OFFER CURVES AND THE TERMS OF TRADE
Appendix 3.2
Offer curves are an alternative way to represent the reciprocal demand that determines the terms of trade.
Figure A 3.2 shows A's desired trade for three different values of the terms of trade. As the TOT line gets steeper we see A's desired imports rise from T0 to T3, while desired exports rise from S0 to S3. As the TOT rises A is able to achieve a higher standard of living.
This change in the TOT is 'favorable' to A because it favors the good that A exports.
Figure 3.3 plots A's desired exports against A's desired imports.
If we think of the TOT as a price then as it rises A 'offers' a specific exchange of S for T.
The offer curve combines supply and demand behavior in one curve. It takes money prices out of the picture. Instead of offering to pay a certain number of dollars for a good, countries are going straight to making a barter offer.
In this approach money is a distraction and models that dispense with it get to the 'real' economics of trade.
Country B also has an offer curve.
Figure 3.4 puts the two offer curves on the same diagram.
There is only one TOT where the desired exports and imports all match. This is the equilibrium TOT.
At this equilibrium the two country's CICs must be tangent to each other.
Production choices, consumption choices, the terms of trade, goods prices and the exchange rate are all consistent with each other in general equilibrium. Unless there is some shock to the system the world will remain in this equilibrium state.
Friday, September 26, 2008
appendix 3.1
THE CLASSICAL MODEL WITH MANY GOODS
Appendix 3.1
Suppose:
In Table 3.1 are the labor/output ratios.
Country A's comparative advantage is in good Y.
We guess that B will export T and A will export Y, but what about the other 3 goods?
We know that goods T and Y determine the range for relative wages.
1/3 < Wa/(E.Wb) < 1
Table 3.2 ranks the value of (labor hours per unit B produced/labor hours per unit A produced) for each good.
B's greatest comparative advantage good (its most competitive export) is on the left. To produce one unit of T, country B only requires one-third as much labor as country A does.
This ordering is called 'the chain of comparative advantage'.
Suppose the relative wage rate was 2/3. Then B would produce all the goods except Y.
Where do the wages rates actually get detemined? In theory the wage rates in each country should adjust so that trade is balanced. If the wage rate in one country is 'too high' then the price of its least competitive export will be too high to compete in the market. So the country will tend to do some combination of lowering the wage rate and cutting back production of its least advantageous good until trade is balanced.
Appendix 3.1
Suppose:
- there are 5 goods
- all other classical assumptions hold especially fixed labor/output ratios
In Table 3.1 are the labor/output ratios.
Country A's comparative advantage is in good Y.
We guess that B will export T and A will export Y, but what about the other 3 goods?
We know that goods T and Y determine the range for relative wages.
1/3 < Wa/(E.Wb) < 1
Table 3.2 ranks the value of (labor hours per unit B produced/labor hours per unit A produced) for each good.
B's greatest comparative advantage good (its most competitive export) is on the left. To produce one unit of T, country B only requires one-third as much labor as country A does.
This ordering is called 'the chain of comparative advantage'.
Suppose the relative wage rate was 2/3. Then B would produce all the goods except Y.
Where do the wages rates actually get detemined? In theory the wage rates in each country should adjust so that trade is balanced. If the wage rate in one country is 'too high' then the price of its least competitive export will be too high to compete in the market. So the country will tend to do some combination of lowering the wage rate and cutting back production of its least advantageous good until trade is balanced.
Monday, September 22, 2008
topic 3.4
THE CLASSICAL MODEL OF INTERNATIONAL TRADE
Topic 3.4
Trade and wages
If labor is the only factor of production then in pretrade equilibrium the price of a good is simply the number of hours to produce it.
Psa = Wa x 3
Pta = Wa x 6
Psb = Wb x 12
Ptb = Wb x 8
Suppose both countries use the same currency.
Then for trade to occur the pretrade price of S must be lower in country A than in country B. And the opposite must be true for T.
Psa < E x Psb
Pta > E x Ptb
Where the exchange rate E converts country B currency into country A currency.
Then
Wa/(E x Wb) < 4
Wa/(E x Wb) > 4/3
that is 4/3 < Wa/(E x Wb) < 4
The middle term is the relative wage ratio.
Workers in A must earn more than in country B as measured in country A currency.
