RICARDIAN MODEL
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1.  INTRODUCTION
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Classical Models of Trade
Classical models of trade emphasize that trade is based on differences between countries.
Examples:
§  Spain (sunny weather and nice beaches) exports tourism to Germany.
§  United States (technologically advanced) exports high-tech goods to the rest of the world.
§  Canada (forests) exports wood products.
Classical model emphasize two types of differences.
§  Technological differences (as in the example of United States): Ricardian model.
§  Factor endowment differences (as in the examples of Spain and Canada): HeckscherOhlin model.
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Classical Models and Comparative Advantage
Countries trade to take advantage of their differences. If countries were identical, there
would be no point in trading.
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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Ricardian Model
Assumptions:
§
§
§
§
Perfect competition
2 countries
2 sectors
1 factor of production (labor)
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2. ROAD MAP
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Road Map
Theory Lecture
§  Closed Economy.
§  Open Economy:
§
§
Comparative Advantage
Gains from Trade: Graphical Analysis
Practical Section
§  Relative Demand and Supply
§
§
Relative Size of Countries and Gains from Trade
Trade with More than Two Goods
§  Graphical and Numerical Applications of Ricardian Models.
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3. THEORY LECTURE
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3.1. CLOSED ECONOMY (AUTARKY)
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Spain
Domestic Country: Spain
Data
§  Unit labor requirement (number of workers to produce one unit of a good):
aLV (wine) = 1
aLT (textile) = 2
§  Number of workers:
L = 100
Observations
§  Linear technology.
§  Unit labor requirement is the inverse of labor productivity.
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Closed Economy
QV
L/aLV =100
Production possibility frontier
- aLT/aLV
L/aLT =50
QT
Slope:
§  Opportunity cost of textile in terms of wine.
§  Productivity of wine / productivity of textile
§  Production cost of textile / Production cost of wine
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Production
QV
If pT / pV < aLT / aLV
L/aLV =100
If pT / pV = aLT / aLV
If pT / pV > aLT / aLV
L/aLT =50
QT
§  If Spain produces both goods, pT / pV = aLT / aLV = 2 (interior solution).
§  If pT / pV > aLT / aLV, the relative price of textile is higher than the relative cost, so that no
one will produce wine (corner solution: complete specialization in textile).
§  Si pT / pV < aLT / aLV, the relative price of textile is lower than the relative cost, so that no
one will produce textile (corner solution: complete specialization in wine).
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Consumption
QV
L/aLV =100
L/aLT =50
QT
§  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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Spain & India
WINE
TEXTILE
WORKERS
SPAIN
1
2
100
INDIA
10
5
1000
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Spain & India
SPAIN
INDIA
QV
Q*V
L/aLV
=100
L*/a*LV
pT / pV = aLT / aLV = 2
=100
- aLT/aLV
L/aLT =50
p*T / p*V = a*LT / a*LV = 1/2
- a*LT/a*LV
QT
Q*T
L*/a*LT =200
§  We now focus only on the relative prices under autarky.
§  From these relative prices we will determine the comparative advantage of each country
and the pattern of trade.
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3.2. OPEN ECONOMY (FREE TRADE)
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Gains from Trade: Intuition
Under autarky: pT / pV = 2 (Spain) and p*T / p*V = 1/2 (India)
Textile is relatively cheaper in India. India will gain if by producing more textile, exporting the
additional production to Spain, and importing wine in exchange.
Example: 10 Indian workers leave the wine industry to go produce textiles
Production
- 1 unit of wine
+ 2 units of textile
Exports the additional production of textile to Spain
- 2 units of textile
Imports wine from Spain (price in Spain is pT / pV = 2)
+ 4 units of wine
Total effect: + 3 units of wine
Conclusion: India gains from trade (it consumes the same quantity of textile and can have 3
more units of wine)
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Absolute Advantage
WINE
TEXTILE
SPAIN
1
2
INDIA
10
5
Spain is
§
§
10 times more productive in the production of wine.
2.5 times more productive in the production of textile.
Therefore, Spain has ABSOLUTE ADVANTAGE in both sectors.
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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Comparative (or Relative) Advantage
WINE
TEXTILE
SPAIN
1
2
INDIA
10
5
The absolute advantage of Spain is higher in wine. Therefore, Spain has COMPARATIVE (or
RELATIVE) ADVANTAGE in wine and India has COMPARATIVE (or RELATIVE)
ADVANTAGE in textile.
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*LV / aLV > a*LT / aLT
10 / 1 > 5 / 2
Another way to determine comparative advantage is
aLT / aLV > a*LT / a*LV
pT / pV > p*T / p*V
Thus, Spain has comparative advantage in the production of wine, and India in the production
of textile. India specializes in textile because its relative price is smaller.
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Price Convergence
Relative prices in autarky: pT / pV = 2 (Spain) and p*T / p*V = 1/2 (India)
Trade: Spain exports wine and India exports textile.
Effects on prices:
§
§
§
§
§
Demand for Spanish wine raises (exports) and demand for Spanish textiles falls (imports).
Relative price of wine raises in Spain.
Relative price of textiles falls in Spain.
The opposite happens in India.
Prices converge (if there are no barriers to trade).
(pT / pV)A = 2 ≥ (pT / pV)FT ≥ (p*T / p*V)A = 1/2
§
The new relative price is called the international relative price or the relative price under
free trade.
