Transcript P c

 Chapter 3
Labor Productivity and
Comparative Advantage
: The Ricardian Model
Introduction

Countries engage in international trade, mainly for two basic
reasons, which contributes to gains from trade :
• They are different from each other.
• They can achieve ‘scale economies’ in production.


As a first step, we look at a simplified models, where only the
first of the two motives is present.
The Ricardian model is based on technological differences
across countries.
• These technological differences are reflected in differences in
the productivity of labor.
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Slide 2-2
(1) Key Concepts of Comparative
Advantage

Opportunity Cost
• Assume there are only two goods, i.e., rose and computer.
• The opportunity cost of a computer (in terms of rose) is the
number of roses that could be produced with the same resources
for one unit of computer.
– To produce one more unit of computer, how many roses should be
given up.

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 other countries.
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Slide 2-3
The Concept of
Comparative Advantage

Suppose 10 million roses can be produced with the same
resources as 100,000 computers in U.S..
• Opportunity cost of one computer is 100 roses in US.
• What is opportunity cost of one rose?

Suppose 10 million roses can be produced with the same
resources as 30,000 computers in Mexico.
• Opportunity cost of one computer is 333 roses in Mexico.

This example assumes that Mexican workers are less
productive than U.S. workers in computer production.
• But more productive in rose production.
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Slide 2-4
The Concept of
Comparative Advantage

If each country specializes in the production of the good with
lower opportunity costs, trade can be beneficial for both
countries.
• Mexico has lower opportunity costs in roses.
• US has lower opportunity costs in computers.
• Mexico (US) has comparative advantage in rose (computer).

The potential benefits from trade based on comparative
advantage can be seen by considering the changes in total
production of roses and computers in the two countries.
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Slide 2-5
The Concept of
Comparative Advantage
Table 3-1: Hypothetical Changes in Production
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Slide 2-6
The Concept of
Comparative Advantage

The example in Table 3-1 illustrates the principle of comparative
advantage:
• If each country exports the goods in which it has comparative advantage
(lower opportunity costs), then both countries can gain from trade.
• World output can increase due to international trade.

Question arise whether this possibility (potential for mutual gain)
will be realized in the market.
• To answer this question, we introduce a theory of international
trade based on comparative advantage, originated from David
Ricardo.
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Slide 2-7
(2) A One-Factor Economy (an economy
dealt with by Ricardian model)
 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 (representing technology)
in each good is fixed or constant.
• Perfect competition prevails in all markets.
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Slide 2-8
A One-Factor Economy
 The constant labor productivity is modeled with the
concept of unit labor requirements:
• 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.
aLW = 2).
– Denote with aLC the unit labor requirement for cheese (e.g.
aLC = 1).
 The economy’s 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).
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Slide 2-9
A One-Factor Economy

Production Possibilities
• The production possibility frontier (PPF) of an economy is the
combinations of output that the economy can possibly produce,
– given the available resources (L) and the production technology (aLW.
aLC )
– PPF shows the maximum amount of a good (wine) that can be
produced for any given amount of another (cheese), and vice versa.
– Trade-offs between the two goods under limited resources.
• The PPF of our economy is given by the following equation:
aLCQC + aLWQW = L
(3-1)
• Opportunity cost of cheese in terms of wine is: aLC/aLW
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Slide 2-10
A One-Factor Economy
Figure 3-1: Home’s Production Possibility Frontier
Home wine
production, QW,
in gallons
L/aLW
P
Absolute value of slope equals
opportunity cost of cheese in
terms of wine
F
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L/aLC Home cheese
production, QC,
in pounds
Slide 2-11
A One-Factor Economy
 Relative Prices and Supply
• The particular amounts of each good actually
produced (on the PPF) are determined by prices.
• The relative price of good X in terms of good Y
(Px/Py) is the amount of good Y that can be
exchanged for one unit of good X in the market.
• Example:
– If price of a cheese (Px) is $2 & price of wine (Py)
is $1, then the relative price of cheese in term of
wine (Px/Py) is 2 (i.e. the amount of wine that can
be exchanged for one unit of cheese).
– The relative price of a wine in terms of cheese is 1/2.
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Slide 2-12
A One-Factor Economy



In this model, production decision is made by the movement of
labor to sector which pays the higher wage.
Let PC and PW be the dollar price of cheese and wine, respectively.
• wC = PC/aLC & ww = Pw/aLw (that is, the wage will equal the value of
•
product which a worker can produce)
Zero profit under perfect competition with one factor of production.

