ECON2915 Economic Growth Lecture 9 : The Ricardian Model. Andreas - PowerPoint PPT Presentation

ECON2915 Economic Growth Lecture 9 : The Ricardian Model. Andreas Moxnes University of Oslo Fall 2016 1 / 29

Reasons for trade 1 Differences between countries (e.g., productivity): ◮ Comparative advantage. 2 Increasing returns to scale. 3 Imperfect competition. Today: One model for (1). Talk briefly about 2) and 3). Next two weeks: Alternative frameworks for (1). 2 / 29

The Ricardian model David Ricardo (1772-1823): One of the most influential of the classical economists. His idea about comparative advantage the cornerstone of the argument in favor of tree trade. Let’s start with an example. Output per farmer (tons): Output per farmer (ton): Rice Cocoa America 2/3 2/3 Nigeria 1 3 Not a realistic picture of either economy (e.g. Nigeria’s oil). But the point we’re making would emerge in a much more complicated, realistic model as well. 3 / 29

The production possibility frontier 130 mill farmers in Nigeria and 390 mill in America, L N = 130, L A = 390. 4 / 29

Opportunity cost Recall Output per farmer (ton): Rice Cocoa America 2/3 2/3 Nigeria 1 3 Definition Opportunity cost (OC): The loss of other alternatives when one alternative is chosen. OC of producing 1 ton rice in Nigeria is x tons of cocoa. OC of producing 1 ton rice in America is y tons of cocoa. OC of producing 1 ton cocoa in Nigeria is 1 / x tons of rice. OC of producing 1 ton cocoa in America is 1 / y tons of rice. The slope of the PPF = - OC of producing rice. 5 / 29

Comparative Advantage Definition The country with the lowest opportunity cost of producing a good has a comparative advantage in that good. Therefore, Nigeria has a comparative advantage in ....., America has a CA in .... A country must have a comparative advantage in something. A country can’t have a comparative advantage in both goods. Due to the reciprocal property of opportunity costs. 6 / 29

Absolute Advantage Definition The country with the lowest cost of producing a good has an absolute advantage in that good. Therefore, Nigeria has an absolute advantage in ....., America has a CA in .... We’ll see that comparative advantage is what determines the pattern of trade. Absolute advantage has no importance at all for the pattern of trade. But absolute advantage is important for the international distribution of income. 7 / 29

Autarky In this model, banning rice imports is effectively the same as shutting down trade completely. This is a thought experiment called “autarky.” Comparing autarky with free trade allows us to analyze what trade does. First, we’ll analyze autarky, then trade, and compare the two. 8 / 29

Autarky equilibrium First, look at supply behavior: Relative supply (quantity of rice)/(quantity of cocoa). As a function of relative price of rice (price of rice)/(price of cocoa). Gives RS curve. In Nigeria, the cost of producing rice is 3x the cost of producing cocoa. Therefore: If P R / P C > 3 then all farmers produce rice, Q R / Q C = ∞ . If P R / P C < 3 then all farmers produce cocoa, Q R / Q C = 0. If P R / P C = 3 then farmers are indifferent. 9 / 29

RS curve : Nigeria 10 / 29

RD curve : Nigeria Assume that every consumer spends half of her income on rice and half on cocoa. Equivalently – Cobb-Douglas utility function with equal weights on the two goods. This implies that P R Q R d = P C Q C ⇐ ⇒ d Q R = P C 1 d P R = Q C P R / P C d This gives the RD curve. 11 / 29

RS & RD Putting them together, 12 / 29

The budget line What’s a farmer’s income? The budget line is wL = P C Q C d + P R Q R ⇐ ⇒ d P C − P R d = wL Q C P C Q R d . If producing cocoa, wL = 3 tons × P C = 3 P C . If producing rice, wL = 1 ton × P R = P R . We know that P R / P C = 3. Therefore: P C − P R d = wL Q C P C Q R d = 3 − 3 Q R d Analysis for America is parallel. 13 / 29

The budget line Where on the budget line (BL) is optimal consumption? Recall preferences, P C Q C = P R Q R ⇐ ⇒ Q C = � P R / P C � Q R = 3 Q R . Inserting into BL: Q C d = 3 − 3 Q R d d = 1 3 Q R d = 3 − 3 Q R ⇒ Q R d = 2 14 / 29

