Leah Marcal: Education

Leah Marcal
• Education:
B.A. in Economics –UC Santa Cruz
M.S. and PhD in Economics –UW Madison
• Background:
Bass Lake
• Teaching Experience:
ECON 160, 310, 406, and 500
Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-1

Leah Marcal (cont.)
• Research:
College Assessment Director
• Employer, alumni, and student satisfaction
surveys
• Returns to college education
• Interests:
Hiking
Texas Hold’em

Your Introductions:
• Name
• Home
• Employment
• Favorite movie

Syllabus
• Preparation:
Completion of ECON 309 and 310, and
passed UDWPE
• Textbook:
Krugman and Obstfeld, International
Economics: Theory and Policy, 8th edition

Syllabus (cont.)
• Review:
Class website:
www.csun.edu/~lem50734/econ405index.html
• PPT slides for each topic/lecture
• Answers to selected questions at the end of each
chapter

Syllabus (cont.)
• Presentation:
Teams of 4 or 5 students
50 min analysis of a current topic using
PPT slides
Preference form (with team members) due
next week!

Syllabus (cont.)
• Assessment:
Presentation (20%)
Midterm (40%)
Final (40%)
• Exams contain T/F, multiple choice, and essay
questions
• No make-up presentations or exams

Syllabus (cont.)
• Office Hours:
JH 4250 on Wednesday from 6:00 to 6:50;
or by appointment
Email your questions:
leah.marcal@csun.edu
• Classes:
14 meetings: 10 lectures, 2 exams, and 2
student presentations

Date Topic Chapters
01-20 to
International Trade 3, 4, 5, 8, and 9
02-17
Student Presentations on
02-24 ---
Trade Topics
03-03 Midterm Exam ---
03-10 to
International Finance 12 through 16
04-28
Student Presentations on
05-05 ---
Finance Topics
05-12 Final Exam ---

Topic 1
Labor Productivity
and Comparative
Advantage: The
Ricardian Model
Slides prepared by Thomas Bishop Copyright © 2009 Pearson Addison-Wesley. All rights reserved.
Preview
• Opportunity costs and comparative advantage
• A one factor Ricardian model
• Production possibilities
• Gains from trade
• Wages and trade
• Misconceptions about trade
• Empirical evidence

Introduction
• Why trade?
Differences in resources (e.g., L, K, T,
natural resources, and technology)
Economies of scale

Comparative Advantage
and Opportunity Cost
• Ricardian model: differences in productivity of
L between countries cause productive
differences, leading to gains from trade.
• Ricardian model uses the concepts of
opportunity cost and comparative advantage.
• The opportunity cost of producing good X is
the cost of not being able to produce good Y
because resources have already been used to
produce good X.

and Opportunity Cost (cont.)
• A country faces opportunity costs when it
uses resources to produce goods and
services.
• E.g., a limited number of workers could be
employed to produce roses or PCs.
 Opportunity cost of producing PCs is the amount
of roses not produced
 Opportunity cost of producing roses is the amount
of PCs not produced
 How many PCs or roses should a country produce
with the limited resources it has?

• Suppose U.S. can produce 10 million roses
with the same resources that could produce
100,000 PCs.
• Ecuador can produce 10 million roses with the
same resources that could produce 30,000
PCs.
• Workers in Ecuador are less productive than
those in U.S. in manufacturing PCs.
• Question: what is the opportunity cost of roses
in Ecuador?

• Ecuador has a lower opportunity cost of
producing roses.
• U.S. has a lower opportunity cost of producing
PCs.
 Ecuador: 10 million roses or 30,000 PCs
 US: 10 million roses or 100,000 PCs

• 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.
• A country with a comparative advantage in
producing a good uses its resources most
efficiently when it produces that good
compared to producing other goods.

• U.S. has a comparative advantage in the production
of PCs.
• Ecuador has a comparative advantage in the
production of roses.
• Suppose initially that Ecuador produces PCs and U.S.
produces roses, and that both countries want to
consume PCs and roses.
• Can both countries be made better off?

Comparative Advantage and Trade
Millions of Roses Thousands of

Computers
U.S. -10 +100
Ecuador +10 -30
Change 0 +70

Comparative Advantage and Trade (cont.)
• Example shows that when countries
specialize in the good in which they have a
comparative advantage, more goods can be
produced and consumed.
 Initially both countries could only consume 10
million roses and 30,000 PCs.
 With specialization, they could still consume 10
million roses, but could consume 70,000 more
PCs.

