International Trade | Trade 1
Comparative Advantage
There are two countries,Home (H) and Foreign (F),There are two goods,units of wine (Qw) and cheese (Qc).
Suppose there is one factor of production,labour,which is available in amounts L and L? respectively.
Suppose both countries have 100 units of labour and the unit labour costs for producing the two goods are given in
the table below,Notice home can produce both goods cheaper | it has an absolute advantage in both.
Wine Cheese
Home 10 20
Foreign 50 25
Before trade Home was producing Qc = 3 and Qw = 4,Foreign was producing Q?w = 1 and Q?c = 2,Trade can make
both countries better ofi,Consider Qc = 1,Qw = 8 and Q?c = 4,Q?w = 0.
If Home exports 3 units of wine in exchange for 2 imported units of cheese,both are strictly better ofi.
Home has a comparative advantage in wine,Foreign has a comparative advantage in cheese.
International Trade | Trade 2
The Ricardian Model
Trade can make both better ofi,This can be seen more generally in the Ricardian model.
There is still one factor of production and two goods,Unit labour costs are lw,lc,l?w and l?c for Home and Foreign
in wine and cheese respectively,Hence production possibilities are given by:
lwQw + lcQc? L and l?wQ?w + l?cQ?c? L?
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Qc
Q?w
Q?c
L=lw
L=lc
L?=l?w
L?=l?c
The absolute value of the slopes are lw=lc and l?w=l?c,They are the cost of wine in terms of cheese,Home has an
absolute advantage in wine when lw < l?w and a comparative advantage when lw=lc < l?w=l?c (assumed throughout).
By deflnition,every country can produce a good in which it has a comparative advantage.
International Trade | Trade 3
Prices and Trade
How is the world price (the exchange rate between goods) set? Plot relative prices against relative world production.
Relative world demand (RD) will be downward sloping,Relative world supply (RS) will be a step function,The
intersection of the two curves clearly yields the world equilibrium price ratio.
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0 Qw+Q?wQc+Q?
c
Pw=Pc
l?w=l?c
lw=lc
RS
RD
L=lw
L?=l?c
Consider RS,If relative price is below lw=lc both countries produce cheese,If relative price is above l?w=l?c both
countries produce wine,If relative prices are in between countries will specialise in their comparative advantage.
In the flrst slide’s example only abroad specialised,This can be illustrated with a difierent demand curve.
International Trade | Trade 4
The Gains from Trade
Both countries can gain from trade,Consider the case where both countries specialise.
The below diagram shows the production possibility frontier along with the world price ratio (the dashed line) for
both countries,Trade expands the consumption possibilities of both countries,beyond their frontier.
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0 0
Qw
Qc
Q?w
Q?c
Imports
Exports Imports
Exports
In the diagram exports and imports can be illustrated,One country’s exports must equal the other’s imports.
International Trade | Trade 5
The Heckscher-Ohlin Model
A more general analysis involves two factors of production,labour and capital,Suppose wine is labour intensive |
it uses relatively more labour to capital than the production of cheese.
Suppose Home has more labour (hence the comparative advantage in wine production).
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Qw
Qc
Exports
Imports
0
x
y
The above diagram shows the production possibility frontier (which is now concave as there are two factors of
production),The straight line is the world price ratio,Home produces at x but consumes (after trade) at y.
They are better ofi,Notice that specialisation is not complete,Countries tend to export goods whose production is
intensive in factors in which they are abundant,Home still exports wine.
International Trade | Trade 6
Trade and Goods Prices
Home is relatively good at producing wine,For a given price it can produce more,Foreign is relatively good at
producing cheese,Therefore the relative supply curves are positioned as in the below picture.
Notice that both countries now produce positive amounts of both goods,There is no complete specialisation.
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0 Qw+Q?w
Qc+Q?c
Pw=Pc
RD
RSF
RSH
Foreign is relatively bad at producing wine.
From Home’s point of view relative supply of wine falls under trade and prices rise,From Foreign’s point of view
relative supply of wine rises under trade and prices fall,World price will be somewhere in between RSF and RSH.
International Trade | Trade 7
Trade and Factor Prices
Recall that wine was labour intensive and cheese capital intensive,How does trade afiect the income distribution?