Differences in labor productivity explain the wage differences. Labor in A is 4/3 times as productive as labor in B (in textiles) and 4 times as productive in S production. These numbers set the limits for wage differences.
If the wage rate for labor in country A is more than four times the wage rate in country B then that would erase the advantage of buying goods from A. The extra high wage in A would erase any price advantage for S goods imported from A.
For good T, if wages in country B are more than ¾ the wages in A, it wipes out the productivity advantage of country B in the production of T.
To summarize, the wage rate in a country cannot be so high that it wipes out the natural comparative advantage that country has in its export good.
Another way of thinking about it: we know that productivity determines the standard of living in a country. It makes sense that relative productivity determines the relative wage rate between two countries. So the relative advantage A has in its export good sets the upper bound on its wage premium.
But, and this is truly surprising – it is not absolute advantage that sets the (limits for) the wage premium. It is comparative advantage. Being the lowest cost producer of a good in terms of labor costs does not raise your relative wage. It is the structure of comparative advantage (lowest opportunity cost) that matters.
Another remarkable result: it is the trade sector that drives relative wages. Because trade in this model drives both countries to specialize completely (by assumption), the whole production pattern of an economy is determined by comparative advantage.
Topic 3.4
Trade and wages
If labor is the only factor of production then in pretrade equilibrium the price of a good is simply the number of hours to produce it.
Psa = Wa x 3
Pta = Wa x 6
Psb = Wb x 12
Ptb = Wb x 8
Suppose both countries use the same currency.
Then for trade to occur the pretrade price of S must be lower in country A than in country B. And the opposite must be true for T.
Psa < E x Psb
Pta > E x Ptb
Where the exchange rate E converts country B currency into country A currency.
Then
Wa/(E x Wb) < 4
Wa/(E x Wb) > 4/3
that is 4/3 < Wa/(E x Wb) < 4
The middle term is the relative wage ratio.
Workers in A must earn more than in country B as measured in country A currency.
Differences in labor productivity explain the wage differences. Labor in A is 4/3 times as productive as labor in B (in textiles) and 4 times as productive in S production. These numbers set the limits for wage differences.
If the wage rate for labor in country A is more than four times the wage rate in country B then that would erase the advantage of buying goods from A. The extra high wage in A would erase any price advantage for S goods imported from A.
For good T, if wages in country B are more than ¾ the wages in A, it wipes out the productivity advantage of country B in the production of T.
To summarize, the wage rate in a country cannot be so high that it wipes out the natural comparative advantage that country has in its export good.
Another way of thinking about it: we know that productivity determines the standard of living in a country. It makes sense that relative productivity determines the relative wage rate between two countries. So the relative advantage A has in its export good sets the upper bound on its wage premium.
But, and this is truly surprising – it is not absolute advantage that sets the (limits for) the wage premium. It is comparative advantage. Being the lowest cost producer of a good in terms of labor costs does not raise your relative wage. It is the structure of comparative advantage (lowest opportunity cost) that matters.
Another remarkable result: it is the trade sector that drives relative wages. Because trade in this model drives both countries to specialize completely (by assumption), the whole production pattern of an economy is determined by comparative advantage.
topic 3.3
THE CLASSICAL MODEL OF INTERNATIONAL TRADE
Topic 3.3
The Gains from International Trade
Consider Figure 3.4
The way we calculate the gains from trade is to compare the equilibrium CIC in autarky with the trade equilibrium CIC.
So moving from K to I is a gain from trade. Since I is above to the right of K it represents a welfare gain.
(But if consumption preferences were extreme (e.g. A residents only consumed S) then there would be no gain from trade.)
Another test of gains is: is the vertical intercept higher (GDP1/ PTO).
The further the TOT is from the PPF of country A, the greater are the gains to that country.
This model does not explicitly solve for the exact equilibrium TOT.
A small country could actually have greater relative trade gains than a larger country if the TOT was equidistant between the two PPFs because equal trade gains are being divided by a smaller base.
Topic 3.3
The Gains from International Trade
Consider Figure 3.4
The way we calculate the gains from trade is to compare the equilibrium CIC in autarky with the trade equilibrium CIC.
So moving from K to I is a gain from trade. Since I is above to the right of K it represents a welfare gain.
(But if consumption preferences were extreme (e.g. A residents only consumed S) then there would be no gain from trade.)
