ECO ESSAY
YANGYANG
3.Ricardian_S.pptx3 Ricardian Model
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Preview
A One-factor Ricardian Model
Closed Economy (Autarky)
Open Economy (Free Trade)
Wages And Trade
Misconceptions About Comparative Advantage
Transportation Costs And Non-traded Goods
Empirical Evidence
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Introduction
Theories trade:
Differences across countries:
Technological differences: Ricardian Model.
Factor endowment differences: Heckscher–Ohlin model.
Economies of scale (larger scale of production is more efficient)
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Introduction
Countries trade to take advantage of their differences.
The differences that matter for trade are relative differences. Example: Suppose the US is technologically more advanced than Mexico in all sectors. In that case we could think that the US would produce and export goods in all sectors.
But if so, what would Mexico produce? What would the US import?
In practice, the US will specialize in those sectors in which its advantage is largest and Mexico will specialize in those sectors in which its disadvantage is smallest.
Lessons:
Relative (or comparative) advantage determines the patterns of trade.
You do not need to be the best in anything to take advantage of trade.
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1. A One-Factor Ricardian Model
2 countries: Home and Foreign
2 sectors: Wine and Cheese
1 factor of production: Labor
Perfect competition: Workers are paid a wage equal to the value of what they produce, and are able to work in the industry that pays the highest wage.
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1. A One-Factor Ricardian Model
Unit labor requirement (hours of labor to produce one unit of a good):
aLC=1 Cheese
aLW=2Wine
Total hours in home L=1,000.
Note that a high unit labor requirement means low labor productivity. Unit labor requirement is the inverse of labor productivity!!!
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2. Closed Economy (Autarky)
Cheese production QC indicates how many pounds of cheese are produced.
Wine production QW indicates how many gallons of wine are produced.
The production possibility frontier (PPF) of an economy shows the maximum amount of a good that can be produced for a fixed amount of resources.
The production possibility frontier of the home economy is:
aLCQC + aLWQW ≤ L
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2. Closed Economy (Autarky)
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2. Closed Economy (Autarky)
The opportunity cost of producing something measures the cost of not being able to produce something else with the resources used.
A country has a comparative advantage in producing a good if the opportunity cost of producing that good is lower in the country than in other countries.
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2. Closed Economy (Autarky)
The opportunity cost of cheese is how many gallons of wine Home must stop producing in order to make one more pound of cheese:
aLC /aLW
The opportunity cost of cheese appears as the absolute value of the slope of the PPF.
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2. Closed Economy (Autarky)
Let PC be the price of cheese and PW be the price of wine.
Due to competition,
Hourly wages of cheese makers equal the value of the cheese produced in an hour: wC =PC /aLC
Hourly wages of wine makers equal the value of the wine produced in an hour: wW =PW /aLW
Workers will choose to work in the industry that pays the higher wage.
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2. Closed Economy (Autarky)
If the price of cheese relative to the price of wine exceeds the opportunity cost of producing cheese PC /PW > aLC /aLW ,
Then the wage in cheese will exceed the wage in wine wC =PC /aLC > PW/aLW =wW
So workers will make only cheese (the economy specializes in cheese production).
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2. Closed Economy (Autarky)
If the price of cheese relative to the price of wine is less than the opportunity cost of producing cheese PC /PW < aLC /aLW ,
then the wage in cheese will be less than the wage in wine PC /aLC < PW/aLW
so workers will make only wine (the economy specializes in wine production).
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2. Closed Economy (Autarky)
If the price of cheese relative to the price of wine equals the opportunity cost of producing cheese PC /PW = aLC /aLW ,
then the wage in cheese equals the wage in wine PC /aLC = PW/aLW
so workers will be willing to make both wine and cheese.
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2. Closed Economy (Autarky)
If the home country wants to consume both wine and cheese (in the absence of international trade), relative prices must adjust so that wages are equal in the wine and cheese industries.
If PC /aLC = PW /aLW workers will not care whether they work in the cheese industry or the wine industry, so that production of both goods can occur.
Production (and consumption) of both goods occurs when the relative price of a good equals the opportunity cost of producing that good:
PC /PW = aLC /aLW
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2. Closed Economy (Autarky)
Consumers maximize utility subject to budget constraint.
In a closed economy, the budget constraint (consumption possibility frontier) coincides with the production possibility frontier.
Without trade, consumption must equal production.
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3. Open Economy (Free Trade)
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| Cheese | Wine | Workers | |
| Home | 1 | 2 | L=1,000 |
| Foreign | 6 | 3 | L*=3,000 |
3. Open Economy (Free Trade)
If a country is more efficient in the production of a good, it has an Absolute Advantage in the production of this good.
