from Gains Trade Chapter 3:
A Simple Model of Production and Trade
Adam Smith
Observed that increasing specialization in production was David Ricardo responsible for increased output. Formulated the
q
theory of free trade and demonstrated the gains from trade: one of the longest-standing
Basic Assumptions of the Model
Only two nations Only two goods Only one input labor Technology is constant No learning effects of production Labor is perfectly mobile and can move back and forth between industries, but not between countries.
Absolute Advantage
Chuck
Rob
Absolute Advantage
Chuck
Rob
Lives off of fish and makes fire. He's really perfected the art of firemaking, but he's a terrible fisherman.
Also lives off fish and makes fire. A very successful fisherman, he eats
Chuck's Production Possibilities
Output per hour 30 20
Rob's Production Possibilities
Output per hour 10 30 Fish
Matches Fish
Matches
Chuck can produce more matches than Rob, with the same input (1 hour labor).
Rob can produce more fish than Chuck, with the same input (1 hour labor).
Chuck's Opportunity Costs
Rob's Opportunity Costs
Output per hour 10 30 Opportunity Cost
Output per hour Matches Fish 30 20 Opportunity Cost Matches
Matches Fish
20/30= 0.67 fish/match
30/20 = 1.5 matches/fish
Matches Fish
30/10 = 3 fish/match 10/30 = 0.34 matches/fish
Each match costs Chuck 0.67 fish. Each fish costs Chuck 1.5 matches.
Fish
Each match costs Rob 3 fish.
It's cheaper for Chuck to makeEach and Rob to costs fish! matches fish
What If Chuck and Rob Specialize and Trade?
Chuck
Before Trade 15 10 Specialization 30 0
Trade (2 fish= 1 match)
Rob
Before Trade 5 15 Specialization 0 30
Trade (2 fish= 1 match)
Matches Fish Matches Fish
Matches Fish Matches Fish
Matche s Fish Matche s Fish
Sell 7 Buy 14 After Trade 23 14
Matches Fish Matches Fish
Buy 7 Sell 14
After trade
7 16
Gains from Trade: PPF
Chuck
Rob
Gains from Trade: Before
Chuck
Rob
Gains from Trade: After
Chuck
Rob
Gains from Trade
Chuck
Rob
Both Chuck and Rob can now consume outside of their PPFs and they both
Exchange Price
Chuck's OC - his relative price - of a match is 0.67 fish. He will sell a match for anything more than this. It costs Rob 3 fish to produce a match (his OC). If he can buy a match for less fish, he will. Chuck and Rob will be willing to trade at any price between 0.67 fish and 3 fish.
Who Benefits More?
The closer the price is to 3 fish, the more Chuck will benefit. The closer the price is to 0.67 fish, the more Rob will benefit.
Comparative Advantage
What if someone does not have an absolute advantage in anything? Even if someone lacks a single good in which he has an absolute advantage, he can still benefit from trade. And, the other guy benefits, too!
Comparative Advantage
Chuck
Gilligan
Lives off of fish and makes fire. He's really perfected the art
Not too great at anything. Can't start a fire and a terrible fisherman, too!
Chuck's Production Possibilities Output per hour
Matches Fish 30 20
Gilligan's Production Possibilities
Output per hour 15 15
Matches Fish
Chuck can produce more matches than Gilligan, with the same input (1 hour labor).
Chuck has an absolute advantage in both matches and fish.
Chuck's Opportunity Costs
Gilligan's Opportunity Costs
Output per hour Matches Fish 30 20 Opportunity Cost Matches Fish
20/30= 0.67 fish/match
30/20 = 1.5 matches/fish
Output per hour Matches Fish Matches Fish 15 15 Opportunity Cost
15/15 = 1 fish/match 15/15 = 1 match/fish
Each match costs Chuck 0.67 fish. Each fish costs Chuck 1.5 matches.
Each match Gilligan 1 fish.
costs
Even though Chuck has both absolute advantages, it's cheaper for
Chuck to make matches and Gilligan to fish!
Each fish costs Gilligan 1 match.
Comparative Advantage
Gilligan has a comparative advantage in fish. A person has a comparative advantage in an activity if that person can perform the activity at a lower opportunity cost than anyone else. A person can have an absolute advantage in all activities but that
Example
John Grisham is a better lawyer and a better author than most people. He has an absolute advantage in both activities. But compared to others, he is a better writer than lawyer, so his comparative advantage is in writing.
What If Chuck and Gilligan Specialize and Trade?
