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Trade and Technology: The Ricardian Model
Readings: Chapter 2 sections 1-3

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Introduction. U.S. Imports of Snowboards

Why do countries trade?

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Introduction

This chapter explains comparative advantage by looking at how technology differences across countries affects trade
This is referred to as the Ricardian model because it was proposed by the 19th century economist David Ricardo

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The Home Country

We will use two goods to develop a Ricardian model of trade: Wheat and Cloth
There are two countries, Home and Foreign.

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Road Map

Part 1. Home country, before trade
Part 2. Home and Foreign countries, who exports wheat and who exports cloth?
Comparative advantage
Part 3. Is trade “good” or “bad”?

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The Home Country

The Home Country
We will assume that labor is the only resource used to produce both goods
One worker can produce 4 bushels of wheat or 2 yards of cloth
The Marginal Product of Labor is the extra output obtained by using one more unit of labor
MPLW = 4 and MPLC = 2
Key Assumption: Marginal Products of Labor are fixed
Suppose Home has 25 workers; i.e. = 25. Labor endowment.

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The Home Country: Summary

Cloth MPL	wheat MPL	Labor
Home	2	4	25

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Drawing the PPF

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Notes: Drawing of PPF

Home Production Possibilities Frontier
We can use the marginal products of labor to construct Home’s PPF.
Assume there are 25 workers in Home.
If all the workers were employed in wheat, the country could produce 100 bushels
If they were all employed in cloth they could produce 50 yards.
The PPF connects these two points

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Slope of PPF

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Notes: PPF Slope: formular

Showing these calculations we can see:
Labor = 25, MPLW = 4, MPLC = 2
If Home produces wheat only, QW = MPLW* = 25*4 = 100
If Home produces cloth only, QC = MPLC* = 25*2 = 50
This gives us a straight line PPF which is a unique feature of the Ricardian model
Assumes marginal production of labor is constant

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Notes: Slope of PPF and Opportunity Cost

The slope of the PPF can be calculated as the ratio of marginal products of the two goods
The slope also equals the opportunity cost of wheat – the amount of cloth that must be given up to obtain one more unit of wheat – if we put wheat quantity on the horizontal axis.

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Slope of PPF and Opportunity Cost

The slope of the PPF reflects the opportunity cost of producing one more bushel of wheat in terms of cloth

Labor used in 1 wheat = labor used in ½ cloth; i.e. cost of 1 wheat = cost of ½ cloth

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Indifference Curves

Wheat, QW (bushels)

Cloth, QC (yards)

The country is indifferent between A and B

U0 < U1 < U2

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Notes: Indifference Curves

Home Indifference Curve
Given Home’s PPF, we still don’t know how much Home will choose to produce
We need information about the country’s preferences – we need indifference curves
A single indifference curve shows the combinations of wheat and cloth that the country can consume and be equally satisfied.

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Notes: Indifference Curves

Indifference curves increase in utility as the curves move northeast.
All points on a single indifferent curve have the same level of utility.
A country cannot produce outside their PPF so, without trade, they are constrained in their utility by the PPF.
We use these indifference curves to show the preferences of an entire country

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closed-economy equilibrium (Home)

Wheat, QW (bushels)

Cloth, QC (yards)

Home PPF

The country could produce at point D but would be at a higher level of utility at point A.

The country is better off on U2 but cannot produce that much

At point A, on U1, is the best the country can do

100

Home closed-economy equilibrium

Figure 2.2

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Notes: Figure 2.2

Home Equilibrium
Without trade, the PPF acts like a budget constraint for the country
The country will produce at its highest level of utility within the limits of the PPF
In the graph, the highest level of utility that can be reached and still stay within the PPF is U1 with production at point A

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Wage Equation

Wages
In competitive markets, suppose for cloth P = $2 and MPL = 4. How much are firms willing to pay?
Cost of a marginal worker to the firm = wage
Value of a marginal worker to the firm = the value of one more hour of production = 4 cloth x $2/cloth = $8
So firms are happy if w = $8

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Wage Equation

w = P*MPL
Meaning in English: The value of one more worker equals the amount of goods produced by this worker (MPL) times the price of the good.

Predictions: (1) you earn more if your products are worth more; (2) you earn more if you are more productive

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Ave. Wage Purdue Graduates 2011

Source: The Exponent, 2011.

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Oil Boom in North Dakota and Wages

Oil prices http://www.macrotrends.net/1369/crude-oil-price-history-chart

The average wage in the energy industry in ND = ?

Source: “U.S. News: North Dakota Enjoys Oil Boom – But Girds for Slowdown”, by Russel Gold,

24 December 2012, The Wall Street Journal.

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Example: A Snow-covered Paradise in Alberta

Wood Buffalo, Alberta

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Wood Buffalo: A Luxury Resort Town?

