Chapter 3 Ricardian Model

1
Chapter 3 Ricardian Model
2
Ricardian Model

• Opportunity costs and comparative advantage
• An Example
• Relative demand-relative supply analysis
• A one factor Ricardian model
• Production possibilities
• Gains from trade
• Wages and trade
• Misconceptions about comparative advantage
• Transportation costs and non-traded goods
• Empirical evidence

3
Introduction

• Theories of why trade occurs can be grouped into
  three categories
• Market size and distance between markets
  determine how much countries buy and sell. These
  transactions benefit both buyers and sellers.
• Differences in labor, physical capital, natural
  resources and technology create productive
  advantages for countries.
• Economies of scale (larger is more efficient)
  create productive advantages for countries.

4
Introduction (cont.)

• The Ricardian model (chapter 3) says differences
  in productivity of labor between countries cause
  productive differences, leading to gains from
  trade.
• Differences in productivity are usually explained
  by differences in technology.
• The Heckscher-Ohlin model (chapter 4) says
  differences in labor, labor skills, physical
  capital and land between countries cause
  productive differences, leading to gains from
  trade.

5
Comparative Advantage and Opportunity Cost

• The Ricardian model uses the concepts of
  opportunity cost and comparative advantage.
• The opportunity cost of producing something
  measures the cost of not being able to produce
  something else.

6
Comparative Advantage and Opportunity Cost
(cont.)

• A country faces opportunity costs when it employs
  resources to produce goods and services.
• For example, a limited number of workers could be
  employed to produce either wine or cheese.
• The opportunity cost of producing wine is the
  amount of cheese not produced.
• The opportunity cost of producing cheese is the
  amount of wine not produced.
• A country faces a trade off how much wine or
  cheese should it produce with the limited
  resources that it has?

7
Comparative Advantage and Opportunity Cost
(cont.)

• A country has a comparative advantage in
  producing a good if the opportunity cost of
  producing that good is lower in the country than
  it is in other countries.
• A country with a comparative advantage in
  producing a good uses its resources most
  efficiently when it produces that good compared
  to producing other goods.

8
Production Possibilities Frontier
9
An Example

• China
• can produce 4,000 wine/hour or
• Can produce 1,333 cheese/hour
• o.c. of 1 cheese is 3 wine
• o.c. 1 unit of wine is 0.333 cheese
• Montenegro
• can produce 1,333 wine/hour or
• can produce 4,000 cheese/hour
• o.c. of 1 cheese is 0.333 wine
• oc. of 1 unit of wine is 3 cheese

Opportunity cost of Opportunity cost of
One wine one cheese
China 1/3 cheese 3 wine
Montenegro 3 cheese 1/3 wine
10
An Example (cont)
5
4
cheese (thousands per hour)
3
2
Montenegros PPF
1
1
Chinas PPF
1 2 3 4
wine (thousands per hour)
11
An Example (cont)
5
Montenegros opportunity cost 1 wine costs 3
cheese, and 1 cheese costs 1/3 wine
Chinas opportunity cost 1 wine costs 1/3
cheese, and 1 cheese costs 3 wine
b'
4
4
cheese (thousands per hour)
3
c
2
Montenegros PPF
a
1
1
Chinas PPF
b
1 2 3 4
wine (thousands per hour)
12
An Example (cont.)

• China has comparative advantage in producing
  wine, and Montenegro has c.a. in producing
  cheese.
• China specializes in wine production and
  Montenegro in cheese production.
• Both countries are better off by engaging in
  international trade!

13
An Example (cont)

• Chinathe country with absolute cost
  disadvantagecan benefit from trade
• Montenegrothe country with absolute cost
  advantagecan benefit from trade too
• But how much exactly do they produce? At what
  prices?

14
Relative Demand Relative Supply Analysis
The two markets in the home country there are
two markets in the foreign country
15
Relative Demand Relative Supply Analysis

• Hence, we dont need two separate diagrams for
  the home country
• We just need to look at one relative
  demand-relative supply diagram

16
Relative Demand-Relative Supply Analysis
17
Relative Demand Relative Supply Analysis

• To study the Ricardian Model, we need to clarify
  what the RD and RS are.
• The RS is determined by the technology
• The RD is determined by consumers preferences
• The preferences to be introduced are general,
  applicable to other models

18
Demand

• Assume identical, homothetic preferences
• Each consumers relative demand depends only on
  relative price, and not on her income level
• Given the relative price, each consumers
  relative demand is determined, so is that of the
  whole population
• One example is Cobb-Douglas utility function

19
Cobb-Douglas Utility Function
20
Relative Demand
Pc/Pw
Relative demand by a single consumer Relative
demand by the whole country Relative demand by
the whole world
High a
Low a
Relative Demand, Qc/Qw, or (QcQc)/(QwQw)
21
Relative Supply

• Assume that we are dealing with an economy (which
  we call Home). In this economy
• Labor is the only factor of production.
• Only two goods (say wine and cheese) are
  produced.
• The supply of labor is fixed in each country.
• The productivity of labor in each good is fixed
  (c.r.t.s. technology).
• Perfect competition prevails in all markets.

