BA 187: International Trade Prof. John M. Veitch
Homework #2 Due Sept. 17th
Comparative Advantage & The Classical Model of Trade
1. Using an appropriate diagram, defend the statement that “the greater the difference between the terms of trade and autarky prices, the greater the gains from trade.” What does your analysis say about the likely division of the gains from trade between a large economy and a small economy?
Answer: It is clear from a diagram of a nation’s PPF and utility curves before and after trade that the higher is the relative price of the nation’s export good after trade, the higher is the level of utility it can attain.
In the small country/large country case, we saw that trade changes only the relative price for the small country, increasing the relative price of its export good the maximum amount possible. Thus the small country captures all the gains from trade, while the large country captures none of the gains.
BA 187: International Trade Prof. John M. Veitch
Homework #2 Due Sept. 17th
Comparative Advantage & The Classical Model of Trade
2. “There cannot be distinct roles within Mercosur, with one country producing primary products while another is industrialized”
Fernando de la Rúa, Front-running Presidential Candidate, Argentina
- What is Mercosur and whom does it involve?
- Would David Ricardo agree with Mr. de la Rúa’s statement? Why? Provide a diagram to supplement Ricardo’s intuitive argument.
- Why might Mr. de la Rúa continue to hold his views despite Ricardo’s compelling argument? (Theory Hint: Classical model assumes markets work. Think about market failures, particularly externalities. Jeopardy Hint: Think Green.)
Answer:
- Mercosur is a free-trade union of South American countries. Its explicit goal is to lower tariff barriers between its members in order to encourage trade between its members.
- Ricardo would completely disagree with Mr. de la Rúa’s statement. Gains from trade arise, at least in part, by a nation’s specialization in the goods in which it has a comparative advantage. In autarky, a nation produces both Goods X and Y. After trade, the change in relative prices will induce each nation to specialize in the good for which it has a comparative advantage. Hence we would expect that Mercosur would in fact encourage the distinct roles that Mr. de la Rúa finds so objectionable.
c. There are at least two ways to go here. Mr. de la Rúa may object to Argentina’s distinct role as producer of primary products because: 1. the result is low real wages for Argentinian workers compared to Brazil, or 2. there are negative externalities, like pollution or environmental degradation, not captured in the market price of the primary products. Mr. de la Rúa may not be objecting to the idea of distinct roles, he may simply be objecting to the particular distinct role Argentina must play because of its comparative advantage.
BA 187: International Trade Prof. John M. Veitch
Homework #2 Due Sept. 17th
Comparative Advantage & The Classical Model of Trade
3. This summer the value of the euro against the US $ moved from US$1.16/euro down to US$1.04.euro. Anguished wails were heard from politicians and central bankers all over Europe about the weak euro and the devastating consequences that threatened parity (US$1/euro) would have for the European Union.
- What would a monetized Ricardo (Classical model plus money wages) have argued the consequences of the euro’s depreciation would be for the European Union?
- Would a monetized Ricardo have expected the euro’s depreciation and its effects to continue indefinitely? Why or why not? (Hint: Remember David Hume!)
- What is the value of the euro today against the US dollar?
Answer:
a. A depreciation in the Euro’s value against the US$ will lower the money price of EU’s goods against those of the US. The result should be an increase in the EU’s exports to the US, and a decrease in its imports. Both factors argue that EU GDP and employment should increase as a result and the EU’s current account surplus should rise. The first two results would seem to be exactly what the EU needs given the lackluster performance of its economies relative to the US throughout the 1990’s.
b. No. A monetized Ricardo would not expect the Euro’s depreciation and its effects to continue indefinitely. The Euro’s depreciation leads to the EU having a larger Current Account surplus. Hume would say that a current account surplus will result in gold flowing from the US to EU. As a result the price level in the US will fall, making its goods cheaper, while the price level in the EU will rise, making its goods more expensive. This change in relative prices continues until trade is balanced once again between the two countries. (While what actually happens today is more complicated in details, it is very similar conceptually to Hume’s argument and its consequences for relative money prices.)
c. The Euro fell to a low of US$1.0148/euro this summer. Its value has since recovered to about US$1.04/euro. Note the Euro was strongest shortly after its initial introduction last January when it was worth US$1.1827 at one point.