My last post adapted Ricardo's model of comparative
advantage to include internationally mobile capital. However, what I think is much more important is the ability of labour to be redeployed between industries when production
patterns are disrupted by trade liberalisation.
So I thought I'd have a go at a version of Ricardo's model
that included just that.
The Model
There are two countries: England and Portugal, and three
goods: wine, cloth and cars. Each
country consumes all three goods and can produce all three. Each country has its own currency.
Labour is the only factor input and there are constant
returns to scale. Prices are set at a
fixed mark-up to unit cost, with the same mark-up in both countries and all
industries. Within each country, a
single fixed nominal wage applies to all industries. (For simplicity, the nominal wage per unit of
labour, grossed up for the mark-up, is set here at one unit of the local
currency, so the price of local produce is simply equal to the requisite labour
input.)
Labour cannot move between countries. Within a country, labour can generally be
redeployed between different industries, with the single exception that labour
currently employed in car production cannot be redeployed to wine or cloth
production. The number of labour units
required to produce one unit of goods varies between industry and country as
follows:
|
Wine
|
Cloth
|
Cars
|
England
|
1.00
|
1.00
|
1.00
|
Portugal
|
0.80
|
0.90
|
0.95
|
There is free trade in wine and cloth but (at least,
initially) no trade in cars. In each
case of wine, cloth and cars, Portugese made versions are perfect substitutes
for English made ones and there are no transport costs so, where there is free
trade, everyone just buys the cheapest. However, wine, cloth and cars are imperfect
substitutes for each other with a constant elasticity of substitution. All income is spent currently on consumption,
with a weighting in both countries of 0.45 on each of wine and cloth and 0.10
on cars. The exact specification of
consumer spending is given in the technical note at the end of the post.
As there is no saving, trade must be balanced, which is achieved
by a variable exchange rate.
(To get the numbers to show what I want, I have assumed a slightly higher labour supply in England than Portugal.)
1. No International
Trade in Cars
Because of the comparative advantages in wine and cloth, England
ends up importing all its wine and Portugal all its cloth. Both countries produce their own cars.
|
England
|
|
|
|
|
Portugal
|
|
|
|
|
Wine
|
Cloth
|
Cars
|
Total
|
|
Wine
|
Cloth
|
Cars
|
Total
|
|
|
|
|
|
|
|
|
|
|
Labour
|
0
|
1,081
|
119
|
1,200
|
|
913
|
0
|
87
|
1,000
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Goods
|
|
|
|
|
|
|
|
|
|
Produced
|
0
|
1,081
|
119
|
|
|
1,142
|
0
|
91
|
|
Traded
|
563
|
-548
|
0
|
|
|
-563
|
548
|
0
|
|
Consumed
|
563
|
533
|
119
|
|
|
579
|
548
|
91
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Expenditure
|
|
|
|
|
|
|
|
|
|
Domestic
|
548
|
533
|
119
|
1,200
|
|
463
|
450
|
87
|
1,000
|
Exports
|
|
548
|
0
|
548
|
|
450
|
|
|
450
|
Imports
|
-548
|
|
|
-548
|
|
|
-450
|
0
|
-450
|
Income
|
0
|
1,081
|
119
|
1,200
|
|
913
|
0
|
87
|
1,000
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Prices
|
Wine
|
Cloth
|
Cars
|
Index
|
|
Wine
|
Cloth
|
Cars
|
Index
|
Domestic
|
1.000
|
1.000
|
1.000
|
1.000
|
|
0.800
|
0.900
|
0.950
|
0.856
|
Import
|
0.973
|
1.095
|
n/a
|
|
|
0.822
|
0.822
|
n/a
|
|
Consumer
|
0.973
|
1.000
|
1.000
|
0.988
|
|
0.800
|
0.822
|
0.950
|
0.823
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Exchange
rate (£/€)
|
1.217
|
|
|
|
|
|
|
|
|
Expenditure and prices are shown in the local currency.
The domestic producer prices shown are the prices that would be
paid for domestically produced product, even though there is no actual
production in industries with import penetration. The index for these prices is weighted by
consumption preference, so it is the price index that would apply with no
trade. This is higher for both
countries than the actual consumer price index, showing that the trade in wine and cloth benefits both nations.
The nominal wage (expressed in the local currency) is the same in
each country, so the fact that the consumer price index is higher in England implies that real wages are lower in England than Portugal.
