Fluent Essays

The evidence cited in chapter 3 using the examples of the East Asia New Industrializing Countries suggests that as international productivities converge, so do international wage levels. Why do you suppose this happened for the East Asian NICs? In light of your answer, what do you think is likely to happen to the relative wages (relative to those in the United States) of China in the coming decade? Explain your reasoning. Word total should be in the 500 words range. Whether you agree or disagree explain why with supporting evidence and concepts from the readings or a related experience.  Include a reference, link, or citation when appropriate. 46 3 Labor Productivity and Comparative Advantage: The Ricardian Model Countries engage in international trade for two basic reasons, each of which contributes to their gains from trade. First, countries trade because they are different from each other. Nations, like individuals, can benefit from their differ- ences by reaching an arrangement in which each does the things it does relatively well. Second, countries trade to achieve economies of scale in production. That is, if each country produces only a limited range of goods, it can produce each of these goods at a larger scale and hence more efficiently than if it tried to produce everything. In the real world, patterns of international trade reflect the interaction of both these motives. As a first step toward understanding the causes and effects of trade, however, it is useful to look at simplified models in which only one of these motives is present. The next four chapters develop tools to help us to understand how differences between countries give rise to trade between them and why this trade is mutually beneficial. The essential concept in this analysis is that of comparative advantage. Although comparative advantage is a simple concept, experience shows that it is a surprisingly hard concept for many people to understand (or accept). Indeed, the late Paul Samuelson—the Nobel laureate economist who did much to develop the models of international trade discussed in Chapters 4 and 5—once described comparative advantage as the best example he knows of an economic principle that is undeniably true yet not obvious to intelligent people. In this chapter, we begin with a general introduction to the concept of compara- tive advantage and then proceed to develop a specific model of how comparative advantage determines the pattern of international trade. LEARNING GOALS After reading this chapter, you will be able to: ■■ Explain how the Ricardian model, the most basic model of international trade, works and how it illustrates the principle of comparative advantage. C H A P T E R M03_KRUG6355_11_GE_C03.indd 46 14/10/2017 08:40 CHAPTER 3   ■   Labor Productivity and Comparative Advantage: The Ricardian Model 47 ■■ Demonstrate gains from trade and refute common fallacies about interna- tional trade. ■■ Describe the empirical evidence that wages reflect productivity and that trade patterns reflect relative productivity. The Concept of Comparative Advantage On Valentine’s Day, 1996, which happened to fall less than a week before the crucial February 20 primary in New Hampshire, Republican presidential candidate Patrick Buchanan stopped at a nursery to buy a dozen roses for his wife. He took the occasion to make a speech denouncing the growing imports of flowers into the United States, which he claimed were putting American flower growers out of business. And it is indeed true that a growing share of the market for winter roses in the United States is supplied by imports flown in from South American countries, Colombia in particular. But is that a bad thing? The case of winter roses offers an excellent example of the reasons why interna- tional trade can be beneficial. Consider first how hard it is to supply American sweet- hearts with fresh roses in February. The flowers must be grown in heated greenhouses, at great expense in terms of energy, capital investment, and other scarce resources. Those resources could be used to produce other goods. Inevitably, there is a trade- off. In order to produce winter roses, the U.S. economy must produce fewer of other things, such as computers. Economists use the term opportunity cost to describe such trade-offs: The opportunity cost of roses in terms of computers is the number of computers that could have been produced with the resources used to produce a given number of roses. Suppose, for example, that the United States currently grows 10 million roses for sale on Valentine’s Day and that the resources used to grow those roses could have produced 100,000 computers instead. Then the opportunity cost of those 10 million roses is 100,000 computers. (Conversely, if the computers were produced instead, the opportunity