A One Factor Ricardian Model
• Example with roses and PCs explains the
intuition behind the Ricardian model.
• Ricardian model assumes:
1. L is the only resource for production.
2. Supply of L in each country is fixed.
3. Only 2 goods are produced and consumed: wine
and cheese.
4. L is not specific to either industry.
5. Only 2 countries: home and foreign.

A One Factor Ricardian Model (cont.)
• aLW and aLC are the unit labor requirements to
produce wine and cheese. Each reflects the
number of L hours required to produce 1 unit of
output.
 E.g., if aLW = 2, then it takes 2 hours to produce 1
gallon of wine.
 E.g., if aLC = 1, then it takes 1 hour to produce 1 lb of
cheese.
 A high unit labor requirement means low labor
productivity.

Production Possibilities
• PPF of a country shows the maximum amount of
goods that can be produced with a fixed amount of
resources.
• PPF has the equation:
aLCQC + aLWQW = L
Total labor supply
Labor used in Labor used in

cheese production wine production

Fig. 1: Home’s Production Possibility
Frontier

Production Possibilities (cont.)
aLCQC + aLWQW = L
• QC = L/aLC when QW = 0
• QW = L/aLW when QC = 0
• Slope of the PPF = ∆Qw / ∆Qc = – (aLC /aLW )

→ opportunity cost of cheese
• Note: slope of any PPF reflects the opportunity cost of
the good that is graphed on the x-axis (in terms of the
good that is graphed on the y-axis).

Production Possibilities (cont.)
• The amount of the economy’s production is
defined by:
aLCQC + aLWQW ≤ L
• This equation describes what an economy
can produce, but to determine what the
economy does produce, we must determine
the price of goods.

Production, Prices and Wages
• Let PC = price of cheese and PW = price
of wine.
• Hourly wages reflect the value of what a
worker can produce in 1 hour.
 Hourly wage in cheese industry = PC /aLC
 Hourly wage in wine industry = PW /aLW
• Workers will work in the industry that pays a

higher hourly wage.

Production, Prices and Wages (cont.)
• If PC /aLC > PW/aLW (or PC /PW > aLC /aLW )
workers will make only cheese.
 Economy specializes in cheese production if the
relative price of cheese > opportunity cost of
cheese.
• If PC /aLC < PW /aLW (or PC /PW < aLC /aLW )

workers will make only wine.
 Economy specializes in wine production if the
relative price of cheese < opportunity cost of
cheese.

Production, Prices and Wages (cont.)
• If a country wants to consume both goods
(without trade), relative prices must adjust so
that wages are equal in both industries.
 If PC /aLC = PW /aLW (or PC /PW = aLC /aLW ) workers
have no incentive to work solely in the cheese
industry or wine industry, so production of both
goods can occur.
 Production (and consumption) of both goods
occurs when the relative price of a good = the
opportunity cost of producing that good.

Trade in the Ricardian Model
• Suppose home has a comparative advantage
in cheese production. Its opportunity cost of
producing cheese is lower than in foreign.
aLC /aLW < a*LC /a*LW
• where * indicates the foreign country

Trade in the Ricardian Model (cont.)
• Suppose home is more efficient in wine and
cheese production.
• It has an absolute advantage in both goods:
 aLC < a*LC and aLW < a*LW
• A country can be more efficient in producing
both goods, but it will have a comparative
advantage in only 1 good—the good that uses
resources most efficiently.

Trade in the Ricardian Model (cont.)
• Even if a country is the most (or least) efficient
producer of all goods, it still can benefit from
trade.
• To see how all countries can benefit from trade,
we calculate relative prices when trade exists.
 Without trade, the relative price of a good equals its
opportunity cost.
• To calculate relative prices with trade, we must
use relative supply and relative demand curves.

Relative Supply
• First we consider relative supply of cheese:
the Qc supplied by all countries relative to the
Qw supplied by all countries at each price of
cheese relative to the price of wine, Pc /PW.

Fig. 2: Relative Supply Curve
Relative price
of cheese, PC/PW
a*LC/a*LW RS
aLC/aLW
L/aLC Relative quantity

L*/a*LW of cheese, QC + Q*C
QW + Q * W

Relative Supply (cont.)
• There is no supply of cheese if its relative
price falls below its opportunity cost.
 Why? because home will specialize in wine
whenever PC /PW < aLC /aLW
 And we assumed that aLC /aLW < a*LC /a*LW so
foreign won’t produce cheese either.
• When PC /PW = aLC /aLW , home will produce

both goods, but foreign will produce only wine.

