L7&8 - ecometrics PDF

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Free Trade between two large countries in HOS Model: HOS Theorem: Under free trade I the 2 x 2 x 2 model (2 countries, 2 goods and 2 factors), a country will export the good that intensively uses its abundant factor of production  As in RM, world good prices under free trade are endogenously determined  Abundant factor of production is the country’s comparative advantage good Assumptions 1. Country A is capital abundant National factor supplies: o KA/LA > KB/LB - Aggregate level of capital and labour is greater in country A than B - Country B is labour abundant 2. Good Y is capital intensive How the input mix different between the two goods Factor mixes in production o KY/LY > KX/LX - Good X is labour intensive - Aggregate level of capital and labour greater food god Y than X o Country B has comparative advantage in X - Lower opportunity cost of X for common Y/X output mix 3. Countries A and B are of similar size o PPFa and PPFb intersect (instead of one being entirely outside the other) - Country A has more capital per worker, but output isn’t that difference - In terms of overall size (amount of resources it contains) they are relatively similar Autarky Equilibria in HOS Model with 2 Countries a. Assume equal utilities for simplicity only and assume everyone everywhere has the same preferences b. Absolute slope of PPFa at autarky point for A, is greater than the absolute slope of PPFb at B’s autarky point o (Px/Py) Autarky A > (Px/Py) Autarky B - This ranking reflects B’s comparative advantage, lower opportunity cost in industry X - B has lower autarky price c. When trade is liberalised where do you expect relative price of X to settle in relation to autarky price of A and B and WHY? o Under free trade expect (Px/Px) autarky A > (Px/Py) free trade world > (Px/Py) autarky B - See below slide 24, PowerPoint 4 - Both countries try to export the same good Trade Liberalisation in HOS Model: Positive Results 1. Under free trade country B exports good X o In line with HOS theorem o Intuitively, for country B trade liberalisation causes (Px/Py) to increase o Unlike the RM, remains diversified under free trade 2. For Country A, trade liberalisation has the opposite effect o Trade liberalisation causes (Px/Py) to decrease o Under free trade, A imports X and exports Y 3. World equilibrium requires that for each good, exports by one country are imports by another country Trade Liberalisation in HOS Model: Normative/Welfare Results Summary effects of trade liberalisation in HOS Model Country B is labour abundant, good X is labour intensive  Trade liberalisation causes (Px/Py) to increase for country B  Country B exports good X under free trade

According to HOS theorem Consumers in country B, substitute away from good X so the demand for good X falls (in country b) o Firms produce more of x so the supply of X increases - Exports = surplus of supply over demand  Including distribution o In country B, real wages rise and real price of capital falls o Workers gain, capital loses (SS Theorem) o In country A, the pattern of gains and losses is revered - Capital gains and labour loses Two Observations:  Countries aggregate welfare gain from free trade (over autarky) is only a potential pareto improvement  In general, a country’s relatively abundant factor gains from trade liberalisation and its other factor loses o o

Summary of Trade Theory under Perfect Competition: RM and HOS Model Common features of RM and HOS  Common assumptions o Full employment of factors of production o Balanced trade o Constant returns to scale in all production processes o Perfect competition in all markets o Factors are mobile within a country and between industries and immobile internationally o Identical preferences across all countries  Under FT the direction in which a given good is traded international is determined by how that goods relative price differs between the countries under autarky o In turn a goods relative price differs internationally under autarky because of differences between the countries in opportunity cost o These opportunity cost differences create comparative advantage  Under free trade a country exports its comparative advantage good o Which has a low relative price under autarky compared to its trading partner  All countries enjoy aggregate gains from trade, that is from free trade compared to autarky o Intuitively, in Rm, specialisation according to comparative advantage: - Production goes up where opportunity cost is low - Production fall where opportunity cost is high - Real income rises as a result of this Differences of RM and HOS  One factor of production in RM and two in HOS  PPFs are linear in RM and bowed out in HOS o Opportunity cost of producing a good is constant in RM but increasing in HOS thus causing a difference  In RM source of comparative advantage comes from technology or productivity differences between countries o Country has CA in the good where relative productivity is highest o RM shows that absolute advantage at that industry level is neither necessary nor sufficient to explain trade patterns  In HOS the source of comparative advantage is differences in endowment mix across countries o Under free trade, a country exports the good whose input mix is similar to its own endowment mix o Intuitive statement of the HOS theorem  Under free trade there is equilibrium in one good in RM whereas countries remain diversified in production in HOS

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In RM all identical agents in a country gain from trade liberalisation...