Medium Single Family House: $625,000
In and out: private airports
Life style of residents:
20-inch flat-screen TV, double bed
high-speed Internet access and daily maid service.
Prime rib is on the Thursday dinner menu.
The bar opens at 6 p.m., there's a yoga class at 7
Earnings of residents:
$100,000 for inexperienced truck drivers
$200,000 for experienced welders

Source: “This Is the Life: Luxurious Digs On Frigid Oil Sands --- Firms in Canada Pay Well, And Steak Is on the Menu;

'Smell of Money' Beckons”, by Douglas Belkin, 5 December 2007, The Wall Street Journal, A1

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Relative Prices at closed-economy equilibrium

W=P*MPL holds for both wheat and cloth
Since labor can move freely between industries, wages must be equalized:

The right had size is the slope of the PPF and the opportunity cost of obtaining one more bushel of wheat.
The left hand side is the relative price of wheat.
Value of 1 wheat = ½ value of 1 cloth

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Relative Prices and OC

The price ratio, PW/PC, always denotes the relative price of the good in the numerator, measured in terms of how much of the good in the denominator must be given up.
For the good on the horizontal axis of the PPF picture, |PPF slope| = OC = relative price before trade

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Real Wages Before Trade

Real Wage = wage/price
Real wage for wheat = wage/price_of_wheat; i.e. quantity of wheat the wage can buy

Calculate the real wage for wheat

Calculate the real wage for cloth

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Notes: the calculation of Real Wages Before Trade

Real Wages
Real wage for wheat = wage/price_of_wheat; i.e. quantity of wheat the wage can buy
Since Home produces both wheat and cloth, Home wage is: w = PW*MPLW = PC*MPLC
The real wage for wheat = w/PW = (PW*MPLW)/PW = MPLW = 4 wheat
The real wage for cloth = w/PC = (PC*MPLC)/PC MPLC = 2 cloth
Before trade, real wage = marginal product of labor

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Real Wages Before Trade

Before trade, real wage = marginal product of labor

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Part 1 Summary

MPL
PPF
PPF Slope and OC
Wage Equation
Relative price before trade

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The Foreign Country: Summary

Cloth MPL	wheat MPL	Labor
Foreign	1	1	100

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Notes: The Foreign Country in Detail

The Foreign Country
Foreign Production Possibilities Frontier
MPL*W = 1, MPL*C = 1
Key Assumption: Marginal Products of Labor are fixed
Assume there are 100 workers available in Foreign
If all workers were employed in wheat they could produce 100 bushels.
If all workers were employed in cloth they could produce 100 yards.
The Foreign country’s PPF connects these two points.

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Foreign PPF

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closed-economy equilibrium (Foreign)

Figure 2.4

50 100 Wheat , (bushels)

Cloth, (yards)

100

Foreign before-trade equilibrium

Foreign PPF

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Notes: Figure 2.4

Equilibrium in Foreign
Foreign’s preferences can also be represented by indifference curves
Economy produces at the point of highest utility for the country within the PPF constraint
|The slope of the PPF| = the opportunity cost of wheat = the before-trade relative price of wheat, P*W/P*C = 1

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Pattern of Trade

Which country exports wheat and which country exports cloth?
Assume: no trade cost

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Absolute Advantage = Higher MPL

Summary of Home and Foreign

MPL, Cloth (Yard/worker)	MPL, wheat (Bushel/worker)	Labor
Home	2	4	25
Foreign	1	1	100

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Notes: Absolute Advantage

Absolute advantage = higher MPL
Foreign’s technology is inferior to Home’s
Home has an absolute advantage in both wheat and cloth as compared to Foreign
Clearly, Home can’t export both wheat and cloth when trade opens up.

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Comparative Advantage = Lower OC

Summary of Home and Foreign

OC of wheat in Home = ??

OC of wheat in Foreign = ??

MPL, Cloth (Yard/worker)	MPL, wheat (Bushel/worker)	Labor
Home	2	4	25
Foreign	1	1	100

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Table of Opportunity Cost

Opportunity Costs for Goods in Home and Foreign

Cloth (Yard)	Wheat (Bushel)
Home	2 wheat	½ cloth
Foreign	1 wheat	1 cloth

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Notes: OC Table

Comparative Advantage = Lower Opportunity Cost
Remember a country has a comparative advantage in a good when it has a lower opportunity cost of producing that good
By looking at the chart we can see that Foreign has a comparative advantage in producing cloth
Foreign’s Opportunity cost of cloth is lower
Home has a comparative advantage in producing wheat
Home’s opportunity cost of wheat is lower

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Why does comparative advantage drive trade patterns?

