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Krugman Obstfeld Ch03 1. Prakhar Rathee. Duke University Press. For example, it might require 1 hour of labor to produce a pound of cheese, 2 hours to produce a gallon of wine. 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. The line PF shows the maximum Home wine amount of cheese Home can production, Qw, in gallons produce given any production of wine, 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, the labor used in producing cheese aLCQc- The production possibility fron- tier 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. 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 MaLW gallons of wine. Thus the opportunity cost of cheese in terms of wine is aLClaLW.
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 cheese in terms of wine is one- half. As Figure 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 individu- als 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 movement of labor to whichever sector pays the higher wage.
Let Pc and Pw be the prices of cheese and wine, respectively. What is the significance of the number aLClaLWl 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 spe- cialize in the production of cheese if the relative price of cheese exceeds its opportunity cost; it will specialize in the production of wine if the relative price of cheese is less than its opportunity cost. 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 oppor- tunity cost. Since opportunity cost equals the ratio of unit labor requirements 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.
Vade 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 sur- prising. 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 constitutes fair interna- tional competition and fair international exchange.
Before we get to these issues, however, let us get the model stated. Suppose that 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. For Foreign we will use a conve- nient notation throughout this book: When we refer to some aspect of Foreign, we will use the same symbol that we use for Home, but with an asterisk.
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. 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 advantage pre- cisely in terms of such opportunity costs. So the assumption about relative productivities embodied in equations and 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 compare the two countries' unit labor requirements in cheese production, aLC and afc. 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 advan- tage 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 discussing international trade is to confuse comparative advantage with absolute advantage. 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 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. Once we allow for the possibility of international trade, however, prices will no longer be determined purely by domestic considerations.
Only true fans of three years. Because Ruth The Babe's World Series pitching record was stopped pitching after and played outfield broken by New York Yankee Whitey Ford in the during all the time he set his famous batting same year, , that his teammate Roger Maris records, most people don't realize that he even shattered Ruth's record of 60 home runs in a could pitch.
What explains Ruth's lopsided repu- single season. The answer is provided by the Although Ruth had an absolute advantage in principle of comparative advantage. As a pitcher, however, tage in pitching. According to historian Geoffrey C. Ruth had to rest his arm between appearances and Ward and filmmaker Ken Burns: therefore could not bat in every game. To exploit Ruth's comparative advantage, the Red Sox In the Red Sox's greatest years, he was their moved him to center field in so that he could greatest player, the best left-handed pitcher bat more frequently.
In he got his first chance to was huge. In he hit 29 home runs, "more than pitch in the World Series and made the most any player had ever hit in a single season," accord- of it. After giving up a run in the first, he ing to Ward and Burns. The Yankees kept Ruth in drove in the tying run himself, after which he the outfield and at the plate after they acquired held the Brooklyn Dodgers scoreless for him in They knew a good thing when they eleven innings until his teammates could saw it.
That year, Ruth hit 54 home runs, set a score the winning run. Ruth's career preceded the designated hitter rule, so American League pitchers, like National League pitchers today, took their turns at bat. 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 8 through 11, it is acceptable to focus only on supply and demand in a single market. In assessing the effects of U. Because Foreign's relative unit Foreign wine labor requirement in cheese is production, Q in gallons higher than Home's it needs to give up many more units of wine to produce one more unit of cheese , its production possi- bility frontier is steeper.
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 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 gal- lons of wine supplied or demanded.
Figure 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 rela- tive supply equal relative demand, and thus the world relative price is determined by the intersection of RD and RS.
The striking feature of Figure is the funny shape of the relative supply curve RS: a "step" with flat sections linked by a vertical section. Once we understand the derivation of the RS curve, we will be almost home-free in understanding the whole model. Next, when the relative price of cheese, PC! So Home will be will- ing to supply any relative amount of the two goods, producing a flat section to the supply curve.
