Transcript Principles of Macroeconomics

BA 187 – International Trade
Ricardo and Comparative Advantage:
The Classical Model of Trade
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Issues in International Trade

Initial attempt to understand two of the important
issues in trade theory.
 Gains from Trade
 Pattern of Trade


Use insight of Adam Smith about different
advantages in production across countries.
Focus on comparative, rather than absolute,
advantage as source of pattern & gains from trade
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Classical Model Assumptions
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Fixed endowment of labor in each country.
Labor completely mobile within a country.
Labor completely immobile between countries.
Commodity value determined by labor content.
Technology fixed but differs across countries.
Prod’n costs constant, do not depend on quantity.
Full employment of labor, perfect competition.
No tariffs or transportation costs.
Two country, two commodity world.
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Constant Cost Technology
Cloth
Wine
Autarky
PC/PW
England
10 hrs/yd
12 hrs/bbl
5/6W : 1C
Portugal
8 hrs/yd
6 hrs/bbl
4/3W : 1C
Ricardo (1817) viewed mutual gains from trade
possible based on comparative advantage.
 Example above Portugal has absolute advantage in
both goods, but trade still possible as England is
relatively more productive in cloth than wine.

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Absolute vs. Comparative Advantage

Absolute Advantage
– A country has an absolute advantage in good X if one
unit of labor produces more X than is produced by one
unit of labor in the other country.

Comparative Advantage
– A country has an comparative advantage in good X if
its opportunity cost of X in terms of Y is less than in the
other country

In previous example Portugal has an absolute
advantage in both goods but a comparative
advantage in wine.
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Opportunity Costs and Advantage

Comparative advantage arises from differing
opportunity costs across countries.
– With total labor fixed, producing more of one good (Cloth) means
producing less of other good (Wine).
– Tradeoff is opportunity cost and differs between the two countries.
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England
– 1 more unit of cloth requires giving up 5/6 unit of wine.
Portugal
– 1 more unit of cloth means giving up 4/3 units of wine.
England’s comparative advantage is producing
cloth, while Portugal’s comparative advantage is
in producing wine.
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Ricardian Comparative Advantage
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
Assume each
country has
120 units of
labor.
Table shows
all feasible
combinations
of cloth and
wine for each
country in
autarky.
England
Labor in Portugal
Cloth
Wine
Cloth
Wine
Cloth
0
12
120 hrs
0
15
3 1/3
8
80 hrs
6 2/3
10
6 2/3
4
40 hrs
13 1/3
5
10
0
0
20
0
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Gains from Trade
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Now trade opens
with terms of trade England Autarky Labor England Trade at
in
1W : 1C
equal to 1W:1C
Cloth
England specializes.
Produces only cloth.
Wine
Cloth
Wine
Cloth
England exports
0
12
120 hrs
0
12
cloth to Portugal in
exchange for imports
3 1/3
8
120 hrs
4
8
of wine.
At least as well off
6 2/3
4
120 hrs
8
4
as in autarky.
Same results for
10
0
120 hrs
12
0
Portugal. Mutual
gains from trade.
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Relative Wages
Assume unit of cloth & unit of wine sell for $12.
 After trade:
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– English workers specialize in cloth, receive $1.20/hr
($12 for 10 hrs work)
– Portuguese workers specialize in wine, receive $2.00/hr
($12 for 6 hours work)

Relative wage of English workers is 60% of that of
Portuguese workers.
– Note English workers are:
50% as productive as Portuguese workers in wine and
 80% as productive as Portuguese workers in cloth
 Relative wage lies between these two productivities.

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BA 187 – International Trade
Visualizing Comparative Advantage
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Visualizing Comparative Advantage
Rather than rely on numerical examples can
develop model visually to demonstrate results.
 Technology: (Constant Costs)
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– aLX = # units of labor for 1 unit of X. (a*LX for foreign)
– aLY = # units of labor for 1 unit of Y. (a*LY for foreign)
– aLXqX + aLYqY = Ltotal (a*LXq*X + a*LYq*Y = L*total)

Tastes:
– Each country possesses community indifference curves,
UH for Home and UF for foreign.
– Maximize utility subject to production constraints
determined by technology and labor endowment.
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Equilibrium in Autarky
Y
Y
Home
Foreign
L*/a*LY
L/aLY
aLX/ aLY < a*LX /a*LY
aLX
AF
aLY
UF
AH
UH
L/aLX
X
L*/a*LX
X
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Prices, Wages & Production

