Reference to Online Resources

 The following slides on trade in an one

factor world are additionally available in
Moodle with audio explanations
(presentation set too sound)

59
 Trade in a One-Factor World (I)

• For the following considerations it is assumed (arbitrarily) that

𝒂𝑳𝑪 𝒂∗𝑳𝑪 𝒂𝑳𝑪 𝒂𝑳𝑾
< which is equivalent to <
𝒂𝑳𝑾 𝒂∗𝑳𝑾 𝒂∗𝑳𝑪 𝒂∗𝑳𝑾

(with * indicating Foreign country)

 Home has a comparative advantage in producing
cheese (Home’s opportunity cost of cheese are lower than
Foreign’s opportunity cost of cheese)

• In the absence of trade the relative prices in each country

would be determined by the opportunity cost
 The relative price of cheese would be
𝒂𝑳𝑪 𝒂∗
𝒂𝑳𝑾
in Home and 𝒂∗ 𝑳𝑪 in Foreign
𝑳𝑾

 Thus, in autarky the relative price of cheese is higher in

Foreign than in Home (see assumption)
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 Trade in a One-Factor World (II)

• If international trade takes place it will be profitable to ship cheese

from Home to Foreign and wine from Foreign to Home if the
relative price of cheese in autarky is higher in Foreign than in
Home
 Due to international trade the relative prices in Home and
Foreign will equalize (relative world market price)
 The level at which the relative price settles is determined by
the forces of supply and demand

• the supply and demand analysis has to be carried out in a general

equilibrium analysis
 Analyzing comparative advantage requires to keep track of
the relationship between markets / to take into account the
linkages between markets which is done by looking at
relative supply and demand
 It is not sufficient to look at one market in isolation (‘partial
equilibrium analysis’)
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 Trade in a One-Factor World (III)

• Deriving the world relative demand and supply curves:

Relative price
of cheese
Pc / Pw
𝑎 ∗ 𝐿𝐶
RS
𝑎 ∗ 𝐿𝑊

𝑎𝐿𝐶 2
𝑎𝐿𝑊
RD
Relative quantity
RD’ of cheese
Q’ 𝐿 𝑄𝑐 + 𝑄 ∗
𝑎𝐿𝐶 𝑄𝑤 + 𝑄 ∗
𝐿∗
𝑎∗

Source: Krugman / Obstfeld (2009), page 34.

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 Trade in a One-Factor World (IV)

 Countries specialize on the production of the good in which they

possess a comparative advantage

 In case both countries will completely specialize their production,

trade lets the price of a trade good (e.g. cheese) relative to that of
another good (wine) end up somewhere in between the pre-trade
levels in the two countries

(the rise of the relative price of cheese in Home will lead Home to
completely specialize on cheese production, the fall in the relative
price of cheese at Foreign will lead Foreign to completely
specialize in the production of wine)

63
 Trade in a One-Factor World (V)

Gains from Trade

• Trade can be regarded as an indirect method of production

 instead of producing wine directly, Home produces wine

‘indirectly’ by trading cheese for wine

 The ‘indirect’ production is more efficient since one hour of

labor leads to more wine in exchange for cheese than the
direct production would have yield to.

 The same applies analogous to Foreign for the ‘indirect’

production of cheese

 Both countries gain

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 Trade in a One-Factor World (VI)

Illustration of the Gains from Trade with an example:

Cheese Wine
Home aLC = 1 hour per aLW = 2 hours per
pound gallon
Foreign a*LC = 6 hours per a*LW = 3 hours
pound per gallon Source:
Krugman / Obstfeld
• Opportunity cost of cheese in terms of wine (2009), page 37.

 in Home: = = 0,5
∗
 In Foreign: = =2
∗

• If the relative price of cheese after trade lies between the opportunity
cost in Home and in Foreign, both countries will specialize:
∗
 < <  0,5 < <2 assumption: =1
∗
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 Trade in a One-Factor World (VII)

• Gains from trade in example:

 If Home would produce wine directly, an hour of

labor would produce only ½ gallon of wine

 If Home would use this hour to produce cheese, this

would yield to 1 pound of cheese
1 pound of cheese can be traded for 1 gallon of wine

 With indirect production Home gets twice the

amount of wine than with direct production

 Home gains from trade

66
 Trade in a One-Factor World (VIII)

• Gains from trade in example (continued):