22
A One-Factor Economy

• The unit labor requirement is the number of hours
  of labor required to produce one unit of output.
• Denote with aLW the unit labor requirement for
  wine (e.g. if aLW 2, then one needs 2 hours of
  labor to produce one gallon of wine).
• Denote with aLC the unit labor requirement for
  cheese (e.g. if aLC 1, then one needs 1 hour of
  labor to produce a pound of cheese).
• The economys total resources are defined as L,
  the total labor supply (e.g. if L 120, then
  this economy is endowed with 120 hours of labor
  or 120 workers).

23
Relative Price and Supply

• I have a unit of labor, should I produce cheese
  or wine?
• To produce cheese, I can make 1/ aLC units and
  get a revenue of Pc/ aLC.
• To produce wine, I make 1/aLw units and hence get
  a revenue of Pw/ aLW.
• Hence,
• If Pc/Pwgt aLC / aLW, I should produce cheese
• If Pc/Pwlt aLC / aLW, I should produce wine
• If Pc/Pw aLC / aLW, I dont mind produce any
  combination

24
Relative Price and Supply

• The above relations imply that if the relative
  price of cheese (PC / PW ) exceeds its
  opportunity cost (aLC / aLW), then the economy
  will specialize in the production of cheese.
• In the absence of international trade, both goods
  are produced, and therefore PC / PW aLC /aLW.

25
Equilibrium under Autarky

• Relative price of cheese, PC/PW

RD (high a)
26
Trade in a One-Factor World

• Assumptions of the model
• There are two countries in the world (Home and
  Foreign).
• Each of the two countries produces two goods (say
  wine and cheese).
• Labor is the only factor of production.
• The supply of labor is fixed in each country.
• The productivity of labor in each good is fixed.
• Labor is not mobile across the two countries.
• Perfect competition prevails in all markets.
• All variables with an asterisk refer to the
  Foreign country.

27
Trade in a One-Factor World

• Absolute Advantage
• A country has an absolute advantage in a
  production of a good if it has a lower unit labor
  requirement than the foreign country in this
  good.
• Assume that aLC gt aLC and aLW gt aLW
• This assumption implies that Home has an absolute
  disadvantage in the production of both goods.
  Another way to see this is to notice that Home is
  less productive in the production of both goods
  than Foreign.
• Even if Home has an absolute disadvantage in both
  goods, beneficial trade is possible.
• The pattern of trade will be determined by the
  concept of comparative advantage.

28
Trade in a One-Factor World

• Comparative Advantage
• Assume that aLC /aLW lt aLC /aLW (2-2)
• In other words, in the absence of trade, the
  relative price of cheese at Home is lower than
  the relative price of cheese at Foreign.
• Home has a comparative advantage in cheese and
  will export it to Foreign in exchange for wine.

29
Trade in a One-Factor World

• Determining the Relative Price After Trade
• What determines the relative price (e.g., PC /
  PW) after trade?
• To answer this question we have to define the
  relative supply and relative demand for cheese in
  the world as a whole.
• The relative supply of cheese equals the total
  quantity of cheese supplied by both countries at
  each given relative price divided by the total
  quantity of wine supplied, (QC QC )/(QW
  QW).
• The relative demand of cheese in the world is a
  similar concept.

30
Relative Word Supply

• Recall aLC /aLW lt aLC /aLW
• If Pc/Pwlt aLC /aLW, no workers will produce
  cheese RS0
• If Pc/Pw aLC /aLW, workers in Foreign will
  produce wine only, workers in Home are
  indifferent. RSSc/(SwL/aLw)
• If aLC /aLWgtPc/Pwgt aLC /aLW, all Home workers
  produces cheese, all Foreign workers produce
  wine. RS(L/ aLC)/(L/aLW)
• .

31
World Relative Supply
Trade in a One-Factor World
aLC/aLW
aLC/aLW
32
Trade Equilibrium
33
Gains from Trade

• If countries specialize according to their
  comparative advantage, they all gain from this
  specialization and trade.

34
Gains from Trade

• LL120
• aLC4, aLW8, hence aLC/aLW1/2
• aLC2, aLW1, hence aLC/aLW2
• If free trade relative price is in between ½ and
  2
• Home specializes in Cheese production.
• Foreign specializes in Wine production.