Because OC = relative prices before trade

Wheat (Bushel)
Home	½ cloth
Foreign	1 cloth

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Notes: Relative Price Table

Why does Home export wheat?
Relative price of wheat in Home is PW/PC = 1/2
Relative price of wheat in Foreign is PW*/PC* = 1
Therefore Home would want to export their wheat to Foreign – they can make it for 0.50 cloth and export it for 1 cloth!
The opposite is true for cloth
Home will export wheat and Foreign will export cloth
Both countries export the good for which they have the comparative advantage

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APPLICATION

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Comparative Advantage in Apparel,
Textiles, and Wheat

US Textile and apparel industries face intense import competition
Burlington Industries announced in January 1999 it would reduce production capacity by 25% due to increased imports from Asia
After layoffs they employed 17,400 persons in the US with a 1999 sales of $1.6 billion
Sales per employee were therefore $92,000
This is the average for all US apparel producers
Textiles are even more productive with annual sales per employee of $140,000 in the US

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Comparative Advantage in Apparel, Textile and Wheat

Table 2.2

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Equilibrium with trade

The relative price of wheat in the trade equilibrium will be between the before-trade prices in the two countries
For now lets assume the free-trade price, PWT/PCT = 2/3. This is between the price of ½ in Home and 1 in Foreign.
We can now take this price and see how trade changes production and consumption in each country

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Notes: Equilibrium with trade

How prices change after trade
As Home exports wheat, quantity of wheat sold at Home falls
The price of wheat at Home goes up
More wheat goes into Foreign’s market
The price of wheat in Foreign falls
For the same reason, as Foreign exports cloth, the quantity sold in Foreign falls. Therefore, the price in Foreign for cloth rises, and the price of cloth in Home falls.

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Notes: Equilibrium with trade

Trade Equilibrium
Two countries are in a trade equilibrium when the relative price of wheat is the same in the two countries – this means the relative price of cloth is also the same in both countries.
This is because we assume there is no trade cost

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Pattern of Production

PWT/PCT = 2/3.

Home exports wheat. How many wheat does Home make?

Opportunity Costs in Home and Foreign

Cloth (Yard)	Wheat (Bushel)
Home	2 wheat	½ cloth
Foreign	1 wheat	1 cloth

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Complete specialization

Home’s workers will want to work in wheat and no cloth will be produced
With trade, Home will be fully specialized in wheat production

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Summary Part 2

Absolute advantage
Comparative advantage
OC = relative price before trade
Trade equilibrium
Free-trade price
Complete specialization

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Is trade good or bad: Home

Wheat, QW (bushels)

Cloth, QC (yards)

Home PPF

PWT/PCT = 2/3.

Home exports wheat

100

Home closed-economy equilibrium

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Consumption possibility frontier

With free trade, what choices does Home country have for consumption? i.e. what is Home country’s “budget line”?

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Consumption Possibility Frontier (CPF), Home

The new world price, PWT /PCT = 2/3, shows us the new range of consumption possibilities

The country can now achieve a higher utility with the new consumption possibilities

CPF, Slope = –2/3

50 100 Wheat , QW (bushels)

Cloth, QC (yards)

Home production

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Is trade good or bad: Foreign

100 Wheat, (bushels)

Cloth, (yards)

100

Foreign closed-economy equilibrium

PWT/PCT = 2/3.

Foreign exports cloth

Foreign PPF

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CPF, Foreign

The new world price, PWT /PCT = 2/3, shows us the new range of consumption possibilities

The country can now achieve a higher utility with the new consumption possibilities

Foreign production

Foreign consumption

60 100 Wheat, (bushels)

Cloth, (yards)

100

World price line, Slope = –2/3

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Notes: Gains from Trade

Gains from trade for BOTH countries!
Under the new production, each country specializes fully in the good for which they have the comparative advantage
They then export some of their production and import some of the other good from the other country
Home specializes in wheat and Foreign specializes in cloth
The new indifference curves show the new consumption points.
The difference between production and consumption give us trade patterns

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Gains from Trade: intuition

International Trade
Trade allows both countries to engage in consumption possibilities they did not have before trade
This is a demonstration of gains from trade
Intuition: trade increases the choices a country can make (the PPF remains available after trade); both countries gain because they help each other out.

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Trade is Balanced: Foreign

Foreign produces 0 wheat but consumes 60 so imports equal 60.

Foreign produces 100 cloth but consumes only 60 so exports equal 40

Foreign production

Foreign consumption

Foreign exports 40 yards of cloth

Foreign imports 60 bushels of wheat

60 100 Wheat, (bushels)

Cloth, (yards)

100

World price line, Slope = –2/3

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Trade is Balanced: Home

Home produces 100 wheat but consumes only 40 so exports equal 60

Home produces 0 cloth but consumes 40 so imports equal 40.

