2
TRADE AND
TECHNOLOGY: THE
RICARDIAN MODEL
1
Reasons for Trade
2
Ricardian Model
3
Determining the
Pattern of
International Trade
4
Solving for
International Prices
5
Conclusions
Introduction
• Why does the U.S. import goods that it could
easily produce itself with its great manufacturing
capability?
• The first part of this book looks at the various
reasons for trade:




Technological differences
Differences in amounts of resources
Differences in costs of outsourcing
The proximity of countries to each other
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Introduction
• This chapter focuses on how technology
differences across countries affect trade.
 Ricardian model proposed by the 19th century
economist David Ricardo.
• It explains how the level of a country’s technology
affects wages paid to labor in a way that countries
with better technology have higher wages.
• We use this to explain a country’s trade pattern—
the products it exports and imports.
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Reasons for Trade
1. Proximity
 The closer countries are the lower the costs of
transportation.
2. Resources
 A country can have resources that give it an edge in
the production of certain goods.

A country with a lot of snow may be very good at
producing snowboards.
 Resources are also called factors of production—
the land, labor, and capital used to produce goods
and services.
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Reasons for Trade
3. Absolute Advantage
 When a country has the best technology for
producing a good, it has an absolute advantage in
the production of that good.
4. Comparative Advantage
 Absolute advantage is actually not a good
explanation for trade patterns.
 A country has a comparative advantage in
producing those goods that it produces best
compared with how well it produces other goods.

China does not have an absolute advantage compared
to U.S. but is better at producing snowboards than
some other goods.
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Ricardian Model
• To develop a Ricardian model of trade, we will use
an example with two goods: wheat and cloth.
 Wheat and other grains are major exports of the U.S.
and Europe.
 Many types of cloth are imported into these countries.
• Home will be the country exporting wheat and
importing cloth.
• Assume that labor is the only factor of production.
• Note that the model has two goods and one factor
of production.
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Ricardian Model
• The Home Country
 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.
 We can use the marginal products of labor to construct
Home’s Production Possibilities Frontier.
 The PPF shows all feasible combinations of wheat and cloth.
 Assume there are 25 workers in Home.
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Ricardian Model
• Using the setup, we can show:
 Labor = 25, MPLW = 4, MPLC = 2
 QW = MPLW(L) = 25(4) = 100
 QC = MPLC(L) = 25(2) = 50
• This gives us a straight line PPF which is a unique
feature of the Ricardian model.
 It assumes the marginal products of labor are
constant.
• 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.
 It is the ratio of the marginal products.
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Ricardian Model
Figure 2.1
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Ricardian Model
• Home Indifference Curve
 Given Home’s PPF, how much wheat and cloth will
home actually produce. The answer depends on
demand.
 Demand can be represented with indifference curve.
 An indifference curve shows the combinations of two
goods that the country can consume and be equally
satisfied.
 All points on an indifference curve have the same level
of utility.
 Points on higher indifference curves have higher utility.
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Ricardian Model
Figure 2.2
The country is indifferent between A
and B
The country is better off on U2 but
cannot produce that much
U0<U1<U2
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Ricardian Model
• Home Equilibrium
 Without trade, the PPF acts as a budget constraint for
the country.
 With perfectly competitive markets, 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.
 Refer to this as the no-trade equilibrium.
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Ricardian Model
• Opportunity Cost and Prices
 The slope of the PPF reflects the opportunity of
producing one more bushel of wheat.
 Under perfect competition the opportunity cost of wheat
should equal the price of wheat.
 Price reflects the opportunity cost of a good.
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Ricardian Model
• Wages
 Determination of wages
 In competitive markets firms hire workers up to the point at which
the hourly wage equals the value of one more hour of production.
 wage = P*MPL for each industry.
 In competitive markets, labor can move freely between
industries.
 Wages must be equal across industries.
 Equalization of wages implies that:
 This is the relative price of wheat.
 Cost of wheat in terms of cloth.
PW  MPLW  PC  MPLC
PW MPLC

PC MPLW
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Ricardian Model
• The Foreign Country
 Assume Foreign’s technology is inferior to Home’s.
