RICARDO’S MODEL OF TRADE

The slope is also the opportunity cost: amount of cloth that needs to be given up in order to
produce one extra unit of wheat. In the absence of international trade, the PPF acts like a
budget constraint for the country.

Several ways to represent the demand in an economy. One of them is the indifference curve.
Each of them shows the combination of two goods that a person can consume and be equally
satisfied.
 WAGE = P · MPL  Equal in both industries

PC/pW = MPLW/MPLC

A country’s no-trade relative price will determine which good it will export and which one will
be imported. Both countries export the good in which they have the comparative advantage.

GAINS FROM TRADE FOR BOTH COUNTRIES

The Ricardian model is presented with just a single factor of production (labour), where wages
are equal to the marginal product of labour times the price of each good.

Terms of trade: price of a country’s export divided by the price of its imports. A rise in a
country’s ToT makes it better off because it’s exporting at higher prices or importing at lower
prices.

Comparative Advantage is going to lead to full specialisation in production (but there’ll be a

new frontier for consumption). Salaries don’t determine the pattern of trade, it’s only
determined by CA.

SPECIFIC FACTOR’S MODEL

Two factors in each industry: labour as the general one for both industries and land and capital
which are specific to each sector.

Labour presents diminishing returns to scale.

As in Ricardian model, the slope of the PPF also equals the relative price of manufacturing.

W=P · MPL  There’s free mobility of labour, so wages must be equal in both sectors.

With free trade, the world equilibrium price will lie between the no-trade relative prices in
the two countries. But not everyone in the economy is better off.
 Let’s suppose the price of M rises and the price of A doesn’t change.

EFFECT ON REAL WAGES

Real wage in terms of M has fallen and real wage in terms of A has increased. Therefore, we
cannot tell if labour is better off or worse off. It’ll depend on how people spend most of their
income. It varies from Ricardian in which workers are always unambiguously better off than in
the absence of trade.

EARNINGS OF CAPITAL AND LAND

What happens with an increase in the price of M?

Labour will shift from agriculture into manufacturing. As more labour is used in manufacturing,
the MPK increases because each machine has more labour to work it, and vice versa.

An increase in the relative price of an industry’s output will suppose an increase in the
quantity of labour used in that industry. This will raise the marginal product of the factor
specific to that industry, and a decrease in labour will lower the marginal product of the
specific factor. Assuming Manufacturing uses capital as the specific factor…

The specific factor in the sector whose relative price has increased gains, the specific factor in
the other sector loses, and labour is ‘caught in the middle’, with its real wage increasing in
terms of one good but falling in terms of the other.

HECKSCHER-OHLIN MODEL
Specific factor is a short-run model because capital and land cannot move between the two
industries. In contrast, Heckscher-Ohlin model is a long-run model because all factors of
production can move between industries. Let’s focus on labour and capital.

Assumption 1: both factors can move freely between the industries. Capital and labour

Assumption 2: shoe production is labour intensive (it requires more labour per unit of capital
to produce shoes than computers)  Ls/Ks > Lc/Kc.

Assumption 3: Foreign is labour-abundant.

Assumption 4: The final outputs can be traded freely between nations, but labour and capital
don’t move between countries.

Assumption 5: Technologies are identical.

Assumption 6: Consumer tastes are the same across countries.

Under free trade, we expect the equilibrium relative price of computers to lie between the no-
trade relative prices in each country.
With two goods and two factors, each country will export the good that uses intensively the
factor of production it has in abundance and will import the other good.

FACTOR-CONTENT TRADE MODEL: Actually, in the HO model, a country exports the factor I
which it’s relatively abundant in the world.

EFFECTS OF TRADE ON FACTOR PRICES

The relative supply is shown as a vertical line because the total amounts of labour and capital
don’t depend on the relative wage; they are fixed by the total amount of factor resources in
each country.

Let’s face an increase in the relative price of computers.

The relative wage W/R falls, reflecting the fall in the relative demand for labour as both factors
move into computer production from shoe production. This lower relative wage induces both
industries to hire more workers per unit of capital.