Chuck
Before Trade 17.25 8.5 Specialization 30 0
Trade (.75 fish= 1 match)
Gilligan
Before Trade 10 5 Specialization 0 15
Trade (.75 fish= 1 match)
Matches Fish Matches Fish
Matches Matches Fish Fish
Matche s Fish Matche s Fish
Sell 12 Buy 9 After Trade 18 9
Matches Fish Matches Fish
Buy 12 Sell 9
After trade
12 6
Gains from Trade
Chuck
Gilligan
Both Chuck and Gilligan are now consuming outside of their PPFs and they
Some Results from the Model
Trade allows consumption to be different than production for each individual. Both individuals can consume more than they can produce on their own. Trade is not a zero-sum game, where one person is better off and the other is worse off. Both parties will be better off, or they would not trade in the first place.
Some Results from the Model, cont.
Although both individuals gain from trade, the model does not imply that their living standards or income are equal. Because Chuck has higher absolute productivity in both matches and fish, his income will be quite a bit higher than Gilligan, with or without trade.
Production and Trade Before Specialization
Let the price of matches settle at 2 fish per match. U.S. trading possibilities are illustrated by the price line or the trade line (TT) with a slope of -2. A = the combination of match and fish
Fish
Matche s
Production to Maximize Income
By specializing in the production of matches and trading matches for fish, Chuck receives gains from trade and can increase his consumption C = the consumption bundle the Chuck obtains by producing at B, or by specializing in matches and trading for fish.
Fish
Matche s
Shortcomings of the Ricardian Model
1.
It predicts an extreme degree of specialization that we do not observe in the real world. Assumes away the effects of trade on the distribution of income within countries. Allows no role for differences in resources among countries as a cause
2.
3.
Empirical Evidence
The basic prediction of the Ricardian model that countries should tend to export those goods in which their productivity is high has been strongly confirmed by a
Mini Case Study
The Resource Curse
Single Resource Countries
Single Resource Countries
Botswana
Saudi Arabia
Chile
Single Resource Countries
Botswana Diamond s Saudi Arabia Oil
Chile Copper
Oil
Comparative Advantage in a Single Resource
Natural resources are a comparative advantage countries.
source of in many
We would expect countries with a significant endowment of a valuable resource would benefit greatly from this endowment. Do they?
What Others Have Said....
"Poor countries dream of finding oil like poor people fantasize about winning the lottery. But the dream often turns into a nightmare as new oil exporters realize that their treasure brings more trouble than help." Juan Pablo Prez Alfonso, one time Venezuelan oil minister, likened oil to "the devil's excrement." Sheikh Ahmed Yamani, his Saudi Arabian
World Rankings
World Ranking by Income 37 54 61 138
Country Saudi Arabia Chile Botswana Nigeria
Per Capita GDP $23,429 $14,331 $13,076 $2,150
Endowment of a single, valuable resource does not guarantee prosperity.
The Case of Oil
Arguably the most important geopolitical resource today. International trade in crude oil exceeds the volume and value of any other good or service except currency trading. In 2008, 85.5 million barrels were traded at an average price of $98 per barrel, or more than $8,375 million per day. This is less than 1% of daily trading in the world's currency markets!
How Are the 10 Largest Oil Producers Doing?
Ten Largest Oil Reserves TRADE RESERVES COUNTRY
* Saudi Arab. Iran Iraq Kuwait UAE Venezuela Russia Libya
*Billions of barrels
PER CAPITA GDP (Rank) 23,429 (37) 11,575 (68) 3,553 (118) 46,079 (7) 57,821 (2) 12,341 (66) 18,945 (45)
SHARE** 88.2 87.3 100 96.4 60.4 92.1 72.5
Ten Richest Countries CAPITA PER COUNTRY
GDP*** 83,978 58,262 57,821 50,701 48,995 46,436 46,079 44,717 41,282 40,715
***World Bank
264.2 138.4 115.0 101.5 97.8 87.0 79.4
Luxembourg Macao UAE Singapore Brunei United States Kuwait Switzerland Ireland Netherlands
16,526 41.5 97.9 **Exports of fuels and mining products divided by total exports x 100 (48)
What Goes Wrong?
Labor and capital become concentrated in that activity alone.
It's difficult to develop a diversified and highly educated labor force.
National income can fluctuate quickly if commodity price changes abruptly.
Can lead instability.
to
severe
macroeconomic
Is the Curse Inevitable?
No. Not every country suffers from the curse. To avoid the curse, have
Strong institutions to guard against corruption Commitment to education and skills to develop human capital and diversify