cost of those 100,000 computers would be 10 million roses.) Those 10 million Valentine’s Day roses could instead have been grown in Colombia. It seems extremely likely that the opportunity cost of those roses in terms of comput- ers would be less than it would be in the United States. For one thing, it is a lot easier to grow February roses in the Southern Hemisphere, where it is summer in February rather than winter. Furthermore, Colombian workers are less efficient than their U.S. counterparts at making sophisticated goods such as computers, which means that a given amount of resources used in computer production yields fewer computers in Colombia than in the United States. So the trade-off in Colombia might be something like 10 million winter roses for only 30,000 computers. This difference in opportunity costs offers the possibility of a mutually beneficial rearrangement of world production. Let the United States stop growing winter roses and devote the resources this frees up to producing computers; meanwhile, let Colom- bia grow those roses instead, shifting the necessary resources out of its computer indus- try. The resulting changes in production would look like Table 3-1. Look what has happened: The world is producing just as many roses as before, but it is now producing more computers. So this rearrangement of production, with the United States concentrating on computers and Colombia concentrating on roses, increases the size of the world’s economic pie. Because the world as a whole is produc- ing more, it is possible in principle to raise everyone’s standard of living. M03_KRUG6355_11_GE_C03.indd 47 14/10/2017 08:40 48 PART ONE   ■   International Trade Theory The reason that international trade produces this increase in world output is that it allows each country to specialize in producing the good in which it has a comparative advantage. A country has a comparative advantage in producing a good if the oppor- tunity cost of producing that good in terms of other goods is lower in that country than it is in other countries. In this example, Colombia has a comparative advantage in winter roses and the United States has a comparative advantage in computers. The standard of living can be increased in both places if Colombia produces roses for the U.S. market, while the United States produces computers for the Colombian market. We therefore have an essential insight about comparative advantage and international trade: Trade between two countries can benefit both countries if each country exports the goods in which it has a comparative advantage. This is a statement about possibilities—not about what will actually happen. In the real world, there is no central authority deciding which country should produce roses and which should produce computers. Nor is there anyone handing out roses and computers to consumers in both places. Instead, international production and trade are determined in the marketplace, where supply and demand rule. Is there any reason to suppose that the potential for mutual gains from trade will be realized? Will the United States and Colombia actually end up producing the goods in which each has a comparative advantage? Will the trade between them actually make both countries better off ? To answer these questions, we must be much more explicit in our analysis. In this chapter, we will develop a model of international trade originally proposed by British economist David Ricardo, who introduced the concept of comparative advantage in the early 19th century.1 This approach, in which international trade is solely due to international differences in the productivity of labor, is known as the Ricardian model. A One-Factor Economy To introduce the role of comparative advantage in determining the pattern of interna- tional trade, we begin by imagining that we are dealing with an economy—which we call Home—that has only one factor of production. (In Chapter 4 we extend the analysis to models in which there are several factors.) We imagine that only two goods, wine and cheese, are produced. The technology of Home’s economy can be summarized by labor productivity in each industry, expressed in terms of the unit labor requirement, the number of hours of labor required to produce a pound of cheese or a gallon of wine. For example, it might require one hour of labor to produce a pound of cheese and two hours to produce a gallon of wine. Notice, by the way, that we’re defining unit labor requirements as the inverse of productivity—the more cheese or wine a worker 1The classic reference is David Ricardo, The Principles of Political Economy and Taxation, first published in 1817. Million Roses Thousand Computers United States - 10 + 100 Colombia + 10 - 30 Total 0 + 70 Hypothetical Changes in ProductionTABLE 3-1 M03_KRUG6355_11_GE_C03.indd 