 Foreign has an absolute disadvantage in producing
both wheat and cloth as compared to Home.
 Foreign Production Possibilities Frontier
 Assume a Foreign worker can produce one bushel of
wheat or one yard of cloth.
 MPL*W = 1, MPL*C = 1
 Assume there are 100 workers available in Foreign.
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Ricardian Model
Figure 2.3
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Ricardian Model
• Comparative Advantage
 Given the opportunity cost information, we can determine
comparative advantages in each country for each good.
• The table below shows the opportunity cost of each good
for both countries:
Cloth
(1 Yard)
Wheat
(1 Bushel)
Home
2 Bushels
of Wheat
½ Yard
of Cloth
Foreign
1 Bushel
of Wheat
1 Yard
of Cloth
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Ricardian Model
• Comparative Advantage
 A country has a comparative advantage in a good when
it has a lower opportunity cost of producing than
another country.
 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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Ricardian Model
• Equilibrium in Foreign
 Foreign’s preferences can also be represented by an
indifference curve.
 The no-trade relative price of wheat is P*W/P*C = 1.
 The relative price exceeds Home’s no-trade relative
price of wheat: P*W/P*C = ½ .
 The difference in relative prices comes from the
comparative advantage that Home has in wheat.
 Shortly, we will show how these differences can form
the basis for trade.
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Ricardian Model—Foreign
Figure 2.4
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Comparative Advantage in Apparel,
Textiles, and Wheat
APPLICATION
• U.S. 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 U.S.
with sales of $1.6 billion in 1999.
• Sales per employee were therefore $92,000.
• This is the average for all U.S. apparel producers.
• Textiles are even more productive with annual sales per
employee of $140,000 in the U.S.
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Comparative Advantage in Apparel,
Textiles, and Wheat
APPLICATION
• In China, however, sales per employee are only $13,500
in apparel and $9,000 in textiles.
• The U.S. is 7 times more productive in apparel and 16
times more productive in textiles.
• So the U.S. has the absolute advantage in these products.
• For wheat, the U.S. produces 27.5 bushels per hour of
labor.
• China produces only 0.1 bushel per hour of labor.
• The U.S. is thus 275 times as productive in wheat.
• It thus has the absolute advantage in wheat.
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Comparative Advantage in Apparel,
Textiles, and Wheat
APPLICATION
• Since the absolute advantage in wheat for the
U.S. is even greater than in apparel and textiles, it
has the comparative advantage in wheat.
• China has the comparative advantage in apparel
and textiles because its productive disadvantage
relative to the U.S. is less than in wheat.
• This explains why the U.S. imports apparel and
textiles from China despite higher productivity in
the U.S.
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Can Comparative Advantage be Created?
The Case of “Icewine”
SIDE BAR
• In general we think of a country having a
comparative advantage in a good.
 Certain countries have a comparative advantage in the
production of wine.
• Can a country create a comparative advantage?
 Areas that get very cold are not good wine producers
because the vines get too cold.
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Can Comparative Advantage be Created?
The Case of “Icewine”
SIDE BAR
 The Niagara Falls region of Canada began producing a
product called “icewine” in 1983; it’s now made in
British Columbia, too.
 The grapes are allowed to freeze on the vine before
they are picked.
 The unique flavor of the wine has led to a relatively high
demand.
 This has created a comparative advantage in a certain
type of wine, even though Canada does not have the
advantage in traditional wine production.
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Determining the Pattern of International Trade
• What happens now when goods are traded
between Home and Foreign?
• We will see the country’s no-trade relative price
determines which product it will export and which
it will import.
• The no-trade relative price equals its opportunity
cost of production.
 Therefore, the pattern of exports and imports will be
determined by the opportunity costs of production in
each country—their comparative advantage.
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Determining the Pattern of International Trade
• International Trade Equilibrium
 Relative price of cloth in Foreign is PC/PW = 1.
 Relative price of cloth in Home is PC/PW = 2.
 Therefore Foreign would want to export their cloth to
Home—they can make it for $1 and export it for more
than $1.
• How Trade Occurs
 As Home exports wheat, quantity of wheat sold at
Home falls.
 The price of wheat at Home is bid up.
