Comparative Advantage

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.

Ricardian Model

This is a general equilibrium model. The society is composed of a number of individuals

who produce and consume a number of goods. We shall describe what they produce,
what they consume, and how they exchange their production for their consumption
bundle.

Home economy:
- N individuals equipped with 1 unit of labor each, 2 goods (food and manufactured
goods);
- Goods produced out of row materials (everybody can get as much of them as he/she
wishes for free), the only costly input is labor; aLF units of labor produces a unit of food,
and aLM units of labor produces a unit of manufactured good;
- Individuals exchange goods at competitive markets, also labor market is competitive
(labor is mobile, people can move from producing food to producing manufactured
goods, and vice versa, at no cost)
This implies that
(1) pF = w·aLF and pM =aLM·w,
where w the market price of labor, and pM the market price of manufactured goods, pF
the market price of food. [Make sure you know why!]
- All individuals are identical, their income comes from labor, and chose their
consumption bundle to maximize their Cobb-Douglas utility u=xFα·xM1-α.

The equilibrium in Home economy (when no trade with the rest of the world is
allowed):
Individuals maximize their utility:
 F
w/pF

xF

xM w/pM M

(2) xF=α·w/pF, xM=(1-α)·w/pM

[You can simply remember this formula. We will not work with other utility
representations.]

In equilibrium “demand=supply”. That is, by (2), N·α·w/pF=LF/aLF and

N·(1-α)·w/pM=LM/aLM, and LF =N·α and LM = N·(1-α), by (1). [LF and LM stand for the
number of people producing F and M, respectively.]
Is the model already solved? Yes! [Make sure you know why.!]
Corollary: pF/pM=aLF/aLM

Foreign (the rest of the world) economy (when no trade with the rest of the world is
allowed): The same as at home, but
(3) aLF/aLM < a*LF/a*LM .
We call aLF/aLM the opportunity cost of F in terms of M. (3) implies that Home has a
comparative advantage in F and Foreign in M.

The world equilibrium (when free trade is allowed, no transportation cost of goods, but
labor is immobile):
Home produces food, Foreign produces manufactured goods.
pF/pM=aLF/aLM ≤ pWF/pWM ≤p*F/p*M=a*LF/a*LM [Make sure you know why.!]

More specifically, since “demand=supply”, [αNwW+ αN* w*W]/pWF = N/aLF and

[(1-α)NwW+ (1-α)N*w*W)]/pWM = N*/a*LM. This yields pWM/pWF= (1- α)Na*LM/αN*aLF.

Proposition: Everybody gains from free trade. [In other words, everybody is better off in
the equilibrium with free trade than without trade.]
Proof: Note first that, since the labor market is competitive,
pWF = wW·aLF and pWM =aLM*·w*W. Then see the figure. The figure shows that a Home
individual is better off with trade. An analogous figure shows that a Foreign individual is
better off.
 w/pF
=
wW / pWF

w/pM < wW/pWM

Example: [Make sure that you can do all calculations yourself.]

If aLF = 1 and aLM = 2, a*LF = 3 and a*LM = 1, N=N*=100, α=1/2, then
pF/pM=1/2 ≤ pWF/pWM =1≤p*F/p*M=3.