In our example, as the home country is more efficient in wine and cheese production, then it has an absolute advantage in all production:
its unit labor requirements for wine and cheese production are lower than those in the foreign country
aLC=1 < a*LC=6 and aLW=2 < a*LW=3
where “*” denotes foreign country variables.
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3. Open Economy (Free Trade)
To determine absolute advantage, we compare productivity sector by sector. That is, we need to compare the numbers column by column.
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3. Open Economy (Free Trade)
The absolute advantage of Home is higher in cheese. Therefore, Home has COMPARATIVE (or RELATIVE) ADVANTAGE in cheese and Foreign has COMPARATIVE (or RELATIVE) ADVANTAGE in wine.
To determine COMPARATIVE ADVANTAGE we need to compare the relative productivity of one country in one sector with the relative productivity of that country in the other sector.
a*LC / aLC > a*LW / aLW, 6 / 1 > 3 / 2
Another way to determine comparative advantage is
aLC / aLW < a*LC / a*LW, pC /pW < p*C /p*W
Thus, Home has comparative advantage in the production of cheese, and Foreign in the production of wine. Foreign specializes in wine because its relative price is smaller.
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3. Open Economy (Free Trade)
A country can be more efficient in producing both goods, but it will have a comparative advantage in only one good.
Even if a country is the most (or least) efficient producer of all goods, it still can benefit from trade.
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3. Open Economy (Free Trade)
As the home country has a comparative advantage in cheese production: its opportunity cost of producing cheese is lower than in the foreign country.
½ = aLC /aLW < a*LC /a*LW = 2
When the home country increases cheese production, it reduces wine production less than the foreign country would.
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3. Open Economy (Free Trade)
Since the slope of the PPF indicates the opportunity cost of cheese in terms of wine, Foreign’s PPF is steeper than Home’s.
To produce one pound of cheese, must stop producing more gallons of wine in Foreign than in Home.
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3. Open Economy (Free Trade)
Before any trade occurs, the relative price of cheese to wine reflects the opportunity cost of cheese in terms of wine in each country.
In the absence of any trade, the relative price of cheese to wine will be higher in Foreign than in Home if Foreign has the higher opportunity cost of cheese.
It will be profitable to ship cheese from Home to Foreign (and wine from Foreign to Home) – where does the relative price of cheese to wine settle?
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3. Open Economy (Free Trade)
To see how all countries can benefit from trade, need to find relative prices when trade exists.
First calculate the world relative supply of cheese: the quantity of cheese supplied by all countries relative to the quantity of wine supplied by all countries
RS = (QC + Q*C )/(QW + Q*W)
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3. Open Economy (Free Trade)
If the relative price of cheese falls below the opportunity cost of cheese in both countries PC /PW < aLC /aLW < a*LC /a*LW,
No cheese would be produced.
Domestic and foreign workers would be willing to produce only wine (where wage is higher).
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3. Open Economy (Free Trade)
When the relative price of cheese equals the opportunity cost in the home country PC /PW = aLC /aLW < a*LC /a*LW ,
Domestic workers are indifferent about producing wine or cheese (wage when producing wine same as wage when producing cheese).
Foreign workers produce only wine.
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3. Open Economy (Free Trade)
When the relative price of cheese settles strictly in between the opportunity costs of cheese aLC /aLW < Pc /PW < a*LC /a*LW ,
Domestic workers produce only cheese (where their wages are higher).
Foreign workers still produce only wine (where their wages are higher).
World relative supply of cheese equals Home’s maximum cheese production divided by Foreign’s maximum wine production (L / aLC ) / (L*/ a*LW).
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3. Open Economy (Free Trade)
When the relative price of cheese equals the opportunity cost in the foreign country
aLC /aLW < PC /PW = a*LC /a*LW ,
Foreign workers are indifferent about producing wine or cheese (wage when producing wine same as wage when producing cheese).
Domestic workers produce only cheese.
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3. Open Economy (Free Trade)
If the relative price of cheese rises above the opportunity cost of cheese in both countries
aLC /aLW < a*LC /a*LW < PC /PW,
No wine is produced.
Home and foreign workers are willing to produce only cheese (where wage is higher).
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3. Open Economy (Free Trade)
World relative supply is a step function:
First step at relative price of cheese equal to Home’s opportunity cost aLC /aLW, which equals 1/2 in the example.
Jumps when world relative supply of cheese equals Home’s maximum cheese production divided by Foreign’s maximum wine production (L / aLC ) / (L*/ a*LW), which equals 1 in the example.
