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CHAPTER

COMPARATIVE ADVANTAGE, INTERNATIONAL TRADE AND FACTOR MOBILITY

8.1 Ricardo's Theory of Comparative Advantage and Benefit from Trade 8.2 Factor Endowment Theory of International Trade 8.3 Factor Mobility

In previous chapters we studied how producers and households interact with each other in product and factor markets. We can think of such interaction as trade between producers and households, in the sense that each party has something to offer to the other. Not only producers and consumers within a country trade with each other, the countries themselves, i.e., consumers and producers across countries, trade/exchange with each other in goods and services. This is called international trade. As an example of trade in goods, India exports tea to the rest of the world and imports petrol. Many foreign banks today offer banking services in India, which is an example of trade in services. In this chapter, our objective is to learn some fundamentals of international trade. This is very important, because countries, in general, are much more interdependent today than they were 30 or 40 years ago. In the process, we learn a very important concept in economics, called comparative advantage. Through this concept, we will understand that promoting international trade is not a bad thing, and, it is not true that, if one country gains from it, some other country has to lose. On the contrary, we will

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learn that trading with each other is, by and large, a mutually beneficial activity. The idea behind comparative advantage (to be defined in Section 8.1) and gains from trade can be understood through this example. Suppose that you are a very good pop singer and a very good cook. But you are much more productive as a singer than as a cook. This is in the sense that if you sing you get Rs. 5,000 per hour, whereas you can hire an excellent cook at the rate of Rs. 300 per hour, i.e., if you cook, you save Rs. 300 per hour. One option for you will be to pursue a singing career and still cook for yourself be selfsufficient, so-to-speak. That is, you are capable of doing both and you actually choose to do both. Consider now the alternative option of hiring a cook and engaging yourself full time in singing. Which option will you prefer? Surely, the latter. Now think about this example in a different light. The option to do both activities is like choosing not to do trade between your service as a cook and your service as a singer. The latter option is like importing the service that you do not have comparative advantage in (that is, cooking) and, specialising and exporting the service you have comparative advantage in (that is, singing). What applies for an individual in the above example also applies to a country. A country, in comparison to producing all goods it can produce and not trading, is better off by

(a) producing more of the goods which it can produce relatively cheaply and exporting part of them and (b) producing less possibly none of the goods which it cannot produce relatively cheaply compared to other countries and importing them. This is the idea behind comparative advantage. Put differently, it implies that countries can trade and benefit by exploiting their differences. In simpler language, it means that you and I are different, I have something which you want but cannot obtain that easily, and you have something that I want but cannot get that easily; both are better off by trading with each other. This principle was first demonstrated formally by a famous English economist, named David Ricardo. In what follows, we first discuss Ricardos theory of comparative advantage. It is the simplest and yet a very elegant exposition of how international trade can be beneficial to a country. Although Ricardo wrote about it almost two hundred years ago (in the early 19th century), its relevance is felt even today. As we will see, Ricardos theory of comparative advantage and trade is based on differences in technology across countries. We also consider another source (basis) of comparative advantage, namely, differences in factor supplies across countries. The next two sections study these alternative sources of comparative advantage.

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International trade refers to movement of goods and services. In the real world, not only goods and services, but also factors of production move from one place to another. The chapter ends with a discussion of movement of factors. 8.1 RICARDOS THEORY OF COMPARATIVE ADVANTAGE AND BENEFIT FROM TRADE

This is written more compactly in Table 8.1. Table 8.1 Labour Coefficients India Cricket Bats Footballs 10 20 Australia 15 60

We will make a number of simplifying assumptions so as to clearly bring out the essence of this theory. Assume that there are two countries in the world: India (N) and Australia (A). Each can produce two goods, say, cricket bats and footballs. Perfect competition prevails in the market for each good. There is one factor of production, say, labour (L). Each country is endowed with a given supply or what is called endowment of labour, say LN = 100 and LA = 120 respectively for India and Australia. Furthermore, the labour required to produce one unit of output, or what is called the labour coefficient, is given in each sector. As a numerical example, suppose that Producing 1 cricket bat in India requires 10 units of labour Producing 1 football in India requires 20 units of labour Producing 1 cricket bat in Australia requires 15 units of labour. Producing 1 football in Australia requires 60 units of labour
1