If wC > ww i.e. PC/aLC > Pw/aLw (or Pc/Pw > aLC/aLw), then there
is no production of wine (i.e., only cheese is produced).
If PC/aLC < Pw/aLw (or Pc/Pw < aLC/aLw), then there is no
production of cheese (i.e., only wine is produced).

If PC/aLC = Pw/aLw (or Pc/Pw = aLC/aLw), then both cheese and
wine are produced.
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Slide 2-13
A One-Factor Economy
 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. – “intuitive understanding” needed.
• (eg.) (PC / PW ) = 2, (aLC / aLW )= 1
• Understand this graphically using PPF.
 In the absence of trade (“closed economy”), both
goods are produced, and therefore PC / PW = aLC /aLW.
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Slide 2-14
(3) Trade in a One-Factor World
 Assumptions of the model:
•
•
•
•
•
•
•
•
There are two countries in the world (Home and Foreign).
Each country produces two goods (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.)
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Slide 2-15
Trade in a One-Factor World

Absolute Advantage (definition)
• 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 < a*LC and aLW < a*LW
– This assumption implies that Home has absolute advantage in the
production of both goods. Namely, Home is more productive in
producing both goods.

(We will see) even if Home has an absolute advantage in both
goods, mutually beneficial trade is possible.
• The pattern of trade will be determined by the concept of
comparative advantage.
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Slide 2-16
Trade in a One-Factor World
 Comparative Advantage
• Assume that aLC /aLW < a*LC /a*LW
(3-2)
– This assumption implies that the opportunity cost of
cheese (i.t.o. wine) is lower in Home than Foreign.
– Or Home is relatively more productive in cheese
(compared to wine) than Foreign.
– In the absence of trade, the relative price of cheese at
Home is lower than that at Foreign.
 Home has a comparative advantage in cheese and will
export it to Foreign in exchange for wine.
• Draw and compare the PPFs of Home and Foreign.
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Slide 2-17
Trade in a One-Factor World
Figure 3-2: Foreign’s Production Possibility Frontier
with steeper slope.
Foreign wine
production, Q*W,
in gallons
L*/a*LW
F*
+1
P*
L*/a*LC
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Foreign cheese
production, Q*C ,
in pounds
Slide 2-18
Specialization in production & trade
 Suppose the relative price is in-between the

opportunity cost of the two countries
That is, aLC /aLW < (PC / PW ) < a*LC /a*LW
 Then, each country will specialize in producing good
of its each other according to comparative advantage.
• Home will produce only cheese, while Foreign
produce only wine.
• Show this graphically.
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Slide 2-19
Trade in a One-Factor World

Determining the Relative Price After Trade
• Need to consider the two markets (cheese & wine)
•
simultaneously to understand trade.
What determines the relative price (PC / PW) when trade is
possible?
– To answer this question, define the relative supply and relative
demand for cheese in the world as a whole.
– The relative supply of cheese equals the total supply of cheese by
both countries at each given relative price divided by the total
supply of wine, (QC + Q*C )/(QW + Q*W).
– The relative demand of cheese in the world is defined in a similar
fashion.
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Slide 2-20
Trade in a One-Factor World

Relative Supply (RS= (QC + Q*C )/(QW + Q*W))
• If PC/PW <aLC /aLW, then both country produce only wine. i.e.
•
•
•

RS= 0.
If PC/PW =aLC /aLW , then Home is indifferent in producing
between cheese and wine. Foreign produce only cheese.
If aLC /aLW <PC/PW <a*LC /a*LW , then Home produce only cheese
(L/ aLC) & Foreign produce only wine (L*/ a*LC) . That is, the RS
= (L/ aLC)/ (L*/ a*LC)
If PC/PW =a*LC /a*LW, , then Foreign begins to produce cheese
together with wine (indifferent).
Relative Demand – assumed a downward sloping curve
(substitution effect).
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Slide 2-21
Trade in a One-Factor World
Figure 3-3: World Relative Supply and Demand
Relative price
of cheese, PC/PW
a*LC/a*LW
RS
1
aLC/aLW
RD
2
RD'
Q'
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L/aLC
L*/a*LW
Relative quantity
of cheese, QC + Q*C
QW + Q*W
Slide 2-22
Trade in a One-Factor World

