Ricardian Model 1. Setup 2. Absolute Advantage 3. Comparative Advantage 4. Production possibility frontier and autarky equilibrium 5.

Trade equilibrium 6. Wages 7. Opportunity cost 8. Gains from trade: big versus small countries

ECON 3150 2. Ricardian Model

1. Setup 2 goods: X, Y 2 countries: H, F Production functions:

X = aLx Y = bL y L = Lx + L y

a, b>0 marginal products of labour

In case of 2 countries: Home:

X = a Lx ; Y = b Ly

Foreign:

X Y
f

= a f Lxf
f = b f Ly

ECON 3150 2. Ricardian Model

Assumptions: A1. Production functions (technology) differ across countries. A2. 1 factor of production (labour) i.e. no difference in relative endowments A3. Constant returns to scale (i.e. labour efficiency is independent of output) A4. Identical and homogenous tastes in all countries A5. Absence of distortions (tariffs, taxes, subsidies etc.) A2, A3 => linear PPF

ECON 3150 2. Ricardian Model

2. Absolute Advantage Definition 1 Country H has an absolute advantage in production of X if ah > af. Country H has an absolute advantage in production of Y if bh > bf. Example 1 1 unit of labour produces (MPl): Home X Y a=20 b =20 Foreign af =30 b f=10 Absolute advantage Foreign (20<30) Home (20>10)
4

ECON 3150 2. Ricardian Model

->H specializes in Y, F specializes in X Changes in output as a result of reallocation of 1 unit of labour: H: 1 worker moves from X to Y F: 1 worker moves from Y to X Home Foreign Change in world output +10 +10

X Y

a=-20 b=+20

af =+30 b f=-10

ECON 3150 2. Ricardian Model

3. Comparative Advantage Definition 2 Country H has a comparative advantage in the production of X if ah/bh > af/bf. Country H has a comparative advantage in the production of Y if ah/ b h < a f/b f. Example 2 1 unit of labour produces (MPl):

ECON 3150 2. Ricardian Model

Home Foreign X Y a=5 b=5 af =30 B f=10 a f / b f=3

Absolute advantage Foreign (5<30) Foreign (5<10)

Comparative a/ b advantage =1

H has CA in Y, F has CA in X. AA- compare absolute MPL, CA - compare relative MPL.

ECON 3150 2. Ricardian Model

Foreign worker is 3 times more efficient at producing X => 3 home workers can be replaced by 1 foreign worker Is trade welfare improving? Yes! Changes in output as a result of reallocation of labour: H: 3 L moves from X to Y F: 1 L moves from Y to X Home Foreign Change in world output +15 +5
8

X Y

ah=-15 af =+30 B h=+15 b f=-10

ECON 3150 2. Ricardian Model

If ratios of marginal products differ for 2 countries, there are gains from specialization

We will show that comparative advantage gives rise to autarky price differences between home and foreign countries, which in turn make trade beneficial to both countries.

ECON 3150 2. Ricardian Model

4. Production possibility frontier and autarky equilibrium Let C- cheese, V wine. V = aLv C = bLc L = Lv + Lc (a, b - MPL of labour in wine and cheese sectors)

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Wine (V)
v = aL

Home

Ah

PPFh

c = bL

Cheese (C)

Slope of PPF: Income:

a v a L = = c b L b

I = pc C + p vV ->
ECON 3150 2. Ricardian Model 11

Budget line:

pc I v= C pv pv In autarky Slope of PPF = Slope of budget line (= autarky price ratio):

P
Auatrky

a Pc = = Pv b

Relative prices = 1/ relative productivities Higher b (productivity in cheese sector) => lower relative price of cheese (<=>higher relative price of wine).

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Higher a (productivity in wine sector) => lower relative price of wine (<=>higher relative price of cheese). Autarky prices reflect comparative advantage: a The more efficient is the economy at producing wine ( b is higher), the lower is the relative price of wine and the higher is the relative price of cheese ( PP is higher).
cheese wine

=> Comparative advantage gives rise to differences in autarky prices: P P =>H, F will gain from trade.
H F

5. Trade equilibrium Ph home autarky price Pf foreign autarky price

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P* - world price (countries trade at P*) 3 cases: 1. i.e. Fs relative price of cheese is higher (= home relative price of cheese is lower) H specializes in cheese:

P >P

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Wine (V)
v =a L
h h

P* PPFh=Pa C*

Ah

Q*
c = b h Lh

Cheese (C)

Note: countries will specialize completely to maximize the value of domestic output at world price:

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Wine (V)
v = a h Lh

P* PPF =P
h h

Value of Ah at P*

Value of Q* at P*

Ah
Value of Ah at Ph

Q*
c = b h Lh

Cheese (C)

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2. i.e. Fs relative price of wine is higher (= home relative price of wine is lower) H specializes in wine:
Wine (V)
v = a h Lh

P <P

Q*

C* Ah P*

PPFh=Pa

c = b h Lh

Cheese (C)

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3. P =P

Consume at Ah, produce anywhere along the PPF

Wine (V)
v = a h Lh

Q* Exports of Wine

Ah=C*

PPFh=Pa= P*

Cheese (C)

Imports of Cheese

c =b L

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i.e. no comparative advantage exists => no gains from trade!!! CA is necessary to gain from trade

Ricardian model predicts complete specialization: each country completely specializes in the good in which it has comparative advantage 2 countries, with 2 prices: p , p , For equilibrium to occur, P* should lie between
h f

Ph , P f

Why?

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h f P , P If P*> -> both countries would want to export cheese, no equilibrium h f P , P If P*< -> both countries would want to export wine, no equilibrium

6. Wages Nominal Wages w nominal wage Wage=value of marginal product of labour = Price* MPL:

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wv = Pv a ; wc = Pc b .

