extensions and tests of the classical model of trade chapter 4 mcgraw-hill/irwincopyright © 2010 by...

Extensions and Tests of the

Classical Model of Trade

Chapter 4

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

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Learning Objectives Demonstrate how wages, productivity,

and exchange rates affect trade patterns.

Examine the implications of extending the basic model of comparative advantage.

Show that real-world trade patterns are consistent with underlying comparative advantage.

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Adding Money to the Classical Model

Suppose a money economy instead of a barter economy.• A wage rate for each country, stated

in that country’s currency (e.g., in U.S. $2 per hr., in the U.K., £1 per hr.).

• An exchange rate that relates the countries’ currencies (e.g., $1 = £1).

An Example

Wheat Cloth

Wage/hr

Labor/unit

Price/unit

Labor/unit

Price/unit

U.S. $2 2 $4 3 $6

U.K £1 6 £6 4 £4

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Adding Money to the Classical Model: An Example The U.S. will export wheat, since it can

produce wheat for a lower price ($4, as compared with $6).

The U.K. will export cloth, since it can produce cloth for a lower price ($4, as compared with $6).

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The Export Condition Country 1 should export good j when:

a1j*W1*e < a2j*W2, wherea1j and a2j are the labor requirements/hr

to produce good j in countries 1 and 2W1 and W2 are the wage rates/hr in

countries 1 and 2e is country 1’s exchange rate (# of

country 2’s currency units per 1 of country 1’s).

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The Export Condition Country 1 should export good j when:

a1j*W1*e < a2j*W2. That is, when country 1’s good j price is lower

than 2’s, stated in a common currency. Therefore, the pattern of trade is determined

by• relative labor efficiency,• relative wage rates, and• the exchange rate.

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The Export Condition Country A should export good j when:

a1j*W1*e < a2j*W2.

Let’s re-write this as follows:Country A should export good j when:

a1j/a2j < W2/(W1*e).

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Wage Rate Limits As Country 1’s wage rate goes up

relative to Country 2’s, Country 1 finds it harder to sell its exports to Country 2.

As Country 1’s wage rate goes down relative to Country 2’s, Country 1 is less interested in importing from Country 2.

Wage Rate Limits: An Example

Wheat Cloth

Wage/hr

Labor/unit

Price/unit

Labor/unit

Price/unit

U.S. $3 2 $6 3 $9

U.K £1 6 £6 4 £4

Suppose e = 0.5 (that is, $1 = £0.5)

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Wage Rate Limits: An Example

Should the U.S. (Country 1) export wheat? It should if a1j/a2j < W2/(W1*e).

Since 2/6 < 1/(3*0.5), the U.S. should export wheat [or: the U.S. wheat price is $6; the U.K. wheat price is £6 = $12].

It’s easy to show that the U.K. should export cloth.

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Wage Rate Limits: An Example

What if the U.S. wage rate rose to $6?

Wage Rate Limits: An Example

Wheat Cloth

Wage/hr

Labor/unit

Price/unit

Labor/unit

Price/unit

U.S. $6 2 $12 3 $18

U.K £1 6 £6 4 £4

Suppose e = 0.5 (that is, $1 = £0.5)

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Wage Rate Limits: An Example

Now the U.S. wheat price is the same as the U.K.’s, if we state them in a common currency.

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Wage Rate Limits: An Example

Now the U.S. wheat price is the same as the U.K.’s, if we state them in a common currency.

Therefore, if the wage rate in the U.S. should rise above $6, the U.K. will no longer buy U.S. wheat (trade will cease).

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Wage Rate Limits: An Example

What if instead the U.S. wage rate fell to $2.67?

Wage Rate Limits: An Example

Wheat (X) Cloth (Y)

Wage/hr

Labor/unit

Price/unit

Labor/unit

Price/unit

U.S. (A) $2.67 2 $5.34 3 $8

U.K (B) £1 6 £6 4 £4

Suppose e = 0.5 (that is, $1 = £0.5)

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Wage Rate Limits: An Example

What if the U.S. wage rate fell to $2.67?

Now the U.S. cloth price is the same as the U.K.’s, if we state them in a common currency ($8).

Therefore, if the wage rate in the U.S. should fall below $2.67, the U.S. will no longer buy U.K. cloth (trade will cease).

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Calculating Wage Rate Limits Using the Export

Condition Solve the export condition for W1, for

good X. Solve the export condition for W1, for

good Y. These will give you Country A’s wage

rate limits.

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Calculating Wage Rate Limits Using the Export

Conditiona1j/a2j < W2/(W1*e)

For wheat:2/6 = 1/(W1*0.5) → W1= 6

For cloth:3/4 = 1/(W1*0.5) → W1= 2.67

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Country 2’s Wage Rate Limits

Changes in Country 2’s wage rates also can affect the pattern of trade.

If 2’s wage rises too much, they will not be able to export any more.

If 2’s wage falls too much, 2 will no longer wish to import.

Solve the export condition for W2 for each good.

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Exchange Rate Limits If Country 1’s currency appreciates,

imports will seem cheaper and exports more expensive.

If 1’s currency appreciates enough, A will no longer be able to export.

If 1’s currency depreciates enough, A will no longer wish to import.

Solve export condition for e.

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Evaluating the Classical Model

Empirical studies generally show that the classical model is consistent with observed trading patterns.

However, the complexity of today’s world means the Classical model cannot supply a complete understanding of international trade.