Equilibrium relative price

Possibility of point 1.
• Determined by the intersection of RS and RD curves.
• Relative price is between the pre-trade prices of the two
•

countries.
Each country specialize in the product in which it has
comparative advantage. (Home-cheese, Foreign-wine)
Possibility of point 2.
• Relative price = opportunity cost at Home.
• Home not specialize (producing both), Foreign- specialize (in
goods with comparative advantage).
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Slide 2-23
Trade in a One-Factor World
 The Gains from Trade
• If countries specialize according to their
comparative advantage, they all gain from this
specialization and trade.
• We can demonstrate gains from trade in two ways.
– Trade as an “indirect method of production”.
– Trade as a channel for expanding consumption
possibilities.
• First, I will use the second approach, then explain
the second approach using the example.
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Slide 2-24
Trade in a One-Factor World
• Consider how trade affects the consumption in each of the
•
two countries.
The consumption possibility frontier shows the
combinations of goods the country can possibly consume.
– maximum amount of consumption of a good a country can
obtain for any given amount of the other good.
• In the absence of trade, the consumption possibility frontier
•
is the same as the production possibility frontier.
Trade enlarges the consumption possibility for each of the
two countries. – See the following graph.
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Slide 2-25
Trade in a One-Factor World
Figure 3-4: Trade Expands Consumption Possibilities
Quantity
of wine, Q*W
Quantity
of wine, QW
F*
T
P
F
Quantity
of cheese, QC
(a) Home
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T*
P*
Quantity
of cheese, Q*C
(b) Foreign
Slide 2-26
Trade in a One-Factor World
 A Numerical Example
• The following table describes the technology
of the two counties:
Table 3-2: Unit Labor Requirements
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Slide 2-27
Trade in a One-Factor World
 The numerical example implies that:
aLC / aLW = 1/2 < a*LC / a*LW = 2
• In world equilibrium, the relative price of cheese may
lie between these values. Assume that Pc/PW = 1.
 Both countries will specialize and gain from this
specialization.
• Consider Home, which can transform wine to cheese
by either producing it internally or by producing
cheese and then trading the cheese for wine.
• Draw PPFs and CPFs, seeing the gains from trade.
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Slide 2-28
Trade in a One-Factor World

Trade as an “indirect method of production”.
• Home can use one hour of labor to produce 1/aLW = 1/2
•
(gallon of) wine if it does not trade.
Alternatively, it can use one hour of labor to produce 1/aLC =
1 (pound of) cheese, sell this amount to Foreign, and obtain
1 wine: labor becomes more productive indirectly via trade .
• (Similarly) Foreign can use one unit of labor to produce
•
1/a*LC = 1/6 cheese in the absence of trade.
Foreign can use one unit of labor to produce 1/a*LW = 1/3
wine, sell this amount to Home, obtaining 1/3 cheese.
– labor becomes more productive indirectly via trade.
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Slide 2-29
Trade in a One-Factor World

Relative Wages
• With specialization & trade, Home workers produce only cheese
& Foreign workers produce only wine.
– The wage at Home is the value of one cheese per worker (aLC =1),
and wage at Foreign is 1/3 of wine (1/a*LW=3).
– To know monetary wages, need to know the prices of cheese and
wine.
• 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.
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Slide 2-30
Trade in a One-Factor World
• This can be illustrated with the help of the previous
numerical example:
– Assume that PC = $12 and that PW = $12. Therefore, we
have PC / PW = 1 as in our previous example.
– Since Home specializes in cheese after trade, its wage will
be (1/aLC)PC = ( 1/1)$12 = $12.
– Since Foreign specializes in wine after trade, its wage will
be (1/a*LW) PW = (1/3)$12 = $4.
– Therefore the relative wage of Home will be $12/$4 = 3.
– Thus, the country with the higher absolute advantage will
enjoy a higher wage after trade.
– Note that a*Lw/aLw < w/w* < a*LC/aLC.
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Slide 2-31
(4) Misconceptions About
Comparative Advantage
 Myth 1: Free trade is beneficial only if a country is
strong enough to withstand foreign competition.
• This argument fails to recognize that trade is based on
comparative not absolute advantage.
 Myth 2: Foreign competition is unfair and hurts other
countries when it is based on low wages. (claimed by
labor union of the advanced countries).
• Again in our example, Home with higher wage and
Foreign with lower wages, both still benefits from trade.
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Slide 2-32
(4) Misconceptions About
Comparative Advantage

