Econ 203 (Week 2 Ricardian Model)

The Ricardian Model: Theory
The Ricardian Model: Empirical Evidence

The General Equilibrium Set-up
International Economics B (Econ 203)

Weeks 2: The Ricardian Model
Dr. Ruanjai Suwantaradon

School of Economics, Singapore Management University
Term 2, 2016-2017
Dr. Ruanjai Suwantaradon School of Economics, Singapore Management University

International Economics B (Econ 203) Weeks 2: The Ricardian Model
Plan for this Class
1. The Ricardian Model: Productivity Differences as a Source of

Comparative Advantage
1.1 Assumptions and Set-up of the Model
1.2 Predictions
2. Empirical Evidence for the Ricardian Model

3. General Equilibrium Set-up

Preamble
We have seen earlier a very general formulation of the principle of comparative

advantage.
All that mattered in providing a motivation for trade were differences in
autarky relative prices.
The Ricardian model provides the oldest explanation for such differences in
autarky relative prices: productivity differences across countries as a source of
comparative advantage
The original theory due to David Ricardo dates back to the early 19th century.

Assumptions
I 2 countries (Home and Foreign)

Variables that refer to the Foreign country indicated by an asterisk:
I 2 sectors (Clothing and Food)
I 1 factor of production (Labor): Quantity L, assumed to be fixed
Labor is homogenous and fully mobile across the two sectors
I In both industries, a simple constant returns-to-scale technology:
The number of units of labor required to produce a unit of output remains
constant even as output expands: constant unit labor requirements
I Markets are perfectly competitive
I Labor markets clear: no unemployment
I No trade costs (can be relaxed)

Set-up of the Model: Technology Coefficients
(Constant) unit labor requirements fully describe the production technology:

I aLF = amount of labor required to produce one unit of food in Home
aLC = amount of labor required to produce one unit of clothing in Home
I Note that:
1/aLF = Home labors productivity in producing food
1/aLC = Home labors productivity in producing clothing
(Unit of measurement of 1/aLF and 1/aLC is output per hour)
I Larger aL corresponds to lower productivity
Reasons for why unit labor requirements differ across countries could be:
differences in technological knowhow, worker skill sets, strength of labor unions
etc.

Deriving the PPF and Autarky Equilibrium

Figure 4.1 The Ricardian Production
Possibilities Schedule
Let
I xF = Homes output of F
I xC = Homes output of C
Full employment implies:
aLF xF + aLC xC = L
This is Homes PPF / Transformation Curve
pyright 2007 Pearson Addison-Wesley. All rights reserved. 4-2


Let:
I xF = Homes output of F
I xC = Homes output of C
Full employment implies:
aLF xF + aLC xC = L
This is Homes PPF / Transformation Curve
MRT = aaLCLF
= Opportunity Cost for another
unit of C in terms of F production foregone
Here, production exhibits constant marginal
returns


Equilibrium in autarky:
I Production: A
I Consumption: A
pC aLC
I Relative price = pF
= aLF
I Welfare = y0
Autarky relative price is completely pinned

down by the ratio of technology coefficients.
Hence, comparative advantage is determined

entirely by technological conditions.

Plan for this Class
1. The Ricardian Model: Productivity Differences as a Source of Comparative

Advantage
1.2 Predictions

3. The General Equilibrium Set-up

Trade Equilibrium
Suppose that Home is relatively more productive in the clothing industry than
a
Foreign: aaLC < aLC

Figure 4.2 Free-Trade Equilibrium
LF LF
This automatically means that Foreign is relatively more productive in the food

aLF aLF
industry than Home:
aLC
< aLC

Trade Equilibrium (cont.)

aLC aLC pC pC
aLF
<
aLF
pF
< pF
Home has a comparative advantage in Clothing; Foreign in Food

W
pC
The world relative price or terms of trade pF
must satisfy
W
pC pC pC
pF
pF
pF
and settles at a level that ensures balanced trade:
Value of Home exports of Clothing = Value of Home imports of Food

Trade Equilibrium
Figure 4.2 Free-Trade Equilibrium
W
pC
Suppose pF
= Slope of EB and E B
Specialization patterns:
I E is the point on Homes PPF through which a budget line with slope
(pC /pF )W will allow Home to reach the highest indifference curve possible: 4-3
Copyright 2007 Pearson Addison-Wesley. All rights reserved.
Home specializes completely in Clothing (moves from A to E )

