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International Economics
Lecture 2

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Outline
more on the Law of Comparative Advantage
an exception

Absolute vs Comparative, and International Wages

Some permutations on the 2x2x1 model

N goods
N countries

International specialisation

Neoclassical Trade Theory

Propositions
Structure of the Neoclassical model
Production

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Exception to the Law of Comparative Advantage

If the absolute advantage of one nation is the same in both commodities, no mutually
benecial trade can take place.

Argentina USA

Unit Labour Requirement

Meat 4 > 2

Microchips 16 > 8

Total Output

Total labour 120 200

Meat 30 < 100

Microchips 7.5 < 25

Opportunity Cost

Meat 0.25 = 0.25

Microchips 4 = 4

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Absolute vs Comparative adv and International Wages

• So far, we argued that it is the opportunity cost and the

comparative advantage that determines international trade
patterns and the gains from trade.

• However, absolute cost advantage determines international

wage patterns and per capita welfare level

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Absolute & Comparative, and International Wages

Argentina USA
Unit Labour Requirement
Meat 4 > 2
Microchips 24 > 8

USA specialises in M'chips, Argentina in Meat

• Assume Dollar/Peso exchange rate = 1, and use Argentinean wage rate as

numéraire (WMeat
A = 1).
• Under perfect competition with Constant Returns to Scale (CRS), price = cost
of production (P = aL ·W )
⇒Pmeat = aAmeat ·W A = 4 · 1 = 4 ; Pm0 chips = aUSA
m0 chips ·W
USA = 8 ·W USA

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Absolute vs Comparative Adv and International Wages

Argentina USA
Unit Labour Requirement
Meat 4 > 2
Microchips 24 > 8
USA specialises in M'chips, Argentina in Meat
Pmeat = aAmeat ·W = 4 · 1 = 4 ; Pm0 chips = aUSA
m0 chips ·W
USA = 8 ·W USA

• What if the USA produced meat? their price of meat would be Pmeat
USA = 2 ·W USA

• since only Argentina produces meat, Pmeat

USA must be higher than P
meat
⇒ 2 ·W USA > 4 ⇒ W USA > 2
• What if Argentina produced microchips? their price of m'chips would be
PmA0 chips = 24 · 1
• since only the USA produces microchips, PmA0 chips must be higher than 8 ·W USA ,
i.e. 24 > 8 ·W USA ⇒ 2 < W USA < 3
Note that W USA is 2 to 3 times W A = 1 (as dierences in absolute productivity)
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Permutation 1: 2xNx1
• the country's technology represented in terms of unit labour
requirements, i.e. aLi & a∗Li ; with 1<i<N
• reshue so that:
aL1 aL2 aL3 aLN
< ∗ < ∗ < ... < ∗ ; (1)
a∗L1 aL2 aL3 aLN
• in order to determine the pattern of trade, we need relative wages
w
w∗
• Cheaper to produce @ Home, if

aL1 w∗ a∗ w
w · aLi < w∗ · a∗Li ; ∗ < ; or L1 > ∗
aL1 w aL1 w
• Cheaper to produce @ Foreign, if

aL1 w∗ a∗ w
w · aLi > w∗ · a∗Li ; ∗ > ; or L1 < ∗
aL1 w aL1 w
• in equation (1),
w
w∗ is the cut-o for what Home produces and Foreign
produces.

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Permutation 2: Nx2x1

• N=4

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Permutation 2: N countries

• N=4

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Revealed Comparative Advantage

Balassa-Liesner-Samuelson or Balassa-Samuelson Index (BI)

• To establish whether a country has a strong position in a

particular sector, j, we can look at its export position
compared to another reference country position:

ExportsAj /Total ExportsA

• BIBA =
ExportsBj /Total ExportsB

• If BI > 1 ⇒ country A has revealed comparative advantage

over country B in the production of good/sector j

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Revealed Comparative Advantage

BI for Finland

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Revealed Comparative Advantage

BI for Italy

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International specialisation

• In reality, international specialisation is not so extreme;

• Why?