In terms of concepts introduced in Chapter 3, the average physical product of labour is the inverse of the labour coefficient. Thus, labour coefficient being given means constant average physical product of labour or constant output per worker.1 We are almost ready to define comparative advantage. 8.1.1 Absolute Advantage and Comparative Advantage Between two countries, one is said to have absolute advantage in a good if it can produce that good absolutely more efficiently than the other country. A country is said to have comparative advantage in a good if it can produce it relatively more efficiently or relatively less inefficiently, compared to the other country. We now apply these definitions to Table 8.1 and say that India has absolute advantage in producing both goods, and Australia in none. Because, in the production of either good, labour required to produce one unit is less in India than in Australia. More importantly for us, let us determine who

In turn, this means constant marginal physical product of labour.

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has comparative advantage in what. See that, in India, the labour coefficient ratio of the football sector to the cricket sector is 20/10 = 2, whereas, in Australia, the same ratio is 60/15 = 4. Hence, in India, labour is relatively more productive or efficient in the football sector. Therefore, India, has comparative advantage in producing footballs. Although Australia is less efficient in producing both goods, it is relatively less so in producing cricket bat. Hence Australia has comparative advantage in producing cricket bats. By definition, both countries cannot have comparative advantage in producing the same good. 8.1.2 Production Possibility Curves Given the labour coefficients and the labour endowment in each country, we can draw the Production Possibility Curve (PPC) for each country. This will serve as a background to analysing how international trade affects an economy. Recall from Chapter 1 the concept of marginal opportunity cost along a PPC. It says how much of one good has to be sacrificed to ensure a unit increase in the production of the other. Consider India for instance. Suppose, starting from a given allocation of labour between the football sector and the cricket bat sector, the production of football increases by one unit. From Table 8.1, this requires additional labour equal to 20 (since this is labour coeffcient in producing football). As 20 units of labour leave the cricket bats sector to produce one extra football, by

how much will the production of cricket bats fall? It is equal to 20 divided by the labour coefficient in producing cricket bats (that is, 10). This gives 20/10 = 2 cricket bats as the marginal opportunity cost of football. Note that the marginal opportunity cost of football is constant (equal to 2 cricket bats) at any initial allocation of resources, because the labour coefficients are constant. You can similarly calculate that cost in Australia, which is also constant, equal to 60/15 = 4. Thus labour coefficients being given imply that the marginal opportunity cost of either good along the PPC is constant. In turn, from Chapter 1, we know that constant marginal opportunity cost implies a straight line PPC. Hence the PPC is a straight line in a Ricardian economy. Fig. 8.1 shows the PPCs of India and Australia. Recall that Indias endowment of labour is 100, i.e., LN =100. If all its labour resources are used in producing football, they will produce 100/20 = 5 footballs. If, instead, they are all used in producing cricket bats, they will produce 100/10 = 10. These points are respectively marked on the football axis and cricket bat axis in fig. 8.1(a). The straight line, DE, joining these two points is the PPC of India. The PPC of Australia, GH, is derived in a similar manner, which is shown in fig. 8.1(b). 8.1.3 No Trade

In order to see how international trade makes a difference, suppose that initially there is no trade between the

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(a) India

(b) Australia

Fig. 8.1 The Production Possibility Curves

two countries. There are four important points to note for the world economy, in which there is no trade. 1. Since there is no opportunity to trade, in each country, the consumption of a good cannot exceed how much of that good is produced. In other words, the consumption possibilities are limited to the PPC, i.e., the country cannot consume at any point outside its PPC. We can say that the PPC is equal to a countrys consumption possibility curve. In our example, it is DE for India and GH for Australia. 2. It will also be useful to know the relative price of one good in terms of the other in each country. What do we mean? Recall that both goods are produced in competitive markets. From Chapter 6, we know that, under perfect competition, free entry and exit imply zero profits.