Figure
Trade 4.2
Equilibrium
W
Free-Trade Equilibrium
pC
Suppose pF
Specialization patterns:
I Likewise, E is the point on Foreigns PPF through which a budget line
with slope (pC /pF )W will allow Foreign to reach the highest indifference
Copyright 2007 Pearson Addison-Wesley. All rights reserved. 4-3
curve possible: Foreign specializes completely in Food (moves from A to
E ) and consumes at B
Figure
Trade 4.2
Equilibrium Free-Trade Equilibrium
W
pC
Suppose pF
Consumption patterns:
I With the new budget line, Home consumes at B and Foreign at B
Trade patterns:
I Home exports Clothing to Foreign; Foreign exports Food to Home
Both countries gain from trade: B and B lie on higher indifference curves
than A and A respectively
Absolute Advantage vs Comparative Advantage
Very important to clearly understand the difference between these two concepts:
I Home has an absolute advantage in the production of clothing if

aLC < aLC , ie if it is more productive in the cloth industry than Foreign.
I Home has a comparative advantage in the production of clothing if

aLC a
< aLC
aLF , ie if it is relatively more productive in the cloth industry (lower
LF
opportunity cost of production)

Absolute Advantage vs Comparative Advantage (cont.)
Consider the following table of unit labor requirements (the as):

Food Clothing
Home 30 10
Foreign 40 20
I Who has the absolute advantage in food? Who has the absolute advantage
in clothing?
I Who has the comparative advantage in each industry?
I What is the range of possible relative world prices at which complete
specialization and trade would occur? Who trades which good?

Absolute Advantage vs Comparative Advantage (cont.)
Consider the following table of unit labor requirements (the as):

Food Clothing
Home 30 10
Foreign 40 20
I Who has the absolute advantage in food? Who has the absolute advantage
in clothing?
I Who has the comparative advantage in each industry?
I What is the range of possible relative world prices at which complete
specialization and trade would occur? Who trades which good?
One country can have an absolute advantage in both food and clothing, but it
cannot have a comparative advantage in both.

Trade Equilibrium: The World PPF

Figure 4.3 The World
Transformation Schedule
Combining the Home and Foreign PPFs, we
obtain the world PPF: ABC
This describes the possible production out-

put of the world. To actually consume at
some of these points, Home and Foreign may
need to trade.
Lets assume that preferences in both

countries are identical and homothetic,
and so can be represented by a set of
world indifference curves
yright 2007 Pearson Addison-Wesley. All rights reserved. 4-4


Some free trade equilibrium possibilities:
Point B: World indifference curve passes

through the kink
I Both countries specialize completely
(Home in Clothing, Foreign in Food)
I Terms of trade lies between the two
relative autarky prices (the slopes of
the two linear segments)


Point J: World indifference curve tangent to

Foreign linear segment of the PPF
I Home completely specializes in
Clothing, but Foreign produces both
goods
I Terms of trade equal to the Foreign
autarky relative price (slope of the
foreign linear segment)
Can you describe situations in which the

equilibrium is likely to be at J?

Trade Equilibrium:
Figure The
4.4 The World World
Market for Supply
Food and Demand
Lets look at the world market for food:

aLF aLF
Recall that
aLC
< aLC
World supply curve for food: A step function
a
I If ppCF < aLF , even Foreign will not want
LC
to produce any food World output
of food (xF )W = 0
a
I If aLF < ppCF < aaLC
LF
, Foreign only
LC
produces food, Home produces only

clothing (xF )W = aL
LF

pF aLF
I IfpC
=
aLC
, Foreign indifferent
between food and clothing; Home
specializes completely in clothing.

