introduction classical economics and comparative advantage analysis of comparative advantage

Introduction

Classical economics and comparative advantage

Analysis of comparative advantage

Production possibility frontier and autarky

Terms of trade and gains from trade

Application: Kenya and the EU

More countries and world ppf

The Balassa index II

Conclusions

CHAPTER 3; COMPARATIVE ADVANTAGEInternational Trade & the World Economy; Charles van Marrewijk

Explanations for trade

Classical 2. Opportunity costs 3. Comparative advantage

Neo-classical 4. Production structure 5. Factor prices 6. Production volume 7. Factor abundance

New trade 9. Imperfect competition 10. Intra-industry trade

Policy

8. Trade policy

11. Strategic trade policy

12. Int. trade organizations 13. Economic integration

17. Applied trade policy modeling

Economicgeography

New interactions 14. Geographical economics 15. Multinationals 16. New goods, growth, and development

Industrialorganization

Internationalbusiness

Growth theory

Par

t I

Part

II

Part

III

Part

IV

18. Concluding remarks

1. The world economy

Introduction








Conclusions


Introduction International Trade & the World Economy; Charles van Marrewijk

Objectives / key terms

Comparative advantage Production possibility frontier (ppf)

Autarky Terms of trade

Gains from trade World ppf

David Ricardo (1772-1823)

Introduction








Conclusions


Classical economics and comparative advantage International Trade & the World Economy; Charles van Marrewijk

One of the few ideas in economics that is true without being obvious

According to Paul Samuelson (1915-; Nobel prize 1970) the theory of comparative advantage is

Technological differences between nations are the classical driving force behind international trade flows.

According to David Ricardo relative or comparative differences are important, not absolute differences.

The idea of comparative advantage is often misunderstood, see

Paul Krugman (1953-) “Ricardo’s difficult idea”

at http://web.mit.edu/krugman/www

Introduction








Conclusions


• 2 countries; EU and Kenya

International trade based on differences in technology assumptions

• No transport costs

• 2 goods; Food and Chemicals

• 1 factor of production; labor L

• Constant returns to scale; CRS

• Labor mobility between sectors, not between countries

• Perfect competition

unit labor requirement = units of labor required to produce one

unit of a final good By assumption this is independent of the

number of laborers active in a sector (CRS), but may differ between the two countries.Let be the for good F in EU, etcunit labor requirement EU

Fa

International Trade & the World Economy; Charles van Marrewijk


Productivity table to summarize the state of technology

Note that the EU is more efficient than Kenya in the production of both goods, requiring 2 < 4 laborers for Food and 8 < 24 laborers for Chemicals. Why would the EU trade with Kenya?

Note: EU is twice more productive in Food, and three times in Chem.

In autarky (without international trade) both countries will produce both goods if consumers demand both Food and Chemicals.



Table 3.1 Productivity table; labor required to produce 1 unit of output

General specification Example

Food Chemicals Food Chemicals

EU EUFa

EUCa EU 2 8

Kenya KFa

KCa Kenya 4 24

According to David Ricardo both countries can gain from international trade through specialization (EU producing more chemicals and Kenya producing more food):

Suppose Kenya produces 1 chemical less, this frees up 24 laborers.

These 24 laborers can now produce 24/4 = 6 units of food

To keep the production level of chemicals constant, the EU should make 1 chemical more. This requires 8 laborers.

These 8 laborers could have made 8/2 = 4 units of food.

Conclusion: EU Kenya change world prod.

production of chem. +1 -1 0

production of food -4 +6 +2

The extra production represents gains from trade



Introduction








Conclusions


Production possibility frontier and autarky International Trade & the World Economy; Charles van Marrewijk

Production possibility frontier (ppf) = All possible combinations of efficient production points given the available factors of production and the state of technology. Note:

• ppf depends on available factors of production

• ppf depends on state of technology

• ppf does not depend on type of market competition

Table 3.2 Total labor available and maximum production levels

Total labor Maximum production

available Food Chemicals

EU 200 EU 100 25

Kenya 120 Kenya 30 5

Production possibility frontier and autarky International Trade & the World Economy; Charles van Marrewijk

Food

Chemicals0

30

255

100

Kenya ppf

EU ppf

A

B

CE

D

Autarky prod. and cons. along ppf (determines autarky price ratio)

Introduction








Conclusions


Terms of trade and gains from trade International Trade & the World Economy; Charles van Marrewijk

Food

Chemicals0

30

255

100

Kenya ppf

EU ppf

A

B

F

Kenyabudgetline

6.25

120

G

EU budgetline

Both countries gain if international price is in between autarky prices

Terms of trade is 4.8 food per unit of chemicals

Terms of trade and gains from trade International Trade & the World Economy; Charles van Marrewijk

Food

Chemicals0

30

255

100

Kenya ppf

EU ppf

A

B

F

Kenyabudgetline

7.5

120

EU budgetline

Only Kenya gains if international price is equal to EU autarky price

Terms of trade is 4 food per unit of chemicals

Introduction








Conclusions


Application: Kenya and the EU International Trade & the World Economy; Charles van Marrewijk

Not all exports behave in accordance with comparative advantage (but explains more trade flows than absolute advantage)

-50

0

50

100

0 50 100 150 200

Relative productivity ratio (Kenya/EU); %

Ken

ya e

xpor

t (%

) -

impo

rt (

%)

food

chemicalsmachinery

Introduction








Conclusions


More countries and world ppfInternational Trade & the World Economy; Charles van Marrewijk

Food

Chemicals

C

B

Country B and C ppf

Food

Chemicals

D

A

Country A and D ppf

If we identify more countries and two goods we can calculate individual ppf’s with a slope depending on comparative advantage.

Combining these in a world ppf gives rise to a concave frontier (next slide)

More countries and world ppfInternational Trade & the World Economy; Charles van Marrewijk

F o o d

C h e m i c a l s0

A

B

C

D

00 / fc ppslope

11 / fc ppslope

E 0

E 1

W o r l d p p f

C m a x

F m a x

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Conclusions


The Balassa index II International Trade & the World Economy; Charles van Marrewijk

The Ottens (2000) calculations of the Balassa index uses the OECD countries as reference. Sometimes all countries in the world are used.

Hinloopen and van Marrewijk (2001) use data on EU exports for 98 sectors to Japan to calculate the Balassa index, such that:

similar trade policy access to the Japanese for all countries

similar development levels for the EU countries

similar distance (physical and pecuniary costs) for all countries

which supposedly results in a ‘cleaner’ measure of comparative advantage and the probability density function of the Balassa index as depicted on the next slide.

0.04 0.68 1.32 1.96 2.60 3.24 3.88

Balassa-index

frequency

The Balassa index II International Trade & the World Economy; Charles van Marrewijk

The probability density function of the Balassa-index based on monthly-moving annual observations (restricted to 0 BI 4)source: Hinloopen and van Marrewijk (2001)

Introduction








Conclusions


ConclusionsInternational Trade & the World Economy; Charles van Marrewijk

Technological differences between countries are the classical driving force for international trade flows.

Only comparative costs, not absolute costs, are important for determining the direction of trade flows.

Absolute costs are important for determining a country’s welfare level.

Empirically, comparative costs performs somewhat better than absolute costs.

Allowing for more countries and more goods is easy, allowing for more than one factor of production is not (see part II).

introduction classical economics and comparative advantage analysis of comparative advantage

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