Consider Home | abundant in labour and relatively good at producing wine,Relative prices rise after trade.
There is a relationship between goods prices and factor prices,Competition ensures goods prices are equal to
marginal cost,costs depend on factor prices,Higher factor prices push up goods prices which involve that factor.
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0 w=r
Pw=Pc
Autarky
Trade
Trade meant a rise in the relative price Pw=Pc for Home,Hence there will be an associated rise in w=r.
Owners of a country’s abundant factor will gain from trade,whilst owners of a country’s scarce factor will lose.
International Trade | Trade 8
The Terms of Trade
The price of the export good divided by the price of the import good is a country’s terms of trade.
For Home this is Pw=Pc since they export wine,The terms of trade are determined by relative world supply and
demand,Suppose initially,supply is given by RS and demand by RD,Which factors afiect the terms of trade?
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0 Qw+Q?w
Qc+Q?c
Pw=Pc
RS
RD
RD1
RS1
RS2
Economic growth (an increase in productivity) will shift the relative supply curve.
1,Import biased growth,Relative supply moves to RS1,Terms of trade \improve".
2,Export biased growth,Relative supply moves to RS2,Terms of trade \get worse".
Better products will result in higher relative demand (RD1) which improves the terms of trade.
International Trade | Trade 9
Tarifis in a Small Country
How does a tarifi afiect a small country? Suppose Home’s demand and supply for cheese are given by D and S
respectively,The world price is P c,The government adds a tarifi on imports of t.
The price now paid by the country is P c + t,More is supplied at Home,Less is imported.
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0 Qc
Pc
S
D
P c
P c + t
Imports
a b c d
The consumer loses area a + b + c + d since they purchase less and pay more.
The producer gains area a since they produce more at a higher price.
The government raises revenue of area c (imports times tarifi),and so the total loss to the country is b + d.
International Trade | Trade 10
Tarifis in a Large Country
In a large country however,world price is afiected by the tarifi,In the same way that taxes afiected a market,a
tarifi will lower the world supply price and raise the world demand price.
The supply price is initially P 1c,It falls to P 2c after the introduction of a tarifi which means Home now faces a price
of P 2c + t,How is welfare afiected? S and D are Home’s supply and demand.
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0 Qc
Pc S
D
P 1c
P 2c + t
P 2c
a b c d
e
The consumer loses a + b + c + d,The flrm gains a,The government now raises a revenue of c + e.
Total loss is therefore b + d?e,This could be negative | that is,a beneflt,Does revenue outweight loss? It might.
International Trade | Trade 11
Tarifis and the Terms of Trade
How does a tarifi afiect the terms of trade? Consider a tarifi on the imported good (cheese).
The lower relative price of wine at Home will result in more demand from Home’s consumer for wine.
The lower relative price of wine will result in Home’s flrm producing less wine (producers will substitute into the
import good | cheese,which is now more profltable),Notice it is only Home’s prices that have changed.
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0 Qw+Q?w
Qc+Q?c
Pw=Pc
RD2
RD1
RS2
RS1
The flrst efiect results in a rise in relative demand (RD1 to RD2) and the second in a fall in relative supply (RS1 to
RS2),Hence world prices also change,The terms of trade improve given a tarifi.
Hence a tarifi at Home can be beneflcial to Home | see earlier slide,but always damages Foreign by worsening
their terms of trade (improving Home’s terms of trade worsens Foreign’s).
International Trade | Trade 12
Export Subsidies
How does an export subsidy afiect the terms of trade? Can it ever beneflt Home?
Export subsidies raise supply of the export good (wine) at Home,Relative supply rises from RS1 to RS2.
They lower Home’s demand for the export good,Relative demand falls from RD1 to RD2.
The terms of trade fall as illustrated below,Home is worse ofi due to this fall.
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Qc+Q?c
Pw=Pc
RD1
RD2
RS1
RS2
Home is also worse ofi due to the distortionary efiect of the subsidy,An export subsidy always reduces welfare.
On the other hand,export subsidies beneflt Foreign by improving their terms of trade,Not a sensible policy.
Comparative Advantage
There are two countries,Home (H) and Foreign (F),There are two goods,units of wine (Qw) and cheese (Qc).