An increase in the relative price of computers (which are capital intensive) leads to a fall in
the relative wage (W/R). In turn, this decrease in the relative wage leads to an increase in
the labour-capital ratio used in each industry.

Because the labour-capital ratio increases in both industries, the marginal product of capital
also increases in both industries. This is because there are more people to work with each
piece of capital.

Therefore, capital owners are clearly better off when the relative price of computers increases.

An increase in the relative price of a good will benefit the factor of production used
intensively in producing that good.

CHANGE IN THE REAL WAGE

Assuming the relative price of computers increases and, therefore, an increase in the labour-
capital ratio in both industries, the law of diminishing returns tells us that the marginal
product of labour must fall in both industries.

Real wage is reduced in terms of both goods. Labour is clearly worse off because of the
increase in the relative price of computers.

This result tells us that some groups (those employed intensively in export industries) can be
expected to support opening an economy to trade because an increase in export prices
 increases their real earnings. But other groups (those employed intensively in import
industries) can be expected to oppose free trade because the decrease in import prices
decreases their real earnings.

SKILL PREMIUM

In the US, export industries tend to use high-skilled labour intensively.

 Why HO – Stolper Samuelson is not valid?

- Theory predicts that in Less Developed Countries relative wage of unskilled workers
would increase. However, in reality we also observe skill premium in Less Developed
Countries.

- This theory assumes that with the increase in skilled labour wage, all sectors become
more unskilled labour intensive. However, this is not true in all the industries.

HO theory is based on trade of final goods, and that’s not happening anymore.

FACTOR PRICE EQUALISATION THEOREM

- International trade in foods is a perfect substitute of international movement of

factors.
- Under the HO assumptions, in the long run, the factor remuneration across countries
is the same.
OFFSHORING
ASSUMPTIONS

1) Foreign wages are less than those at home  W*L < WL and
2) Costs of capital and trade and costs of communication or transport are equal to all
tasks in the value chain (T>1).

(H= High-skilled labour; L= Low-skilled labour)

Cost of a task “s”: C(s) = sWH + (1-s) WL.

Price of final good: ∑C(s).

SHOCK: TIC Revolution: This makes the developed country to offshore their low-skill intensive
tasks, which means an increase in the relative demand of skilled labour for both countries
(since low-skilled labour for developed countries are high-skilled labour for the less developed
ones)  Skill Premium.

Offshoring increase gains for both countries. However, there are winners and losers (same
consequences as migration). The relative wage for low-skilled workers falls in both countries.

Furthermore, the ability of firms to relocate some production activities abroad means that
their costs are reduced. In a competitive market, lower costs mean lower prices, so offshoring
benefits consumers.
MONOPOLISTIC COMPETITION
BASICS OF IMPERFECT COMPETITION

To maximize its profits, the monopolist sells up to the point at which the Marginal Revenue
(MR) earned from selling one more unit equals the Marginal Cost (MC).

- We’re not going to have anymore infinite suppliers and consumers. We’re introducing
n (finite) number.
- We don’t have perfect information anymore. In the New Trade Theory, price is not
everything.
- No more free entry and exit. Under monopolistic competition, firms can enter and exit
freely, therefore monopoly profits are zero in the long run.
- No more Constant Returns to Scale. Now, there’ll be Increasing Returns to Scale.

- No more homogeneous products. Now there’s heterogeneity.

 DEMAND

For obtaining the equilibrium we have two curves: CC curve (average cost as function of n) and
PP curve (average price as function of n).

CC CURVE:

Costs are high when there are too many firms (each firm produces in
small quantities).

PP CURVE:

Markups (P-c) are lower, and prices are closer to MC (perfect competition) with many firms.

Deviating from n2 to n1: PP above the CC curve  P>AC: positive profits  new firms enter (n
increases).

Deviating from n2 to n3: PP below the CC curve  P<AC: negative profits  firms exit (n
decreases).
LET’S APPLY TRADE
 GAINS FROM TRADE

- Price has fallen as compared with point A (consumers benefit).

- Increase in variety (consumers benefit).
- Market integration: under imperfect competition, the largest market is going to have
an advantage thanks to economies of scale.
- Rationalization of the industry:

Core-Periphery models help us to understand how rationalization of an industry works.

