Feenstra Taylor Econ CH02

74
TRADE AND TECHNOLOGY: THE RICARDIAN MODEL 1 Reasons for Trade 2 Ricardian Model 3 Determining the Pattern of International Trade 4 Solving for International Prices 5 Conclusions 2

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TRADE ANDTECHNOLOGY: THE

RICARDIAN MODEL

1Reasons for Trade2

Ricardian Model3

Determining thePattern of 

International Trade4

Solving for International Prices

5Conclusions

2

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Introduction

Why does the U.S. import goods that it couldeasily produce itself with its great manufacturingcapability?

• The first part of this lecture looks at the various

reasons for trade: Technological differences

Differences in amounts of resources

Differences in costs of outsourcing

The proximity of countries to each other 

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Introduction

This chapter focuses on how technologydifferences across countries affect trade. Ricardian model proposed by the 19th century

economist David Ricardo.

• It explains how the level of a country’s technologyaffects wages paid to labor in a way that countrieswith better technology have higher wages.

• We use this to explain a country’s trade pattern—the products it exports and imports.

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Reasons for Trade

1. Proximity The closer countries are the lower the costs of transportation.

For example, the largest trading partner of most

European countries is another European country. Proximity often leads to countries joining into a free

trade area.

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Reasons for Trade

1. Resources A country can have resources that give it an edge inthe production of certain goods. A country with a lot of snow may be very good at producing

snowboards.

Geography includes natural resources (including landand minerals), labor resources, and capital.

Resources are also called factors of production—the land, labor, and capital used to produce goods

and services.

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Reasons for Trade

1. Resources Some countries produce unfinished products that arethen processed in another country.

Unfinished snowboards produced in Mexico

Trade in unfinished goods is an example of outsourcing—when production activities are spreadacross several countries and trade semi-finishedproducts between them.

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Reasons for Trade

1. Absolute Advantage When a country has the best technology for producinga good, it has an absolute advantage in theproduction of that good.

Germany has an absolute advantage in the productionof snowboards.

Why is it that so many are imported from China then?

Or why doesn’t the U.S. just make all its ownsnowboards?

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Reasons for Trade

1. Comparative Advantage Absolute advantage is actually not a good explanation

for trade patterns. Comparative advantage is the primary explanation for 

trade among countries.

A country has a comparative advantage in producingthose goods that it produces best compared with howwell it produces other goods. China does not have an absolute advantage compared to

U.S. but is better at producing snowboards than some other 

goods.

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Ricardian Model

To develop a Ricardian model of trade, we willuse an example with two goods: wheat and cloth. Wheat and other grains are major exports of the U.S.

and Europe.

Many types of cloth are imported into these countries.• Home will be the country exporting wheat and

importing cloth.

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Ricardian Model

The Home Country We will assume that labor is the only resource used toproduce both goods.

One worker can produce 4 bushels of wheat or 2 yards

of cloth. The Marginal Product of Labor is the extra output

obtained by using one more unit of labor.

MPLW = 4 and MPLC = 2.

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Ricardian Model

• Home Production Possibilities Frontier  We can use the marginal products of labor to construct

Home’s PPF.

Assume there are 25 workers in Home.

If all the workers were employed in wheat, the countrycould produce 100 bushels.

If they were all employed in cloth they could produce 50yards.

The PPF connects these two points.

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Ricardian Model

• Showing these calculations we can see:

Labor = 25, MPLW = 4, MPLC = 2

QW = MPLW(L) = 25(4) = 100

QC = MPLC(L) = 25(2) = 50

• This gives us a straight line PPF which is a uniquefeature of the Ricardian model.

It assumes the marginal products of labor areconstant.

There are no diminishing returns because the modelignores the use of other resources.

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Ricardian Model

• The slope of the PPF can be calculated as the ratio of marginal products of the two goods.

• The slope also equals the opportunity cost of wheat—theamount of cloth that must be given up to obtain onemore unit of wheat.