Thus, in each sector, price will be equal to the average cost. In this economy, the average cost of a good is equal to the wage rate times the labour required to produce one unit of the good. For example, let WN be the wage rate in India. Then the average cost of, say, football is Rs. WN 20. This will be equal to the price of football, say PF. Similarly, PC = Rs. WN 10, where PC is the price of cricket bats. Thus the relative price of football is equal to PF/PC = WN 20/(WN 10) = 2. That is, if you have a football, sell it in the market and use the money to buy cricket bats, you will get 2 cricket bats. The relative price of cricket bats is the inverse of that of football, equal to 1/2. In general, the relative price of a good is defined in terms of some other good and is equal to the amount of the

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other good that one gets in exchange for one unit of the good in question. Put differently, it is an exchange ratio between goods. We then have the exchange ratio in India in the no-trade situation equal to 2 cricket bats for 1 football. You can similarly calculate the exchange ratio in Australia: 4 cricket bats for 1 football. We can call these the domestic exchange ratios. 3. Notice that the relative price of a good in each country is equal to its marginal opportunity cost (as price is equal to marginal cost under competitive conditions). In Australia for example, the relative price of football is 4 cricket bats and the marginal opportunity cost of football is also 4 cricket bats. 4. Also notice from the exchange ratios that football is relatively cheaper in India, which has comparative advantage in producing football, and cricket bats are relatively cheaper in Australia, which has comparative advantage in producing cricket bats. This is intuitive. The stage is ready now to understand the effect of international trade. 8.1.4 Effect of International Trade Let India and Australia now open up trade. Further, let there be free trade, i.e., no restrictions like trade taxes or any limits on how much a country can

export or import etc. Also, assume that there is no transport cost of moving goods between the two countries. (We make these strong assumptions, not because they are critical for our argument, but because they help us to see the effect of trade very clearly.) The above assumptions imply that the exchange ratios or the relative price of a good will be the same in the two countries. It is because, if a good is cheaper in one country than in the other, every one in both countries will buy the product from the former country and this will push its price up. In equilibrium, the exchange ratios will be the same. We can call this the world exchange ratio or what is called the world terms of trade. Range of World Terms of Trade The next question is: what will be the equilibrium world terms of trade? Terms of trade, in general, refer to a relative price and we know from Chapter 5 that the equilibrium price of a good is determined by supply and demand forces. The supply side of an economy is represented by the PPC of a country. But we do not have any information on the demand side. Hence, we cannot determine the world terms of trade exactly. We can, however, find its range: it will lie in between the domestic exchange ratios. In this example, it means that the world relative price of football will be in between 2 and 4 cricket bats. It cannot exceed 4 or fall short 2. Why? Suppose it exceeds 4, say

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1 football for 5 cricket bats. Then, in both countries, a football fetches more than it fetches in the no-trade situation and thus both would like to export football. But this is not possible, since there is no third country they can both export to: by definition, the two countries comprise the world economy. (When there are more than two countries, you can group them into the home country and the rest of the world and the same argument holds.) You can similarly argue that if the world terms of trade are 1 football for something less than 2 cricket bats, both countries would want to import football and that is not possible. This proves that the equilibrium world terms of trade will lie between the domestic exchange ratios. Assume that the world terms of trade lie strictly in between the two domestic exchange ratios. As an example, suppose that they are equal to 1 football for 3 cricket bats. Specialisation Now think about how much of each good will be produced in the two countries. From the viewpoint of India, the relative price of football is 3 cricket bats, which is greater than its the marginal opportunity cost (equal to 2 cricket bats). This will mean that there are abnormal profits in the football sector. Hence resources (labour) will move out of the cricket bat sector to the football sector. This process will continue until there is no production of cricket bats in India. That is, India specialises in football, i.e. produces

football only. Mark that football is the good, in the production of which India has comparative advantage. By similar argument, Australia specialises in cricket bats, in which it has comparative advantage. Specialisation occurs as the world terms of trade are different from the domestic exchange ratio. This is shown in fig. 8.2, which graphs the same PPCs as in fig. 8.1 (shown by the dashed lines). Indias and Australias production points in free trade are shown at points D and H respectively. We can then summarise that in the Ricardian world economy, as long as the world terms of trade differ from the domestic exchange ratio, a trading country specialises in the good, in the production of which it has comparative advantage. This is how international trade affects production and resource allocation in an economy. Consumption Possibilities Now we come to the last stage of our discussion. What are the consumption possibilities facing the two countries and how do they benefit from trade? But before we address this question, we should know what we mean by exports and imports. Exports of a commodity are equal to its production minus its consumption, whereas imports of a commodity are equal to its consumption minus its production. In other words, if a good is exported (imported), then its production exceeds (falls short of) its consumption in the country.