Another test of gains is: is the vertical intercept higher (GDP1/ PTO).
The further the TOT is from the PPF of country A, the greater are the gains to that country.
This model does not explicitly solve for the exact equilibrium TOT.
A small country could actually have greater relative trade gains than a larger country if the TOT was equidistant between the two PPFs because equal trade gains are being divided by a smaller base.
Sunday, September 21, 2008
topic 3.3
THE CLASSICAL MODEL OF INTERNATIONAL TRADE
Topic 3.3
The Gains from International Trade
Consider Figure 3.4
The way we calculate the gains from trade is to compare the equilibrium CIC in autarky with the trade equilibrium CIC.
So move from K to I is a gain from trade. Since I is above to the right of K it represents a welfare gain.
If consumption preferences were extreme (eg A residents only consumed S) then there would be no gain from trade.
Another test of gains is the vertical intercept higher (GDP,/ PTO).
The further the TOT is from the PPF of country A, the greater are the gains to that country.
This model does not explicitly solve for the exact equilibrium TOT.
A small country could have greater relative trade gains than a larger country if the TOT was equidistant between the two PPFs.
Topic 3.3
The Gains from International Trade
Consider Figure 3.4
The way we calculate the gains from trade is to compare the equilibrium CIC in autarky with the trade equilibrium CIC.
So move from K to I is a gain from trade. Since I is above to the right of K it represents a welfare gain.
If consumption preferences were extreme (eg A residents only consumed S) then there would be no gain from trade.
Another test of gains is the vertical intercept higher (GDP,/ PTO).
The further the TOT is from the PPF of country A, the greater are the gains to that country.
This model does not explicitly solve for the exact equilibrium TOT.
A small country could have greater relative trade gains than a larger country if the TOT was equidistant between the two PPFs.
topic 3.2
THE CLASSICAL MODEL OF INTERNATIONAL TRADE
Topic 3.2
The GE solution to the classical model.
Suppose we have the PPFs from figure 3.1.
In the test the two PPFs are not drawn to the same scale.
Figure 3.2 adds the CICs that are at a tangency with the PPFs.
If we allow trade to occur what will happen?
There will be only one would price. This price will be between the two autarky prices.
How much specialization will occur?
If we know what the new equilibrium will be we can say.
Comparative advantage determines specialization and trade.
Figure 3.3 illustrates an equilibrium.
The new world price is in between the autarky prices.
Suppose the new price is 3/4. This represents the ‘terms of trade’.
A will produce more S
B will produce more T
A will produce only S because this allows A to reach the highest CCI.
Similarly B will only produce T and reach its highest CCI.
How do we know that the new price is feasible? I.e. why should supply and demand be matched perfectly at that price? Because the price adjusts until it is at the equilibrium value (choosing ¾ is just a guess for illustration only).
This price is called the terms of trade: ‘TOT’
HIJ in Figure 3.3 is the ‘trade triangle’.
The trade triangle tells us how much S country A will export (J – H) and how much T it will import (all of its T consumption).
The trade triangles for the two countries must be congruent since the horizontal sections are equal and the hypotenuse has the same slope.
Walras Law
If there are n markets in a GE economy and (n-1) are in equilibrium then the last market must be in equilibrium.
Topic 3.2
The GE solution to the classical model.
Suppose we have the PPFs from figure 3.1.
In the test the two PPFs are not drawn to the same scale.
Figure 3.2 adds the CICs that are at a tangency with the PPFs.
If we allow trade to occur what will happen?
There will be only one would price. This price will be between the two autarky prices.
How much specialization will occur?
If we know what the new equilibrium will be we can say.
Comparative advantage determines specialization and trade.
Figure 3.3 illustrates an equilibrium.
The new world price is in between the autarky prices.
Suppose the new price is 3/4. This represents the ‘terms of trade’.
A will produce more S
B will produce more T
A will produce only S because this allows A to reach the highest CCI.
Similarly B will only produce T and reach its highest CCI.
How do we know that the new price is feasible? I.e. why should supply and demand be matched perfectly at that price? Because the price adjusts until it is at the equilibrium value (choosing ¾ is just a guess for illustration only).
This price is called the terms of trade: ‘TOT’
HIJ in Figure 3.3 is the ‘trade triangle’.