SUMMARY OF LONG-TERM EFFECTS OF TRADE:

- Lower prices, lower markups.

- More brands available to consumers.
- Each firm produces more.
- Total number of firms decreases.

DETERMINANTS OF RATIONALISATION:

- Firm heterogeneity. After trade liberalisation, less productive firms exit the market
while more productive firms expand.
o Different firms have different MCs.
o Trade costs vary among exporters.
Two effects of market integration:

- For good firms, the size effect is going to dominate. They are going to become bigger.
- For bad firms, the competition effect is going to dominate. They are going to lose
market share.

As a consequence of market integration, good firms are going to see how their profits increase,
while bad firms are going to see how their profits go down.

GAINS FROM TRADE:

- Intra-industry reallocation process. Intra-industry average cost is going to decrease, so

overall level of productivity is going to increase (AC is the inverse of productivity).
- Intra-firm relocation.
PROTECTIONISM
IMPORT TARIFFS FOR A SMALL COUNTRY

The export supply curve is horizontal because, since it’s a small country, it can import any
amount at the price PW without having any impact on that price.

Deadweight loss is due to an inefficiency in the market due to the higher cost (producer side)
and price (consumer side) applied to the product.

Under the small country assumption, we know for sure that the deadweight loss is positive;
that is, the importing country is always harmed by the tariff.

IMPORT TARIFFS FOR A LARGE COUNTRY

However, if we consider a large enough importing country, we might expect that its tariff will
change the world price. In that case, the welfare can be improved by a tariff.

We are no longer going to assume a horizontal export supply curve.

Let’s observe how the introduction of the tariff affects the large country’s welfare:

As a consequence of the tariff (and considering a large country), the tariff will reduce the
country’s consumption and, therefore, world consumption. Thus, price of imports will
decrease, and Terms of Trade (PX/PM) will increase.

For large country to be a winner of the tariff, e > b + d. Foreign is always a loser.

OPTIMAL TARIFF FOR A LARGE IMPORTING COUNTRY

The optimal tariff is defined as the tariff that leads to the maximum increase in welfare for the
importing country.
It’s possible to find the optimal tariff. However, it’s so easy to arrive to the prohibitive one
since it’s very close. However, the optimal tariff it’s normally very high.

CONDITIONS FOR AN OPTIMAL TARIFF TO EXIST

- Large economy (no optimal tariff for small economies).

- The improvement in ToT has to surpass the loses. Inelastic supply curve (as the
elasticity of foreign export supply decreases, the optimal tariff is higher).
- No retaliation.

There are three set-ups where we can impose an optimal tariff in imperfect competition:

- The international supplier is a monopoly and there are no domestic suppliers (it’s a
way to steal a bit of rent thanks to the optimal tariff).
- Argument of protection of an infant industry. It’s accepted by the WTO, but it doesn’t
work normally.
- Antidumping, countervailing measures, safeguard measures.

QUOTAS

It’s the worst instrument in International Economics for three reasons:

1) Worse than the tariff in perfect competition because we don’t know who appropriates
the quota rent.

2) Worse than the tariff in imperfect competition because the quota perpetuates the
monopoly.

3) Worse than the tariff because it stops the adoption of technological progress.

The less developed is the economy, the biggest is its tendency to use quotas since it’s the
easiest way in administrative terms.
Where does the Government Revenue improvement go with quotas? 4 possibilities:

- Giving the Quota to Home Firms. Free quota licenses. There’s no quota rent, so all the
loss falls in the consumers.
- Rent seeking. Lobbies. Rent disappears. Corruption clientelism
- Auctioning the Quota. Subasta. In a well-organized, competitive auction, the revenue
collected should exactly equal the value of the rents (so that area c would be earned
by the government). Best option.
- Voluntary Export Restraint. The license goes to the foreign country and, therefore, the
rent goes for the exporter country too.

Export subsidy is, in perfect competition, even worse than quotas. If the objective is to have a
domestic production, the correct instrument would be a subsidy for production instead of
exporting.