Relative Supply (cont.)
• When a*LC /a*LW > Pc /PW > aLC /aLW , home
specializes in cheese and foreign specializes
in wine.
 Here home produces L/aLC lbs of cheese and foreign
produces L* /a*LW gallons of wine. This, the relative supply of
cheese = L/aLC / L* /a*LW
• When PC / PW = a*LC /a*LW, foreign produces

both goods, but home produces only cheese.
• When Pc /PW > a*LC /a*LW , there is no supply of
wine.

Relative Demand
• Relative demand for cheese is the Qc
demanded in all countries relative to the Qw
demanded at each PC /PW.
• As PC /PW rises, consumers in all countries will
tend to purchase less cheese and more wine
so that the relative Qc demanded falls.

Fig. 3: World Relative Supply and
Demand

Determination of Prices After Trade
• Equilibrium (PC /PW)t is determined by the
intersection of RS and RD.
• In Fig. 3, point 1, each country specializes in
the production of the good in which it has a
comparative advantage. Home produces
cheese and foreign produces wine.
• In Fig. 3, point 2, home produces both goods
and foreign produces wine.

Gains From Trade
• Gains from trade come from specializing in
the type of production which uses resources
most efficiently, and using the income
generated from that production to buy the
goods and services that countries desire.
 where “using resources most efficiently” means
producing the good in which a country has a
comparative advantage.

Gains From Trade (cont.)
• Think of trade as an indirect method of
production or a means of converting cheese
into wine or vice versa.
• Without trade, a country has to allocate
resources to produce all of the goods that it
wants to consume.
• With trade, a country can specialize its
production and trade (“convert”) produced
goods for the goods that it wants to consume.

Gains From Trade (cont.)
• Without trade, consumption is restricted to
what is produced.
• With trade, consumption possibilities expand
beyond the PPF.
• Easier to understand gains from trade by
using a numerical example.

A Numerical Example
Unit labor requirements for both countries
Cheese Wine
Home aLC = 1 hour/lb aLW = 2 hours/gal
Foreign a*LC = 6 hours/lb a*LW = 3 hours/gal
• aLC /aLW = 1/2 < a*LC /a*LW = 2

A Numerical Example (cont.)
• Home has an absolute advantage in both
goods, but it has a comparative advantage in
cheese production.
• Foreign is less efficient in both goods, but it
has a comparative advantage in wine
production.
• Question: what is home’s opportunity cost of
producing wine? What is its opportunity cost
of producing cheese?

A Numerical Example (cont.)
• With trade, (PC /PW)t must be between aLC /aLW
= 1/2 and a*LC /a*LW = 2.
• Why? What if (PC /PW)t = 3? Then foreign
would refuse to trade as it must give up 3 gal
of wine to purchase 1 lb of cheese.
• Suppose that (PC /PW)t = 1.
 In words, 1 lb of cheese trades for 1 gallon of wine.

Fig. 4: Equilibrium Price with Trade
Pc/Pw
aLC*/aLW* = 2 RS
(Pc/Pw)t = 1
aLC/aLW= 1/2 RD
0 3 (Qc + Qc*)/(Qw + Qw*)

Assumes L = L* = 30

Fig. 5: Gains from Trade Trade
Home Foreign
Qw Qw*
30
CPFt
PPF
L/aLW = 15 CPFt*
10 L*/a*LW = 10 PPF*
0 20 L/aLC = 30 Qc 0 L*/a* = 5 10 Qc*

LC
Note: Slope of the PPF in each country is the opportunity cost of cheese
in terms of wine (i.e., ½ for home and 2 for foreign) and the slope of the
CPFt for both countries is the traded price (i.e., 1).
Assumes each country has 30 hours of labor available (i.e., L = L* = 30).
Gains from Trade (cont.)
• Question: What drives the two countries to

specialize?
 Home views (Pc/Pw)t = 1 which is greater than its
opportunity cost of cheese (1/2), so it increases its
production of cheese.
 Foreign also views (Pc/Pw)t = 1 which is lower
than its opportunity cost of cheese (2), so it
decreases its production of cheese and increases
its production of wine.

Gains from Trade (cont.)
before trade in 1 hr could produce 1 C or ½ W

Home
after trade in 1 hr produces 1 C and trades for 1 W

Foreign
before trade in 1 hr could produce 1/6 C or 1/3 W
after trade in 1 hr produces 1/3 W and trades for 1/3 C
Labor is used twice as effectively when trading for what it

needs instead of producing everything itself.
Wages
• Although the Ricardian model predicts that
relative prices equalize across countries after
trade, it does not predict that relative wages
will equalize.
• Productivity differences determine wage
differences in the Ricardian model.