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(a) India Fig. 8.2

(b) Australia

Free International Trade in the Ricardian Economy

In fig. 8.2, since India produces at D, one consumption possibility for her is the point D itself. But there are other possibilities. For instance, it can export one football in exchange for 3 cricket bats (all imported), or 2 footballs in exchange for 6 cricket bats (all imported) and so on. These possibilities give rise to the heavy line DE', whose slope is 3, equal to the relative price of football in the world market. 2 Put differently, the consumption possibility curve for India at the world terms of trade, equal to 1 football for 3 cricket bats, is the heavy line DE'. This situation is surely a better proposition for India than no trade, which only offered the consumption possibilities along the PPC

that lies to the left of or inside the line DE'. Alternatively, you can see that for every possible consumption point in the no-trade situation, e.g., A, except the corner points on the PPC, there is at least one point on DE', which guarantees more consumption of each good. Hence, free trade must be preferred to no trade. By similar argument, Australias consumption possibility curve is now the heavy line G'H, whose slope is also equal to 3, the relative price of football in the world market. The line G'H lies outside Australias PPC. Thus Australia also benefits from free trade. Note that, irrespective of which consumption points on DE' and G'H are chosen, India exports footballs and Australia exports cricket bats. That is,

The concept of slope of a straight line is explained in Appendix 2.

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each country exports the good it has comparative advantage in. This is a very general principle of international trade. The lesson to be learnt from the Ricardian theory is that a country benefits from international trade by specialising and exporting the products that it has comparative advantage in. This is true even when a country is more efficient in producing all goods in an absolute sense. 8.2 FACTOR ENDOWMENT THEORY OF INTERNATIONAL TRADE In the Ricardian theory, it is the difference in technology that forms the basis of comparative advantage and mutually beneficial trade. Otherwise, if the ratio of labour coefficients is the same between the two countries, then the domestic exchange ratios will be the same; no country will have comparative advantage in producing any good and there will be no reason to trade. Even if international trade is opened between the two countries, nothing will change in any country. However, technology differences are not only basis for comparative advantage and trade. Differences in relative factor endowment (to be defined in a moment) form another major basis for comparative advantage. The theory
3 4

that brings out this point is called the factor endowment theory.3 View the world as having two countries once again, say, India (N) and America (A). They produce two goods: Chairs (C) and Medicine (M). Instead of one factor of production, suppose that there are two, labour and capital. They are required in producing each of these two goods. There are constant returns to scale. Furthermore, the technology of producing either good is same between India and America and the production of chairs is relatively labourintensive and that of medicine is relatively capital-intensive.4 All markets are perfectly competitive. Suppose that the supply of each factor in each country is given. We can call these factor endowments, just like labour endowment in the Ricardian theory. 8.2.1 Factor Endowment Difference Let LN and KN denote the endowments of labour and capital in India. Likewise, let L A and KA denote the endowments of labour and capital in America. These are absolute factor endowments. The ratio of absolute endowments is called the relative factor endowment. For example, LN/KN is the relative endowment of labour in India. Having defined relative endowment, we can always compare it between countries. In our example, we say that

It was formulated originally by two Swedish economists, Eli Heckscher and Bertil Ohlin, and is called the Heckscher-Ohlin theory. It is not that the technology cannot differ between countries. But the idea here is to suppress such difference and focus on difference in factor endowments.

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India is the relatively labour-abundant country and America is the relatively capital-abundant country, if

( A)