48 14/10/2017 08:40 CHAPTER 3   ■   Labor Productivity and Comparative Advantage: The Ricardian Model 49 can produce in an hour, the lower the unit labor requirement. For future reference, we define aLW and aLC as the unit labor requirements in wine and cheese production, respectively. The economy’s total resources are defined as L, the total labor supply. Production Possibilities Because any economy has limited resources, there are limits on what it can produce, and there are always trade-offs; to produce more of one good, the economy must sacrifice some production of another good. These trade-offs are illustrated graphically by a production possibility frontier (line PF in Figure 3-1), which shows the maximum amount of wine that can be produced once the decision has been made to produce any given amount of cheese, and vice versa. When there is only one factor of production, the production possibility frontier of an economy is simply a straight line. We can derive this line as follows: If QW is the economy’s production of wine and QC its production of cheese, then the labor used in producing wine will be aLWQW, and the labor used in producing cheese will be aLCQC. The production possibility frontier is determined by the limits on the economy’s resources—in this case, labor. Because the economy’s total labor supply is L, the limits on production are defined by the inequality aLCQC + aLWQW … L. (3-1) Suppose, for example, that the economy’s total labor supply is 1,000 hours, and that it takes 1 hour of labor to produce a pound of cheese and 2 hours of labor to produce a gallon of wine. Then the total labor used in production is (1 * pounds of cheese produced) + (2 * gallons of wine produced), and this total must be no more than the 1,000 hours of labor available. If the economy devoted all its labor to cheese production, it could, as shown in Figure 3-1, produce L>aLC pounds of cheese (1,000 pounds). If it devoted all its labor to wine production instead, it could produce L>aLW gallons—1,000>2 = 500 gallons—of wine. And it can produce any mix of wine and cheese that lies on the straight line connecting those two extremes. F I G U R E 3 - 1 Home’s Production Possibility Frontier The line PF shows the maximum amount of cheese Home can produce given any production of wine, and vice versa. Home wine production, QW , in gallons L/aLW (500 gallons in our example) L/aLC (1,000 pounds in our example) Home cheese production, QC, in pounds F Absolute value of slope equals opportunity cost of cheese in terms of wine P M03_KRUG6355_11_GE_C03.indd 49 14/10/2017 08:40 50 PART ONE   ■   International Trade Theory When the production possibility frontier is a straight line, the opportunity cost of a pound of cheese in terms of wine is constant. As we saw in the previous section, this opportunity cost is defined as the number of gallons of wine the economy would have to give up in order to produce an extra pound of cheese. In this case, to produce another pound would require aLC person-hours. Each of these person-hours could in turn have been used to produce 1>aLW gallons of wine. Thus, the opportunity cost of cheese in terms of wine is aLC>aLW. For example, if it takes one person-hour to make a pound of cheese and two hours to produce a gallon of wine, the opportunity cost of each pound of cheese is half a gallon of wine. As Figure 3-1 shows, this opportunity cost is equal to the absolute value of the slope of the production possibility frontier. Relative Prices and Supply The production possibility frontier illustrates the different mixes of goods the economy can produce. To determine what the economy will actually produce, however, we need to look at prices. Specifically, we need to know the relative price of the economy’s two goods, that is, the price of one good in terms of the other. In a competitive economy, supply decisions are determined by the attempts of indi- viduals to maximize their earnings. In our simplified economy, since labor is the only factor of production, the supply of cheese and wine will be determined by the move- ment of labor to whichever sector pays the higher wage. Suppose, once again, that it takes one hour of labor to produce a pound of cheese and two hours to produce a gallon of wine. Now suppose further that cheese sells for $4 a pound, while wine sells for $7 a gallon. What will workers produce? Well, if they produce cheese, they can earn $4 an hour. (Bear in mind that since labor is the only input into production here, there are no profits, so workers receive the full value of their output.) On the other hand, if workers produce wine, they will earn only $3.50 an hour, because a $7 gallon of wine takes two hours to produce. So if cheese sells for $4 a pound while wine sells for $7 a gallon, workers will do better by producing