• more than one factor of production

• protectionist policies
• transportation costs
• non-traded goods

• These explanations are next

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Problems with absolute and comparative cost advantage

• largest dierences in absolute and comparative advantage

between nations with largest dierences in development

• however, trade between developed-less developed nations often

smaller than trade between developed nations
• other factors are probably relevant: capital? natural resources?

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Neoclassical trade theory

• We now turn to the analysis of comparative advantage in

economies that are

• perfectly competitive
• have identical technologies
• exhibit constant returns to scale
• Trade results from dierences in factor endowment
• for the moment, let's ignore trade policy (e.g. taris).
• we will return to trade policy later

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Neoclassical Trade
Four main propositions

1. Factor Price Equalisation (Samuelson, 1948/49):

free international trade of nal goods leads to the equalisation
of production factors rewards in the two nations;

2. Stolper-Samuelson (Stolper and Samuelson, 1941):

an increase in the price of a nal good increases the reward to
the factor of production used intensively in the production of
that good;

3. Rybczynski (Rybczynski , 1955):

an increase in the supply of a production factor increases the
output of the nal good that uses that factor intensively;

4. Heckscher-Ohlin (Ohlin, 1933):

a country will export the good which intensively uses the
relatively abundant factor of production.

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Neoclassical Model
Structure and assumptions

• 2 countries (A & B), 2 goods (M & F), 2 factors (K & L): 2 x 2 x 2;

• production under Constant Returns to Scale (CRS), with dierent

production functions;

• two countries adopt same technology (sectoral production functions are

identical):

• trade ows do not originate from Ricardian dierences in

technology;

• K & L are mobile between sectors within a country, but immobile across
countries;

• perfect competition, no transport costs or other impediments to trade;

• two countries have same demand structure (identical homothetic

preferences);

• BUT amounts of K & L are dierent between the two nations:

⇒ dierences in factor abundance determine international trade ows.

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CRS + Perfect Competition

a digression on the microeconomics of production

These assumptions determine the relationship between the cost of

production and the equilibrium price in the market

• Under CRS, knowing the cost of producing one unit of good x

gives enough information to know the cost of producing any
number of units of x, Nx , even if there are many inputs.

• Under perfect competition, the rm takes

• c as given, determined by technology (the PF) and the cost of

inputs
total cost = cx
• p as given, determined by the market

total revenues = px

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under perfect competition

• Prots, π = px − cx = (p − c) · x
• p < c ⇒ xπmax = 0
• p = c ⇒ π max = 0
• p > c ⇒ xπmax = ∞

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Production function
• Cobb-Douglas production functions:
1−αm ; M = K f L f α 1−α
Mm = Kmαm Lm f f f ; 0 < αm , α f < 1
• both K and L necessary and can be substituted to produce
same amount of output
• isoquant: all ecient combinations of K & L to produce a
certain level of output

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slope of isoquants
The isoquant species all possible ecient input combinations to obtain a certain output,
i.e. M = M̄
• Totally dierentiate production function and set to 0:
M = K α L1−α
∂M ∂M
dM = dK + dL = d M̄ = 0
∂K ∂L
αK
|
α−1 1−α
{zL } dK + (1 − α)K α L−α dL = d M̄ = 0
| {z }
∂ M/∂ K ∂ M/∂ L

−αK α−1 L1−α dK = (1 − α)K α L−α dL;

dK (1 − α)K α L−α (1 − α) K
=− 1−α
=−
dL αK α−1 L α L
slope of isoquant depends only on K/L ratio. If K & L are
multiplied by a same proportion, slope does not change.