When Home specializes in cheese production, it produces LlaLC pounds. Thus here we again have a flat section of the supply curve. There will be no wine production, so that the relative supply of cheese will become infinite. The relative demand curve RD does not require such exhaustive analysis. The downward 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 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.
In this case each country specializes in the production of the good in which it has a comparative advantage: Home produces only cheese, Foreign 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 horizontal sec- tions of RS.
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 hori- zontal axis is less than it would be if Home were in fact completely specialized. It therefore remains true that if a country does specialize, it will do so in the good in which it has a comparative advantage.
Let us for the moment 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. The effect of this convergence in relative prices is that each country specializes in the pro- duction of that good in which it has the relatively lower unit labor requirement.
The rise in the relative price of cheese in Home will lead Home to specialize in the production of cheese, pro- ducing at point F in Figure a. The Gains From Trade We have now seen that countries whose relative labor productivities differ across industries will specialize in the production of different goods. We next show that both countries derive gains from trade from this specialization. This mutual gain can be demonstrated in two alternative ways.
The first way to show that specialization and trade are beneficial is to think of trade as an indirect method of production. Home could produce wine directly, but trade with Foreign allows it to "produce" wine by producing cheese and then trading the cheese for wine. This indirect method of "producing" a gallon of wine is a more efficient method than direct production.
Consider two alternative ways of using an hour of labor. This will be more wine than the hour could have produced direct- ly as long as. This shows that Home can "produce" wine more efficient- ly by making cheese and trading it than by producing wine directly for itself. Quantity Quantity of wine, Qw of wine,.
Quantity Quantity of cheese, Qc of cheese,. International trade allows Home and Foreign to consume anywhere within the colored lines, which lie outside the countries' production possibility frontiers.
Foreign can "produce" cheese more efficiently by making wine and trading it. This is one way of seeing that both countries gain. Another way to see the mutual gains from trade is to examine how trade affects each country's possibilities for consumption. Once trade is allowed, however, each economy can consume a different mix of cheese and wine from the mix it produces.
In each case trade has enlarged the range of choice, and therefore it must make residents of each country better off. A Numerical Example In this section, we use a numerical example to solidify our understanding of two cru- cial points:. When two countries specialize in producing the goods in which they have a compar- ative advantage, both countries gain from trade.
Comparative advantage must not be confused with absolute advantage; it is compar- ative, not absolute, advantage that determines who will and should produce a good. Suppose, then, that Home and Foreign have the unit labor requirements illustrated in Table A striking feature of this table is that Home has lower unit labor requirements, that is, has higher labor productivity, in both industries.
Let us leave this observation for a moment, however, and focus on the pattern of trade. In world equilibrium, the relative price of cheese must lie between these values.
It takes only half as many person-hours in Home to produce a pound of cheese as it takes to produce a gallon of wine 1 versus 2 ; so Home workers can earn more by produc- ing cheese, and Home will specialize in cheese production.
Conversely, it takes twice as many Foreign person-hours to produce a pound of cheese as it takes to produce a gallon of wine 6 versus 3 , so Foreign workers can earn more by producing wine, and Foreign will specialize in wine production.
Let us confirm that this pattern of specialization produces gains from trade. First, we want to show that Home can "produce" wine more efficiently by making cheese and trading it for wine than by direct production. In direct production, an hour of Home labor produces only Vi gallon of wine.
The same hour could be used to produce 1 pound of cheese, which can then be traded for 1 gallon of wine. Clearly, Home does gain from trade. Similarly, For- eign could use 1 hour of labor to produce[A pound of cheese; if, however, it uses the hour to produce 'A gallon of wine it could then trade the A gallon of wine for XA pound of cheese.
In this example, each country can use labor twice as efficiently to trade for what it needs instead of producing its imports for itself. Relative Wages Political discussions of international trade often focus on comparisons of wage rates in dif- ferent countries. Our discus- sion of international trade up to this point has not explicitly compared wages in the two countries, but it is possible in the context of this numerical example to determine how the wage rates in the two countries compare.