 More wheat goes into Foreign’s market.
 The price of wheat in Foreign falls.
 Similar logic applies to cloth.
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Determining the Pattern of International Trade
• International Trade Equilibrium
 Two countries are in a trade equilibrium when:
 the relative price of each good is the same in the two
countries
 the amount of each good that the countries want to trade is
equal
 In understanding the trade equilibrium we need to
do two things:
 Determine the relative price of wheat or cloth in the trade
equilibrium.
 See how the shift from the no-trade equilibrium to the trade
equilibrium affects production and consumption in both
Home and Foreign.
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Determining the Pattern of International Trade
• International Trade Equilibrium
 The relative price of wheat in the trade equilibrium will
be between the no-trade price in the two countries.
 Assume the free-trade price of PW/PC is 2/3.
 We can now take this price and see how trade changes
production and consumption in each country.
 Home producers of wheat can earn more than the
opportunity cost of wheat by selling it to Foreign.
 We can show this with our wage equations.
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Determining the Pattern of International Trade
PW MPLW  2   4  8
      1
PC MPLC  3   2  6
Therefore
PW MPLW  PC MPLC
Wages in wheat  Wages in cloth
• 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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Determining the Pattern of International Trade
• International Trade
 Home can export wheat at the international relative
price of 2/3.
 For each bushel of wheat it exports, it gets 2/3 yards of
cloth in return.
 In figure 2.5 we trace this out to get a new price line
showing the world price.
 The world price line shows the range of consumption
possibilities that a country can achieve by specializing in one
good and trading.
 Remember: this is only a consumption possibility because
production is still constrained by the PPF.
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Determining the Pattern of International Trade
• The new world price, PW/PC =
2/3, shows us the new range of
consumption possibilities
Cloth, QC (yards)
50
• The country can now achieve a
higher utility with the new
consumption possibilities
U2
World price line,
Slope = –2/3
A
25
U1
Home production
B
50
100
Wheat, QW (bushels)
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Determining the Pattern of International Trade
Home produces 100 bushels but
consumes only 40, so exports equal 60
Cloth, QC (yards)
Home produces 0 yards of cloth but
consumes 40, so imports equal 40.
Home consumption
50
40
C
U2
Home imports 40
yards of cloth
25
World price line,
Slope = –2/3
A
U1
Home production
B
40 50
50
100
100
Wheat, QW (bushels)
Home exports 60 bushels of wheat
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Determining the Pattern of International Trade
• International Trade
 Trade allows a country to engage in consumption
possibilities it did not have before trade.
 We can see this as Home can now be on a higher
indifference curve with trade than they were without it.
 This is the first demonstration of gains from trade.
• Pattern of Trade and Gains from Trade
 From figure 2.5, we can also see that Home’s exports
and imports are equal when valued in the same units.
 Trade is balanced.
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Determining the Pattern of International Trade
Figure 2.6
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Determining the Pattern of International Trade
• Pattern of Trade and Gains from Trade
 Each country is exporting the good for which it has the
comparative advantage.
 This confirms that the pattern of trade is determined by
comparative advantage.
 This is the first lesson of the Ricardian model.
 There are gains from trade for both countries.
 This is the second lesson of the Ricardian model.
 It refutes the notion that free trade benefits one country while
harming the other.
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Determining the Pattern of International Trade
• Pattern of Trade and Gains from Trade
 However, we have not yet determined the level of
wages across countries.
 Relative prices converge. Do wages?
 Wages do rise in each country, but they do not
converge. (Important political implications)
 They are determined by absolute advantage, not
comparative advantage.
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Determining the Pattern of International Trade
• Solving for Wages Across Countries
 As stated before, in competitive labor markets, firms will
pay workers the value of their marginal product.
 Since Home produces and exports wheat, they will be
paid in terms of that good—the real wage is MPLW = 4
bushels of wheat.
 The workers sell the wheat on the world market at a
relative price of PW/PC = 2/3.
 We can use this to calculate the real wage in terms of
cloth: (PW/PC)MPLW = (2/3)4 = 8/3 yards.