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Gains from Trade
SPAIN
INDIA
QV
Q*V
Production (free trade)
100
Consumption (free trade)
100
Consumption (free trade)
Production (free trade)
- (pLT/pLV
)A
- (pLT/pLV
50
Production and
Consumption (autarky)
§
§
§
- (pLT/pLV)LC
)LC
- (p*LT/p*LV)A
QT
Production and
Consumption (autarky)
200 Q*
T
Assume (pT / pV)FT = 1.
Spain (completely) specializes in wine production and India (completely) specializes in textiles.
Both countries gain from trade: budget constraints shift upwards and consumption is on a higher indifference
curve.
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Relative Prices and Gains from Trade
Spain
§  Trade increases the price of the good it exports (wine). It jumps from (pV / pT)A = 1/2 to
(pV / pT)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 wine that Spain exports, it now receives more textiles.
India
§  As in Spain, its terms of trade improve: the relative price of textile increases from (p*T /
p*V)A = 1/2 to (pT / pV)LC = 1.
It is not a coincidence that the terms of trade improve in both countries: it is precisely
because the relative price of wine (textile) rises in Spain (India) that Spain (India) exports wine
(textiles).
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Wages, productivity and costs
§
Wage in Spain: w = pV / aLV = pV / 1
§
Wage in India: w* = pT / a*LT = pT / 5
§
Relative wage in Spain: w / w* = pv a*LT / pT aLV = 5
§
India can be competitive in textile production (even though it has lower productivity)
because c*T = w* a*LT < w aLT. That is equivalent to: w / w* (=5) > a*LT /aLT (=2.5).
Spanish productivity (in textiles) is 2.5 times higher than in India but Spanish wages are 5
times higher.
§
Similarly, even though Spanish wages are higher (5 times), Spanish wine is competitive,
because it is much more productive (10 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. PRACTICAL SECTION
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Relative Demand and Supply
§
In the theory lecture, we have seen that the free trade relative price will be inside a band
(pT / pV)A = 2 ≥ (pT / pV)LC ≥ (p*T / p*V)A = 1/2
§
However, which price will appear in equilibrium depends on the relative supply and
demand.
§
We will now draw the relative supply and demand and determine the free trade relative
price.
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Relative Demand and Supply
PT/PV
RS
aLT/aLV = 2
(PT/PV)LC
aLT*/aLV* = 1/2
RD
L*/ aLT*
L/ aLV
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=2
QT +QT*/Qv +Qv*
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Size Matters: Big vs Small Countries
WINE
TEXTILE
WORKERS
SPAIN
1
2
100
INDIA
10
5
10
Let us reduce the number of Indian workers from 1000 to 10.
There is no other change.
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RS/RD for Countries with Different Size
PT/PV
OR
(PT/PV)LC = aLT/aLV = 2
aLT*/aLV* = 1/2
DR
L*/ aLT*
L/ aLV
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= 0.02
QT +QT*/Qv +Qv*
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Gains from Trade with Countries
of Different Size
§
All gains from trade go to the small country (India).
§
Terms of trade do not change in Spain. That is the reason why Spanish welfare does not
change.
§
Small countries have more incentives to open up to trade.
§
§
In the data there exists a negative relationship between country size and openness to trade.
As the UE gets bigger, it has less incentives to open up to third countries.
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Trade with More than Two Goods
SPAIN
INDIA
RELATIVE
PRODUCTIVITY
CARS
2
5
2.5
COMPUTERS
1
10
10
PLANES
8
16
2
CARPETS
4
5
1.25
§
Each good is produced where it is cheaper to do so.
§
Good i is produced in Spain if
w aLi < w* a*Li
⇔
§
w/w* < a*Li / aLi
Spain produces good i if its relative wage is lower than its relative productivity in
good i.
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Trade with More than Two Goods
Chain of comparative advantage
10
Computers
>
2.5
Cars
>
2
Planes
>
1.25
Carpets
§
Spain produces the good(s) to the left and India the good(s) to the right.
§
Assume w/w* = 3.
§
In this case, Spain produces computers and India the other goods.
§
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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Transportation Costs
10
Computers
>
2.5
Cars
>
2
Planes
>
1.25
Carpets
§
Keep assuming w/w* = 3.
§
Let us introduce transport costs between countries. These costs add 100% to the
production costs.
§
For example, importing a car from India requires 5 workers for production and 5 for
shipping (that is, 10 workers).
§
Without transportation costs, Spain imported cars from India. What happens now?
§
§
§
Price of Spanish car= Production cost = 2 w
Price of Indian car to be sold in Spain = Production + Transportation costs = 10 w*
The relative wage in Spain (= 3) is lower than the relative productivity (=5). Thus, Spain
stops importing cars from India. Cars become non-traded.
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Transportation Costs
10
Computers
§
2.5
Cars
>
2
Planes
>
1.25
Carpets
If we solve the rest of the exercise, we will find that
§
§
§
§
>
Spain exports computers.
India exports carpets.
Cars and planes become non-traded.
What matters is not the absolute transportation costs but the transportation costs relative
to the production cost.
§
§
Cement is very costly to transport (it is heavy and cheap, so the transport cost relative to the price is high).
Diamonds are very cheap to transport (they are very expensive and transport costs are relatively small).
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Problem Set
See Problem Set “Ricardian Model”
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