21

)(

)(

100

50

−=−=

=−=

MPLMPL

 LMPL

 LMPLSlopePPF 

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Ricardian Model

Figure 2.1

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Ricardian Model

• Home Indifference Curve Given Home’s PPF, how much wheat and cloth will

home actually produce. The answer depends ondemand.

Demand can be represented with indifference curve.

An indifference curve shows the combinations of twogoods that the country can consume and be equallysatisfied.

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Ricardian Model

• All points on an indifference curve have the samelevel of utility.

• Points on higher indifference curves have higher utility.

• Indifference curves are often used to show thepreferences of an individual.

• But we use indifference curves to show the

preferences of an entire country.

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Ricardian Model

The country is indifferent between Aand B

The country is better off on U2 butcannot produce that much

U0<U1<U2

Figure 2.2

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Ricardian Model

• Home Equilibrium

Without trade, the PPF acts as a budget constraint for the country.

With perfectly competitive markets, the country willproduce at its highest level of utility within the limits of the PPF.

In the graph, the highest level of utility that can be

reached and still stay within the PPF is U1 withproduction at point A.

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Ricardian Model

• Home Equilibrium

Point A is the no-trade equilibrium.

The country can reach point A its own production.

The assumption of perfect competition will assure thecountry ends up at the highest level of utility possible.

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Ricardian Model

The country could produce at point Dbut would be at a higher level of utilityat point A.

At point A, on U1, is the best the

country can do

Figure 2.2

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Ricardian Model

• Opportunity Cost and Prices

The slope of the PPF reflects the opportunity of producing one more bushel of wheat.

Under perfect competition the opportunity cost of wheatshould equal the price of wheat. Price reflects the opportunity cost of a good.

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Ricardian Model

• Wages Determination of wages

In competitive markets firms hire workers up to the point atwhich the hourly wage equals the value of one more hour of production.

The value of one more hour of labor equals the amount of 

goods produced in that hour (MPL) times the price of thegood. Labor hired up to the point where wage equals P*MPL for 

each industry.

In competitive markets, labor can move freely between

industries. Labor will move to the higher paid industry. This will continue until there is equalization of wages

between industries.

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Ricardian Model

The equalization of wages will give us the following: The right hand side is the slope of the PPF and the

opportunity cost of obtaining one more bushel of wheat. The left hand side is the relative price of wheat.

The price ratio, PW/PC, always denotes the relative priceof the good in the numerator, measured in terms of howmuch of the good in the denominator must be given up.

W W C C  

W C 

C W  

  P MPL P MPL

  P MPL

  P MPL

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Ricardian Model

• The Foreign Country Assume Foreign’s technology is inferior to Home’s.

Foreign has an absolute disadvantage in producingboth wheat and cloth as compared to Home.

Foreign Production Possibilities Frontier  Assume a Foreign worker can produce one bushel of wheat or 

one yard of cloth.

MPL*W = 1, MPL*C = 1

Assume there are 100 workers available in Foreign. If all workers were employed in wheat they could produce 100

bushels.

If all workers were employed in cloth they could produce 100yards.

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Ricardian Model

Figure 2.3

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Ricardian Model

• Comparative Advantage Given the information we have gathered, we can begin

to talk about the opportunity cost of production of eachgood in each country.

Given the opportunity cost information, we candetermine comparative advantages in each country for each good.

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Ricardian Model

Opportunity Costs for Goods in Homeand Foreign

1 Yard

of Cloth

1 Bushel

of Wheat

Foreign

½ Yard

of Cloth

2 Bushels

of Wheat

Home

Wheat

(1 Bushel)

Cloth

(1 Yard)

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Ricardian Model

• Comparative Advantage A country has a comparative advantage in a good when

it has a lower opportunity cost of producing thananother country.

By looking at the chart we can see that Foreign has acomparative advantage in producing cloth. Foreign’s Opportunity cost of cloth is lower.

Home has a comparative advantage in producingwheat. Home’s opportunity cost of wheat is lower.

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Ricardian Model

• Equilibrium in Foreign Foreign’s preferences can also be represented by

an indifference curve.

Its economy produces at the point of highest utilityfor the country within the PPF constraint.

