chapter 3 -- classical model

1Chapter 3 -- Classical Model

• INTERNATIONAL ECONOMICS,ECO 486

• Display your name card

2Learning Objectives

• Understand five more assumptions

• Determine and understand comparative and absolute advantage

• Find international trade equilibrium

• Explain gains from trade

• Derive range of wages that will permit trade

3Learning Objectives

• Understand five more assumptions

• Determine and understand comparative and absolute advantage

• Find international trade equilibrium

• Explain gains from trade

• Derive range of wages that will permit trade

4Assumption #8

• Factors of production cannot move between countries

5Assumption #9

• There are no barriers to trade in goods.

6Assumption #10

• Exports must pay for imports

• Assumptions 8-10 apply to both the Classical and HO Models

• Assumptions 11 & 12 apply only to Classical Model

7Assumption #11

• Labor is the only relevant factor of production in terms of productivity analysis or costs of production.

8Assumption #12

• Production exhibits constant returns to scale, CRS, between labor and output.

9CRS Implies Linear PPF

• See Figure 3.1, page 68

10Autarky

• See Figure 3.2, page 69

• Given perfect competition,

11Autarky

• See Figure 3.2, page 69

• Given perfect competition,

– P = MC

– Autarky price of S equals slope of PPF

– Resource payments correspond to their productivity

12Learning Objectives

• Understand five more assumptions

• Determine and understand comparative and absolute advantage

• Find international trade equilibrium

• Explain gains from trade

• Derive range of wages that will permit trade

13Absolute Advantage

• Compare one good across countries.

• Country with lower labor input has an absolute advantage in that good.

14Comparative Advantage

• Calculate opportunity costs.

• Compare one good across countries.

• Country with lower opportunity cost has a comparative advantage in that good.

15Which Advantage?

• Absolute advantage is a special case.

• Comparative advantage is the general case.

16Learning Objectives

• Understand five more assumptions

• Determine and understand comparative and absolute advantage

• Find international trade equilibrium

• Explain gains from trade

• Derive range of wages that will permit trade

17Terms of Trade

• Once trade begins, an international equilibrium results

• Results in one world price for a good

18Terms of Trade

• Once trade begins, an international equilibrium results

• Results in one world price for a good

– called the terms of trade

– between the two autarky prices

– determined by reciprocal demand

19International Trade Equilibrium

• See Figure 3.3, page 71

• Complete specialization in Comparative Advantage good

• CIC & ToT tangent at consumption point

• Congruent trade triangles imply balanced trade

20Learning Objectives

• Understand five more assumptions

• Determine and understand comparative and absolute advantage

• Find international trade equilibrium

• Explain gains from trade

• Derive range of wages that will permit trade

21Gains From Trade

• Higher CIC shows a gain

• Measure gains from trade using GDP

• Sources of gain:

22Gains From Trade

• Higher CIC shows a gain

• Measure gains from trade using GDP

• Sources of gain:

– production (gains from specialization)

– consumption (ToT price lower than autarky)

23Learning Objectives

• Understand five more assumptions

• Determine and understand comparative and absolute advantage

• Find international trade equilibrium

• Explain gains from trade

• Derive range of wages that will permit trade

24Perfect Competition Review

(Product & Resource Markets)

• PXC = MC for a good, X, in a country, C

• MC = w/MPPL (Labor, L, is only var. input)

• w=MRPL =(MR) MPPL=(P) MPPL=VMPL

25Perfect Competition Review

(Product & Resource Markets)• PXC = MC for a good, X, in a country, C

• MC = w/MPPL (Labor, L, is only var. input)

• w=MRPL =(MR) MPPL=(P) MPPL=VMPL

• MRPL = Marginal Revenue Product MR = Marginal Revenue;MPPL = Marginal Physical Product of LVMPL = Value Marginal Product of L

26Prices & Wages

• PXC = MC = w/MPPL

• MPPL is measured as units of X per hour

• hoursXC is stated as hours per unit of X

• PXC = wC (hoursXC)

27Exchange Rates

• State exchange rate, E, in US dollars per UK pound

– say $2/£

• A good will be imported if its foreign pre-trade price (x E) is less than the domestic price

PSA < E x PSB

28Buy Low . . .

• Trade requires

PSA < E x PSB

PTA > E x PTB

autarky prices

A has comparative advantage in S

B has comparative advantage in T

29Trade & Wages

• Substitute PXC = wC (hoursXC)

wA (hoursSA) < E x wB (hoursSB)

wA (hoursTA) > E x wB (hoursTB)

To solvedivide both sides by (E x wB)

divide both sides by (hoursXA)

30Trade & Wages (Cont.)

hourshours

WEW

hourshours

WEW

TA

TB

B

A

SA

SB

B

A

31Trade & Wages (Cont.)

• Trade will occur if the wage ratio does not exceed the productivity ratio hours

hoursWEW

hourshours

WEW

TA

TB

B

A

SA

SB

B

A

33Trade & Wages (Cont.)

• If one country is technologically advanced, it must have a higher wage rate.

hourshours

WEW

hourshours

WEW

TA

TB

B

A

SA

SB

B

A

34Losing Comparative Advantage

• If the wage ratio exceeds the productivity ratio, trade will not occur

• If a currency is overvalued (say $1/£ instead of $2/£), both goods may be cheaper in one country

35

Review Homework

36

0 2 4 6 8 10

2

4

6

8

10

SOYBEANS, S (millions of bushels per year)

C

Q#8: Degree of Specialization

X

CIC1

CIC2

CIC0

G

Autarky Equilibrium

TE

XT

ILE

S, T

(mill

ions

of y

ards

per

yea

r)

PPF

C = COMPLETE SPECIALIZATION,ALLOWS GREATER CONSUMPTION

X = COMPLETE SPECIALIZATION,P = PARTIAL SPECIALIZATION

P

D

37

0 2 4 6 8 10

2

4

6

8

10

SOYBEANS, S (millions of bushels per year)

L

Quantity of Soybeans Demanded

H

CIC1

CIC2

CIC0

G

Autarky General Equilibrium|slope PPF| = PS/PT = 2 yd.T/bu.S

TE

XT

ILE

S, T

(mill

ions

of y

ards

per

yea

r)

PPF

PS/PT = 1 yd.T/bu.S

PS/PT = 2.5 yd.T/bu.S

4.71.8