In this example, once the countries have specialized, all Home workers are employed producing cheese. Our discussion of the gains from trade would deprive both the United States and Britain was considered a "thought experiment" in which of the gains from trade, but Jefferson hoped that we compared two situations: one in which coun- Britain would be hurt more and would agree to tries do not trade at all, another in which they have stop its depredations.
It's a hypothetical case that helps us to Irwin presents evidence suggesting that the understand the principles of international econom- embargo was quite effective: although some smug- ics, but it doesn't have much to do with actual gling took place, trade between the United States events. After all, countries don't suddenly go from and the rest of the world was drastically reduced.
Or do they? Although quite a the country actually did carry out something very lot of guesswork is involved, Irwin suggests that close to the thought experiment of moving from real income in the United States may have fallen free trade to no trade. The historical context was by about 8 percent as a result of the embargo.
Both countries endeavored to bring transport costs were still too high, for example, to economic pressures to bear: France tried to keep allow large-scale shipments of commodities like European countries from trading with Britain, while wheat across the Atlantic—that's a pretty substan- Britain imposed a blockade on France.
The young tial sum. United States was neutral in the conflict but suf- Unfortunately for Jefferson's plan, Britain did fered considerably. In particular, the British navy not seem to feel equal pain and showed no inclina- often seized U. Fourteen months forcibly recruited their crews into its service. In an effort to pressure Britain into ceasing these Britain continued its practices of seizing American practices, President Thomas Jefferson declared a cargoes and sailors; three years later the two coun- complete ban on overseas shipping.
This embargo tries went to war. Home earn the value of 1 pound of cheese per hour of their labor. Similarly, Foreign work- ers produce only wine; since it takes 3 hours for them to produce each gallon, they earn the value of 'A of a gallon of wine per hour. To convert these numbers into dollar figures, we need to know the prices of cheese and wine. The relative wage of a country's workers is the amount they are paid per hour, compared with the amount workers in another country are paid per hour.
The relative wage of Home workers will therefore be 3. As long as the relative price of cheese—the price of a pound of cheese divided by the price of a gallon of wine—is 1, the wage of Home workers will be three times that of Foreign workers.
Notice that this wage rate lies between the ratios of the two countries' productivities in the two industries. Home is six times as productive as Foreign in cheese, but only one-and- a-half times as productive in wine, and it ends up with a wage rate three times as high as Foreign's.
It is precisely because the relative wage is between the relative productivities that each country ends up with a cost advantage in one good. Because of its lower wage rate, Foreign has a cost advantage in wine, even though it has lower productivity. Home has a cost advantage in cheese, despite its higher wage rate, because the higher wage is more than offset by its higher productivity. We have now developed the simplest of all models of international trade. Even though the Ricardian one-factor model is far too simple to be a complete analysis of either the causes or the effects of international trade, a focus on relative labor productivities can be a very useful tool for thinking about international trade.
In particular, the simple one-factor model is a good way to deal with several common misconceptions about the meaning of comparative advantage and the nature of the gains from free trade. These misconceptions appear so frequently in public debate about international economic policy, and even in statements by those who regard themselves as experts, that in the next section we take time out to discuss some of the most common misunderstandings about comparative advantage in light of our model.
There is no shortage of muddled ideas in economics. Politicians, business leaders, and even economists frequently make statements that do not stand up to careful economic analysis. For some reason this seems to be especially true in international economics. Open the business section of any Sunday newspaper or weekly news magazine and you will probably find at least one article that makes foolish statements about international trade.
Three misconceptions in particular have proved highly persistent, and our simple model of comparative advantage can be used to see why they are incorrect. Productivity and Competitiveness Myth 1: Free trade is beneficial only if your country is strong enough to stand up to foreign competition.