The trade triangle tells us how much S country A will export (J – H) and how much T it will import (all of its T consumption).
The trade triangles for the two countries must be congruent since the horizontal sections are equal and the hypotenuse has the same slope.
Walras Law
If there are n markets in a GE economy and (n-1) are in equilibrium then the last market must be in equilibrium.
topic 3.1
THE CLASSICAL MODEL OF INTERNATIONAL TRADE
Topic 3.1
Mercantilism aimed to limit imports and promote exports.
Adam Smith developed his ideas to refute mercantilism.
We shall continue to develop a model of international trade.
Factors of production cannot move between countries.
This keeps the PPF fixed (with static technology) and it also prevents wage equalization
There are no barriers to trade in goods.
So there are no tariffs or quotas.
Exports pay for imports.
This is balanced trade.
There are no flows of money or bonds (there are no ‘capital flows’).
Labor is the only factor of production
This is the ‘labor theory of value’.
Production exhibits constant returns to scale between labor and output.
Proportional changes in imports lead to proportional changes in outputs when labor is the only factor of production this means that there is a fixed ratio of output to input.
The constant returns assumption allows us to derive formulas that are independent of the absolute level of output.
Absolute advantage can be illustrated by tables.
There are two variations of these tables. One version assumes that each country has the same amount of labor and then presents the maximum output of each good that is possible for each country. The other version holds the production levels the same for each country the same and then presents the different amounts of labor required within each country.
Both variations are equivalent – they are different approaches to presenting the same information. Tables are only useful for presenting linear PPFs.
Table 3.1 is the second type of table.
From table 3.1 we see than country A has an absolute advantage in producing S and country B has the absolute advantage in producing T.
Diagram 3.1
If each country had 12 hours of labor A has the absolute advantage in T (it can produce more units of T) and B has the absolute advantage of S (if can product more units of S).
In order to know where each country would be in autarky and where they would change production if trade was allowed we need information about consumption preferences (not in diagram 3.1).
Under reasonable consumption preferences (the best we can do without being given the ‘true’ CICs) and assuming that both countries consume both goods it is likely that A will specialize in T and B will specialize in S.
Table 3.3 represents a situation where A has the absolute advantage in both good.
Diagram 3.2
A has the absolute advantage in both goods, but its comparative advantage is S.
There is potential for A to specialize in production of S while B specializes in production of T.
Topic 3.1
Mercantilism aimed to limit imports and promote exports.
Adam Smith developed his ideas to refute mercantilism.
We shall continue to develop a model of international trade.
Factors of production cannot move between countries.
This keeps the PPF fixed (with static technology) and it also prevents wage equalization
There are no barriers to trade in goods.
So there are no tariffs or quotas.
Exports pay for imports.
This is balanced trade.
There are no flows of money or bonds (there are no ‘capital flows’).
Labor is the only factor of production
This is the ‘labor theory of value’.
Production exhibits constant returns to scale between labor and output.
Proportional changes in imports lead to proportional changes in outputs when labor is the only factor of production this means that there is a fixed ratio of output to input.
The constant returns assumption allows us to derive formulas that are independent of the absolute level of output.
Absolute advantage can be illustrated by tables.
There are two variations of these tables. One version assumes that each country has the same amount of labor and then presents the maximum output of each good that is possible for each country. The other version holds the production levels the same for each country the same and then presents the different amounts of labor required within each country.
Both variations are equivalent – they are different approaches to presenting the same information. Tables are only useful for presenting linear PPFs.
Table 3.1 is the second type of table.
From table 3.1 we see than country A has an absolute advantage in producing S and country B has the absolute advantage in producing T.
Diagram 3.1
If each country had 12 hours of labor A has the absolute advantage in T (it can produce more units of T) and B has the absolute advantage of S (if can product more units of S).
In order to know where each country would be in autarky and where they would change production if trade was allowed we need information about consumption preferences (not in diagram 3.1).
Under reasonable consumption preferences (the best we can do without being given the ‘true’ CICs) and assuming that both countries consume both goods it is likely that A will specialize in T and B will specialize in S.
Table 3.3 represents a situation where A has the absolute advantage in both good.
Diagram 3.2
A has the absolute advantage in both goods, but its comparative advantage is S.
There is potential for A to specialize in production of S while B specializes in production of T.
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