The slope of the PPF is the opportunity cost of wheat.

The no-trade relative price of wheat is P*W/P*C = 1.

The relative price exceeds Home’s no-traderelative price of wheat: P*W/P*C = ½ .

The difference in relative prices comes from thecomparative advantage that Home has in wheat.

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Ricardian Model—Foreign

Figure 2.4

Comparative Advantage in Apparel

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APPLICATION 

Comparative Advantage in Apparel,

Textiles, and Wheat 

• U.S. Textile and apparel industries face intense importcompetition.

• Burlington Industries announced in January 1999 it wouldreduce production capacity by 25% due to increased

imports from Asia.

• After layoffs they employed 17,400 persons in the U.S.with sales of $1.6 billion in 1999.

• Sales per employee were therefore $92,000.

• This is the average for all U.S. apparel producers.

• Textiles are even more productive with annual sales per employee of $140,000 in the U.S.

Comparative Advantage in Apparel

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APPLICATION 

Comparative Advantage in Apparel,

Textiles, and Wheat 

• In China, however, sales per employee are only $13,500 inapparel and $9,000 in textiles.

• The U.S. is 7 times more productive in apparel and 16times more productive in textiles.

• So the U.S. has the absolute advantage in these products.

• For wheat, the U.S. produces 27.5 bushels per hour of labor.

China produces only 0.1 bushel per hour of labor.• The U.S. is thus 275 times as productive in wheat.

• It thus has the absolute advantage in wheat.

Comparative Advantage in Apparel

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APPLICATION 

Comparative Advantage in Apparel,

Textiles, and Wheat 

• Since the absolute advantage in wheat for theU.S. is even greater than in apparel and textiles, ithas the comparative advantage in wheat.

• China has the comparative advantage in appareland textiles because its productive disadvantagerelative to the U.S. is less than in wheat.

• This explains why the U.S. imports apparel andtextiles from China despite higher productivity inthe U.S.

Can Comparative Advantage be Created?

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SIDE BAR

Can Comparative Advantage be Created? 

The Case of “Icewine” 

• In general we think of a country having acomparative advantage in a good. Certain countries have a comparative advantage in the

production of wine.• Can a country create a comparative advantage?

Areas that get very cold are not good wine producersbecause the vines get too cold.

Can Comparative Advantage be Created?

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SIDE BAR

Can Comparative Advantage be Created? 

The Case of “Icewine” 

The Niagara Falls region of Canada began producing aproduct called “icewine” in 1983; it’s now made inBritish Columbia, too.

The grapes are allowed to freeze on the vine beforethey are picked.

The unique flavor of the wine has led to a relatively highdemand.

This has created a comparative advantage in a certaintype of wine, even though Canada does not have theadvantage in traditional wine production.

f

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Determining the Pattern of International Trade

• What happens now when goods are tradedbetween Home and Foreign?

• We will see the country’s no-trade relative pricedetermines which product it will export and which

it will import.• The no-trade relative price equals its opportunity

cost of production. Therefore, the pattern of exports and imports will be

determined by the opportunity costs of production ineach country—their comparative advantage.

D t i i th P tt f I t ti l T d

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Determining the Pattern of International Trade

• International Trade Equilibrium

Relative price of cloth in Foreign is PC/PW = 1.

Relative price of cloth in Home is PC/PW = 2.

Therefore Foreign would want to export their cloth to

Home—they can make it for $1 and export it for morethan $1.

The opposite is true for wheat.

Home will export wheat and Foreign will export cloth.

Both countries export the good for which they have thecomparative advantage.

D t i i th P tt f I t ti l T d

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Determining the Pattern of International Trade

• How Trade Occurs As Home exports wheat, quantity of wheat sold at

Home falls.

The price of wheat at Home is bid up.

More wheat goes into Foreign’s market. The price of wheat in Foreign falls.

As Foreign exports cloth, the quantity sold in Foreignfalls, and the price in Foreign for cloth rises.

The price of cloth at Home falls.