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Determining the Pattern of International Trade
• Solving for Wages Across Countries
 We can do this for Foreign as well and summarize:
 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
 Foreign workers earn less than Home workers as
measured by their ability to purchase either good.
 This fact reflects Home’s absolute advantage in the production
of both goods.
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Determining the Pattern of International Trade
• Wages are determined by absolute advantage
and trade is determined by comparative
advantage.
• This should make sense.
 The only way a country with poor technology can export
at a price others are willing to pay is by having low
wages.
• As a country develops better technology, its
wages will rise. (Compare to autarky wages)
 Workers become better off through receiving higher
wages.
 As countries engage in trade, the Ricardian model
predicts that their real wages will rise.
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Determining the Pattern of International Trade
• We can see this in the real world
 Per capita income in China in 1978 was estimated at
$925.
 In 2000, per capita income in China had risen to $3750.
 Per capita income in India more than doubled from
$1180 in 1978 to $2480 in 2000.
 It is strongly believed that the opportunity for these
countries to engage in international trade has been
crucial in raising their standard of living.
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Labor Productivity and Wages
APPLICATION
• 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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Labor Productivity and Wages
APPLICATION
Figure 2.7: Labor Productivity and Wages, 2001
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Labor Productivity and Wages
APPLICATION
• We can also see the connection between
productivity and wages over time.
• Figure 2.8 shows that 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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Labor Productivity and Wages
APPLICATION
Figure 2.8
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Solving for International Prices
• In the previous analysis we assumed the world
price of wheat was 2/3.
• In reality world price is determined by a market for
exports and imports.
• We will derive a Home export supply curve.
 Shows the amount it wants to export at various relative
prices.
• Similarly we will derive a Foreign import demand
curve.
 Shows the amount of wheat that it will import at various
relative prices.
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Solving for International Prices
• Home Export Supply Curve
 The export supply curve will have the relative price of
wheat on the Y-axis and the amount of wheat on the Xaxis.
 We use the information in figure 2.9 to derive the curve.
 Compare production and consumption at each relative price.
 When Pw/Pc=1/2, Exports=0.
 When Pw/Pc=2/3, Exports=60.
• The flat portion of the export supply curve is a
special feature of the Ricardian model.
 The PPF is a straight line.
 Production can occur anywhere along the PPF as
workers shift between industries.
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Solving for International Prices
Figure 2.9
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Solving for International Prices
• Foreign Import Demand
 We can use a similar analysis to construct the import
demand for wheat in figure 2.10.
 At the world relative price of 2/3, Foreign imports 60
bushels of wheat, C* and C*’.
 The no-trade equilibrium in Foreign, with a relative
price of 1, is zero imports, A* and A*’.
 Production can shift from point A, at a price of 1, as
workers move between industries:
 If workers all shift to cloth.
 Foreign imports 50 bushels of wheat, B* and B*’.
 This gives us the import demand curve.
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Solving for International Prices
Figure 2.10
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Solving for International Prices
• International Trade Equilibrium
 We need to put the Home export supply together with
the Foreign import demand.
 The exports from Home come from the excess
domestic supply.
 The imports to Foreign come from the excess domestic
demand.
 This is the World market for wheat (figure 2.11):
 Equilibrium price of 2/3 and trade of 60 bushels of wheat.
 This is the amount that clears the world market.
 Desired sales of Home equal the desired purchases by Foreign.
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Solving for International Prices
Figure 2.11
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Solving for International Prices
• The Terms of Trade
 The price of a country’s exports divided by the price of
its imports.
 For Home, PW/PC is their terms of trade.
 An increase in PW or a fall in PC will raise Home’s terms
of trade.
 An increase in the terms of trade is good for a country:
it makes it better off.
 A country will earn more for its exports.
 A country will pay less for its imports.
 For Foreign, PC/PW is the terms of trade and a higher
relative price for cloth makes it better off.
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The Terms of Trade for Primary Commodities
APPLICATION
• Latin American economist Raúl Prebisch and
British economist Hans Singer each put forward
the hypothesis that the price of primary
commodities would decline over time relative to
the price of manufactured goods.
• Primary commodities are often exported by
developing countries, so their terms of trade
would decline over time.
• Empirical evidence for this theory is mixed.
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