Wk2: Thursday, 8/27/2014

I. Role of Autarky Price Differences

Impact of opening to trade
Distribution of GFT across nations
Algebra
II. Begin Ricardo Model
Adam Smith and Doctrine of Mercantilism
Labor Productivity
Smith and Absolute Advantage
Ricardo and Comparative Advantage
Comparative advantage=highest relative productivity=lowest opportunity cost of production
Ricardo Model Graphically
Smith and Mercantilism
Doctrine of Mercantilism
Smiths Criticism
Smiths Result:
world output higher if nations specialize according
to absolute advantage
the industry with the highest labor productivity is
said to have an absolute advantage
Labor Productivity
(1) Assume labor only factor of production.
(2) How to measure labor productivity?

1. Obtain industry data on production (Qi) and employment (Li)
http://www.bea.gov/index.htm
2. Construct ratio:
Q
i
/L
i
or L
i
/Q
i
= a
i


Labor productivity: a
i
= # hrs per good i

Suppose production of 1 cloth: a
C
= 3 hrs per C
Improved productivity lowers a
i
: a
C
= 2 hrs per C

Two industries in each economy

Mexico industry (a
i
) U.S. industry (a
i
*)

4 hrs per 1 C 1.0 hrs per 1 C
2 hrs per 1 W 2.5 hrs per 1 W




Smith & Absolute Productivity
What???
Two industries in each economy

Mexico industry (a
i
) U.S. industry (a
i
*)

4 hrs per 1 C 1.0 hr per 1 C
2 hrs per 1 W 1.5 hrs per 1 W



Ricardos Correction
For trade, its what you do relatively best that
matters.
The product which has the highest RELATIVE
productivity is the one in which you have a
comparative advantage.

IN MODERN TERMS: comparative advantage means
having the lowest opportunity cost or price

<Lets return to previous slides>
Ricardo Theorem


A country should specialize in and export the good in
which its relative productivity is highest.

opportunity cost is lowest
Opportunity Cost
Price of C in autarky

Mexican industry a
i
U.S. industry

a
i
*
4 hrs per 1 C 1.0 hr per 1 C
2 hrs per 1 W 1.5 hrs per 1 W



Autarky prices:
Pc/Pw = 2 W/C > Pc/Pw = 2/3 W/C
Mexico U.S.
- 2 Ws - 2/3 Ws
Pattern of Trade
Mex U.S.
P
c
/P
w
= 2 W/C > P
c
/P
w
= 2/3 W/C


Predicted Trade Pattern:
Mexico imports C U.S. exports C
Mexico exports W U.S. imports W
Sudan before Partition
Six Industries ranked by
absolute productivity
Corn
Wheat
Shoes


Corn
Wheat
Shoes
Sudan After Partition



Sudan South Sudan
Corn Corn*
*Wheat Wheat
Shoes Shoes*


Ricardo Models Insightful Graph
Preliminaries: Ricardo Model
MCc is Marginal Cost
Wheat Slope of PPC always = MCc/MCw
L/a
W
= 50 In autarky, Pc/Pw = MCc/MCw





L/a
C
= 25 Cloth
PPC for Mexico
L=100, a
W
= 2, a
c
= 4

Wheat
50 Pc/Pw = 2 W/C

Diagonal Demand
Dw/Dc


25 Cloth
Determining Consumption Point
L=100, a
W
= 2, a
c
= 4

Wheat

L/a
w
= 66 2/3 Pc/Pw = MCc/MCw = 2/3s W/C




L/a
C
= 100 C
PPC for United States
If L=100, a
W
= 1.5, a
c
= 1
Dw/Dc
Mexico U.S.
W W

Pc/Pw=2 w/c Pc/Pw=2/3 w/c

50


25 C 100 C
Autarky Equilibrium
Dw/Dc
66 2/3
Dw/Dc
Pattern of Trade & Terms of Trade (ToT)
Mexico U.S.


Pc/Pw = 2 W/C > ToT > Pc/Pw = 2/3 W/C

US exports W RoW exports C
Trade Causes Changes in
Composition of Production
Country specializes in producing
product it has comparative advantage in
and shuts down production of other
product