Prices, Wages, & Production
– Let PX and PY be the price of each good.
– Perfect competition implies wage to worker equals
value of output produced, PX/aLX or PY/aLY
– Labor mobility implies:
 If PX/aLX > PY/aLY, or equivalently when PX/ PY >
aLX /aLY then economy produces only X.
 If PX/aLX < PY/aLY, or equivalently when PX/ PY <
aLX /aLY then economy produces only Y.
– In autarky, economy must produce both goods so
relative prices of goods must equal their relative unit
labor requirements, i.e. px = PX/ PY = aLX /aLY.
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Potential Gains from Trade
Y
Y
Home
L*/a*LY
Foreign
QF
L/aLY
CF
CH
AF
U’F
U’H
UF
AH
UH
QH
L/aLX
X
L*/a*LX
X
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Equilibrium and Trade
Equilibrium occurs at relative price that makes the two triangles equal
Y
Y
Home
Foreign
L*/a*LY
QF
Foreign
Exports
L/aLY
AF
CH
CF
U’F
U’H
Home
Imports
UF
AH
UH
QH
L/aLX
Home Exports
X
L*/a*LX
X
Foreign Imports
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Determining Terms of Trade
How can we determine exactly what the relative price
will be in equilibrium with trade?
 Terms of trade for a country:
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– Ratio of the price of its export commodity to the price of its
import commodity.
– In our example, terms of trade for Home are PX/PY, and
PY/PX for Foreign.
Number of analytical tools to determine the
equilibrium relative price ratio with trade.
 K&O focus on Relative Demand and Supply analysis.

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Relative Demand and Supply
Relative analysis focuses on ratio of prices PX/PY &
ratio of total quantities (qX+ q*X)/(qY+ q*Y).
 Relative Demand:
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– Rise in PX/PY makes X more expensive relative to Y.
– Substitution away from X towards Y, leads to downwardsloping Relative Demand Curve, RD.

Relative Supply:
–
–
–
–
If PX/PY < aLX /aLY : no Good X produced.
If PX/PY = aLX /aLY : Home produces X as demanded.
If a*LX /a*LY > PX/PY > aLX /aLY : Home specializes in X.
If PX/PY > a*LX /a*LY : Both Home & Foreign produce X.
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Relative Demand and Supply
Relative Price of X
PX/PY
a*LX/a*LY
RS
1
aLX/aLY
RD
2
RD’
(L/aLX)/(L*/aLY)
Relative Quantity of X
(qX+ q*X)/(qY + q*Y)
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BA 187 – International Trade
Summary of Results from the
Classical Model of Trade
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Results of Trade

Mutual Gains from Trade
– Trade enlarges the range of consumption choices for
each nation over autarky.

Absolute vs. Comparative Advantage
– Gains arise from specializing in producing goods in
which have a comparative (not absolute) advantage.
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Trade & Specialization
– Expect trade to lead nation to specialize in prod’n.

Relative Wages
– What matters for trade is relative wage versus relative
labor productivities.
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Shortcomings of Ricardo Model

Classical approach has serious shortcoming, in that it
assumes rather than explains comparative advantage.
 Classical model does not explain why labor productivities
differ between nations. It is these differences which are the
source of comparative advantage.
 Ignores how relative resource endowments change as
countries grow (constant costs assumption).
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Benefits of trade come from more efficient use of
domestic resources through specialization.
 Specialization can have negative aspects if it results in a
lopsided pattern of growth within a developing country.
 May produce an export enclave rather than a well-balanced
economy.
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Statements to Address

Productivity & Competitiveness
“Free trade is beneficial only if your country is strong enough
to stand up to foreign competition.”
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Pauper Labor
“Foreign competition is unfair and hurts other countries when
it is based on low wages.”
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Exploitation
“Trade exploits a country and makes it worse off if its workers
receive much lower wages than workers in other countries.”
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Specialization
“There cannot be distinct roles within Mercosur, with one
country producing primary products while another is
industrialized” Fernando de la Rita, Presidential Candidate Argentina
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BA 187 – International Trade
Appendix: Small Country vs. Large
Country Gains from Trade
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Does Trade Exploit Small Nations?
Examine effects of opening trade between a large
economy and a small economy. (Think NAFTA)
 Is it true that the large nation will use its economic
clout to exploit the small nation?
 Next slide examines this case.
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– SC = Small Country, LC = Large Country
– Begin with both nation’s in autarky, ASC and ALC.
– Open trade, change relative prices to find equilibrium
(equal trade triangles) between the countries.
– Equilibrium with trade (Consumption, Production)
given by (CSC, QSC) and (CLC, QLC)

Surprising results for Small vs. Large Country.
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Large/Small Country
Y
Small Country = SC
Large Country = LC
QL
LC production point
with trade
C
LC
Exports
LC consumption point
in autarchy & trade
CL
CS
C
C
SC
Imports
AS
ULC
U’SC
C
SC consumption point
with trade
QSC
X
LC Imports
SC Exports
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Summary of Small vs. Large Country
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Small Economy
– Receives maximum gains available by opening trade.
– As a price-taker, it trades at the relative prices set by the
large economy.
– Completely specializes in good for which it has the
comparative advantage.