America equilibrium 15 / 29

Trade equilibrium We’ve solved for production, consumption and relative prices in autarky. Now, assume that there are no impediments to trade between the two countries. No tariffs or transport costs: One world price of rice, one world price of cocoa. Now, we need the world RS curve and RD curve to pin down relative prices. The RD curve is easy, since it’s the same as before. 16 / 29

The RS curve : Trade We combine the autarky RS curves as follows. 17 / 29

The RS curve : Trade 18 / 29

The RS curve : Trade 19 / 29

The RS curve : Insights Relative price 1 < P R / P C < 3 : Complete specialization − → trade. Relative price < 1 or > 3 : Both countries produce the same good (not an equilibrium if consumers value both goods). Relative price = 3: Nigeria produces both goods, America specializes in rice. Relative price = 1: Nigeria specializes in cocoa, America produces both goods. Why is Q R / Q C = 2 / 3? Recall q R America per farmer = 2 / 3 and q C Nigeria = 3. Hence Q C = q R Q R L America = 2 / 3 390 130 = 2 93 = 2 America q C L Nigeria 3 3 Nigeria 20 / 29

RS & RD Inserting Q R / Q C = 2 / 3 into the RD curve gives Q R = P C ⇒ P R P C = 3 d 2 . P R = Q C d → Trade: p R / p C up in America, down in Nigeria. Autarky − 21 / 29

Trade Patterns (In)complete specialization + demand for both goods − → trade. America exports its comparative advantage good. Nigeria exports its comparative advantage good. This is a general result in a large class of models. America exports rice even though it has an absolute disadvantage. ◮ Why? 22 / 29

What does trade do to human well-being? Inspect the budget lines in autarky and trade. Recall, for (Nigeria,autarky) we had P C − P R d = wL Q C P C Q R d = 3 − 3 Q R d Under free trade, income in Nigeria is wL = 3 tons × P C = 3 P C . Budget line is d = 3 − 3 Q C 2 Q R d 23 / 29

What does trade do to human well-being? Trade unambigously raises welfare. Autarky inferior because Nigeria cannot exploit its CA. Trade allows farmers to produce the expensive good, and use the proceeds to purchase the cheap good (rice). By giving up food self-sufficiency, is rice consumption ↑ or ↓ ? 24 / 29

Trade theory and reality Import ban on rice + other cereals in Nigeria during 1986-1995. Objective was self-sufficiency in food. Part of Nigeria’s Structural Adjustment Program. Huge increase in consumer prices for food. Food consumption and nutrition: Mixed evidence. 25 / 29

Trade theory and reality Hard to disentangle impact of policy change from other changes occuring at the same time. ◮ Macroeconomic recovery. ◮ Improvement in literacy. ◮ Government programs to help small farmers. ◮ Huge improvement in agricultural productivity. 26 / 29

Summing up : The Ricardian Model Comparative advantage provides huge argument for allowing countries to specialize in response trade. Strong argument against national self-sufficiency (in food or anything else). Case study: ◮ Norwegian agricultural sector heavily protected against foreign competition. ◮ What is the impact of removing Norwegian import barriers? ⋆ On production, trade and welfare & growth? ⋆ In the context of the model. ⋆ Outside the model. 27 / 29

Reasons for trade: Increasing returns Consider a car factory: ◮ Setting up and maintaining an assembly line requires huge fixed costs. ◮ E.g., even just to maintain the machines in line to be able to produce 1 car per month. Induces increasing returns to scale (IRS). IRS is a reason for trade: Motive to concentrate production of each product in one spot. Three types of IRS: Internal, external national, and external international. In serving a foreign market, stronger IRS argues for exporting, but higher tariffs or transport costs argue for local production via FDI. 28 / 29

Reasons for trade: Imperfect competition Consider an oligopoly. Can generate international trade even when the firms produce identical products (at identical costs). The reason is that each firm wants to grab the others’ customers, in order to grab some of the oligopolistic rents that go with them. More: MC Ch4. 29 / 29