 If Foreign would produce cheese directly, an hour of

labor would produce only 1/6 pound of cheese

 If Foreign would use this hour to produce wine, this

would yield to 1/3 gallon of wine
1/3 gallon of wine can be traded for 1/3 pound of
cheese

 With indirect production Foreign gets twice the

amount of cheese than with direct production

 Foreign gains from trade

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 Trade in a One-Factor World (IX)

• Trade expands consumption possibilities

Quantity Quantity
of wine of wine
T F*

F T*
Quantity P* Quantity
of cheese of cheese
Home Foreign

 In the absence of trade, the consumption possibilities are

equal to the production possibilities
 Trade enlarges the range of choice
 Specialization allows the countries to realize consumption
combinations that are outside the production possibilities
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 Trade in a One-Factor World (X)

Relative Wages

• The hourly wage of a worker is equal to the value of the good

produced with one hour of work

Using the numeric example for illustration:

 Home specializes on the production of cheese with one hour
of work producing one pound of cheese, thus a worker in
Home earns the value of one pound of cheese per hour of
their labor
 Foreign specializes on the production of wine with one hour of
work leading to 1/3 gallon of wine, thus a worker in Foreign
earns the value of 1/3 gallon of wine per hour of work
 If we assume the price of both goods is for example EUR 12,
then Home workers will earn EUR 12 per hour and Foreign
workers EUR 4 per hour
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 Trade in a One-Factor World (XI)

Relative Wages (continued)

• The relative wage is the amount paid per hour to a country’s

worker compared to the amount paid per hour to a worker in
another country
 In the example the relative wage of Home’s workers is 3
respectively the relative wage of Foreign’s workers is 1/3
 This means the wage of Home’s workers is three times
that of a foreign worker

• The relative wage lies in between the relative productivities of

the countries
 Home is six times as productive as Foreign with regard to
cheese and one-and-a-half times as productive in wine;
the wage is three times as high as in Foreign (6 > 3 > 1,5)

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 Trade in a One-Factor World (XII)

Relative Wages (continued)

 Because of its low wage rate, Foreign has a cost

advantage in wine (even though it has a 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

71
Considering Transport Costs and Nontraded Goods (I)

• Based on the assumptions of the (simple) Ricardian model,

international specialization is very extreme
 usually a good is produced either in Home or in Foreign
 only in exceptional cases a good is produced in both
countries

• There are three main reasons, why specialization in the real

international economy is only incomplete:
 The existence of more than one factor of production reduces
the tendency toward specialization (→ Heckscher-Ohlin
model)
 Countries sometimes protect their industries from foreign
competition (→ protectionism, trade policy)
 It is costly to transport goods and services, and in some
cases the cost of transportation is enough to have countries
remaining self-sufficient in certain sectors
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Considering Transport Costs and Nontraded Goods (II)

• Transportation cost can offset cost advantages of a country in the

production of a good
 In the presence of transportation cost, some goods can
become nontraded goods

• There is a wide range of transportation scenarios

 Sometimes transportation is not reasonably possible (e.g.
services like haircuts or auto repair)
 Goods with a high weight-to-value ratio (e.g. cement) are
also traded only in small amounts

 Many goods end up being nontraded either because of the

absence of a strong national cost advantage or because of high
transportation cost

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 Limits of the Ricardian model

• The Ricardian model predicts an extreme degree of

specialization which cannot be observed in the real world
 Results from considering only one factor of labor, abstracting
from protectionist trade policies and ignorance of
transportation cost

• The Ricardian model ‘assumes away’ the effects of international

trade on the distribution within countries; despite the overall
welfare gain, some parts of the economy may lose from trade
 International trade has strong effects on income distribution
which are not considered

• The Ricardian model does not consider differences in resources

among countries as a cause of trade (i.e. differences in factor
endowments)

• The Ricardian model cannot explain trade between similar

countries since it neglects the possible role of economies of scale
74
 Empirical Evidence on the Ricardian Model (I)

• Despite its shortcomings the Ricardian model is an

extremely useful tool for thinking about the reasons and
effects of international trade

• The basic prediction of the Ricardian model - that countries

tend to export those goods in which their productivity is
relatively high - has been strongly confirmed by a number
of studies

• Evidence also confirms that trade depends on comparative,

not absolute advantage

75
 Empirical Evidence on the Ricardian Model (II)

 The Ricardian model is not a fully adequate description of

the causes and consequences of world trade

 Nevertheless, its principal implications are supported by

evidence

 Productivity differences play an important role in

international trade

 Comparative rather than absolute advantage matters

 Both countries gain from trade

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