A small island (with 3 houses) in Helsinki harbor. Whether this small island joins a free trade area or not, it will hardly affect the prices in Helsinki or EU. All gains from free trade go to the small country.

Offer Curves and Trade Equilibrium


1. Offer Curves

Problem with Ricardo's Theory

David Ricardo only asserted that specialization maximizes national income of each trading country, but did not explain how trading countries will find the equilibrium prices when they trade.

Ricardo did not explain how equilibrum price is determined. For this purpose, we need offer curves.

why assume identical preferences

If consumers in the two countries have different tastes, they may not trade. For example, consumers in each country like their local beers, there would be no need for international trade of beers.

Thus, we want to assume consumers have the same tastes throughout the world, and explain how the trade pattern is determined. 

 Zero transportation costs

Even if consumers in the two countries have the same tastes, trade may not occur if transporation costs are prohibitively high. Transport costs are trade barriers.

Thus, Ricardo assumed zero transportation costs, and considered trade based on comparative advantages.Decline in Transportation Costs

In ancient times, high transport costs, together with lack of knowledge about the surrounding countries were a main reason for not trading with neighboring countries. Instead, countries with surplus labor trained men to become warriors to be used as conquerors.

 

 

By changing the prices from the autarky level, one can obtain different free trade consumption bundles, as shown in Figure 17a. As long as free trade price ratio (p*1/p*2) is great than its autarky counterpart (slope of the PPF), then free trade production always occurs at point B. Free trade consumption bundle depends on the actual price. By connnecting the free trade consumption bundles chosen as the price changes, one can obtain the offer curve.

  However, it is more convenient to express the offer curve in terms of traded goods. Instead of using the above origin (0) in Figure 17a, one can use the free trade production point B as the new origin and retrace the offer curve as shown in Figure 17. The trade vector can be written as: (z1,z2) = (x1 - y1,x2 - y2). The free trade production point B is now the new orgin, B = (0,0), representing the autarky equilibrium.


 

2. Trade Equilibrium

  Combine two offer curves, O (domestic) and O* (foreign).

If one country is not disproportionately large or small, the intersection of two offer curves yields the equilibrium terms of trade, which falls between two autarky (relative) prices.

   
Terms of Trade

Equilibrium price ratio is p*1/p*2 = Imports/Exports when trade is balanced.

This price ratio is often called the terms of trade.

   

 

3. Small Country in a Ricardian World

 

Tallinn, Capital of Estonia, a view from St. Olaf Church in Tallinn.

Estonia became a member of the European Union.

How does its entry into the EU affect their prices?

   A sleepy town of Tallinn is likely to experience a sweeping change in its lifestyle and production patterns after Estonia joined EU in May 2004, together with 9 other new members. Estonia's accession will hardly affect the prices within EU, but Estonia's prices will significantly change, which is the source of gains from trade.
small country case The free trade price will generally be somewhere between the two autarky prices of two trading countries.

However, if one country is very large, then the free trade price may reduce to the autarky price of the large country. In this case, the large country does not gain at all, whereas the small country reaps all the gains from trade.

 

 

4. Trade promotes the adoption of a universal language

 

Since small countries reap all the gains from trade, the large country has no incentive to initiate trade.

Accordingly, traders of small countries must absorb all the costs associated with trade. In particular, they learn and adopt the dominant language of the large coutry or trading bloc (Choi, 2002). This is one reason why citizens of small countries in Europe and elsewhere are learning English and why American are reluctant to learn foreign languages. Citizens of small European countries often speak English and a few other European languages.


Hieronymus Bosch

Traders speak many languages

Attributed to Hieronymus Bosch, early 16th century, Philadelphia Museum of Art. In an outburst of pity, Pilate may have said one phrase in Latin, "Ecce homo" (Behold the man) to the crowd.

5. Wages will not be Equalized

 w = w*?

In the absence of transportation costs and tariffs, trade equalizes the prices of outputs.

Will the wage rates be equalized between the two countries?

No.

Why not?

because wages reflect labor productivities.