LN KN

LA .5 KA

Let us assume this, since it is reasonable to suppose that India is a relatively labour-abundant country, compared to America. 8.2.2 Factor Price Difference What does this difference in relative factor endowment imply for factor prices? We first define two terms: absolute factor price difference and relative factor price difference. In general, we say that there is an absolute factor price dif ference between two regions or countries if the reward (price) of a factor dif fers between the two regions or countries in absolute terms. For instance, if labour earns wage equal to Rs. 50 per day in India and Rs. 200 per day in America, we say that there is an absolute wage difference and the wage rate is less in India than in America. Similarly, there can be an absolute difference in the rental rate of capital between the two countries. Given our ranking of the relative endowment in (A), can we say anything about absolute factor price differences between India and America? The answer is no, because the ranking (A) does not say anything about absolute endowment levels. But it can say
5

something about relative factor price difference, where relative factor price is defined as the ratio of factor rewards. Suppose that, in America, labour earns wage equal to Rs. 200 and capital earn rental equal to Rs. 1,000. In India, let the wage rate and the rental to capital be Rs. 100 and Rs. 900 respectively. Thus, the two absolute factor rewards are less in India. But, relatively speaking, the wage/rental ratio is greater in America. It is 1/5 there and 1/9 in India. In this case, we say that relative reward (price) of labour is greater in America and the relative reward of capital is greater in India. Indeed, our relative factor ranking (A) implies this. How? Our analysis of factor price determination in Chapter 7 comes into play. Let us invoke a result from that chapter which states that, greater the supply of a factor, the lower is its reward. In the present context, it implies that, since India (respectively America) is relatively labour (respectively capital) abundant, the wage/rental ratio in India will be less than that in America. In other words, India is the relatively lowwage country and America is the relatively high-wage country. 8.2.3 Comparative Advantage We now proceed to analyse how the dif ference in the relative factor endowment and the resulting difference in the relative factor price determine the flow of goods between the

For example, let LN = 1, 500, KN = 500, LA=2,000 and KA = 1000. Then LN/KN = 3, LA/KA = 2, and thus L N/K N>L A/K A.

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two countries. Ask yourself which good will be produced more efficiently (i.e. with lower cost) in the low wage/rental ratio country and in the high wage/ rental ratio country. Remember that the production technology of chairs (C) is labour-intensive and that of medicines (M) is capital-intensive. The answer is that the labour-intensive good C will be produced relatively more efficiently in the relatively low-wage, labour abundant country, and, the capitalintensive good (M) will be produced relatively more efficiently in the relatively high-wage, capital-abundant country. We can state this in terms of comparative advantage. The relatively labour-abundant, low wage/rental ratio, country (India) will have comparative advantage in producing the relatively labour-intensive good. The relatively capital-abundant, high wage/rental ratio country (America) will have comparative advantage in producing the relatively capitalintensive good. 8.2.4 International Trade

Thus far we have linked relative factor endowment difference and relative factor price difference to comparative advantage. We next link comparative advantage to international trade: i.e.,compared to no trade, in free trade, a country will produce more and export the product, in which it has comparative advantage. Joining the two links now, we can say that the relatively labour-abundant, low wage/rental ratio, country (India) will export the relatively labour-

intensive good (chair) and the relatively capital-abundant, high wage/rental ratio, country (America) will export the relatively capitalintensive good (medicine). This is how the relative factor endowment difference and the relative factor price difference are linked to international trade. You can reflect back to see that the aforementioned result is quite reasonable. This is the gist of the factor endowment theory. It emphasises relative factor endowment difference as the basis of comparative advantage and predicts that a country will export those products which uses its relatively abundant factor more intensively. Three remarks are in order. 1. Unlike the material in previous chapters and our discussion of the Ricardian theory, the factor endowment theory has been merely sketched. A specialised course in international economics will deal with this theory in more detail. 2. In Chapter 7, we learnt that the demand for a factor is called a derived demand. This is because changes in product markets affect the demand for a factor. In contrast, the factor endowment theory illustrates how factor market differences influence the product market the pattern of flow of goods between countries. Thus, a general and an important point to be learnt is that, in an economy, factor and product markets are very much interrelated.

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3. Recall the central prediction of the factor endowment theory. In our example, India, the relatively labour-abundant country, exports relatively labour-intensive goods and America, the relatively capitalabundant country exports relatively capital-intensive goods. We can look at this conclusion in a different light. India exporting relatively labour-intensive goods can be thought of as India exporting the services of labour. Likewise, America exporting relatively capital-intensive goods means that America is exporting capital services. Put differently, international trade in goods can be seen as international trade in factor services. This again shows how interrelated goods and factor markets are; it is as if factors are moving internationally, although they are not (in our analysis). 8.3 FACTOR MOBILITY The very last point made brings us to the very last topic to be analysed in this book. That is, factors do move between regions and countries. In our country daily labour moves typically from villages to towns. There are thousands of workers from India who are working in middle-east countries like Kuwait and Yemen. These are not the only instances of mobility. Unskilled labour moves from Mexico to America. Skilled workers move typically from countries like India and China to Europe and America.