Wages (cont.)
Before trade:
wage = 1 lb cheese/hr or ½ gal of wine/hr
wage* = 1/6 lb of cheese/hr or 1/3 gal of wine/hr
After trade:
wage = 1 lb cheese/hr exchange for 1 gal of wine/hr
wage* = 1/3 gal of wine/hr exchange for 1/3 lb of cheese/hr
Before trade (in terms of cheese) wages are 6x higher at home. After
trade, wages are only 3x higher at home.

Wages (cont.)
• Recall: home has an absolute advantage in
both goods as it is 6x more productive in
cheese and 1.5x more productive in wine.
• Foreign wages are 1/3 of home’s wages with
trade.
• Foreign has a cost advantage in making wine
(even though home is 1.5x as productive in
wine) because of its low wages.

Wages (cont.)
• Because foreign workers have a wage that is
only 1/3 the wage of domestic workers, they
are able to attain a cost advantage (in wine
production), despite low productivity.
• Because domestic workers have a
productivity that is 6 times that of foreign
workers (in cheese production), they are
able to attain a cost advantage, despite
high wages.

Misconceptions About Trade
1. Free trade is beneficial only if a country is
more productive than foreign countries.
 The least efficient country can still gain from trade
by specializing in its least inefficient (i.e.,
comparative advantage) industry.
• Our example shows home has an AA in both goods. Yet,
foreign still gains by producing wine (its least inefficient
good).
 The benefits of free trade do not depend on

absolute advantage. They depend on comparative
advantage: specializing in industries that use
resources most efficiently.

Misconceptions About Trade (cont.)
2. Free trade with countries that pay low wages
hurts high wage countries.
 Our example shows home is more productive in
both goods and therefore has higher wages than
foreign.
 Foreign’s lower wages are irrelevant to the
question of whether home gains from trade.
 Home gains from trade because it is cheaper in
terms of its own labor for home to produce
cheese and trade for wine rather than produce
wine itself.

Misconceptions About Trade (cont.)
3. Free trade exploits less productive countries.
• Bob Herbert in NY Times (1995): wages CEO of
Gap = $2 million/year vs. wages of its workers in
Central America = $0.56/hr.
• Free trade does not make poor workers worse
off. What are their alternatives?
• Our example shows (with trade) foreign workers
are paid 1/3 of what home workers are paid, Yet,
without trade, foreign workers earn only 1/6 of
home’s workers.

Empirical Evidence
• Ricardian model predicts that countries tend to export
goods in which their productivity is relatively high.
• World trade in textiles/apparel illustrates the principles
of comparative advantage.
 By any measure, the U.S. has a higher labor productivity in
manufacturing than that of newly industrialized countries
(e.g., China or Mexico).
 Technology of manufacturing clothing is relatively simple, so
the productivity advantage of advanced countries in textiles
is less than their advantage in many other industries.
 In 1992, average U.S. worker was 5x as productive as a
Mexican worker but only 1.5x as productive in textiles.
 Thus, textiles/apparel are a major export from low-wage to
high-wage countries.

Leah Marcal: Education

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Millions of Roses Thousands of

U.S. -10 +100

Ecuador +10 -30

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Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-20

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Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-22

Labor used in Labor used in

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• Slope of the PPF = ∆Qw / ∆Qc = – (aLC /aLW )

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Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-26

• Workers will work in the industry that pays a

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• If PC /aLC < PW /aLW (or PC /PW < aLC /aLW )

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L/aLC Relative quantity

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• When PC /PW = aLC /aLW , home will produce

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• When PC / PW = a*LC /a*LW, foreign produces

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Unit labor requirements for both countries

Home aLC = 1 hour/lb aLW = 2 hours/gal

Foreign a*LC = 6 hours/lb a*LW = 3 hours/gal

• aLC /aLW = 1/2 < a*LC /a*LW = 2

Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 3-43

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0 3 (Qc + Qc*)/(Qw + Qw*)

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0 20 L/aLC = 30 Qc 0 L*/a* = 5 10 Qc*

• Question: What drives the two countries to

• When PC / PW = aLC /aLW, foreign produces

Foreign aLC = 6 hours/lb aLW = 3 hours/gal

• aLC /aLW = 1/2 < aLC /aLW = 2

0 3 (Qc + Qc)/(Qw + Qw)

0 20 L/aLC = 30 Qc 0 L/a = 5 10 Qc*