(xF )W [0, aL ]
LF

Trade Equilibrium:
Figure The
4.4 The World World
Market for Supply
Food and Demand
World supply curve for food: A step function
I If ppCF = aaLC
LF
, Foreign specializes
completely in food; Home is indifferent
between food and clothing.
Total output of food,

(xF )W [ aL , aL + aLF
L
]
LF LF
aLF pF
I If aLC
< pC
, both countries produce
L
food (xF )W =
aLF
+ L
aLF
Exact food output depends on demand

Trade Equilibrium:
Figure The
4.4 The World World
Market for Supply
Food and Demand
World demand curve for food: Total demand

for food in the two countries, downward slop-
ing

Point J 0 :
I Foreign produces both goods
I Home specializes completely in clothing
Point B 0 :
I Foreign specializes completely in food
I Home specializes completely in clothing

Trade Equilibrium: Wage Determination
With perfect competition:
The marginal cost of production(MC) must be the price of the good,

otherwise profits would be positive, and entrants would come in, bidding up the
wage rate (w ).
Thus, the competitive profit conditions (from the Kuhn-Tucker Theorem) are
I waLC pC and
waLC = pC if xC > 0 (zero-profit condition: ZPC)
waLC > pC if xC = 0
I waLF pF analogously
be the value of the

Equivalently, the wage rate must marginal product(VMP)
1 1
of that unit of labor: w pC aLC
, w pF aLF

Figure 4.5 Relative Wages and the

Terms of Trade
Technology coefficients determine the equi-
librium nominal wage.
I If ppCF < aLC

aLF
: Both countries produce
food
waLF = pF and w aLF

= pF
w 1/aLF
w
=
1/aLF
a
I If ppCF > aLC
: Both countries produce
LF
clothing
waLC = pC and w aLC

= pC
w 1/aLC
w
=
1/aLC


Terms of Trade
a
I If aaLC
LF
< ppCF < aLC
: Home produces
LF
clothing, Foreign produces food
waLC = pC and w aLF

= pF
w 1/aLC pC
w
= p
1/aLF F
pC w
As pF
increases, w
increases.
Equilibrium relative wage must lie between
the two relative productivity ratios


Terms of Trade
a
I If aaLC
LF
< ppCF < aLC
: Home produces
LF
waLC = pC and w aLF

= pF
w 1/aLC pC
w
= p
1/aLF F
pC w
As pF
increases, w
increases.
Note: Home workers real wages improve as
pC
pF
increases:
w 1
I
pC
= aLC
stays constant, but
w 1 pC
I
pF
= aLC pF
increases
So Home workers are better off (in terms of
Food they can buy).


Terms of Trade
a
I If aaLC
LF
< ppCF < aLC
: Home produces
LF
waLC = pC and w aLF

= pF
w 1/aLC pC
w
= p
1/aLF F
pC w
As pF
increases, w
increases.
Intuition: The change in relative prices favors
the sector in which Home is specializing.
(Conversely, you should verify that Foreign

workers are indeed worse off; wpC while wpF
is constant)

Summary of Predictions of Ricardian Model
In a 2-country, 2-good Ricardian model:

The patterns of specialization and trade are determined entirely
by technological conditions, namely by the relative labor
productivities of each country.
I If Home has a higher relative labor productivity in the clothing industry

(compared to the food industry), it has a lower autarky price of clothing
relative to food.
I Suppose demand conditions are such that with an opening to trade, the
world terms of trade lie strictly between the two autarky relative prices of
Home and Foreign.
I Home then specializes in clothing and exports it to Foreign. Conversely,
Foreign will specialize in food, and export it to Home.
I Both countries gain from this mutually beneficial exchange.

Summary of Predictions of Ricardian Model (cont.)
In a multi-country, multi-good world:

I We cannot make as sharp a prediction about the patterns of specialization
and trade.
I Nevertheless, we can still measure a countrys relative productivity in
various industries in terms of a reference industry and then rank them.
I What we can say is: on average, a country will tend to export those goods
in which it has a relative productivity advantage, and import those goods
in which it has a relative productivity disadvantage.
I Where the exact cut-off between exporting and importing lies will depend
on other factors such as demand conditions, size of the labor force in each
country etc.

Some Drawbacks of the Ricardian Model
I Its predictions are much too stark in the 2 2 case:

Complete specialization in an industry following an opening to trade.
This is at odds with the data: We do know that countries export a wide
range of industries and are not so narrowly specialized.
I The model features only one factor of production, labor. Thus, it does not
allow us to talk about distributional consequences.