D t i i th P tt f I t ti l T d

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Determining the Pattern of International Trade

• International Trade Equilibrium Two countries are in a trade equilibrium when:

the relative price of each good is the same in the twocountries

the amount of each good that the countries want to trade

is equal In understanding the trade equilibrium we need to

do two things: Determine the relative price of wheat or cloth in the trade

equilibrium.

See how the shift from the no-trade equilibrium to thetrade equilibrium affects production and consumption inboth Home and Foreign.

D t i i th P tt f I t ti l T d

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Determining the Pattern of International Trade

• International Trade Equilibrium

The relative price of wheat in the trade equilibrium willbe between the no-trade price in the two countries.

For now we will assume the free-trade price of PW

/PC

is

2/3. This is between the price of ½ in Home and 1 inForeign.

We can now take this price and see how trade changes

production and consumption in each country.

D t i i th P tt f I t ti l T d

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Determining the Pattern of International Trade

• Change in Production and Consumption Home producers of wheat can earn more than the

opportunity cost of wheat by selling it to Foreign.

Home will therefore shift labor resources toward theproduction of wheat and increase its production.

Remember wages are calculated by the price of thegood times its marginal product.

Given the information from before, we can calculate theratio of wages in the two industries.

D t i i th P tt f I t ti l T d

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Determining the Pattern of International Trade

• Home’s workers will want to work in wheat and no

cloth will be produced.• With trade, Home will be fully specialized in wheat

production.

2 4 813 2 6

W W 

C C 

W W C C  

  P MPL

  P MPL

Therefore

  P MPL P MPLWages in wheat Wages in cloth

   

D t i i th P tt f I t ti l T d

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Determining the Pattern of International Trade

• International Trade Home can export wheat at the international relative

price of 2/3.

For each bushel of wheat it exports, it gets 2/3 yards of cloth in return.

In figure 2.5 we trace this out to get a new price lineshowing the world price. The world price line shows the range of consumption 

possibilities that a country can achieve by specializing in one

good and trading. Remember: this is only a consumption possibility because

production is still constrained by the PPF.

D t i i th P tt f I t ti l T d

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Determining the Pattern of International Trade

U2

World price line,Slope = –2/3

U1

A

  50 100 Wheat, QW (bushels)

Cloth, QC (yards)

B

Home production

50

25

• The new world price, PW

/PC

=

2/3, shows us the new range of consumption possibilities

• The country can now achieve ahigher utility with the newconsumption possibilities

D t i i th P tt f I t ti l T d

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Determining the Pattern of International Trade

Home imports 40yards of cloth

Home exports 60 bushels of wheat

Home consumption

A

B

Home production

25

C40 World price line,Slope = –2/3U2

U1

  50 100 Wheat, QW (bushels)

Cloth, QC (yards)

50

  100

Home produces 100 bushels but

consumes only 40, so exports equal 60

50

Home produces 0 yards of cloth butconsumes 40, so imports equal 40.

40

Determining the Pattern of International Trade

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Determining the Pattern of International Trade

• International Trade

Trade allows a country to engage in consumptionpossibilities it did not have before trade.

We can see this as Home can now be on a higher indifference curve with trade than they were without it.

This is the first demonstration of gains from trade.

Determining the Pattern of International Trade

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Determining the Pattern of International Trade

• Pattern of Trade and Gains from Trade

From figure 2.5, we can also see that Home’s exportsand imports are equal when valued in the same units.

Home exports 60 bushels of wheat; multiplying this bythe price of wheat in terms of cloth, 2/3, gives 40. Thisequals the amount of cloth that is imported.

Now consider Foreign. Conditions there are shown in

figure 2-6. 

Determining the Pattern of International Trade

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Determining the Pattern of International Trade

Figure 2.6

Determining the Pattern of International Trade

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Determining the Pattern of International Trade

• Pattern of Trade and Gains from Trade

Each country is exporting the good for which it has thecomparative advantage.

This confirms that the pattern of trade is determined bycomparative advantage. This is the first lesson of the Ricardian model.

There are gains from trade for both countries.

This is the second lesson of the Ricardian model.