cheese—and the economy as a whole will specialize in cheese production. But what if cheese prices drop to $3 a pound? In that case, workers can earn more by producing wine, and the economy will specialize in wine production instead. More generally, let PC and PW be the prices of cheese and wine, respectively. It takes aLC person-hours to produce a pound of cheese; since there are no profits in our one-factor model, the hourly wage in the cheese sector will equal the value of what a worker can produce in an hour, PC>aLC. Since it takes aLW person-hours to produce a gallon of wine, the hourly wage rate in the wine sector will be PW>aLW. Wages in the cheese sector will be higher if PC>PW 7 aLC>aLW; wages in the wine sector will be higher if PC>PW 6 aLC>aLW. Because everyone will want to work in whichever indus- try offers the higher wage, the economy will specialize in the production of cheese if PC>PW 7 aLC>aLW. On the other hand, it will specialize in the production of wine if PC>PW 6 aLC>aLW. Only when PC >PW is equal to aLC>aLW will both goods be produced. What is the significance of the number aLC>aLW? We saw in the previous section that it is the opportunity cost of cheese in terms of wine. We have therefore just derived a crucial proposition about the relationship between prices and production: The economy will specialize in the production of cheese if the relative price of cheese exceeds its oppor- tunity cost in terms of wine; it will specialize in the production of wine if the relative price of cheese is less than its opportunity cost in terms of wine. In the absence of international trade, Home would have to produce both goods for itself. But it will produce both goods only if the relative price of cheese is just equal to its opportunity cost. Since opportunity cost equals the ratio of unit labor requirements M03_KRUG6355_11_GE_C03.indd 50 14/10/2017 08:40 CHAPTER 3   ■   Labor Productivity and Comparative Advantage: The Ricardian Model 51 in cheese and wine, we can summarize the determination of prices in the absence of international trade with a simple labor theory of value: In the absence of international trade, the relative prices of goods are equal to their relative unit labor requirements. Trade in a One-Factor World To describe the pattern and effects of trade between two countries when each country has only one factor of production is simple. Yet the implications of this analysis can be surprising. Indeed, to those who have not thought about international trade, many of these implications seem to conflict with common sense. Even this simplest of trade models can offer some important guidance on real-world issues, such as what consti- tutes fair international competition and fair international exchange. Before we get to these issues, however, let us get the model stated. Suppose there are two countries. One of them we again call Home and the other we call Foreign. Each of these countries has one factor of production (labor) and can produce two goods, wine and cheese. As before, we denote Home’s labor force by L and Home’s unit labor requirements in wine and cheese production by aLW and aLC, respectively. For Foreign, we will use a convenient notation throughout this text: When we refer to some aspect of Foreign, we will use the same symbol that we use for Home, but with an asterisk. Thus Foreign’s labor force will be denoted by L*, Foreign’s unit labor requirements in wine and cheese will be denoted by aLW* and aLC* , respectively, and so on. In general, the unit labor requirements can follow any pattern. For example, Home could be less productive than Foreign in wine but more productive in cheese, or vice versa. For the moment, we make only one arbitrary assumption: that aLC>aLW 6 aLC* >aLW* (3-2) or, equivalently, that aLC>aLC* 6 aLW>aLW* . (3-3) In words, we are assuming that the ratio of the labor required to produce a pound of cheese to that required to produce a gallon of wine is lower in Home than it is in Foreign. More briefly still, we are saying that Home’s relative productivity in cheese is higher than it is in wine. But remember that the ratio of unit labor requirements is equal to the opportunity cost of cheese in terms of wine; and remember also that we defined comparative advan- tage precisely in terms of such opportunity costs. So the assumption about relative productivities embodied in equations (3-2) and (3-3) amounts to saying that Home has a comparative advantage in cheese. One point should be noted immediately: The condition under which Home has this comparative advantage involves all four unit labor requirements, not just two. You might think that to determine who will produce cheese, all you need to do is com- pare the two countries’ unit labor requirements in cheese production, aLC and aLC* . If aLC 6 aLC* , Home