Large Economy
– Receives no gains from trade with small nation.
– No change in its production constraint.
– Produces both goods after trade, though more of good
in which it has comparative advantage.
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BA 187 – International Trade
Extensions to the Classical Model of Trade
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Adding Money to Ricardo
So far have dealt with trade in terms of barter of one
good for another.
 How to move to monetary economy?
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Domestic value of good found as PX = W•aLX

Link economies through exchange rate.
e = # units of foreign currency per unit domestic currency

Put price of good in common terms (foreign currency)
– Domestic Country: PX = aLX •W•e
– Foreign Country: P*X = a*LX •W*
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Trade occurs based on differences in money prices
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Example of Money & Ricardo
Wage/hr
Labor req.
for Cloth
Price of
Cloth
Labor req.
for Wine
Price of
Wine
England
£1 /hr
1 hrs/yd
£1
3 hrs/bbl
£3
Portugal
0.6 esc./hr
2 hrs/yd
1.2 esc.
4 hrs/bbl
2.4 esc.

Assume Exchange Rate of 1 escudo:£1
–
–
–
–
Cheaper to buy cloth in England, buy wine in Portugal.
Consistent with relative labor efficiency ( ½ < ¾ )
Terms of trade for England PCloth/PWine = 1/2.4
If trade not balanced, then specie flows to country with
trade surplus. Raises prices & wages, offsets trade.
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The Export Condition

Monetized version of Classical trade model.
– Country exports any product it can produce most
inexpensively, given wage rate & exchange rate.
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Export Condition
– Cost conditions necessary for country to export a good.
PX = aLX W e < a*LX W* = P*X
or
a*LX/ aLX > We/W*
– In a monetized world, ability to export depends not
only on relative labor efficiency but also on relative
wage rates and the exchange rate.
– Establishes limits on wage rates and/or exchange rate
for trade to take place between countries.
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Wage and Exchange Rate Limits

Trade in a two-good, two country world requires each country produce
one good more cheaply. This imposes limits on wage rates & exchange
rates for trade to occur.
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Wage Rate Limits (assumes e = £1:1escudo)
– In previous example, England loses export market in cloth if
English wage rises to £1.2/hr or higher.
– England gains export market in wine if it wage falls to £0.8/hr or
lower.

Exchange Rate Limits (assumes wages fixed)
– Similar logic dictates that at if EXR rise to 1.2 esc/£1 or higher
England loses export market in cloth.
– England gains export market in wine if it EXR falls to 0.8esc./ £ 1
or lower.
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Trade in Multi-Commodity World
Cloth
Wine
Bread
a*LC/aLC > a*Lw/aLw > a*LB/aLB >
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Relative
Wages
Cheese
[We/W*] > a*LCh/aLCh >
Tools
Pots
a*LT/aLT >
a*LP/aLP
Home Exports
Home Imports
Foreign Imports
Foreign Exports
Pattern of trade in multi-commodity world depends on
relative labor requirements versus ratio of relative wages.
Also can see effects of change in exchange rate or relative
wages on the pattern of trade.
Finally trade flows equalized by changes in relative wage
rates due to flows of gold or exchange rate changes.
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Effects of Change in Relative Wages
Cloth
Wine
a*LC/aLC > a*Lw/aLw >
Relative
Wages
[We/W*] >
Bread
Cheese
a*LB/aLB > a*LCh/aLCh >
Tools
Pots
a*LT/aLT >
a*LP/aLP
Home Exports
Home Imports
Foreign Imports
Foreign Exports

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Increase in Home wage rate, decrease in Foreign wage rate,
or rise in exchange rate (home currency more valuable)
Makes home country goods more expensive, reduces the
number of goods exported by the home country.
Again any imbalance in trade flows will be equalized by
changes in relative wage rates due to flows of gold or
exchange rate changes.
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Determining the Relative Wage
Relative Wage , We/W*
RS
RD = Relative Derived
Demand for labor
RS = Relative Supply
of labor, L/L*
a*LC/aLC
Cloth
Wine
(We/W*)eq
Bread
Cheese
Tools
RD
Relative Quantity of Labor
L/L*
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Evidence on Comparative Advantage

MacDougall (1951)
– Looked at ratio of labor productivity US vs. UK plotted
against export volume ratio, US vs. UK.
– Found that higher relative productivity for US vs. UK
associated with higher export volume for US vs. UK in
that industry.
– In addition found that relative productivity above
relative wage associated with higher export volume.
– Similar results obtained by Balassa(1963) and Stern
(1962)
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