Plan for this Class

Advantage
1.2 Predictions


Empirical Evidence for the Ricardian Model
The Ricardian model suggests that countries should tend on average to export
more from those industries in which they are relatively more productive.
There are many empirical evidence in support of this.
I Earlier Work: G.D.A. MacDougall (1951), Balassa (1963) and Stern

(1962)
I Golub and Hseih (2000)
I Nunn (2007), an influential paper in the Trade and Institutions literature

Comparing UK and US, tested the

prediction that nations export goods
in which their labor productivity is rel-
atively high.
Source: Balassa(ReStat, 1963)

Looking at US-Japan exports.
The US tends to export more rela-

tive to Japan, in those industries in
opyright 2007 South-Western, a division of Thomson Learning. All rights reserved.
which the US enjoys relatively lower

unit costs than Japan.
Source: Golub (1995)

Discussions
Based on the Ricardian model which we have seen so far, what responses would
you give to each of these statements? Do you think this model is adequate for
shedding light on these statements?
1. International trade will only benefit a country if it is better at making

something than its trading partner.
2. Low wages in China and India will allow these two countries to take over
production of nearly everything.
3. The CEO of The General Motors Company made US$28 million in 2015.
The workers in her Central American assembly line made US$5 per hour.
This is exploitation, pure and simple.

Plan for this Class

Advantage
1.2 Predictions


Two countries (i): Country 1 and Country 2
Two goods (j): Good 1 and Good 2
Identical utilities of representative consumer/worker in countries i = 1, 2, for

example:

u c1i , c2i = b1 ln c1i + b2 ln c2i
Endowments of labor in countries i = 1, 2:

i
L units of labor
Different production technologies across countries: i = 1, 2
l1i li
y1i = i
and y2i = 2i
a1 a2

Definition of an Autarky Equilibrium

An autarky equilibrium in country i is a set of: prices pb1i , pb2i ; a wage rate w
bi ;
i i i i bi bi
comsumption plans cb1 , cb2 ; and production plans yb1 , yb2 , l1 , l2 such that:
1. Taking the prices pb1i , pb2i and w
b i as given, the representative consumer
solves:

max u cb1i , cb2i
cb1i , cb2i
i
s.t. pb1i cb1i + pb2i cb2i = w
bi L
2. Given pbji and w
b i , firms in sector j = 1, 2 solve
i
lj
b
max pbji ybji w
bib
lji s.t. ybji =
ybji , b
lji aji
3. The goods markets clear:

cb1i =
cb2i =
4. The labor market in country i clears:
i
l1i + b
b l2i = L
Definition of a Free Trade Equilibrium

A free trade equilibrium is a set of: prices pb1 , pb2 ; wages w b 1, w
b 2;
1 1 2 2
comsumption plans cb1 , cb2 , cb1 , cb2 ; and
production plans yb11 , yb21 , b
l11 , b
l21 , yb12 , yb22 , b
l12 , b
l22 such that:
1. Taking the prices pb1 , pb2 and w b i as given, the representative consumer in
country i, i = 1, 2 solves:

max u cb1i , cb2i
cb1i , cb2i
i
s.t. pb1 cb1i + pb2 cb2i = w
bi L
l1i
b i a1i 0,
2. pb1 w = 0 if yb1i > 0, i = 1, 2 where y1i = a1i
l2i
b i a2i 0, = 0 if yb2i > 0, i = 1, 2
pb2 w where y2i = a2i
3. The goods markets clear:
cb11 + cb12 = yb11 + yb12
cb21 + cb22 = yb21 + yb22
4. The labor market in country i, i = 1, 2, clears:
i
l1i + b
b l2i = L
Example 1
Suppose that both countries have identical preference: u c1i , c2i = ln c1i + ln c2i ,

but different labor endowment and production technologies.

In particular, Country 1 has labor endowment L1 =1000 and unit labor
requirements a11 = 1 and a11 = 2.
Country 2 has labor endowment L2 =1800, and unit labor requirements a12 = 2
and a22 = 3.
Solve for each countrys autarky equilibrium and for a free-trade equilibrium.
Please refer to the supplementary note Example 1 of Ricardian GE Model.