Suppose there is one factor of production,labour,which is available in amounts L and L? respectively.
Suppose both countries have 100 units of labour and the unit labour costs for producing the two goods are given in
the table below,Notice home can produce both goods cheaper | it has an absolute advantage in both.
Wine Cheese
Home 10 20
Foreign 50 25
Before trade Home was producing Qc = 3 and Qw = 4,Foreign was producing Q?w = 1 and Q?c = 2,Trade can make
both countries better ofi,Consider Qc = 1,Qw = 8 and Q?c = 4,Q?w = 0.
If Home exports 3 units of wine in exchange for 2 imported units of cheese,both are strictly better ofi.
Home has a comparative advantage in wine,Foreign has a comparative advantage in cheese.
International Trade | Trade 2
The Ricardian Model
Trade can make both better ofi,This can be seen more generally in the Ricardian model.
There is still one factor of production and two goods,Unit labour costs are lw,lc,l?w and l?c for Home and Foreign
in wine and cheese respectively,Hence production possibilities are given by:
lwQw + lcQc? L and l?wQ?w + l?cQ?c? L?
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.......0 0Q
w
Qc
Q?w
Q?c
L=lw
L=lc
L?=l?w
L?=l?c
The absolute value of the slopes are lw=lc and l?w=l?c,They are the cost of wine in terms of cheese,Home has an
absolute advantage in wine when lw < l?w and a comparative advantage when lw=lc < l?w=l?c (assumed throughout).
By deflnition,every country can produce a good in which it has a comparative advantage.
International Trade | Trade 3
Prices and Trade
How is the world price (the exchange rate between goods) set? Plot relative prices against relative world production.
Relative world demand (RD) will be downward sloping,Relative world supply (RS) will be a step function,The
intersection of the two curves clearly yields the world equilibrium price ratio.
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0 Qw+Q?wQc+Q?
c
Pw=Pc
l?w=l?c
lw=lc
RS
RD
L=lw
L?=l?c
Consider RS,If relative price is below lw=lc both countries produce cheese,If relative price is above l?w=l?c both
countries produce wine,If relative prices are in between countries will specialise in their comparative advantage.
In the flrst slide’s example only abroad specialised,This can be illustrated with a difierent demand curve.
International Trade | Trade 4
The Gains from Trade
Both countries can gain from trade,Consider the case where both countries specialise.
The below diagram shows the production possibility frontier along with the world price ratio (the dashed line) for
both countries,Trade expands the consumption possibilities of both countries,beyond their frontier.
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..,,,,,,
0 0
Qw
Qc
Q?w
Q?c
Imports
Exports Imports
Exports
In the diagram exports and imports can be illustrated,One country’s exports must equal the other’s imports.
International Trade | Trade 5
The Heckscher-Ohlin Model
A more general analysis involves two factors of production,labour and capital,Suppose wine is labour intensive |
it uses relatively more labour to capital than the production of cheese.
Suppose Home has more labour (hence the comparative advantage in wine production).
.......,......,......,......,......,......,......
......
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......
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......
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.......,......,......,....
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...................
Qw
Qc
Exports
Imports
0
x
y
The above diagram shows the production possibility frontier (which is now concave as there are two factors of
production),The straight line is the world price ratio,Home produces at x but consumes (after trade) at y.
They are better ofi,Notice that specialisation is not complete,Countries tend to export goods whose production is
intensive in factors in which they are abundant,Home still exports wine.
International Trade | Trade 6
Trade and Goods Prices
Home is relatively good at producing wine,For a given price it can produce more,Foreign is relatively good at
producing cheese,Therefore the relative supply curves are positioned as in the below picture.
Notice that both countries now produce positive amounts of both goods,There is no complete specialisation.
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0 Qw+Q?w
Qc+Q?c
Pw=Pc
RD
RSF
RSH
Foreign is relatively bad at producing wine.
From Home’s point of view relative supply of wine falls under trade and prices rise,From Foreign’s point of view
relative supply of wine rises under trade and prices fall,World price will be somewhere in between RSF and RSH.