Home consumption

Home production

Home imports 40 yards of cloth

Home exports 60 bushels of wheat

40 100 Wheat , QW (bushels)

Cloth, QC (yards)

World price line, Slope = –2/3

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Notes: Trade is Balanced

Trade is the difference between domestic production and consumption
Quantity of exports = quantity of production – quantity of consumption
Quantity of imports = quantity of consumption – quantity of production

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Trade and Wages

How do wages change after trade for Home and Foreign?
Under free trade, which country has a higher wage?
Wages actually differ – they are determined by absolute advantage – not comparative advantage
Real wages: = wage/price.

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Real Wages Before Trade: Home

Before trade, real wage = marginal product of labor since Home makes both wheat and cloth
The real wage for wheat = MPLW = 4 wheat
The real wage for cloth = MPLC = 2 cloth

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Real Wages After Trade: Home

Solving for Real Wages Across Countries
Since Home produces and exports wheat, Home wage is: w = PWT*MPLW
The real wage for wheat = w/PWT = (PWT*MPLW)/PWT = MPLW = 4 wheat. Same as before trade
The real wage for cloth = w/PCT = (PWT*MPLW)/PCT =(PWT/PCT)*MPLW = (2/3)*4 = 8/3 cloth. Higher than before trade.
Trade increases real wage for cloth! Same intuition as gains from trade.

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Terms of Trade

The real wage for cloth =(PWT/PCT)*MPLW
The Terms of Trade for Home = PWT/PCT
An increase in PWT or a fall in PCT will raise Home’s terms of trade
An increase in the terms of trade is good for a country
They earn more for its exports
They pay less for their imports
Home real wage for cloth is higher
In general, the price of a country’s exports divided by the price of its imports.
Foreign’s Terms of Trade = PCT/PWT

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Real Wages Before Trade: Foreign

Before trade, real wage = marginal product of labor since Foreign makes both wheat and cloth
The real wage for wheat = MPLW* = 1 wheat
The real wage for cloth = MPLC* = 1 cloth

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Real Wages After Trade: Foreign

Solving for Wages Across Countries
Since Foreign produces and exports cloth, Foreign wage is: w* = PCT *MPLC*
The real wage for cloth = w*/PCT = (PCT*MPLC*)/PCT = MPLC* = 1 cloth, same as before trade
The real wage for wheat = w*/PWT = (PCT*MPLC*)/PWT = (PCT/PWT)*MPLC* = (3/2)*1 = 3/2 wheat, higher than before trade
Again, free trade increases real wages!

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Comparing Wages Across Countries

Summarizing
Home real wage is
4 bushels of wheat
8/3 yards of cloth
Foreign real wage is
3/2 bushels of wheat
1 yard of cloth
The ratio Home_wage/Foreign_wage = 8/3, so Foreign workers earn less
What is the intuition for this?

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Comparing Wage Across Countries

What determines w/w*?
Since Home produces and exports wheat, Home wage is: w = PWT*MPLW
Since Foreign produces and exports cloth, Foreign wage is: w* = PCT *MPLC*

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Summary: Comparing Wages Across Countries

Home_wage/Foreign_wage depends on Home country’s TOT and absolute advantage
So comparative advantage gives you trade patterns, and absolute advantage gives you high wages
The intuition: the only way a country with poor technology can export at a price others are willing to pay is by having low wages.

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Predictions

Prediction:
In a given year, the countries that have better technology should have higher wages (i.e. comparing across countries)

Over time, as a given country develops better technology, its wages will rise (i.e. looking at changes for a given country)

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APPLICATION

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Labor Productivity and Wages for 2001

Figure 2.7

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APPLICATION

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Notes: Figure 2.7.

Labor productivity can be measured by the value-added per hour in manufacturing
Value-added is the difference between sales revenue in an industry and the costs of intermediate inputs
Equals the payments to labor and capital in an industry.
The Ricardian model ignores capital so we can measure labor productivity as value-added divided by the number of hours worked, or value-added per hour
Figure 2.7 shows value added per hour in manufacturing for several countries
Countries with higher labor productivity pay higher wages, just as the Ricardian model predicts

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APPLICATION

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Figure 2.8. Labor Productivity and Wage Over Time

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APPLICATION

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Notes: Figure 2.8.

We can also see the connection between productivity and wages over time
Figure 2.8 shows the general upward movement in labor productivity is matched by upward movement in wages
This is also predicted by the Ricardian Model

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Summary Part 3

CPF
Trade is balanced
Real wages

501

1002

CCC

QMPLLMPL

SlopePPF

MPL

MPLL

=-=-==-=-

WWCC

PMPLPMPL

PMPL

Cloth

Wages

Wheat

Wages

MPL

Therefore

MPL

***

248

()()

313

WWWW

CCCC

PMPLPMPL

==´=