This argument seems extremely plausible to many people. For example, a well-known historian recently criticized the case for free trade by asserting that it may fail to hold in reality: "What if there is nothing you can produce more cheaply or efficiently than anywhere else, except by constantly cutting labor costs? He is concerned that your country may turn out not to have anything it produces more efficiently than anyone else—that is, that you may not have an absolute advantage in anything.
Yet why is that such a terrible thing? In our simple numerical example of trade, Home has lower unit labor requirements and hence higher productivity in both the cheese and wine sectors. Yet, as we saw, both countries gain from trade. Tt is always tempting to suppose that the ability to export a good depends on your country having an absolute advantage in productivity.
But an absolute productivity advantage over other countries in producing a good is neither a necessary nor a sufficient condition for having a comparative advantage in that good. In our one-factor model the reason why abso- lute productivity advantage in an industry is neither necessary nor sufficient to yield com- petitive advantage is clear: The competitive advantage of an industry depends not only on its productivity relative to the foreign industry, but also on the domestic wage rate relative to the foreign wage rate.
A country's wage rate, in turn, depends on relative productivity in its other industries. In our numerical example, Foreign is less efficient than Home in the man- ufacture of wine, but at even a greater relative productivity disadvantage in cheese.
Because of its overall lower productivity, Foreign must pay lower wages than Home, sufficiently lower that it ends up with lower costs in wine production. Similarly, in the real world, Portugal has low productivity in producing, say, clothing as compared with the United States, but because Portugal's productivity disadvantage is even greater in other industries it pays low enough wages to have a comparative advantage in clothing all the same.
But isn't a competitive advantage based on low wages somehow unfair? Many people think so; their beliefs are summarized by our second misconception.
The Pauper Labor Argument Myth 2: Foreign competition is unfair and hurts other countries when it is based on low wages. This argument, sometimes referred to as the pauper labor argument, is a particu- lar favorite of labor unions seeking protection from foreign competition.
People who adhere to this belief argue that industries should not have to cope with foreign industries that are less efficient but pay lower wages. This view is widespread and has acquired considerable political influence.
In Ross Perot, a self-made billionaire and former presidential candidate, warned that free trade between the United States and Mexico, with its much lower wages, would lead to a "giant sucking sound" as U. In the same year Sir James Goldsmith, another self-made billionaire who was an influential member of the European Parliament, offered similar if less picturesquely expressed views in his book The Trap, which became a best-seller in France.
Again, our simple example reveals the fallacy of this argument. In the example, Home is more productive than Foreign in both industries, and Foreign's lower cost of wine produc- tion is entirely due to its much lower wage rate. Foreign's lower wage rate is, however, irrel- evant to the question of whether Home gains from trade. Whether the lower cost of wine produced in Foreign is due to high productivity or low wages does not matter.
All that mat- ters to Home is that it is cheaper in terms of its own labor for Home to produce cheese and trade it for wine than to produce wine for itself. This is fine for Home, but what about Foreign? Isn't there something wrong with basing one's exports on low wages? Certainly it is not an attractive position to be in, but the idea that trade is good only if you receive high wages is our final fallacy.
Exploitation Myth 3: Trade exploits a country and makes it worse off if its workers receive much lower wages than workers in other nations. This argument is often expressed in emotional terms. In the numerical example that we use worker in South Korea was only 20 percent of the to puncture common misconceptions about com- U.
The country a cost advantage in one of the two goods. This is a necessary implication of our theoretical The first two columns show compensation wages model. But many people are unconvinced by that plus benefits as a percent of the U. In particular, rapid increases in productivi- and ; clearly there was a dramatic conver- ty in "emerging" economies like China have wor- gence of wages toward the U. The U. Bureau of their productivity increases—putting high-wage Labor Statistics has calculated rates of change in countries at a cost disadvantage—and dismiss the unit labor costs for South Korea and Taiwan, contrary predictions of orthodox economists as though not for the other Asian economies.
