Chapter 2 -- Ricardian Model

This chapter presents a simple model of trade that highlights the role of comparative
advantage as a motive for trade and a means of gaining from trade.

The insight that you should gain from today’s class is that free trade with a country that is
the US’s technological inferior can benefit both that country and the U.S.

Ricardo's basic idea is that what matters for gaining from trade is your opportunity cost
rather than your actual costs.

The opportunity cost of a good x is how much of some other good, say y, you have to
give up in order to produce/get one unit of good x.

Gains from Trade

If each country produces the good for which it has the lowest opportunity cost, the world
as a whole produces more, making it possible in principle to raise everyone’s standard of
living.

A country has a comparative advantage in producing a good if the opportunity cost of

producing that good in terms of other goods is lower in that country than it is in other
countries.

In this way, Trade between two countries can benefit both countries if each country
exports the goods in which it has a comparative advantage.
We still need a model to show that countries will indeed export the goods in which they
have comparative advantage.

We’ll develop simplest possible model in which trade is solely due to international
differences in labor productivity.

Ricardian (One-factor) Model

Two countries: “Home” and “Foreign” (*)
Two goods produced: wine (W) and cheese (C)
Fixed labor supplies, L and L*, in each country.

UNIT LABOR REQUIREMENTS:

 aLW = hours of labor (L) required to produce one gallon of wine (W) in Home
 aLW* = " " " " " Foreign.
 aLC = hours of labor (L) required to produce one yard of cloth (C) in Home
 aLC* = " " " " " " " " Foreign.

Example: 1 hour of labor in Home can produce 1/aLW gallons of wine.

Denote wages by w and w*

Assume labor is perfectly mobile across industries within a country (implies zero profits
for firms).

Use unit labor requirements to draw Production Possibilities Frontiers (PPF) for each
country.

The opportunity cost of a good only equals the absolute value of the slope of PPF when
the good in question is on the horizontal axis.

If instead you were asked for opportunity cost of wine in terms of cheese, answer would
be 1/[absolute value of slope of PPF]

The PPF determines what the economy can produce. It doesn’t tell you what it will
produce. But it’s useful in determining supplies of different goods as a function of prices.

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Perfect labor mobility implies zero profits:
aLCwC = PC
aLWwW = PW
so wages in each industry
wC=PC/aLC
wW=PW/aLW

wC>wW  QC = L/aLC, QW = 0.
(workers only willing to take jobs in cheese industry)

wC<wW  QC = 0, QW = L/aLW.
(workers only willing to take jobs in wine industry)

Gives supplies as function of relative prices:

QC = 0 QW = L/aLW if PC/PW < aLC/aLW

QC = L/aLC , QW = 0 if PC/PW > aLC/aLW

Can describe specialization as function of opportunity costs:

The economy will specialize in the production of cheese if the relative price of cheese
exceeds its opportunity cost;
will specialize in wine if relative price of cheese is less than its opportunity cost.

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Definition
AUTARKY: A country-wide policy of self-sufficiency (absence of international trade).

In autarky, so long as Home wants to consume some of each good, then country must be
diversified.

Requires relative prices equal opportunity costs of production:

PC/PW = aLC/aLW

Definition:
FREE TRADE: trade between countries without any artificial impediments such as
import/export quotas, tariffs, and so on.

Consider free trade between Home and Foreign.

Without loss of generality, assume

aLC/aLW < aLC*/aLW*
(i.e. that Home has lower opportunity cost of producing cheese)

 Home has comparative advantage in cheese.

Since oppty cost of wine = 1/[oppty cost of cheese]

then Foreign has comparative advantage in wine.

Result: each country will have comparative advantage in at least one good.

Comparative advantage is not the same as absolute advantage (what most people usually
think about).

Definition
A country is said to have an ABSOLUTE ADVANTAGE in the production of a good if its unit
labor requirement for that good is less than that of its trade partner.

For example, if aLC < aLC* then Home has absolute advantage in production of cheese.

It might also be the case that aLW < aLW*, in which case Home also has absolute advantage
in production of wine

Important: just because a country has absolute advantage in production of some good
doesn’t necessarily mean it will export that good.

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To see who produces/exports what, look at PPF for Foreign country:

EQULIBRIUM PRICES IN FREE TRADE

In trade, relative prices could lie anywhere (weakly) between aLC/aLW and aLC*/aLW*:
PC/PW  [aLC/aLW , aLC*/aLW* ]

"contained
To see what the prices are exactly, first draw Relative Supply for the whole world.

Calculating Relative Supply

Home will produce wine only if PC/PW  aLC/aLW
Foreign will produce wine only if PC/PW  aLC*/aLW*
etc.