labor is more efficient than Foreign in producing cheese. When one country can produce a unit of a good with less labor than another country, we say that the first country has an absolute advantage in producing that good. In our example, Home has an absolute advantage in producing cheese. What we will see in a moment, however, is that we cannot determine the pattern of trade from absolute advantage alone. One of the most important sources of error in dis- cussing international trade is to confuse comparative advantage with absolute advantage. M03_KRUG6355_11_GE_C03.indd 51 14/10/2017 08:40 52 PART ONE   ■   International Trade Theory Given the labor forces and the unit labor requirements in the two countries, we can draw the production possibility frontier for each country. We have already done this for Home, by drawing PF in Figure 3-1. The production possibility frontier for Foreign is shown as P*F* in Figure 3-2. Since the slope of the production possibility frontier equals the opportunity cost of cheese in terms of wine, Foreign’s frontier is steeper than Home’s. In the absence of trade, the relative prices of cheese and wine in each country would be determined by the relative unit labor requirements. Thus, in Home the relative price of cheese would be aLC>aLW; in Foreign it would be aLC* >aLW* . Once we allow for the possibility of international trade, however, prices will no lon- ger be determined purely by domestic considerations. If the relative price of cheese is higher in Foreign than in Home, it will be profitable to ship cheese from Home to For- eign and to ship wine from Foreign to Home. This cannot go on indefinitely, however. Eventually, Home will export enough cheese and Foreign enough wine to equalize the relative price. But what determines the level at which that price settles? Determining the Relative Price after Trade Prices of internationally traded goods, like other prices, are determined by supply and demand. In discussing comparative advantage, however, we must apply supply-and- demand analysis carefully. In some contexts, such as some of the trade policy analysis in Chapters 9 through 12, it is acceptable to focus only on supply and demand in a single market. In assessing the effects of U.S. import quotas on sugar, for example, it is reasonable to use partial equilibrium analysis, that is, to study a single market, the sugar market. When we study comparative advantage, however, it is crucial to keep track of the relationships between markets (in our example, the markets for wine and cheese). Since Home exports cheese only in return for imports of wine, and Foreign exports wine in return for cheese, it can be misleading to look at the cheese and wine markets F I G U R E 3 - 2 Foreign’s Production Possibility Frontier Because Foreign’s relative unit labor requirement in cheese is higher than Home’s (it needs to give up many more units of wine to produce one more unit of cheese), its production possibility frontier is steeper. Foreign wine production, QW, in gallons L*/aLW L*/aLC Foreign cheese production, QC , in pounds P* * * * * F* M03_KRUG6355_11_GE_C03.indd 52 14/10/2017 08:40 CHAPTER 3   ■   Labor Productivity and Comparative Advantage: The Ricardian Model 53 in isolation. What is needed is general equilibrium analysis, which takes account of the linkages between the two markets. One useful way to keep track of two markets at once is to focus not just on the quantities of cheese and wine supplied and demanded but also on the relative supply and demand, that is, on the number of pounds of cheese supplied or demanded divided by the number of gallons of wine supplied or demanded. Figure 3-3 shows world supply and demand for cheese relative to wine as functions of the price of cheese relative to that of wine. The relative demand curve is indicated by RD; the relative supply curve is indicated by RS. World general equilibrium requires that relative supply equal relative demand, and thus the world relative price is determined by the intersection of RD and RS. The striking feature of Figure 3-3 is the funny shape of the relative supply curve RS: It’s a “step” with flat sections linked by a vertical section. Once we understand the deri- vation of the RS curve, we will be almost home-free in understanding the whole model. First, as drawn, the RS curve shows that there would be no supply of cheese if the world price dropped below aLC>aLW. To see why, recall that we showed that Home will specialize in the production of wine whenever PC>PW 6 aLC>aLW. Similarly, Foreign will specialize in wine production whenever PC>PW 6 aLC* >aLW* . At the start of our discussion of equation (3-2), we made the assumption that aLC>aLW 6 aLC* >aLW* . So at relative prices of cheese below aLC>aLW , there would be no world cheese production. Next, when