If wage unrealistic theoretical speculation. Leaving aside growth lagged behind productivity, unit labor costs the logic of this position, what is the evidence? The labor costs would rise. In fact, as the third column so-called Asian tigers—South Korea, Taiwan, of the table shows, South Korea's unit labor costs Hong Kong, and Singapore—began a rapid pro- lagged slightly behind those in the United States, cess of development in the s and achieved while Taiwan's grew more rapidly.
For example, output per ty increases are reflected in wage increases. American workers who produce some of its merchandise. If one is asking about the desirability of free trade, however, the point is not to ask whether low-wage workers deserve to be paid more but to ask whether they and their coun- try are worse off exporting goods based on low wages than they would be if they refused to enter into such demeaning trade.
And in asking this question one must also ask, what is the alternative? Abstract though it is, our numerical example makes the point that one cannot declare that a low wage represents exploitation unless one knows what the alternative is.
In that example, Foreign workers are paid much less than Home workers, and one could easily imagine a columnist writing angrily about their exploitation. The columnist who pointed out the contrast in incomes between the executive at TJie Gap and the workers who make its clothes was angry at the poverty of Central American workers.
But to deny them the opportunity to export and trade might well be to condemn them to even deeper poverty. This simplified analysis allows us to capture many essential points about comparative advantage and trade and, as we saw in the last section, gives us a surprising amount of mileage as a tool for discussing policy issues. To move closer to reality, however, it is necessary to understand how comparative advantage functions in a model with a larger number of goods.
As before, each country has only one factor of production, labor. Each of these countries will now, however, be assumed to consume and to be able to produce a large number of goods—say, N different goods alto- gether. We assign each of the goods a number from 1 to N; The technology of each country can be described by its unit labor requirement for each good, that is, the number of hours of labor it takes to produce one unit of each.
We label Home's unit labor requirement for a particular good as au, where i is the number we have assigned to that good. If cheese is now good number 7, aL1 will mean the unit labor require- ment in cheese production.
The trick is to relabel the goods so that. That is, we reshuffle the order in which we number goods in such a way that. Relative Wages and Specialization We are now prepared to look at the pattern of trade. This pattern depends on only one thing: the ratio of Home to Foreign wages. Once we know this ratio, we can determine who pro- duces what. The rule for allocating world production, then, is simply this: Goods will always be produced where it is cheapest to make them.
The cost of making some good, say good i, is the unit labor requirement times the wage rate. To produce good i in Home will cost waLi. It will be cheaper to produce the good in Home if. All the goods to the left of the cut end up being produced in Home; all the goods to the right end up being produced in Foreign. It is possible, as we will see in a moment, that the ratio of wage rates is exactly equal to the ratio of unit labor requirements for one good.
In that case this borderline good may be produced in both countries. Table offers a numerical example in which Home and Foreign both consume and are able to produce five goods: apples, bananas, caviar, dates, and enchiladas. The first two columns of this table are self-explanatory.
The third column is the ratio of the Foreign unit labor requirement to the Home unit labor requirement for each good—or, stated differently, the relative Home productivity advantage in each good. We have labeled the goods in order of Home productivity advantage, with the Home advantage greatest for apples and least for enchiladas. Apples 1 10 10 Bananas 5 40 8 Caviar 3 12 4 Dates 6 12 2 Enchiladas 12 9 0.
Which country produces which goods depends on the ratio of Home and Foreign wage rates. Home will have a cost advantage in any good for which its relative productivity is higher than its relative wage, and Foreign will have the advantage in the others.
If, for example, the Home wage rate is five times that of Foreign a ratio of Home wage to Foreign wage of five to one , apples and bananas will be produced in Home and caviar, dates, and enchiladas in Foreign. If the Home wage rate is only three times that of Foreign, Home will produce apples, bananas, and caviar, while Foreign will produce only dates and enchiladas. Is such a pattern of specialization beneficial to both countries?
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