Labour Productivity and Comparative Advantage: Ricardian
Model
• Why countries engage in trade?
(i) Countries are different from each other
(ii) Specialization and economies of scale in production
• A one-factor economy→ Home: Labour: Two goods (Wine
and Cheese)
• Technology: labour productivity in each industry (unit labour
requirement) – no. of hours of labour required to produce a
pound of cheese or a gallon of wine
alw = unit labour requirements in wine
alc = unit labour requirements in cheese
L = total labour supply or resources
alcQc + alwQw ≤ L
(Qc, Qw = production of Cheese, Wine)
• Trade-offs and PPF
Ricardian Model
• Opportunity cost: no. of gallons of wine the economy would
have to give up in order to produce an extra pound of cheese
- To produce another pound of cheese would require alc
person-hours. Each of this hours in turn could have been
used to produce (1/ alw) gallons of wine
- The opportunity cost of Cheese = (alc / alw) = slope of
PPF
• Relative supply is determined by movement of labour to
whichever sector pays the higher wages
• Hourly wage in Cheese: (Pc / alc) = value of what a worker can
produce in one hour (zero profit assumption)
• Hourly wage in Wine: (Pw / alw)
• Wages in Cheese will be higher if (Pc / Pw ) > (alc / alw) …..(1)
• Wages in Wine will be higher if (Pc / Pw ) < (alc / alw) ….. . (2)
Ricardian Model
• The economy will specialize in Cheese if: (1)
• The economy will specialize in Wine if: (2)
• Both goods will be produced if: (Pc / Pw ) = (alc / alw)
• Simple labour theory of value: In the absence of international
trade, the relative prices of goods are equal to their relative
unit labour requirements
• Trade in a one factor world: Home and Foreign
• Assume: (alc / alw) < (alc* / alw *) → Home has a comparative
advantage in Cheese
• alc < alc* → Home has absolute advantage in Cheese
• Comparative advantage, not absolute advantage, is the basis
for trade
Ricardian Model
• Home (autarky): (Pc / Pw ) = (alc / alw)
• Foreign (autarky): (Pc* / Pw * ) = (alc * / alw *)
• Trade opening: (Pc* / Pw * ) > (Pc / Pw ) → it is profitable to export
cheese from Home to Foreign and to import Wine from Foreign
to Home → until (Pc* / Pw * ) = (Pc / Pw )
• General equilibrium (relative supply and relative demand)
analysis to determine the relative prices after trade opening
No. of pounds of cheese demanded (supplied) / No. of
gallons of wine demanded (supplied)
• World general equilibrium → relative demand = relative supply
• If world relative price (Pct / Pwt ) < (alc / alw) → world supply of
cheese is zero
Home will not produce cheese because relative price of
cheese is less than the opportunity cost of producing
Cheese
Foreign also will not produce cheese by the assumption
that (alc / alw) < (alc* / alw *)
Ricardian Model
• (Pct / Pwt ) = (alc / alw) → Workers in Home will be indifferent
• (Pct / Pwt ) > (alc / alw) → Home will specialize in the
production of Cheese
• As long as (Pct / Pwt ) < (alc* / alw*) → Foreign will specialize
in Wine
• Home will produce (L / alc) of Cheese: Foreign (L* / al*w) of
Wine
• For any relative price of cheese between (alc / alw) and (alc* /
alw*) , the relative supply of cheese is: (L / alc) / (L* / al*w)
• (Pct / Pwt ) = (alc* / alw*) → Foreign workers are indifferent
• (Pct / Pwt ) > (alc* / alw*) → No wine production by both Home
and Foreign
• Equilibrium by the intersection of relative demand and
relative supply curves
Ricardian Model
• When there is complete specialization, the result of trade is
that the world relative price ends up somewhere in between the
pre trade levels in the two countries
• Each country specializes in the production of that good in
which it has the relatively lower unit labor requirement
• Both countries derive gains from trade. How?
• Two alternative ways of using an hour of labor: (i) Home
could use the hour directly to produce (1/ alw) gallons of wine,
(ii) Home could use the hour to produce (1/ alc ) pounds of
Cheese.
• Cheese could then be trade for wine with each pound trading
for (Pc / Pw ) gallons, so our original hour of labor yields (1/ alc)
(Pc / Pw ) gallons of wine
• This will be more wine than the hour could have produced
directly as long as (1/ alc) (Pct / Pwt ) > (1/ alw) or
(Pct / Pwt) > (alc / alw), which is true in equilibrium when neither
country produces both the goods
Ricardian Model
• Gains from trade: trade enlarges the range of choice for
consumers
• Consumption possibilities are the same as production
possibilities in autarky
• Trade enlarges the consumption possibilities
• Numerical example: Home has absolute advantage in both the
industries
• (Pct / Pwt ) must lie between the opportunity costs of cheese in
the two countries
• (alc / alw) = ½
(alc* / alw*) = 6 / 3 = 2
• (Pct / Pwt ) must lie between ½ and 2
• Assume (Pct / Pwt ) = 1 → a pound of cheese trades for a gallon
of wine
Numerical example
Country
Cheese
Wine
Home
alc = 1 hour per pound
alw = 2 hour per gallon
Foreign
alc* = 6 hours per pound alc* = 3 hours per gallon
Ricardian Model
• It takes only a half as many person hours in Home to produce
a pound of Cheese as it takes to produce a gallon of wine (1
versus 2)
• Home workers can earn more by producing cheese
• Home will specialize in Cheese
• Foreign will specialize in Wine
• Gains from trade: In direct production, an hour of Home labor
produces only ½ gallon of wine. The same hour could be used
to produce 1 pound of cheese which can then be traded for 1
gallon of wine
• Foreign could use 1 hour of labor to produce 1/6 pound of
cheese. The same hour could be used to produce 1/3 gallon of
Wine which can then be traded for 1/3 pound of cheese
Ricardian Model
• Relative wages: Home workers earn the value of 1 pound of
Cheese per hour – Foreign workers earn the value of 1/3 of a
gallon of wine per hour
• Assume, Pc = Pw = $12 → Home workers will earn $12 per
hour – Foreign workers will earn $4 per hour
• The relative wage of Home workers = 12/4 = $3
• Because of lower wage rate, Foreign has a cost advantage in
Wine, even though it has lower productivity
• Home has a cost advantage in Cheese despite its higher wage
rate, because the higher wage is more than offset by its higher
productivity
Misconceptions about comparative advantage
• Myth 1: The pauper labor argument: Foreign competition is
unfair and hurts other countries when it is based on low
wages
• Whether the low cost of wine produced in Foreign is due to
high productivity or low wages does not matter
• Myth 2: Exploitation: Trade exploits a country and makes it
worse off if its workers receive much lower wages than
workers in other nations
• Are the workers worse off exporting goods based on low
wages than they would be if they refuse to enter into trade:
what is the alternative
• Trade raises the real wage of workers
• Myth 3: Trade Pessimism: Free trade is beneficial only if
your country is strong enough to stand up to foreign
competition