International Trade | Trade 7
Trade and Factor Prices
Recall that wine was labour intensive and cheese capital intensive,How does trade afiect the income distribution?
Consider Home | abundant in labour and relatively good at producing wine,Relative prices rise after trade.
There is a relationship between goods prices and factor prices,Competition ensures goods prices are equal to
marginal cost,costs depend on factor prices,Higher factor prices push up goods prices which involve that factor.
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0 w=r
Pw=Pc
Autarky
Trade
Trade meant a rise in the relative price Pw=Pc for Home,Hence there will be an associated rise in w=r.
Owners of a country’s abundant factor will gain from trade,whilst owners of a country’s scarce factor will lose.
International Trade | Trade 8
The Terms of Trade
The price of the export good divided by the price of the import good is a country’s terms of trade.
For Home this is Pw=Pc since they export wine,The terms of trade are determined by relative world supply and
demand,Suppose initially,supply is given by RS and demand by RD,Which factors afiect the terms of trade?
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0 Qw+Q?w
Qc+Q?c
Pw=Pc
RS
RD
RD1
RS1
RS2
Economic growth (an increase in productivity) will shift the relative supply curve.
1,Import biased growth,Relative supply moves to RS1,Terms of trade \improve".
2,Export biased growth,Relative supply moves to RS2,Terms of trade \get worse".
Better products will result in higher relative demand (RD1) which improves the terms of trade.
International Trade | Trade 9
Tarifis in a Small Country
How does a tarifi afiect a small country? Suppose Home’s demand and supply for cheese are given by D and S
respectively,The world price is P c,The government adds a tarifi on imports of t.
The price now paid by the country is P c + t,More is supplied at Home,Less is imported.
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0 Qc
Pc
S
D
P c
P c + t
Imports
a b c d
The consumer loses area a + b + c + d since they purchase less and pay more.
The producer gains area a since they produce more at a higher price.
The government raises revenue of area c (imports times tarifi),and so the total loss to the country is b + d.
International Trade | Trade 10
Tarifis in a Large Country
In a large country however,world price is afiected by the tarifi,In the same way that taxes afiected a market,a
tarifi will lower the world supply price and raise the world demand price.
The supply price is initially P 1c,It falls to P 2c after the introduction of a tarifi which means Home now faces a price
of P 2c + t,How is welfare afiected? S and D are Home’s supply and demand.
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0 Qc
Pc S
D
P 1c
P 2c + t
P 2c
a b c d
e
The consumer loses a + b + c + d,The flrm gains a,The government now raises a revenue of c + e.
Total loss is therefore b + d?e,This could be negative | that is,a beneflt,Does revenue outweight loss? It might.
International Trade | Trade 11
Tarifis and the Terms of Trade
How does a tarifi afiect the terms of trade? Consider a tarifi on the imported good (cheese).
The lower relative price of wine at Home will result in more demand from Home’s consumer for wine.
The lower relative price of wine will result in Home’s flrm producing less wine (producers will substitute into the
import good | cheese,which is now more profltable),Notice it is only Home’s prices that have changed.
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0 Qw+Q?w
Qc+Q?c
Pw=Pc
RD2
RD1
RS2
RS1
The flrst efiect results in a rise in relative demand (RD1 to RD2) and the second in a fall in relative supply (RS1 to
RS2),Hence world prices also change,The terms of trade improve given a tarifi.
Hence a tarifi at Home can be beneflcial to Home | see earlier slide,but always damages Foreign by worsening
their terms of trade (improving Home’s terms of trade worsens Foreign’s).
International Trade | Trade 12
Export Subsidies
How does an export subsidy afiect the terms of trade? Can it ever beneflt Home?
Export subsidies raise supply of the export good (wine) at Home,Relative supply rises from RS1 to RS2.
They lower Home’s demand for the export good,Relative demand falls from RD1 to RD2.
The terms of trade fall as illustrated below,Home is worse ofi due to this fall.
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0 Qw+Q?w
Qc+Q?c
Pw=Pc
RD1
RD2
RS1
RS2
Home is also worse ofi due to the distortionary efiect of the subsidy,An export subsidy always reduces welfare.
On the other hand,export subsidies beneflt Foreign by improving their terms of trade,Not a sensible policy.