We now ask why factors move the way they do? Here, unlike in the factor endowment theory, the absolute factor price difference (already defined) plays a role. As an example, we have already noticed that in India daily labour moves from rural to urban areas. Why is this so? Because, there is an absolute factor price difference. Given such a difference, a factor moves from the low-reward region to a high-reward region. Daily labour earns more in an urban area on an average than in a rural area on an average. This induces it to move from rural to urban areas. However, the absolute factor price difference or in this case the ruralurban wage differential, is just an immediate cause of factor/labour migration, not the underlying cause. This chapter and the book ends with an investigation of why a ruralurban wage differential exists. We can think of this issue in terms of demand and supply of a factor, studied in Chapter 7. Indeed there are differences in both demand and supply sides, which explain the rural-urban difference in daily wage. First, there are more nucleus families, as opposed to joint families, in urban areas than in rural areas. In many urban households, both husband and wife work outside the home. Hence there is a greater demand for household services like cleaning, cooking etc. Also, construction works are more prevalent in urban than in rural areas. Both these factors imply higher demand for daily labour in urban areas, compared to rural areas.

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Second, the urban cost of living is higher than the rural cost of living, so that families of many daily workers prefer to live in rural areas. This implies that, ceteris paribus, the supply of daily labour in towns is less than in villages. Both these factors together imply that the urban wage must be higher. We can see this in terms of fig. 8.3. There are two demand curves. The one to the right, DDB, can be interpreted as the demand curve for daily labour in the urban area and the one to the left, DDR, can be thought of as that in the rural area. There are also two supply curves. The one to the left, SSB, marks the supply curve in the urban area and the one to the right, SSR, marks that in the rural area. The urban labour market equilibrium is shown at the point EB where DDB and SSB intersect. Likewise, the labour market equilibrium in the rural area occurs at the point ER where the curves DDR and SSR intersect. As we can see clearly, the urban wage, WB is greater than the rural wage, WR. Once we establish that there is an absolute difference in wages, it is easy to predict that labour wants to move from a low-wage region to a high-wage region.

Fig. 8.3 Urban and Rural Wage for Daily Labour

We note that this is true not just for unskilled labour but also for skilled labour. Skilled workers want to move out of countries like India and China to the U.S. and Europe in order to earn higher wage for their skill. Similarly, capital, which earns less rental in capital-abundant developed countries, has an incentive to move (through multinational firms) to capital-poor, high-rental, developing countries. We should carefully note however that absolute factor price difference is only an immediate cause or an indicator of factor movement. Regional differences or differences between countries in demand and supply conditions of factors are the underlying cause of factor movement.

SUMMARY
l l l

The principle of comparative advantage implies that countries can benefit from trade by exploiting their differences. In the Ricardian theory, differences in technology form the basis of comparative advantage. Average physical product a factor is the inverse of its coefficient.

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l l l

l l l l l

In the Ricardian economy, constant labour coefficients imply that the marginal opportunity cost of a good, in terms of the other along the PPC, is constant. This in turn implies that the PPC is a straight line. In the absence of trade, a countrys PPC is same as its consumption possibility curve. The world terms of trade lie in between the domestic exchange ratios. In the Ricardian economy, a country specialises, in free trade, in the good in which it has comparative advantage, as long as the world terms of trade are different from the domestic exchange ratio. In the Ricardian economy, as long as the world terms of trade are different from the domestic exchange ratio, the consumption possibility curve in free trade lies outside its PPC. The Ricardian theory illustrates that a country benefits from international trade by specialising and exporting the products that it has comparative advantage in. This is true even when a country is more efficient in producing all goods in an absolute sense. The differences in relative factor endowment also form a basis of comparative advantage. This is captured by the factor endowment theory. A difference in the relative factor endowment causes a difference in the relative factor price. A relatively labour (capital) abundant country will have comparative advantage in relatively labour (capital) intensive goods. Factor endowment theory of trade predicts that a country will export the products which use its relatively abundant factor more intensively. This prediction can also be interpreted as that a country exports the services of its relatively abundant factor and imports the services of its relatively scarce factor. Absolute factor price difference is the immediate cause, not the underlying cause, of factor mobility. In turn, absolute factor price difference arises because of variations in demand and supply factors in respective regions. Compared to rural areas, in urban areas, the daily wage rate is higher. This is because of greater demand for daily labour and less supply of daily labour in the urban areas. The greater demand for daily labour in urban areas stems from higher demand for household work and construction projects. Higher cost of living in urban areas implies less supply of daily labour in these areas, as families of many daily workers prefer to live in rural areas.