Trade raises the price of the exportable and raise the wage in that sector, but does not equalize the wages between coutries.

  The equilibrium price of a traded good is determined by the world supply and demand curves. However, factor prices are not determined by the world supply of and demand for inputs.

Output prices are equalized by free trade, but input prices are not equalized between countries.

 How are wages determined? Perfect Compeition implies:

pi = ACi if output is positive. Ricardo Theorem implies that each country specializes in one good. Specifically, HC specializes in good 1, and the foreign country in good 2. Thus,

p1 = aL1 w. (HC exports good 1)

p*2 = aL2* w*. (FC exports good 2)

 

Thus, the factoral terms of trade, w/w*, is:

w/w* = (p1/p2*)(aL2*/aL1) [not equal to 1].

   

 

6. General Ricardian Model with Many Countries

 3 country model  Consider three countries: There is a third country with an intermediate autarky price between those of the other two countries.

Country 1: specializes in 1
Country 3: specializes in 2
Country 2: diversifies, i.e., produces both goods, 1 and 2, and facilitates trade between countries 1 and 3, even though it does anot reap any gains from trade.

Figure 20.

   Each country exports its comparative advantage product and gains from trade. However, the country in the middle does not gain.
 Example For example, Europe, Japan and North America (excluding Mexico) have a compative advantage in the capital intensive goods or services, but China and India have a comparative advantage in labor intensive goods. Both regions gain from trade. However, other countries in Asia that are neither abundant in capital or labor may not gain much from trade.
Evaluation of Ricardo's Model In Ricardo's model each country specializes and exports only one good. It is not adequate to explain the pattern of trade between countries which produce many goods. If there are many industries, they can be ranked in terms of comparative advantage. If there are n industries, one country exports the first m good in which it has a comparative advantage and imports the rest, i.e., (n - m) goods in which it has a comparative disadvantage. However, if there is more than one factor (e.g., capital and land inputs), this chain cannot be established.
   

         


EXTRA

7. General Ricardian Model with Many Industries

While the Ricardian theory with two goods convincingly shows which of the two goods a country will export, it is not very helpful in deciding which products to export when there are many industries. A country cannot simply export one good and import the rest, i.e., (n - 1) goods. If there are n commodities, a country is likely to export some and import the rest. The theory of comparative advantage does tell us that a country cannot import or export all goods.

Note that in a world of two goods, the HC does not have a CA in good 2. If good 2 were produced, its unit cost would be

p2 = aL2 w > p*2 = aL2* w* (domestic cost of good 2 is greater than its foreign cost).

Also, since the HC has a CA in good 1,

p1 = aL1 w < p*1 = aL1* w* (domestic unit cost of good 1 is less than its foreign cost)

Since labor productivities differ between countries, it is generally impossible to force wage equalization in two export industries. The workers receive their value of marginal products in each industry in which the country has a CA. That is,

pi = aLi wi < p*i = aLi* wi* (domestic unit cost of good i is less than its foreign cost, if the HC has a CA in good i)

The HC specializes in every comparative advantage industry (its domestic unit cost is less than the foreign cost). It is important to note that the above inequality cannot hold for all industries, in which case the HC exports all goods, and hence trade will not be balanced.

Since wage rates are different in these industries, domestic workers fill up the industries that pay the highest wage first and gradually move to other industries with lower wages.

Competitive Advantage

"Competitive Advantage" is often used in the business world. A firm is said to have a competitive advantage when it can sustain above normal profits compared with other firms in the same industry. According to Michael Porter, a firm can maintain a competitive advantage when (i) either its production cost is lower than its rivals (cost advantage), or (ii) its product has more desirable attributes than those of its rivals at the same cost (differentiation advantage).

 

Empirical Evidence The Hungarian economist, Bela Balassa, provides some supporting evidence for the Ricardian model.

He compares the ratio of US to British exports in 1951 with the ration of US to British labor productivity for 26 manufacturing industries. His data shows a positive correlation between the labor productivity and exports.

References

Choi, E. Kwan, "Trade and the Adoption of a Universal Language," International Review of Economics and Finance 11 (2002), 265-75