What Determines a Country’s Comparative Advantage ?

3. What Determines a Country’s Comparative Advantage? • Exogenous factors are the most obvious

4. Climate (long growing season)

5. Natural Resources (petroleum reserves)

6. 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 ….

7. 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

8. 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

9. 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

10. 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)

11. Getting a sense of the gains from expanded markets

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

17. Now, summarize the results using a new curve

18. 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:

19. Now, summarize the result that more firms lead to a lower price in another new curve

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

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

22. End of Lecture