35
Gains from Trade
Slope-aLC/aLW -2
SlopePc/Pw
SlopePc/Pw
(b) Foreign
36
Gains from Trade
Trade moves Home countrys consumption bundle
from A to B, surely an improvement! A similar
conclusion for Foreign country.
37
When is complete specialization?
38
When is complete specialization?
39
Incomplete specialization

• If a1/9, then Home has incomplete
  specialization, it is neither better off nor
  worse off under trade. But Foreign still has
  complete specialization and is still strictly
  better off
• If a1/3, then Foreign has incomplete
  specialization, it is neither better off nor
  worse off under trade. But Home is still better
  off

40
Incomplete Specialization
If a is low enough, there will be incomplete
specialization by Home.
2
-1/2
RD for higher a
RD for lower a
41
Wages

• Relative Wages
• Because there are technological differences
  between the two countries, trade in goods does
  not make the wages equal across the two
  countries.
• A country with absolute advantage in both goods
  will enjoy a higher wage after trade.

42
Wages

• This can be illustrated with the help of a
  numerical example
• Assume that PC 12 and that PW 12.
  Therefore, we have PC / PW 1.
• Since Home specializes in cheese after trade, its
  wage will be (1/aLC)PC ( 1/4)12 3.
• Since Foreign specializes in wine after trade,
  its wage will be (1/aLW) PW (1/1)12 12.
• Therefore the relative wage of Home will be
  3/12 1/4.
• Thus, the country with the higher absolute
  advantage will enjoy a higher wage after trade.

43
Comparative Advantage with Many Goods

• Setting Up the Model
• Both countries consume and are able to produce a
  large number, N, of different goods.
• Relative Wages and Specialization
• The pattern of trade will depend on the ratio of
  Home to Foreign wages.
• Goods will always be produced where it is
  cheapest to make them.
• For example, it will be cheaper to produce good i
  in Home if waLi lt waLi , or by rearranging if
  aLi/aLi gt w/w.

44
Comparative Advantage with Many Goods
Table 2-4 Home and Foreign Unit Labor
Requirements
45
Comparative Advantage with Many Goods

• Which country produces which goods?
• A country has a cost advantage in any good for
  which its relative productivity is higher than
  its relative wage.
• If, for example, w/w 3, Home will produce
  apples, bananas, and caviar, while Foreign will
  produce only dates and enchiladas.
• Both countries will gain from this
  specialization.

46
Comparative Advantage with Many Goods

• Determining the Relative Wage in the Multigood
  Model
• To determine relative wages in a multigood
  economy we must look behind the relative demand
  for goods (i.e., the relative derived demand).
• The relative demand for Home labor depends
  negatively on the ratio of Home to Foreign wages.

47
Comparative Advantage with Many Goods
Figure 2-5 Determination of Relative Wages
48
Comparative Advantage With Many Goods (cont.)

• Finally, suppose that relative supply of labor is
  independent of w/w and is fixed at an amount
  determined by the populations in the domestic and
  foreign countries.

49
Comparative Advantage With Many Goods (cont.)

50
Transportation Costs and Non-traded Goods

• The Ricardian model predicts that countries
  should completely specialize in production.
• But this rarely happens for primarily 3 reasons
• More than one factor of production reduces the
  tendency of specialization (chapter 4)
• Protectionism (chapters 811)
• Transportation costs reduce or prevent trade,
  which may cause each country to produce the same
  good or service

51
Transportation Costs and Non-traded Goods (cont.)

• Non-traded goods and services (e.g., haircuts
  and auto repairs) exist due to high
  transportation costs.
• Countries tend to spend a large fraction of
  national income on non-traded goods and services.
• This fact has implications for the gravity model
  and for models that consider how income transfers
  across countries affect trade.

52
Empirical Evidence

• Do countries export those goods in which their
  productivity is relatively high?
• The ratio of US to British exports in 1951
  compared to the ratio of US to British labor
  productivity in 26 manufacturing industries
  suggests yes.
• At this time the US had an absolute advantage in
  all 26 industries, yet the ratio of exports was
  low in the least productive sectors of the US.

53
Empirical Evidence (cont.)

54
Summary

• A country has a comparative advantage in
  producing a good if the opportunity cost of
  producing that good is lower in the country than
  it is in other countries.
• A country with a comparative advantage in
  producing a good uses its resources most
  efficiently when it produces that good compared
  to producing other goods.
• The Ricardian model focuses only on differences
  in the productivity of labor across countries,
  and it explains gains from trade using the
  concept of comparative advantage.

55
Summary (cont.)

1. When countries specialize and trade according to
   the Ricardian model the relative price of the
   produced good rises, income for workers rises and
   imported goods are less expensive for consumers.
2. Trade is predicted to benefit both high
   productivity and low productivity countries,
   although trade may change the distribution of
   income within countries.
3. High productivity or low wages give countries a
   cost advantage that allow them to produce
   efficiently.

56
Summary (cont.)

1. Although empirical evidence supports trade based
   on comparative advantage, transportation costs
   and other factors prevent complete specialization
   in production.