Determining the Pattern of International Trade

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Determining the Pattern of International Trade

• Pattern of Trade and Gains from Trade

However, we have not yet determined the level of wages across countries.

Relative prices converge. Do wages?

Wages do rise in each country, but they do notconverge. (Important political implications)

They are determined by absolute advantage, notcomparative advantage.

Determining the Pattern of International Trade

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Determining the Pattern of International Trade

• Solving for Wages Across Countries As stated before, in competitive labor markets, firms

will pay workers the value of their marginal product.

Since Home produces and exports wheat, they will bepaid in terms of that good—the real wage is MPLW = 4

bushels of wheat.

The workers sell the wheat on the world market at arelative price of PW/PC = 2/3.

We can use this to calculate the real wage in terms of cloth: (PW/PC)MPLW = (2/3)4 = 8/3 yards.

Determining the Pattern of International Trade

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Determining the Pattern of International Trade

• Solving for Wages Across Countries We can do this for Foreign as well and summarize:

Home real wage is 4 bushels of wheat

8/3 yards of cloth

Foreign real wage is 3/2 bushels of wheat

1 yard of cloth

Foreign workers earn less than Home workers asmeasured by their ability to purchase either good. This fact reflects Home’s absolute advantage in the production

of both goods.

Determining the Pattern of International Trade

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Determining the Pattern of International Trade

• Wages are determined by absolute advantage

and trade is determined by comparativeadvantage.

• This should make sense. The only way a country with poor technology can export

at a price others are willing to pay is by having lowwages.

• As a country develops better technology, itswages will rise. (Compare to autarky wages) Workers become better off through receiving higher 

wages. As countries engage in trade, the Ricardian model

predicts that their real wages will rise.

Determining the Pattern of International Trade

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Determining the Pattern of International Trade

• We can see this in the real world Per capita income in China in 1978 was estimated at

$925.

In 2000, per capita income in China had risen to $3750.

Per capita income in India more than doubled from$1180 in 1978 to $2480 in 2000.

It is strongly believed that the opportunity for thesecountries to engage in international trade has beencrucial in raising their standard of living.

Labor Productivity and Wages

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APPLICATION 

Labor Productivity and Wages

• Labor productivity can be measured by the value-added per hour in manufacturing. Value-added is the difference between sales revenue in an

industry and the costs of intermediate inputs.

Equals the payments to labor and capital in an industry. The Ricardian model ignores capital so we can measure labor 

productivity as value-added divided by the number of hoursworked, or value-added per hour.

• Figure 2.7 shows value-added per hour in manufacturing

for several countries. Countries with higher labor productivity pay higher wages, just as

the Ricardian model predicts.

Labor Productivity and Wages

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APPLICATION 

Labor Productivity and Wages

Figure 2.7: Labor Productivity and Wages, 2001

Labor Productivity and Wages

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APPLICATION 

Labor Productivity and Wages

• We can also see the connection betweenproductivity and wages over time.

• Figure 2.8 shows that the general upward

movement in labor productivity is matched byupward movement in wages. This is also predicted by the Ricardian Model.

Labor Productivity and Wages

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APPLICATION 

Labor Productivity and Wages

Figure 2.8

Solving for International Prices

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Solving for International Prices

• In the previous analysis we assumed the world

price of wheat was 2/3.

• In reality world price is determined by a market for exports and imports.

• We will derive a Home export supply curve. Shows the amount it wants to export at various relative

prices.

• Similarly we will derive a Foreign import demand

curve. Shows the amount of wheat that it will import at various

relative prices.

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Solving for International Prices

• Home Export Supply Curve We can use the information we gathered from before to

derive an export supply curve.

The export supply curve will have the relative price of wheat on the Y-axis and the amount of wheat on the X-

axis.

We saw before a relative price of 2/3 related to exportsof 60 bushels. The first point on the export supply curve: the horizontal

distance from point B to C in figure 2-9(a) and point C’ in figure2-9(b).

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Solving for International Prices

• To derive other points on the export supply curve

we look at the no-trade equilibrium. When the relative price of wheat is ½, Home exports of 

wheat are zero (no-trade equilibrium). Point A and A’ in figure 2.9

For the 3rd point, we keep the relative price of wheat at½. At this price, Home could export some wheat in exchange for 

cloth.