2 After
Trade Liberalisation in Cars
At the prevailing exchange rate, England can produce cars
more cheaply than Portugal. This means
that Portugal starts to import cars and closes down its own production. By assumption, these workers cannot be
employed elsewhere, so overall income in Portugal is reduced. This reduces demand for cloth imports but,
because of the additional import of cars, demand for foreign exchange is
increased overall. This causes the exchange
rate to change, worsening the terms of trade for Portugal (making Portugese cars cheaper but still not as cheap as English ones).
|
England
|
|
|
|
|
Portugal
|
|
|
|
|
Wine
|
Cloth
|
Cars
|
Total
|
|
Wine
|
Cloth
|
Cars
|
Total
|
|
|
|
|
|
|
|
|
|
|
Labour
|
0
|
982
|
218
|
1,200
|
|
913
|
0
|
0
|
913
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Goods
|
|
|
|
|
|
|
|
|
|
Produced
|
0
|
982
|
218
|
|
|
1,142
|
0
|
0
|
|
Traded
|
607
|
-460
|
-102
|
|
|
-607
|
460
|
102
|
|
Consumed
|
607
|
522
|
116
|
|
|
535
|
460
|
102
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Expenditure
|
|
|
|
|
|
|
|
|
|
Domestic
|
562
|
522
|
116
|
1,200
|
|
428
|
397
|
88
|
913
|
Exports
|
|
460
|
102
|
562
|
|
485
|
|
|
485
|
Imports
|
-562
|
|
|
-562
|
|
|
-397
|
-88
|
-485
|
Income
|
0
|
982
|
218
|
1,200
|
|
913
|
0
|
0
|
913
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Prices
|
Wine
|
Cloth
|
Cars
|
Index
|
|
Wine
|
Cloth
|
Cars
|
Index
|
Domestic
|
1.000
|
1.000
|
1.000
|
1.000
|
|
0.800
|
0.900
|
0.950
|
0.856
|
Import
|
0.927
|
1.043
|
1.101
|
|
|
0.863
|
0.863
|
0.863
|
|
Consumer
|
0.927
|
1.000
|
1.000
|
0.966
|
|
0.800
|
0.863
|
0.863
|
0.833
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Exchange
rate (£/€)
|
1.159
|
|
|
|
|
|
|
|
|
England responds to falling cloth exports by redeploying
labour to production of more cars.
Conclusions
The main result here is that, if trade liberalisation
results in job losses and those workers cannot be employed elsewhere, then
overall output will be impaired. This is
perhaps not entirely surprising. But
there are some more interesting points here:
Trade liberalisation results in production of cars switching
to England even though Portugal can produce cars with fewer labour units and
thus has an absolute advantage in car production. The reason is that English wages are lower
when expressed in a common currency. The
lower wage offsets the less efficient production (less efficient in an absolute
sense, not a comparative one).
In this example trade liberalisation in car production not
only results in unemployment for Portugese car workers, but actually reduces
the real wages of Portugese wine workers.
This is because the increased demand for imports worsens the terms of
trade. Although they can now buy cheap
imported cars, cloth has become more expensive.
Everyone in Portugal has lost out.
The same is true here even if we relax the assumption that Portugese
car workers cannot be employed in other industries. As a natural importer of cars, Portugal
benefits when international trade in cars is restricted, even though that means
that cars are more expensive there.
However, it is still better off than if there were no trade at all.
Reducing the nominal wage in Portugal makes no difference, as
it simply leads to an offsetting exchange rate movement. However, relative wages between industries do
matter. I have assumed that the same
wage applies across industries, so that wages for Portugese car workers remain the
same as for wine workers, even when they cannot be employed elsewhere. If they were to fall (relatively), then Portugese
car production could be preserved.
This change in relative wages is what standard economics
says should happen. It all comes down to
opportunity cost. The opportunity cost
of Portugese car production is in fact zero, because the car workers have no
alternative use. Portugese car production
is lost, because the cost to producers does not reflect the true opportunity
cost.
Although trade liberalisation in the car industry is
damaging in this example, that does not imply that introducing measures to restrict
existing trade will be beneficial. In
fact any such measures would reduce welfare here. If we extend the assumption on labour
inflexibility, then such measures may be even more damaging as workers made unemployed from exporting industries might not be employed elsewhere. It is
the fact of change that matters here,
not whether it is liberalisation or protectionism.
However, being able to adapt to change is crucial to an
economy's ability to develop and grow.
Even without trade, progress involves old products and procedures dying
out and being replaced. Job losses and
job creation is an inevitable part of that.
Whilst there is a strong case for factoring in the dynamic consequences
of trade liberalisation, that cannot be an excuse for avoiding the need for flexibility,
if an economy is to secure long-term growth.
Technical Note
Consumption of good i in each country is given by
Ci = ai . (Pi / P )-σ
. Y / P
where: ai is the weighting, Ci is number of units consumed, Pi
is the price of good, Y is nominal income and P is the price index, which is
given by:
P = { sum for i [ ai . pi(1-σ) ] }1/(1-σ)
σ is the price elasticity of demand, set at 2 for both
countries.