What Determines a Country’s Comparative Advantage?

• Exogenous factors are the most obvious

Climate (long growing season)

Natural Resources (petroleum reserves)

But there are also endogenous factors: education, skills,

capital,... • Implies that comparative advantage can

change over time: • electronic goods to pharmaceutical goods to

internet software to ….

Let’s take a closer look at how capital (K) and labor (L)

affect comparative advantage– Definitions:

• capital abundant country: has high K/L• labor abundant country: has low K/L• capital intensive production: uses high K/L• labor intensive production: uses low K/L

• Capital abundant countries: comparative advantage in capital intensive production

• Labor abundant countries: comparative advantage in labor intensive production

Factor Price Equalization

• Factor prices: – wage rate for labor– rental rate for capital

• Factor price equalization: even if factors are not mobile, factor prices will tend to equalize with trade

What causes factor price equalization? • suppose U.S. has high K/L• suppose Mexico has low K/L• then opening up trade will shift

– U.S. production toward capital intensive goods• thus demand for capital rises in U.S

– M. production toward labor intensive goods• thus demand for labor rises in Mexico

• U.S. wages fall and Mexican wages rise– that is a move toward factor price equalization– assumes ceteris paribus, productivity would rise

Gains from Expanded Markets

• Theory combines two features of production– economies of scale (declining ATC over the

relevant range of production)– product differentiation: leads to monopolistic

competition• Focuses on intraindustry trade (same industry)

– comparative advantage focuses on interindustry trade (different industries)

Getting a sense of the gains from expanded markets

17_03

Production: 1,000 MRI units Cost: $300,000 per unit

Production: 1,000 ultrasound units Cost: $200,000 per unit

United States

Production: 1,000 MRI units Cost: $300,000 per unit

Production: 1,000 ultrasound units Cost: $200,000 per unit

Germany

Production: 2,000 MRI units Cost: $150,000 per unit

U.S. exports 1,000 MRI units to Germany.

No Trade

Germany exports 1,000 ultra- sound units to U.S.

United States

Production: 2,000 ultrasound units Cost: $150,000 per unit

Germany

Now let’s develop a model to show the gains from expanded markets

• First derive a relationship between – the number of firms, – the size of the market– costs per unit (ATC)

• Second, derive a relationship between the number of firms and the price

• Third, combine the two relationships

17_04D

Cost per unit Cost per unit

1 of 4 1 of 4

DOLLARS35302520151050

DOLLARS35302520151050

QUANTITY QUANTITY

Smaller Market Larger Market

17_04C

Cost per unit Cost per unit

1 of 4 1 of 4 1 of 31 of 3

DOLLARS35

30

25

20

15

10

5

0

DOLLARS35

30

25

20

15

10

5

0QUANTITY QUANTITY

Smaller Market Larger Market

17_04B

Cost per unit Cost per unit

1 of 4 1 of 4 1 of 3 1 of 21 of 3 1 of 2

DOLLARS35302520151050

DOLLARS35302520151050

QUANTITY QUANTITY

Smaller Market Larger Market

17_04A

DOLLARS35

30

25

20

15

10

5

0

Cost per unit Cost per unit

Numberof

firms

1 102 203 254 30

Costper unit($)

Numberof

firms

Costper unit($)

1 52 153 204 25

1 of 4 1 of 4 1 of 3 1 of 2

1 of 1

1 of 3 1 of 2 1 of 1

DOLLARS35

30

25

20

15

10

5

0

Smaller Market Larger Market

QUANTITY QUANTITY

Now, summarize the results using a new curve

17_05DOLLARS

50

45

40

35

30

25

20

15

10

5

NUMBER OF FIRMSIN THE MARKET

1 102 3 4 5 6 7 8 9

Cost per unitwith largermarket

Cost per unitwith smallermarket

Curve shifts downas market gets larger.

0

Recall results from monopolistic competition model

• Product differentiation• Firms face downward sloping demand curve• With more firms in the industry, the demand

curve shifts– and gets flatter (a point we did not emphasize

earlier), so the price falls– sketch this by hand:

Now, summarize the result that more firms lead to a lower price

in another new curve17_06DOLLARS

50

45

40

35

30

25

20

15

10

5

NUMBER OF FIRMS IN THE MARKET

1 102 3 4 5 6 7 8 9

Price in the market

0

Put the two new curves in the same diagram; look at the long run equilibrium

17_07DOLLARS

50

45

40

35

30

25

20

15

10

5

NUMBER OF FIRMSIN THE MARKET

1 102 3 4 5 6 7 8 9

.... but the price each firmwill charge falls with thenumber of firms.

Cost per unit at each firmincreases as more firms entera market of a fixed size...

0

Equilibriumnumber of firms

Long-runequilibriumprice

The condition of long-runequilibrium is where priceequals cost per unit.

Price (P) inthe market

Cost per unit

Finally, open up the economy; curve shifts showing effect of a larger market

17_08

DOLLARS

50

45

40

35

30

25

20

15

10

5

NUMBER OF FIRMSIN THE MARKET

1 102 3 4 5 6 7 8 9

Price

Cost per unit with smaller market

Cost per unit with larger market

Increase in numberof firms and variety

Reductionin price

0

Cost per unitat eachfirm falls as market sizeincreases.

End of Lecture