Since aLC/aLW < aLC*/aLW* we have

if then
PC/PW < aLC/aLW QC = 0
PC/PW = aLC/aLW QC [0, L/aLC]
aLC/aLW < PC/PW < aLC*/aLW* QC = L/aLC
PC/PW = aLC*/aLW* QC [L/aLC, L/aLC + L*/aLC*]
PC/PW > aLC*/aLW* QC = L/aLC + L*/aLC*

Similarly, we can figure out world output of wine

if then
PC/PW < aLC/aLW QW = L/aLW + L*/aLW*
PC/PW = aLC/aLW QW [L*/aLW*, L/aLW + L*/aLW*]
aLC/aLW < PC/PW < aLC*/aLW* QW = L*/aLW*
PC/PW = aLC*/aLW* QW [0, L*/aLW*]
PC/PW > aLC*/aLW* QW = 0

Put these together in one diagram:

Relative price of
cheese, PC/PW

aLC*/aLW* RS

aLC/aLW

L/aLC Relative quantity of cheese

[QC + QC*]/[QW + QW*]
L/aLW*
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In order to find out what the prices are, need to draw a relative demand curve.

Exact shape of RD curve depends on consumers preferences for the different goods.
Is safe to say relative demand for cheese decreasing as PC/PW 
(unless cheese is a giffen good – we’ll assume it isn’t).

Draw a possible RD curves.

Relative price of
cheese, PC/PW

aLC*/aLW* RS

aLC/aLW RD1

L/aLC Relative quantity of cheese

L/aLW* [QC + QC*]/[QW + QW*]

RD1, sufficient demand for cheese, get intermediate price:

PC/PW  (aLC/aLW , aLC*/aLW*)

Go back to PPFs,
 each country specializes in good in which it has comparative advantage.
____________________________________________________________
If instead RD2 (low preference for cheese) get PC/PW = aLC/aLW,
Relative price of
cheese, PC/PW

aLC*/aLW* RS

aLC/aLW RD1
2
RD2
L/aLC Relative quantity of cheese
L/aLW* [QC + QC*]/[QW + QW*]

Go back to PPFs
 Foreign would produce only wine and Home would be diversified.
____________________________________________________________

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What will be the effect of trade on wages?

Suppose without trade (you won't have been able to get these without knowing about the
money supply):
w = $15/hour
w* =2$/hour

Does Trade with lower paid Foreign workers make Home workers worse off? No.

Suppose in trade that PC = PW = $12.00 (maintains PC/PW =1.)

 Then Home workers (producing only cheese) earn $12.00/ hour
 Foreign workers (producing only wine) now earn $4.00/hour.

 In dollars Home workers look worse off.

 But need to look at real wage (wage divided by cost of goods consumed).

Purchasing power in autarky and trade

1 hour of work cheese wine
can buy in autarky in free trade in autarky in free trade
Home worker 1 lb 1 lb 1/2 gallon 1 gallon
Foreign worker 1/6 lb 1/3 lb cheese 1/3 gallon wine 1/3 gallon of wine

POINT
Even though Nominal Home wage falls, both Home and Foreign workers better off with
trade.

Aside: result that all workers gain from trade is specific to this model; the result that both
countries as a whole gain from trade is quite general.

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 MYTHS ABOUT FREE TRADE

Use Ricardian model to try and dispel three myths about gains from trade.

Myth 1: high income countries can’t gain from trade because they will never be the least
cost producer of any goods (unless they cut wages) (p.23)

 Analysis: confuses comparative advantage with absolute advantage.

 Both examples we’ve looked at have had one country with absolute technological
advantage in both goods, but always gains from trade by producing the good that they
are the relatively least cost producer of.
 So even though US workers might be higher paid than Mexican workers, because US
workers are also the more productive workers, for goods that the US is the most
relatively efficient at producing the US will still be the lowest cost producer in dollar
terms.

-

Myth 2: Foreign competition is unfair and hurts other countries when it is based on low
wages. (p.24)

 This was one of the arguments underlying the WTO riots in Seattle.
 You can see from the Home/Foreign example that this needn’t be so.
 Saw trade raise Foreign wage from $2/hour to $4/hour and purchasing power of
hourly wage rise with respect to imported goods.
 Suggests Foreign workers still paid less than Home in Trade but are made better off.
 In chapters 3 and 4 we’ll see that it is more likely that American workers don’t want
trade with low wage countries because it lowers own wages.

-
Myth 3: Trade exploits a country and makes it worse off if its workers receive much
lower wages than workers in other nations. (p.24)

 Trade economists don’t disagree that it would be nice if everyone earned first world
wages.
 They ask instead whether trade between rich and low income countries raises (real)
wages in low income countries.
 The examples we’ve worked through shows it does.
 And every other model of trade we’ll look at also shows that trade brings about
convergence of real wages.