Myth 3: Trade makes the workers worse off in
countries with lower wages. (Exploitation).
• In the absence of trade these workers would be worse
off.
• Denying the opportunity to export is to condemn poor
people to continue to be poor.
• Consider the real world data for the changes in wage
level of many developing economies.
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Slide 2-33
(5) Comparative Advantage
with Many Goods
 Setting Up the Model
• Both countries consume and are able to produce a
large number (denote, N) of different goods.
• Technology of each country: unit labor requirement aLi
• Number the goods according to the size of aLi/a*Li.
– aL1/a*L1. < aL2/a*L2. < --- < aLN/a*LN.
• As i increases, Home is more relatively productive
than Foreign
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Slide 2-34
Comparative Advantage
with Many Goods
Table 3-4: Home and Foreign Unit Labor Requirements
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Slide 2-35
Comparative Advantage
with Many Goods

Relative Wages and Specialization:
• The pattern of trade (which country produces which goods? )
•
will depend on the ratio of Home to Foreign wages.
Goods will be produced where it is cheapest to produce them.
– It will be cheaper to produce good i in Home if waLi < w*a*Li , or if
a*Li/aLi > w/w*.
• A country has cost advantage in any good for which its relative
productivity is higher than its relative wage.
– If, for eg., w/w* = 3, Home produce apple, banana, and caviar,
while Foreign produce only date and enchiladas.
– Both countries will gain from this specialization (trade).
– Home imports a date which requires 12 unit of Foreign labor. It is
equivalent to 4 unit of Home labor, given the wage ratio of 3. If Home
produce it domestically, 6 unit of labor is required. That is, import is
less costly. (indirect production).
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Slide 2-36
Comparative Advantage
with Many Goods

Determining the Relative Wage in the Multigood Model (i.e.,
how w/w* is determined? )
• To determine relative wages in a multigood economy we must
•
look behind the relative demand for goods (i.e., the relative
derived demand for labor).
The relative demand for Home labor depends negatively on the
ratio of Home to Foreign wages.
– As w/w* increases, goods produced in Home becomes relatively
more expensive, and world demand decreases.
– As w/w* increases, fewer (more) goods will be produced in Home
(Foreign), further decreasing demand for Home labor.
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Slide 2-37
Comparative Advantage
with Many Goods
Figure 3-5: Determination of Relative Wages
Relative wage
Rate, w/w*
RS
Apples
10
8
Bananas
4
3
2
0.75
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Caviar
Dates
Enchiladas
RD
Relative quantity
of labor, L/L*
Slide 2-38
(6) Adding Transport Costs
and Non-traded Goods

There are three main reasons why specialization in the real
international economy is not extreme:
• The existence of more than one factor of production.
• Countries sometimes protect industries from foreign competition.
• It is costly to transport goods and services.

Introducing transport costs makes some goods non-traded.
• Above example of 5 goods with 100% transport cost.- caviar and
dates becomes non-traded goods.

In some cases transportation is virtually impossible.
• Example: Services such as haircuts and auto repair cannot be
traded internationally.
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Slide 2-39
(7) Empirical Evidence
on the Ricardian Model


Does Ricardian model predict actual trade flows?
Qualified Yes.
• Misleading predictions. –complete specialization, neglect
•
distribution effect within a country, neglect economies of scale,
etc.
Basic prediction confirmed. (countries tend to export goods in
which their productivities are higher).
– Eg. US & Britain in post-World War II. (Figure 3.6)., clothing trade
• More recent evidence is less clear-cut.
– But partly due to no data for products with comp. disadvantage
(therefore not producing).
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Slide 2-40
Summary
 We examined the Ricardian model, the simplest model
that shows how differences between countries give
rise to trade and gains from trade.
 In the Ricardian model, a country will export that
commodity in which it has comparative (as opposed
to absolute) labor productivity advantage.
• Productivity difference play important role in int’l trade.
• Comparative, rather than absolute, advantage matters.
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Slide 2-41
Summary
 The fact that trade benefits a country can be shown in
either of two ways:
• Think of trade as an indirect method of production.
• Trade enlarges a country’s consumption possibilities.
 Extending the two-good model to many commodity

model makes it possible to show transportation costs
can give rise to the existence of non-traded goods.
The basic prediction of the Ricardian model has been
confirmed by a number of empirical studies.
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Slide 2-42