Example 2 for Self Practice
u c1i , c2i = ln c1i + ln c2i

l21 1
y11 = l11 , y21 = 2
, L = 12
l12 2
y12 = 2
, y22 = l22 , L = 12
In this case, we have a free-trade equilibrium in which

pb1i pb2i bi
w cb1i cb2i yb1i yb2i l1i
b l2i
b
Country 1 1 1 1 6 6 12 0 12 0
Country 2 1 1 1 6 6 0 12 0 12
Note that with free trade pb11 = pb12 = pb1 and pb21 = pb22 = pb2 .

Summary
In the 2-country, 2-good setting setting, you should know how to:
I relate the slope of the PPF for a given country to its unit labor coefficients
/ technology coefficients
I predict the pattern of specialization and trade, given a set of unit labor
coefficients
I recognize that pinning down the actual terms of trade ultimately depends
on demand conditions
I understand broadly what forms of empirical evidence have been found in
support of the Ricardian model
I know how to solve a general equilibrium model for an autarky and
free-trade equilibrium for the Ricardian framework

Disclaimer
These slides have been made available to students for the sole purpose of self study. They should not be
disseminated without my prior permission, nor should they be re-used for commercial purposes. The material draws
on:
I Slides from Caves, Frankel, and Jones, World Trade and Payments: An Introduction, 10th edition. c 2007,
Pearson Addison-Wesley.
I Slides from Carbaugh, International Economics, 12th edition. c 2009, South-Western, a division of
Thomson Learning.
I Slides from Krugman and Obstfeld, International Economics: Theory and Policy, 7th edition. Prepared by
Thomas Bishop. c 2006, Pearson Addison-Wesley.
I Slides from Husted and Melvin, International Economics, 7th edition. c 2007, Pearson Addison-Wesley.
I have also greatly benefited from material shared by Davin Chor (in turn drawn from Pol Antras, Pao-Li Chang, C.
Fritz Foley, and Edwin Lai). All errors are my own.


Econ 203 (Week 2 Ricardian Model)

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The Ricardian Model: Theory

The Ricardian Model: Empirical Evidence

International Economics B (Econ 203)

Dr. Ruanjai Suwantaradon

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management University

Plan for this Class

1. The Ricardian Model: Productivity Differences as a Source of

2. Empirical Evidence for the Ricardian Model

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management University

We have seen earlier a very general formulation of the principle of comparative

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management University

I 2 countries (Home and Foreign)

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management University

Set-up of the Model: Technology Coefficients

(Constant) unit labor requirements fully describe the production technology:

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management University

Deriving the PPF and Autarky Equilibrium

Full employment implies:

This is Homes PPF / Transformation Curve

pyright 2007 Pearson Addison-Wesley. All rights reserved. 4-2

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management University

Deriving the PPF and Autarky Equilibrium

Full employment implies:

This is Homes PPF / Transformation Curve

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management University

Deriving the PPF and Autarky Equilibrium

Autarky relative price is completely pinned

Hence, comparative advantage is determined

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management University

Plan for this Class

1. The Ricardian Model: Productivity Differences as a Source of Comparative

2. Empirical Evidence for the Ricardian Model

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management University

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management University

Trade Equilibrium (cont.)

Home has a comparative advantage in Clothing; Foreign in Food

and settles at a level that ensures balanced trade:

Value of Home exports of Clothing = Value of Home imports of Food

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management University

Home specializes completely in Clothing (moves from A to E )

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management University

Absolute Advantage vs Comparative Advantage

I Home has an absolute advantage in the production of clothing if

I Home has a comparative advantage in the production of clothing if

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management University

Absolute Advantage vs Comparative Advantage (cont.)

Consider the following table of unit labor requirements (the as):

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management University

Absolute Advantage vs Comparative Advantage (cont.)

Consider the following table of unit labor requirements (the as):

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management University

Trade Equilibrium: The World PPF

This describes the possible production out-

Lets assume that preferences in both

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management University

Trade Equilibrium: The World PPF

Point B: World indifference curve passes

yright 2007 Pearson Addison-Wesley. All rights reserved. 4-4

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management University

Trade Equilibrium: The World PPF

Point J: World indifference curve tangent to

yright 2007 Pearson Addison-Wesley. All rights reserved. 4-4

Can you describe situations in which the

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management University

be the value of the