the relative price of cheese PC>PW is exactly aLC>aLW, we know that workers in Home can earn exactly the same amount making either cheese or wine. So Home will be willing to supply any relative amount of the two goods, producing a flat section to the supply curve. We have already seen that if PC>PW is above aLC>aLW, Home will specialize in the production of cheese. As long as PC>PW 6 aLC* >aLW* , however, Foreign will continue to specialize in producing wine. When Home specializes in cheese production, it produces F I G U R E 3 - 3 World Relative Supply and Demand The RD and RD’ curves show that the demand for cheese relative to wine is a decreasing function of the price of cheese relative to that of wine, while the RS curve shows that the supply of cheese relative to wine is an increasing function of the same relative price. Relative price of cheese, PC/PW aLC /aLW L /aLC Relative quantity of cheese, RD * RD L*/aLW* Q * aLC /aLW QC + QC QW +QW* 1 2 RS * (2 in our example) (1/2 in our example) M03_KRUG6355_11_GE_C03.indd 53 14/10/2017 08:40 54 PART ONE   ■   International Trade Theory L>aLC pounds. Similarly, when Foreign specializes in wine, it produces L*>aLW* gallons. So for any relative price of cheese between aLC>aLW and aLC* >aLW* , the relative supply of cheese is (L>aLC)>(L*>aLW* ). (3-4) At PC>PW = aLC* >aLW* , we know that Foreign workers are indifferent between pro- ducing cheese and wine. Thus, here we again have a flat section of the supply curve. Finally, for PC>PW 7 aLC* >aLW* , both Home and Foreign will specialize in cheese production. There will be no wine production, so that the relative supply of cheese will become infinite. A numerical example may help at this point. Let’s assume, as we did before, that in Home it takes one hour of labor to produce a pound of cheese and two hours to pro- duce a gallon of wine. Meanwhile, let’s assume that in Foreign it takes six hours to pro- duce a pound of cheese—Foreign workers are much less productive than Home workers when it comes to cheesemaking—but only three hours to produce a gallon of wine. In this case, the opportunity cost of cheese production in terms of wine is 1�2 in Home—that is, the labor used to produce a pound of cheese could have produced half a gallon of wine. So the lower flat section of RS corresponds to a relative price of 1�2. Meanwhile, in Foreign the opportunity cost of cheese in terms of wine is 2: The six hours of labor required to produce a pound of cheese could have produced two gallons of wine. So the upper flat section of RS corresponds to a relative price of 2. The relative demand curve RD does not require such exhaustive analysis. The down- ward slope of RD reflects substitution effects. As the relative price of cheese rises, consumers will tend to purchase less cheese and more wine, so the relative demand for cheese falls. The equilibrium relative price of cheese is determined by the intersection of the relative supply and relative demand curves. Figure 3-3 shows a relative demand curve RD that intersects the RS curve at point 1, where the relative price of cheese is between the two countries’ pretrade prices—say, at a relative price of 1, in between the pretrade prices of 1�2 and 2. In this case, each country specializes in the production of the good in which it has a comparative advantage: Home produces only cheese, while Foreign produces only wine. This is not, however, the only possible outcome. If the relevant RD curve were RD′, for example, relative supply and relative demand would intersect on one of the horizon- tal sections of RS. At point 2, the world relative price of cheese after trade is aLC>aLW, the same as the opportunity cost of cheese in terms of wine in Home. What is the significance of this outcome? If the relative price of cheese is equal to its opportunity cost in Home, the Home economy need not specialize in producing either cheese or wine. In fact, at point 2 Home must be producing both some wine and some cheese; we can infer this from the fact that the relative supply of cheese (point Q′ on the horizontal axis) is less than it would be if Home were in fact completely specialized. Since PC>PW is below the opportunity cost of cheese in terms of wine in Foreign, however, Foreign does specialize completely in producing wine. It therefore remains true that if a country does specialize, it will do so in the good in which it has a comparative advantage. For the moment, let’s leave aside the possibility that one of the two countries does not completely specialize. Except in this case, the normal result of trade is that the price of a traded good (e.g., cheese) relative to that of another good (wine) ends up somewhere in between its pretrade levels in the two countries. M03_KRUG6355_11_GE_C03.indd 54 14/10/2017 08:40 CHAPTER 3   ■   Labor …