International Trade Theory
Lecture 1 : The Ricardian Model of Comparative Advantage
Kornkarun Kungpanidchakul, Ph.D
Opportunity cost
- Comes from the next best foregone alternative
- To find the opportunity cost, you must have more than one alternative, goods or
activities
Adam Smith (wealth of Nations, 1776)
- introduces principles of division of labor and specialization among countries
- each country produces goods that it can produce more for the same level of
resources/time.
- “ law of absolute advantage”
Absolute Advantage: Country A has absolute advantage in good X comparing with
country B if country A can produce more units of good X than country B, given that both
countries have the same level of resources, technology and time.
Assumption:
1. Constant opportunity cost (linear PPF)
2. Two countries with one factor “labor”
3. Two commodities (suppose Fish and Chips)
Country
Canada
Japan
Amount produced / unit of labor
Fish
Chips
100
50
50
150
So Canada has absolute advantage in producing fish and Japan has absolute advantage in
producing chips.
What is Adam Smith’s suggestion?
 Canada produces only fish and Japan produces only chips. Then trade pattern is
Canada exports fish, Japan exports chips.
The Ricardian Model of Comparative Advantage
Consider the following table,
country
Canada
Japan
Amount produced / unit of labor
Fish
Chips
100
160
50
150
Opportunity Cost
Fish
Chips
1 F= 1.6 C
1 C= 5/8 F
1 F=3 C
1F =1/3 C
Canada has absolute advantage in both Fish and Chips. Therefore, according to
absolute advantage, no trade occurs.
David Ricardo introduced principle of “Comparative Advantage” or
“Comparative Cost”
Assumptions:
1. Labor is only production factor. The technology is constant returns to scale.
2. Identical tastes in both countries. Therefore, relative prices are solely determined
by supply side or technology.
Example 1: Suppose that there are two countries, namely Canada and Japan. They have
the total level of resource of L and L* respectively.
Country
Canada
Japan
Amount produced / unit of labor
Fish
Chips
1
1/2
1
1
Opportunity Cost
Fish
Chips
1F = ½ C
1C = 2 Fish
1F = 1 C
1C = 1F
Comparative Advantage
Country A has comparative advantage in good X comparing with country B if
country A can produce good X with the lower opportunity cost.
Define the formal notation of comparative advantage. Given that aLF is the unit
cost required to produce fish, aLC is the unit cost required to produce chips. Then
*
a LF a LF
 * means that the opportunity cost of fish in Canada is lower than the
a LC a LC
opportunity cost in Japan. Therefore, Canada has a comparative advantage in fish while
*
Japan has comparative advantage in chips. If a LF  a LF
, Canada has an absolute
advantage in fish.
Autarky Equilibrium
Production Possiblity Frontier: A curve showing all combinations of two goods that
can be produced for given resources and technology. The slope is opportunity cost.
Fish
-
Perfect substitutes
Constant opportunity
cost
Chips
In autarky economy, the country will product at the point that the indifference
curve is tangent to PPF.
Fish
A
Chips
Equilibrium Condition:
1. pC  waLC
2. pF  waLF
3. L  LF  LC
Therefore, if we have interior solution, 1. and 2. implies:
pC waLC a LC


p F waLF a LF
Trading Equilibrium
There are three possible types of equilibrium. Let (
pC w
) is the world relative
pF
price, then we have:
p
a*
a
1. If ( C ) w  LC
 LC , then Japan diversifies between fish and chips while
*
pF
a LF a LF
Canada specializes in Fish.
a*
p
a
2. If LC
 ( C ) w  LC , then both countries specialize with Canada specializes in
*
pF
a LF
a LF
fish and Japan specializes in chips.
a*
p
a
3. If LC
 ( C ) w  LC , then Japan will specialize in chips while Canada
*
pF
a LF
a LF
diversifies.
In all equilibriums, Canada exports fish while Japan export chips. Therefore, even
diversified economy, patterns of international trade is specialized in the Ricardian model.
The Gains from Trade
*
pC w a LC
a
)  *  LC , Canada gains from trade since it can consume
pF
a LF a LF
outside its own PPF.
1. When (
F
C
F
Canada’s PPF
C
Japan’s PPF
2. When
*
a LC
p
a
 ( C ) w  LC , both countries can consume outside its own PPF.
*
pF
a LF
a LF
F
C
Canada’s PPF
F
C
Japan’s PPF
F
*
a LC
p
a
3.When *  ( C ) w  LC , only Japan’s PPF shifts up.
pF
a LF
a LF
C
Canada’s PPF
F
C
Japan’s PPF
Comparative Advantage with Many Goods
Suppose instead that both Canada and Japan consume and produce N different
goods, for good i ={1,…,N}. We still assume that each country has only one factor of
production which is labor. Suppose that a Li and a Li* are unit labor requirement for good i
of Canada and Japan respectively.
a
To analyze trade, we calculate Li* , the ratio of Canada’s unit labor requirement to
a Li
Japan’s and rank the good so that the lower the number, the lower the ratio, i.e.
a
a
a L1
 ...  Li*  ..  LN
(1)
*
*
a L1
a Li
a LN
Let w and w* be the wage rate per hour in Canada and Japan respectively. The
relative wage is used to determine a set of goods produced in each country. Good i will
a
a
w*
w*
be produced in Canada if Li* 
and will be produced in Japan if Li* 
. Suppose
a Li w
a Li w
a LJ w*

, then all the goods to the left of J will be
*
a LJ
w
produced in Canada and all the goods to the right of J will be produced in Japan. The
that good J  {1,..., N } is such that
relative wage is determined by the relative demand for labor and the relative supply of
labor. The relative demand for labor can be derived from the relative demand for goods
and have downward sloping. The relative supply of labor is fixed since L and L* are
given.