ECO230Y1 Lecture Notes - Lecture 2: Factor Endowment, Invisible Hand, Money Supply

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Published on 30 Apr 2016
School
UTSG
Department
Economics
Course
ECO230Y1
RICARDO AND COMPARATIVE ADVANTAGE: THE
CLASSICAL MODEL OF TRADE
Gravity trade model
Tij = A Yi x Tj
Di
As the cost of transportation is decreasing over time (death of distance), distance
becomes less important for trade
oGravity model has been very successful to explain the level of trade
empirically, yet has limited use, because:
It does not explain the trade structure, in terms of produced and
imported/exported goods
It does not explain the relation between the trade structure and
factor endowments and prices
It does not measure the benefits of trade for the trade partners
Mercantilism (1500-1750)
National Wealth: Country’s holdings of bullion (specie)
Economic activities are viewed as zero-sum game
oExporter wins, and importer loses
Positive trade balance means inflow of precious metal to the exporting
country from importing country
Increase in national wealth guarantees the financing for stronger military
capabilities
Strong state power is critical to economic success. State should regulate
activities to ensure favourable (positive) trade balance
Commodities are priced by relative labou0=r content. So implicitly assuming
that if economy is below or above full employment, there will be no impacts
on inflation.
David Hume and Price-Specie Mechanism
David Hume (1752) attacks mercantilist views, and focuses on price-specie
flow mechanism:
oTries to include the role of demand
Trade surplus leads to inflow of specie to country
oThis will increase the country’s money supply
oThis in turn will result in higher prices
oCompetitiveness of the country’s goods falls,
oTrade surplus falls
oExact opposite occurs in trading partner. So, trade surplus/deficit is
self-correcting
Adam Smith and Absolute Advantage:
Adam Smith (1776) believed the nation’s wealth arises from its labour
productivity not its store of precious metals:
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oIndividual self-interest & invisible hand of market leads to
specialization & higher productivity
oCountries should specialize,
oCountries should export goods for which they have absolute
advantage, and import where absolute disadvantage
Absolute advantage is the ability to produce goods cheaper, because of a
country’s unique endowments of factors of production.
This argument believes trade is positive sum game with mutual benefits,
which is used for expanding trade, and against mercantilist view.
Ricardian Model of Trade
First attempt to understand gains from trade and pattern of trade, using insight of
Adam Smith about different advantages in production across countries, but focusing
on comparative, rather than absolute advantage.
ASSUMPTIONS: 2 X 2 X 1 model
oOnly two countries and two goods are modeled
oLabour force is the only input important for production
oThe supply of labour force in each country is constant
oLabour force is mobile within countries, but not across countries.
oLabour force productivity is fixed but varies across countries, due to
differences in technology
oLabour market is competitive, so wage is a function of labour
productivity. Labour market is always in full employment
oNo tariffs or transportation costs
*Assumptions are very important in this model
Cars Wheat
Home 10 5
Foreign 2 10
World 30 15
- Consider Home and Foreign countries have 100 units of labour, each
- Required units of labour to produce cars and wheat are:
- If each country allocated half of the labour to each sector
-Absolute Advantage: A country has an absolute advantage in producing X, if
cost producing X is less than in the other country (or its uses less labour force
to produce on unit of X). In this example, Home has an absolute advantage in
producing wheat, and Foreign has an absolute advantage in producing cars
Cars Wheat
Home 10 (2) 5 (0.5)
Foreig
n
2 (0.2) 10 (5)
World 30 15
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RICARDO AND COMPARATIVE ADVANTAGE: THE
CLASSICAL MODEL OF TRADE
- Because resources (labour) are scarce, countries face a trade off or an
opportunity cost.
- In home country, the opportunity cost of producing a car is 2 units of wheat –
the opportunity cost of producing one unit of wheat in home country is ½ a
car
- In foreign country, the opportunity cost of producing one car is 0.2 unit of
wheat, and opportunity cost of wheat is 5 cars.
Opportunity Cost of car = 1/Opportunity Cost of wheat
- home has absolute advance in both sectors
- In home country, the opportunity cost of producing a car is 2 units of wheat,
and opportunity cost of wheat if 0.5 car
- In foreign country, the opportunity cost of producing a car is 0.5 of wheat and
opportunity cost of wheat is 2 cars.
-Comparative advantage: a country has a comparative advantage in
producing X, if the opportunity cost of producing X is less than in the other
country
-Comparative advantages always exist because opportunity costs are
inverse of each other.
Cars Wheat
Home 10 5
Foreig
n
25 50
Cars Wheat
Home 10 5
Foreig
n
25 50
- Based on the Ricardo’s view, countries should specialize in producing goods
that have comparative advantage, not necessarily absolute advantage
- In this example, Home has comparative advantage in producing wheat, and
Foreign has comparative advantage in producing cars. So there is a gain from
specialization and trade.
- Suppose home country wants 1 more car.
1 – home country can sacrifice 2 units of wheat to produce the car
2 – home country can produce 1 more unit of wheat of trade it with 1 car
produced by Foreign country  Home is better off
- Foreign country is willing to make the exchange, because foreign country has
to sacrifice 2 cars to produce…
Hours needed for each house: John Jack
Mowing 1 6
Painting 2 3
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Document Summary

As the cost of transportation is decreasing over time (death of distance), distance becomes less important for trade: gravity model has been very successful to explain the level of trade empirically, yet has limited use, because: It does not explain the trade structure, in terms of produced and imported/exported goods. It does not explain the relation between the trade structure and factor endowments and prices. It does not measure the benefits of trade for the trade partners. National wealth: country"s holdings of bullion (specie) Economic activities are viewed as zero-sum game: exporter wins, and importer loses. Positive trade balance means inflow of precious metal to the exporting country from importing country. Increase in national wealth guarantees the financing for stronger military capabilities. Strong state power is critical to economic success. State should regulate activities to ensure favourable (positive) trade balance. Commodities are priced by relative labou0=r content.

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