Second step at relative price of cheese equal to Foreign’s opportunity cost a*LC /a*LW, which equals 2 in the example.
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3. Open Economy (Free Trade)
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3. Open Economy (Free Trade)
Gains from trade come from specializing in the type of production which uses resources most efficiently, and using the income generated from that production to buy the goods and services that countries desire.
where “using resources most efficiently” means producing a good in which a country has a comparative advantage.
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3. Open Economy (Free Trade)
Domestic workers earn a higher income from cheese production because the relative price of cheese increases with trade.
Foreign workers earn a higher income from wine production because the relative price of cheese decreases with trade (making cheese cheaper) and the relative price of wine increases with trade.
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3. Open Economy (Free Trade)
Think of trade as an indirect method of production that converts cheese into wine or vice versa.
Without trade, a country has to allocate resources to produce all of the goods that it wants to consume.
With trade, a country can specialize its production and exchange for the mix of goods that it wants to consume.
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3. Open Economy (Free Trade)
Consumption possibilities expand beyond the production possibility frontier when trade is allowed.
With trade, consumption in each country is expanded because world production is expanded when each country specializes in producing the good in which it has a comparative advantage.
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3. Open Economy (Free Trade)
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3. Open Economy (Free Trade)
With trade, the equilibrium relative price of cheese to wine settles between the two opportunity costs of cheese.
Suppose that the intersection of RS and RD occurs at PC /PW = 1 so one pound of cheese trades for one gallon of wine.
Trade causes the relative price of cheese to rise in the home country and fall in foreign.
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3. Open Economy (Free Trade)
Home
Trade increases the price of the good it exports (cheese). It jumps from (pC / pW)A = 1/2 to (pC / pW)FT = 1.
The relative price of a country’s exports is called its terms of trade.
An increase (or improvement) in the terms of trade explains the gains from trade. For each unit of cheese that Home exports, it now receives more wine.
Foreign
As in Home, its terms of trade improve: the relative price of wine increases from (p*W / P*C)A=1/2 to (pW /pC)FT=1.
It is not a coincidence that the terms of trade improve in both countries: it is precisely because the relative price of cheese (wine) rises in Home (Foreign) that Home (Foreign) exports cheese (wine).
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SIZE
Small countries have more incentives to open up to trade.
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4. Wages and trade
Relative wages are the wages of the home country relative to the wages in the foreign country.
Productivity (technological) differences determine relative wage differences across countries.
The home wage relative to the foreign wage will settle in between the ratio of how much better Home is at making cheese and how much better it is at making wine compared to Foreign.
Relative wages cause Home to have a cost advantage in only cheese and Foreign to have a cost advantage in only wine.
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4. Wages and trade
Wage in Home: w=pC /aLC =pC /1
Wage in Foreign: w*=pw /a*LW =pW /3
Relative wage in Home: w/w*=pC a*LW /pW aLC = 3
Foreign can be competitive in wine production (even though it has lower productivity) because C*W = w* a*LW < w aLW. That is equivalent to: w / w* (3) > a*LW /aLW (2/3). Home productivity (in wine) is 2/3 times higher than in Foreign but Home wages are 3 times higher.
Similarly, even though Home wages are higher (3 times), Home cheese is competitive, because it is much more productive (6 times).
To determine competiveness, we cannot look only at productivity or only at wages. Instead, what matters are production costs. Production costs are wages divided by productivity.
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4. Wages and trade
These relationships imply that both countries have a cost advantage in production.
High wages can be offset by high productivity.
Low productivity can be offset by low wages.
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Do Wages Reflect Productivity?
Do relative wages reflect relative productivities of the two countries?
Evidence shows that low wages are associated with low productivity.
Wage of most countries relative to the U.S. is similar to their productivity relative to the U.S.
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Do Wages Reflect Productivity?
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A country’s wage rate is roughly proportional to the country’s productivity
Source: International Monetary Fund and The Conference Board.
Do Wages Reflect Productivity?
Other evidence shows that wages rise as productivity rises.
As recently as 1975, wages in South Korea were only 5% of those of the United States.
As South Korea’s labor productivity rose (to about half of the U.S. level by 2007), so did its wages.
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5. Misconceptions about Comparative Advantage
Free trade is beneficial only if a country is more productive than foreign countries.
But even an unproductive country benefits from free trade by avoiding the high costs for goods that it would otherwise have to produce domestically.
High costs derive from inefficient use of resources.
The benefits of free trade do not depend on absolute advantage, rather they depend on comparative advantage: specializing in industries that use resources most efficiently.
