Question

DB#3: Two questions related to Sources of Comparative Advantage - answer questions by one paragraph for each.

1. Explain how immigration and trade may worsen wage inequality, and how college education may mitigate against that.

2. How does Staffan Linder explain world trade patterns?

Answer 1

Part 1

Let us assume,

1. A 2 country economy, where A is developed country and B is a emerging market (far less developed).
2. Wage rate in country A is higher than in B.
3. B is labour intensive while A is capital intensive economy.
4. A has comparative advantage in producing good 1 and B has in producing good 2. Labour in A skilled at producing good 1 only and labour in B skilled in good 2 only
5. There exists a trade pattern so that both the economies have comparative advantage.

Now by assumption 2 and 3, there is excess labour in B and lower wage rate than A. Hence workers will immigrate from B to A in search of better pay and standard of living. Continued immigration would lead to excess labour supply in A's market and wage rates would wall in A. Also, with immigration, along with cheap labour, there came the skills for producing good 2 (which B has comparative advantage in). Hence, due to excess labour supply for producing good 1, A can allocate it towards more production of good 2. Hence by assumption 1, the terms-of-trade (trading can become less beneficial) could fall and thereby lead to fall in wages due to firm shutdown and rising unemployment in country B, thereby could worsen the wage inequality. However college education can impart the knowledge from which a person can learn the skills to produce both good 1 or good 2 or both. Hence, in this situation, people in country B, after firm shutdown, can use the skills learned to produce good 1 and being labour intensive could produce at a cheaper price than A and hence develop a comparative advantage in producing good 1. Thereby saving the economy from financial collapse by redefining terms-of-trade for A and B.

Part 2 (reference link: http://www.economicsdiscussion.net/linders-theory-of-demand/linders-theory-of-demand-and-trade-pattern-economics/30832)

According to Linder, the countries will trade in goods for which domestic demand is present and the foreign market is assumed to be more risky than the home market. A large domestic market induces an expansion in output ensuring the economies of scale and cost reduction. In these conditions, it is beneficial for the country to enter the foreign market. Also, a country will export its products largely to such countries, that have similar patterns of demand and levels of income. He coins it as the ‘preference similarity’. As a result of preference similarity, the country will have overlapping demands.

This can be explained with the help of the below diagram

Let per capita income and products be measured against x a nd y axis respectively. Let there be 2 products and 2 countries, A and B. Also assume that there is demand for both products in both the countries . Line OP measures relation between products and per capita income and passes thorough origin. A has per capita income Y₁ than B (Y₀) and correspondingly, Q₁ and Q₀ are higher and lower quality of the 2 products. A demands Q₁ and B demands Q₀. Assume that in country A, demand for both products in given by range AN and that in B is BC. The range of overlapping demand in the two countries is BD = RN. The existence of overlapping demand creates the possibility of trade between them.