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IPPTChap003.pptxCHAPTER 3:
The Classical World of David Ricardo and Comparative Advantage
Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
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Learning Objectives
Explain comparative advantage as a basis of trade between nations.
Identify the difference between comparative advantage and absolute advantage.
Calculate gains from trade in a two-country, two-good model.
Illustrate comparative advantage and the potential gains from trade using production possibility frontiers.
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Assumptions of the Ricardian Model
A 2-country, 2-commodity world
Perfect competition
No transportation costs
Factors mobile internally, immobile internationally
Constant costs of production
Fixed technology for each country
All resources are fully employed
The “labor theory of value” holds
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Notation
Let:
ax = labor time to produce 1 X in country A
ay = labor time to produce 1 Y in country A
bx = labor time to produce 1 X in country B
by = labor time to produce 1 Y in country B
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Comparative Advantage Defined
Country A has a comparative advantage in good X if:
(Px/Py)A < (Px/Py)B OR if
ax/ay < bx/by OR if
ax/bx < ay/by
If country A has a comparative advantage in good X, country B must have a comparative advantage in good Y.
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Comparative Advantage: An Example
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Comparative Advantage
Since the U.S.’s APR for corn is lower than Mexico’s (1/5 < 1/2), the U.S. must have a comparative advantage in corn.
Since Mexico’s APR for blankets is lower than the U.S.’s (2 < 5), Mexico must have a comparative advantage in blankets.
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Comparative Advantage and the Total Gains from Trade
Ricardo’s argument is that trade will be mutually advantageous as long as the two countries’ autarky price ratios are different.
How do we know that this is true?
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Comparative Advantage and the Total Gains from Trade
The Production Possibilities Frontier (PPF) is the set of all combinations of goods that a country is capable of producing, given available technology and resources.
Suppose in our example the U.S. has 1000 hours of labor available and Mexico has 1800.
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U.S. Production Possibilities
1000
Corn
Blankets
200
500
100
A
Slope: rise/run = -1000/200 = -5
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Slope of the PPF
for this example, -5
Notice: the slope (in absolute value) is the APR of the good on the horizontal axis.
Therefore, the slope is the opportunity cost of the good on the horizontal axis.
The slope is also the marginal rate of transformation.
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Mexico’s Production Possibilities
600
Corn
Blankets
300
Slope = -2,
or the opportunity cost of blankets
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Classical Model: The Gains from Trade
Suppose that in autarky, the U.S. is at point A, producing and consuming 500 corn and 100 blankets.
Suppose that in autarky, Mexico is at point B, producing and consuming 300 corn and 150 blankets.
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U.S. Production Possibilities
1000
Corn
Blankets
200
500
100
A
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Mexico’s Production Possibilities
600
Corn
Blankets
300
300
150
B
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Classical Model: The Gains from Trade
Suppose now that the U.S. and Mexico agree to trade at an “exchange rate” of 1B = 3.33C (or, 1C = .3B).
If the U.S. specializes in corn, how many units of corn could it produce? 1000.
If Mexico specializes in blanket manufacture, how many blankets could be made? 300.
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The Gains from Trade: U.S.
If the U.S. wants to continue to consume 500C, they will now have 500C to trade for blankets.
If the “exchange rate” is 1B = 3.33C (or, 1C = .3B), how many blankets can the U.S. get in exchange for 500C?
150
Therefore, the U.S. can consume outside its PPF (to point C) by trading!
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U.S. Production Possibilities
1000
Corn
Blankets
200
500
100
C
A
150
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The Gains from Trade: Mexico
If Mexico wants to continue to consume 150B, they will now have 150B to trade for corn.
If the “exchange rate” is 1B = 3.33C (or, 1C = .3B), how much corn can Mexico get in exchange for 150B?
500
Therefore, Mexico can also move outside its PPF (to point D) by trading!
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Mexico’s Production Possibilities
600
Corn
Blankets
300
150
B
300
500
D
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The Gains from Trade
Note: In general, the Ricardian model results in complete specialization.
However, in trade between a small and a large country the small country may not be able to produce enough to satisfy the large country; the large country might then partially specialize.
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The Consumption Possibilities Frontier (CPF)
The CPF is a collection of points that represent combinations of corn and blankets that a country can consume if it trades.
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U.S. Consumption Possibilities
1000
Corn
Blankets
200
500
100
C
A
150
300
CPF
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The Consumption Possibilities Frontier (CPF)
The CPF’s slope is the same as the terms of trade.
The CPF pivots around the production point.
If trade is to the benefit of a country, the CPF lies outside the PPF.
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Mexico’s Consumption Possibilities
600
Corn
Blankets
300
150
B
300
500
D
1000
CPF
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The Limits to Mutually Advantageous Trade
“Exchange rate” must be at least as great as Mexico’s APR.
“Exchange rate” must be no greater than the U.S.’s APR.
Bottom line: we still don’t know how the terms of trade will be determined, but they must be between the countries’ APRs if trade is to be mutually beneficial.
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Mexico’s APR: 1B = 2C; why trade if U.S. isn’t paying more than that? Also, Mexico can buy corn for ½ a blanket; why import if U.S. sells at a higher price than that?
The CPF and “Small” Countries
The nearer are the terms of trade to a country’s APR, the less that country will gain from trade.
The farther away the terms of trade are from a country’s APR, the more that country will gain from trade.
Moral: to Ricardo, small countries stand to gain a lot from trade, large countries gain less.
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Corn (X)
Blankets (Y)
U.S. (A)
1 hour/
bu
5 hrs/
bl
Mexico (B)
3 hrs/
bu
6 hrs/
bl
Autarky Price
Ratios (APRs)
1B = 5C,
1C = 1/5B
1B = 2C,
1C = 1/2B
Corn (X)
Blankets (Y)
U.S. (A)
1 hour/bu
5 hrs/bl
Mexico (B)
3 hrs/bu
6 hrs/bl
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Autarky Price Ratios (APRs) |
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1B = 5C, 1C = 1/5B |
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1B = 2C, 1C = 1/2B |