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slope of isoquant and the size of α

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Cost Minimisation
Graphical analysis
• Costs = w · Lm + r · Km ⇒ Km = Cr − wr Lm & −w/r is the slope of the isocost
line

Point C gives the optimal combination Km (w, r) and Lm (w, r)

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Cost minimisation
From graphical analysis to analytical solution

T OTAL COST S = C = wLm + rKm ;

|{z} |{z}
labour capital
cost cost

ISOCOST : Km = C
r − wLr m ; slope = − wr

MPLm w
= ⇒
MPKm r
dYm 1−αm −1
MPLm = = (1 − αm )K αm Lm ; MPKm = αm K αm −1 L1−αm ;
dLm

MPLm (1 − αm )K αm Lm1−αm −1 w

Km 1 − αm

w Km αm w
= = ⇒ = ⇒ =
MPKm αm K αm −1 L1−αm r Lm αm r Lm 1 − αm r
MPLf w Kf αf w
= ⇒ =
MPKf r Lf 1 − αf r
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Cost minimisation
solution by Lagrangean

min wL + rK s.t. M = K α L1−α ≥ 1

K,L

• set Lagrangean: Γ = wL + rK + λ (1 − K α L1−α )

• Derive First Order Conditions (F.O.C.), ∂ Γ/∂ K, ∂ Γ/∂ L = 0
w = λ (1 − α)K α L−α & r = λ αK α−1 L1−α
• Take ratio between w and r, and solve for
K
L:
K α w
=
L 1−α r
• To nd L(w, r) and K(w, r),substitute into M=1 and solve for L∗ and K∗:
 α
α w
M = K α L1−α = L L1−α = 1
1−α r
 −α  1−α
α w α w
L(w, r) = K(w, r) =
1−α r 1−α r
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Cost minimisation
Duality result

• What are the minimum costs for producing 1, c(w, r)?

 −α  1−α
α w α w
c(w, r) = wL(w, r) + rK(w, r) = w +r
1−α r 1−α r
• After simplication, we can rewrite as unit cost function:

c(w, r) = γrα w1−α γ ≡ α −α (1 − α)−(1−α) ;

• Note: unit cost function is also Cobb-Douglas and similar to production
function
α w −α
 
∂ c(w, r)
= = L(w, r)
∂w 1−α r
α w 1−α
 
∂ c(w, r)
= = K(w, r)
∂r 1−α r
This result is known as DUALITY

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interpretation of capital intensity parameter, α

share of total cost paid for the use of capital

K α w 1−α
= y rK = wL
L 1−α r α
insert this in the total cost to solve for α
1−α αrK + rK − αrK rK
C = rK + wL = rK + rK= =
α α α
cost o f capital
z}|{
rK rK
rK + wL = ⇒α =
α rK + wL
| {z }
total cost
α represents the share of total costs paid for the use of capital
1 − α represents the share of total costs paid for the use of labour

it is usually assumed that manufacturing is more capital

intensive than food production

αm > α f
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Role of wage and rental rates

• The optimal input of labour and capital depends on the wage rate ratio w
r
• notice that it depends on the RATIO, not absolute levels; if w and r
change by same %, isocost slope does not change ⇒cost minimising
inputs combination does not change;
ceteris paribus, an increase in the price of inputs reduces their demand
• if the price of an input increases, there is a substitution eect for the
other input (as r ↑, labour demand ↑)

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Substitution Eect
lower wages⇒substitute capital with labour

Km (w1 , r) < Km (w0 , r); Lm (w1 , r) > Lm (w0 , r)

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Constant Returns to Scale (CRS)

y = F(K, L); multiply by k ⇒ F(kK, kL) = kF(K, L) = ky

Cobb-Douglas PF:

(k · K)α (k · L)1−α = kα+1−α K α L1−α = k · K α L1−α

• CRS depends on the imposition that [α + (1 − α)] = 1

• CRS assumption allows two simplications:

• structure of all isoquants can be derived by looking at only one

isoquant
• cost minimisation: solving for production of M = 1, sucient
to determine cost minimisation for all M

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Structure of the isoquant

Doubling inputs, doubles outputs

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Cost minimisation
Expansion path

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