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5. Misconceptions about Comparative Advantage
Free trade with countries that pay low wages hurts high wage countries.
While trade may reduce wages for some workers, thereby affecting the distribution of income within a country, trade benefits consumers and other workers.
Consumers benefit because they can purchase goods more cheaply.
Producers/workers benefit by earning a higher income in the industries that use resources more efficiently, allowing them to earn higher prices and wages.
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5. Misconceptions about Comparative Advantage
Free trade exploits less productive countries whose workers make low wages.
While labor standards in some countries are less than exemplary compared to Western standards, they are so with or without trade.
Are high wages and safe labor practices alternatives to trade? Deeper poverty and exploitation may result without export production.
Consumers benefit from free trade by having access to cheaply (efficiently) produced goods.
Producers/workers benefit from having higher profits/wages—higher compared to the alternative.
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Comparative Advantage with Many Goods
Suppose now there are N goods produced, indexed by i = 1,2,…N.
The home country’s unit labor requirement for good i is aLi, and the corresponding foreign unit labor requirement is a*Li .
Goods will be produced wherever cheapest to produce them.
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Comparative Advantage with Many Goods
Let w represent the wage rate in the home country and w* represent the wage rate in the foreign country.
If waL1 < w*a*L1 then only the home country will produce good 1, since total wage payments are less there.
Or equivalently, if a*L1 /aL1 > w/w*, if the relative productivity of a country in producing a good is higher than the relative wage, then the good will be produced in that country.
The “threshold good” depends on the relative wage (The relative wage depends on the relative productivity, the relative demand, and the relative supply of workers).
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Comparative Advantage with Many Goods
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Comparative Advantage with Many Goods
Suppose there are 5 goods produced in the world: apples, bananas, caviar, dates, and enchiladas.
If w/w* = 3, the home country will produce apples, bananas, and caviar, while the foreign country will produce dates and enchiladas.
The relative productivities of the home country in producing apples, bananas, and caviar are higher than the relative wage.
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Comparative Advantage with Many Goods
If each country specializes in goods that use resources productively and trades the products for those that it wants to consume, then each benefits.
If a country tries to produce all goods for itself, resources are “wasted”.
The home country has high productivity in apples, bananas, and caviar that give it a cost advantage, despite its high wage.
The foreign country has low wages that give it a cost advantage, despite its low productivity in date production.
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6. Transportation Costs and Non-traded Goods
The Ricardian model predicts that countries completely specialize in production.
But this rarely happens for three main reasons:
More than one factor of production reduces the tendency of specialization (Econ/Trade Chapters 4-5).
Protectionism (Econ/Trade Chapters 9–12).
Transportation costs reduce or prevent trade, which may cause each country to produce the same good or service.
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6. Transportation Costs and Non-traded Goods
Nontraded goods and services (ex., haircuts and auto repairs) exist due to high transport costs.
Countries tend to spend a large fraction of national income on nontraded goods and services.
This fact has implications for the gravity model and for models that consider how income transfers across countries affect trade.
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7. Empirical Evidence
Do countries export those goods in which their productivity is relatively high?
The ratio of U.S. to British exports in 1951 compared to the ratio of U.S. to British labor productivity in 26 manufacturing industries suggests yes.
At this time the U.S. had an absolute advantage in all 26 industries, yet the ratio of exports was low in the least productive sectors of the U.S.
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7. Empirical Evidence
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7. Empirical Evidence
A very poor country like Bangladesh can have comparative advantage in clothing despite being less productive in clothing than other countries such as China because it is even less productive compared to China in other sectors.
Productivity (output per worker) in Bangladesh is only 28 percent of China’s on average.
In apparel, productivity in Bangladesh was about 77 percent of China’s, creating strong comparative advantage in apparel for Bangladesh.
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7. Empirical Evidence
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7. Empirical Evidence
The main implications of the Ricardian model are well supported by empirical evidence:
Productivity differences play an important role in international trade
Comparative advantage (not absolute advantage) matters for trade
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Summary
Differences in the productivity of labor across countries generate comparative advantage.
A country has a comparative advantage in producing a good when its opportunity cost of producing that good is lower than in other countries.
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Summary
Countries export goods in which they have a comparative advantage - high productivity or low wages give countries a cost advantage.
With trade, the relative price settles in between what the relative prices were in each country before trade.
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Summary
Trade benefits all countries due to the relative price of the exported good rising: income for workers who produce exports rises, and imported goods become less expensive.
Empirical evidence supports trade based on comparative advantage, although transportation costs and other factors prevent complete specialization in production.
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