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EXERCISES

Section I
8.1 8.2 8.3 8.4 8.5 8.6 8.7 8.8 8.9 What is meant by international trade? Give one example of international trade in services. What is meant by labour coefficient? Give the meaning of absolute advantage. Give the meaning of comparative advantage. What does the Ricardian theory emphasise as a basis of comparative advantage? In the Ricardian theory, which good does a country specialise in free trade? In the no-trade situation, what is the relationship between a countrys PPC and its consumption possibility curve? In the Ricardian theory, in the free-trade situation, what is the relationship between a countrys PPC and its consumption possibility curve? What does the factor endowment theory emphasise as a basis of comparative advantage? What is meant by relative factor endowment difference? What is meant by relative factor price difference? What is meant by absolute factor price difference?

8.10 8.11 8.12 8.13

Section II
8.14 8.15 8.16 Give two examples of international trade in services. Explain the concept of comparative advantage by using a suitable example. Explain that, in a two-country Ricardian world economy, both countries cannot have comparative advantage in producing the same good. Explain how, in the Ricardian world economy, constant labour coefficients imply that the PPC is a straight line. In an economy, there is one factor of production, labour. Two goods are produced: sitar and guitar. 5 units of labour is required to produce one sitar and 12 units of labour is required to produce one guitar. Determine the domestic exchange ratio between sitars and guitars in this country. The following table gives labour coefficients in the two sectors in two countries. Determine which country has absolute advantage and comparative advantage in which good.

8.17 8.18

8.19

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Popland Sitar Guitar 8.20 50 60

Rockland 60 50

8.21

8.22 8.23 8.24 8.25 8.26 8.27 8.28 8.29

Refer to the previous question. Suppose technological progress occurs in Popland. As a result, the labour coefficients are now 40 and 30 respectively for the sitar sector and the guitar sector. Determine which country now has absolute and comparative advantage in which good. A Ricardian economy can produce two goods: tooth brush and shoe brush. The labour coefficients in these two sectors are respectively 30 and 90. Its labour endowment is equal to 1,800. If the world terms of trade facing this country are 1 tooth brush for 4 shoe brushes, determine how many tooth brushes and shoe brushes this country will produce in free trade. Differentiate (with example) between a capital-intensive good and a labour-intensive good. Explain absolute factor price difference. Why may it arise? Explain relative factor price difference. Why may it arise? Name two commodities which are relatively labour-intensive in production. Name two commodities which are relatively capital-intensive in production. Name two relatively labour-abundant countries. Name two relatively capital-abundant countries. The world consists of two countries: Blueland and Yellowland. There are two factors, labour and land. They produce two goods, apples and grapes. The production of apples is relatively more land intensive compared to grapes. Suppose the endowments in the two countries are as given in the following table. If both countries engage in free trade with each other, determine which country will export what. Blueland Labour Land 50 70 Yellowland 60 140

8.30 8.31

Give two instances where factors are mobile. Name two labour-intensive commodities in India.

COMPARATIVE ADVANTAGE, INTERNATIONAL TRADE

AND

FACTOR MOBILITY

153

8.32

Suppose the supply of workers for household services declines in the economy. How will it affect the urban and rural wage for these services?

Section III
8.33 8.34 8.35 Explain why a relatively labour-abundant country will export relatively labour-intensive goods. Analyse why daily wage is higher in urban areas than in rural areas. Suppose that many of our computer professionals migrate to foreign countries. Ceteris paribus, how will it affect the salary of computer professionals in India and abroad?