grown with much less labour than in the country from which it was imported." – David Ricardo |13 .Comparative Advantage • "A country … enabled to manufacture commodities with much less labour that her neighbours may.

Comparative Advantage North is MORE productive in both goods Output per worker (Productivity) Manuf (pieces) Food (bushels) NORTH SOUTH 10 3 10 9 |14 .

|15 . there are gains from specialization Output before after • A country has Comparative Advantage in a given good if its relative productivity in that good is higher than in other goods 1 northerner (Food to Manuf) 10 Food 10 Manuf • 2x3 6 Manuf 2x9 18 Food 2 southerners (Manuf to Food) Specialization according to Comparative Advantage creates value.Even so. by increasing output.

How does the market work? • Does the decentralized international market achieve this pattern of specialization? How? Who benefits and who looses from international trade in the free-market? – Among individuals within a country? – Among countries? • |16 .

North Northern worker They work in both sectors.. and trade among them at the autarky relative price The relative price P=p Manuf/pFood Manuf •In equilibrium. •They must get the same wage |17 South Food .. workers must be indifferent between the two sectors.In Autarky.

The prices in autarky (closed economy) The relative price of Manuf (P) denotes how many bushels of Food for one piece of Manuf. Manuf (pieces) Food (bushels) P NORTH SOUTH 10 10 10/10 = 1 3 9 9/3 = 3 |18 .

Relative prices. relative demand P PS= 3 Relative Supply (RSs) South PN= 1 Relative Supply(RSN) North Relative demand (RDW) It is the same in both countries if preferences are the same [Manuf/Agro]S [Manuf/Agro]N Manuf/Agro |19 . relative supply.

.In Autarky.. Northern worker Southern worker North Food The Northerners trade among them at the autarky price PN = 1 South Food The Southerners trade among them at the autarky price PS= 3 Manuf Manuf |20 .

Wages and productivity • Are the wages the same in both sectors? Why? – If not. where are they higher? Why? • Are they the same in both countries? Why? – If not. where are they higher? Why? |21 .

So that both goods are produced -1/PN = -1 10 Northern Workers in Agro Agro |22 .The Production Possibility Frontier and Welfare North Manuf 10 +1 Production Possibility Frontier Northern Workers in Manuf Slope = -1 -ProdF / ProdM The choice of consumers …determines the allocation of labor MRS =MUFood/ MUManuf = 1/P =1 UN Equilibrium P=1.

The beginnings of Trade… • Manuf is relatively cheaper in the North. she could sell 1 Foods for 1 Manuf with a net gain of 1 Food. – An enterprising Northerner takes 1 Manuf to the South and exchange it for 3 Foods. • There are gains from exchange because prices are different: Trade occurs! – What happens to the relative price of Manuf in North? … – And in the South? |23 . – Back in the North.

. Prices adjust to new scarcity P rises in the North and falls in the South South PS < 9/3 Food Food Manuf 1 . North PN >10/10 2 ..Openness in the Short Run. Trade starts due to arbitrage Manuf |24 .

Factors (workers) respond to new prices and profitability -. the good in which it has PS < 9/3 Food comparative advantage Food Manuf There is one world price. and exports. there is reallocation North PN >10/10 South Each country specializes completely in. which is between the initial prices 10/10 < PW <9/3 Manuf 3 .In the Long-Run.specialization |25 .

How to determine the world price? North and South produce only Manuf P 3 North and South specialize completely North produces Manuf only South produces both Relative Supply (RSW) World 1<PW <3 1 North and South produce only Food South produces Food only North produces both Relative Demand (RDW) World Manuf/Food |27 .

The Gains from Trade according to Comparative Advantage Manuf 10 -1/PW -1/PN North Manuf South UN(Manuf) 3 UN US(Food) -1/PW -1/PS US 9 |28 10 Food Food .

Some unrealistic features of the model. so far… • What if there are transport costs? • What if there are more than two goods? • What if factors cannot adjust to other sectors? • What if there are more than one factor? • Why is there always complete specialization? |30 .

• Otherwise. if transport costs fall or the productivity advantages widen (globalization).Transport Costs and Non-traded goods • If there are transport costs. even if it is cheaper to produce in one country. • It can become tradable. the competitiveness edge of a country must more than make up for this transport cost. |31 . – In reality. economies spend large proportions of their income in these type of goods. This good is called non-tradable. the good will not be traded.

many goods and services have become tradable. • Non-tradable goods have their prices set by supply and demand in local markets. Nontradables • Cement • Housing • McDonalds Hamburger Tradables Goods • Textiles • Machinery • Almost all goods • With globalization. local markets TRADABLES and NON-TRADABLES • Tradable goods can travel across borders and have international markets that set prices. – Often.Global markets vs. the same good exists in different countries because it is produced locally. Services • Hairdressers • Government services • Auto-repair • Almost all services • • • • Consulting Banking Telecom’s Tourism |32 .

• Every country always has an industry in which it has Comparative Advantage and it is competitive in world markets for that industry.Summary • Comparative advantage: – Consumers react to price differences and buy from lower price foreign producers the goods in which their country does not have comparative advantage (gains from exchange). |33 . exporting those goods (gains from specialization). – Producers react to price differences and allocate resources to industries where relative productivity is higher.