If Wc>Ww -> everyone will work in cheese industry, economy specializes in cheese If Wc<Ww -> everyone will work in wine industry, economy specializes in wine What if there is no trade, and a country has to produce both goods for itself, it has to be that Wc=Ww=W. (Note: if both goods are produced, nominal wages are equal in 2 sectors:
ECON 3150 2. Ricardian Model 21

wwine = wcheese Pwine a = Pcheese b a Pcheese = . b Pwine which is the same result as on page 5) Real Wages

w w w p - real wage; pv - real wage in terms of wine; pc - real wage in terms of cheese ( e.g. wage=$100, price of cheese=$10 => a worker can buy 10 units of cheese)
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Real Wage=Value of Marginal product of labour /Price =>

w =a Real wage in terms of wine: Pwine w =b Real wage in terms of cheese: Pcheese real autarky wage in terms of each good is equal to marginal product of labour

Trade changes prices from Ph to P*

Assume: P > P (or
h *
h * Pcheese Pcheese > * h Pwine Pwine

Home specializes in wine, export wine and imports cheese

ECON 3150 2. Ricardian Model 23

* w = P va ; Then nominal wage in wine sector is: v Real wages are constant in terms of exported good. If a country exports wine at price P , then home nominal wages are w * wwine = Pwine a . Real wages in terms of wine are P * = a - same wine as in autarky.
* wine

What are the real wages in terms of cheese (imported good)?

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w
* Pcheese

w * Pwine a a = * = * = * Pcheese Pcheese P * * Pwine Pwine

How does it compare to real wages in terms of cheese in w =b ? autarky Pcheese w h Pwine w a = h = h h P Pcheese P In autarky cheese h Pwine

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Home country exports wine => P > P (<=>

>b * => Pcheese a

h * Pcheese Pcheese > * h Pwine Pwine

I.e. real wage in terms of imported good (cheese) is higher in free trade than in autarky.

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H exports wine, F exports cheese

Autarky Home Real wage in terms of wine Real wage in terms of cheese Foreign Real wage in terms of winei Real wage in terms of cheese

Trade

a b(= Pa )
h

= <

a
a p*

af(= P b )
f f

< =

p *b f

bf

bf

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 All workers gain real income in moving from autarky to free trade (b/c all workers consume both wine and cheese) More productive economies (higher a, b) enjoy higher wages under free trade
Comparative advantage => direction of trade Absolute advantage => differences in real wages: larger a or b=> larger real wages in terms of both goods.

(Note that for this conclusion we need complete specialization: this allows us to pin down the real wage in terms of exported good.)

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7. Opportunity cost

Comparative advantage can be stated in terms of opportunity costs, rather than MPL. Definition 3 Opportunity cost of good Y in terms of good X is equal to the amount of good X a country has to sacrifice to produce 1 more unit of Y. In example (2), opportunity cost of 1 unit of Y is 1 unit of X at home, and 3 units of X abroad. => H has lower opportunity cost of Y => H has CA in Y, and F has CA in X.

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Home Foreign X Y a=5 b=5 af =30 b f=10 a f / b f=3

Absolute advantage Foreign (5<30) Foreign (5<10)

Comparative a/ b advantage =1

ECON 3150 2. Ricardian Model

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8. Gains from trade: big versus small countries Assume home country is small, and foreign country is large (e.g. Canada and the USA). As foreign country grows, it increases supply of its exports, and demand for its imports. When a large country grows economically, its PPF expands => country produces more of exported good and wants to consume more of imported good.
Definition: Terms of Trade: ratio of the price of an export commodity to the price of an import commodity

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Growth in Large Country

deterioration in terms of trade

P0* P1*

C1 C0

As large country grows, its demand for imported good grows and its supply of exports grows. Small exporter cannot satisfy all demand of the growing large country. So price of imports of the large country increases: the large country suffers deterioration in its terms of trade. The small country faces improvement in its terms of trade (its exports become more expensive).
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Excess demand has linear segments (feature of Ricardian model): at autarky prices countries are indifferent between exporting and importing. Excess demand for X is downward-sloping: lower P* gives incentive to import X, higher P* gives incentive to export X.

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Excess Demand Diagram

P*

Pha

Eh

P*

PPa
Ef

a f

-(Xc-Xp)

Foreign Exports

0 =

Domestic Imports

(Xc-Xp)

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Excess Demand Diagram P

D deterioration in Fs terms of trade, improvement in Hs terms of trade

B Eh

P*

P*

Ef

Ef

-(Xc-Xp)

Foreign Exports

0 =

Domestic Imports

(Xc-Xp)

Before growth: at P* small country H imports X (AB), which is equal to CA= Fs exports. After growth in F, at P* F wants to supply exports of X=DA, but H wants to import only AB (as
ECON 3150 2. Ricardian Model

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before). Because DA is larger than AB, F oversupplies its exports. To bring the market into equilibrium P* has to fall to P*. H experiences improvement in its terms of trade. Small H gains more and more from trade:
Y
Small Country Gains from Growth in Large Trading Partner

u* u*

P*

P* Hs PPF X

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Implications: 1. Small countries are likely to be major gainers from free trade. 2. Countries may benefit from growth in their trading partners.
i

Foreign country exports cheese and imports wine. Real wage in terms of cheese in F is bf. What are the real wages in terms of wine (imported good)?

wf * Pwine

wf P* bf bf = cheese = = = P *b f * * 1 Pwine Pwine * * P* Pcheese Pcheese

How does it compare to real wages in terms of wine in autarky

wf = af ? f Pwine

w
f Pcheese w bf = f = = Pfbf In autarky f 1 Pwine Pwine f Pf Pcheese f

Because P > P by assumption => P b

> Pfbf

ECON 3150 2. Ricardian Model

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