Production could shift from A to any other place on the PPF.• Workers are willing to shift between industries as the wages are the

same.

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Solving for International Prices

• If we assume that all workers have moved into

wheat production.

• With the relative price of ½, consumption is still atpoint A and the difference between A and B is the

amount of wheat that Home is exporting. At the relative price of ½, with wheat exports of 50,

gives another point on the Home export supply curve:B’.

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Solving for International Prices

Figure 2.9

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Solving for International Prices

• The flat portion of the export supply curve is a

special feature of the Ricardian model. The PPF is a straight line.

Production can occur anywhere along the PPF asworkers shift between industries.

This leads to all the export levels between A’ and B’.

At prices above ½, production is the same butconsumption changes, rising above point A.

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Solving for International Prices

• Foreign Import Demand We can use a similar analysis to construct the import

demand for wheat in figure 2.10.

At the world relative price of 2/3, Foreign imports 60bushels of wheat, C* and C*’.

The no-trade equilibrium in Foreign, with a relative priceof 1, is zero imports, A* and A*’.

Production can shift from point A, at a price of 1, asworkers move between industries: If workers all shift to cloth.

Foreign imports 50 bushels of wheat, B* and B*’.

This gives us the import demand curve.

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Solving for International Prices

Figure 2.10

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Solving for International Prices

• International Trade Equilibrium We need to put the Home export supply together with

the Foreign import demand.

The exports from Home come from the excess domestic supply.

The imports to Foreign come from the excess domesticdemand.

This is the World market for wheat (figure 2.11): Equilibrium price of 2/3 and trade of 60 bushels of wheat.

This is the amount that clears the world market.

Desired sales of Home equal the desired purchases byForeign.

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Figure 2.11

Solving for International Prices

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Solving for International Prices

• The Terms of Trade The price of a country’s exports divided by the price of 

its imports.

For Home, PW/PC is their terms of trade.

An increase in PW or a fall in PC will raise Home’s termsof trade.

An increase in the terms of trade is good for a country:it makes it better off.

A country will earn more for its exports. A country will pay less for its imports.

For Foreign, PC/PW is the terms of trade and a higher 

relative price for cloth makes it better off.

The Terms of Trade for Primary Commodities

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APPLICATION 

y

• Latin American economist Raúl Prebisch andBritish economist Hans Singer each put forwardthe hypothesis that the price of primarycommodities would decline over time relative tothe price of manufactured goods.

• Primary commodities are often exported bydeveloping countries, so their terms of trade

would decline over time.

The Terms of Trade for Primary Commodities

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APPLICATION 

y

• This theory might be true for a couple of reasons:• First,

As countries become richer, they spend a smaller shareof their income on food.

As world income grows, demand for food falls relativeto the demand for manufactured goods.

Therefore, the price of agricultural products can also beexpected to fall relative to manufactured goods.

The Terms of Trade for Primary Commodities

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APPLICATION 

y

• Second, For mineral products, industrialized countries

continually find substitutes in the production of manufactured products.

The substitution away from mineral products is a formof technological progress, and as it proceeds, can leadto a fall in the price of raw materials.

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APPLICATION 

y

• There are also reasons why the theory might notbe true:

• First, Technological progress in manufactured goods can

certainly lead to a fall in the price of these goods asthey become easier to produce. This is a fall in terms of trade for industrialized countries

rather than developing countries.

• Second, At least for oil, the cartel restricting prices has caused

an increase in the terms of trade for oil-exportingcountries.

The Terms of Trade for Primary Commodities

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APPLICATION 

y

• Figure 2.12 shows 24 primary commodities from1900–1998, with their world price relative to theoverall price of manufactured goods.

• From these results for different commodities, we

can conclude that there are some that follow thepattern predicted by Prebisch and Singer, withfalling prices relative to manufacturing.

• However, this is not the general rule—other 

primary commodities have had increasing or non-consistent change in their prices.