Ch. 3: Labor Productivity and
Comparative Advantage –
The Ricardian Model
1
Why Do Countries Trade?
Countries trade with each other because
they are different from each other.
 Countries trade with each other because
enlarging the market creates economies of
scale and reduces cost per unit.

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Comparative Advantage
A person, a region, a country has
comparative advantage in producing a good
if the opportunity cost of producing that good
is lower than others.
 Even if a country has absolute disadvantage
in every thing it produces compared to
another one, it still will have comparative
advantage in some goods.

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Do What You Do Best;
Trade for the Rest
In a year, an Eastern worker can make two
bikes or grow four bushels of wheat. A
Westerner, however, can manage only one
bushel or one bike. Each country has 100
workers, and initially both of their workforces
are split evenly between the two industries.
Find opportunity costs.
East is relatively more efficient at growing
wheat, where it is four times as productive as
West, than it is at making bikes, where it is
only twice as productive. In other words, it
has a comparative advantage in wheat.
http://www.economist.com/surveys/displaystory.cfm?story_id=E1_GDVTQQ
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WEST
Comparative Advantage
EAST
B
B
200
100
100
50
50
100
W
200
W
400
In a year, an Eastern worker can make two bikes or
grow four bushels of wheat. A Westerner, however,
can manage only one bushel or one bike. Each
country has 100 workers, and initially both of their
workforces are split evenly between the two
industries.
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Comparative Advantage
WEST
EAST
B
B
200
100
75
100
80
50
25
50
100
W
200 240
W
400
East shifts 10 workers from its bicycle factories to its
fields. West moves 25 workers from wheat farming
into bike making,
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WEST
Comparative Advantage
EAST
B
B
200
100
110
100
60
50
50 60
100
W
200 235
W
400
Can we improve the standard of living even more?
Suppose we have complete specialization. East
produces 400 wheat and West produces 100
bicycles. Let them trade with the outside world at
1.5 wheat per bicycle.
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Relative Wages
The wages of workers represent their
productivity.
 In autarky

East workers get 4 wheat or 2 bikes.
 West workers get 1 wheat or 1 bike.


Why are East workers paid more? Are
West workers exploited?
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Relative Wages
Under trade 1 Bicycle = 1.5 Wheat.
 East makes 400 wheat; each worker gets
paid 4 wheat or 2.67 bikes.
 West makes 100 bicycles; each worker
gets paid 1 bicycle=1.5 wheat.
 Did the lower wage of West workers take
all the jobs away from East workers?
 Did trade increase the wages for both
countries?

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Another Example
HOME: Labor required for cheese
production (aLC) is 2. Labor required for
wine production (aLW) is 4. Home has
100 units of labor.
 FOREIGN: Labor required for cheese
production (a*LC) is 5. Labor required
for wine production (a*LW) is 5. Foreign
has 200 units of labor.

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PPF for Home and Foreign
Wine
Home
40
Foreign
25
50 Cheese
40 Cheese
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Prices

Home has to use twice as much labor to
produce wine compared to cheese.
Therefore, wine costs twice; or cheese
costs half as much.
 Pc/Pw

= aLC/aLW = 2/4 = ½
Foreign uses equal amounts of labor for
cheese and wine. They should cost the
same.
 P*c/P*w
= a*LC/a*LW = 5/5 = 1
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Relative Supply of Cheese
Relative supply of cheese is
Qc+Q*c/Qw+Q*w.
 If (Pc/Pw)<1/2, Home would be better off
producing wine.
 At Pc/Pw=1/2, Home is free to produce
between 0 and 50 units of cheese.
 At P*c/P*w=1/2, Foreign would only
produce wine.
 Once P*c/P*w=1, Foreign would produce
between 0 and 40 units of cheese.

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Relative Supply of Cheese
Pc/Pw
1
1/2
50/40
70/20
Cheese/Wine
Relative quantity of cheese
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Relative Demand
As Pc/Pw falls, more cheese would be
demanded.
 Suppose Demand for Cheese/Demand
for Wine = Pw/Pc.
 At Pc/Pw = 1, Pw/Pc = 1.
 At Pc/Pw = ½, Pw/Pc = 2

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Relative Demand and Supply of
Cheese
Pc/Pw
1
1/2
50/40
70/20
Relative quantity of cheese
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Specialization and Trade
If ½ < Pc/Pw < 1, then Home should
specialize on cheese and Foreign
should specialize on wine.
 WHY?
 Suppose Pc/Pw in our example is ¾.
That is, the exchange is worth ¾ wine
for 1 cheese.

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Relative Wages
Suppose cheese is $7.50 and wine is $10.
 Home produces only cheese: 50x$7.50 =
$375. Divide by 100 units of labor: $3.75.
 Foreign produces only wine: 40x$10 =
$400. Divide by 200 units of labor: $2.00.
 The more productive labor is paid higher
wage.

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Gains for Home and Foreign
Wine
50x3/4
Home
40
Foreign
25
50 Cheese
40
40x4/3
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Misconceptions About
Comparative Advantage
Myth 1: Free trade is beneficial only if your
country is strong enough to stand up to foreign
competition.
 Myth 2: Foreign competition is unfair and hurts
other countries when it is based on low
wages.
 Myth 3: Trade exploits a country and makes it
worse off if its workers receive much lower
wages than workers in other nations.

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Myth 1: Productivity and
Competitiveness
Absolute disadvantage in every sector still
allows a country to benefit from trade since it
has comparative advantage in some
industries.
 Comparative advantage is dependent on
internal opportunity costs.
 Average wage in a country reflects the
average productivity.

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Myth 2: Pauper Labor Argument
Wages and productivity go hand in hand.
 If the average wage in a country is low
because of overall low productivity, the
country still exports products to relatively
higher productivity industries.
 The country with the absolute advantage will
not lower its own average wage by importing
because it can reallocate the labor into high
productivity industries and raise its own
average wage.

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Myth 3: Exploitation



Refusing to buy soccer balls or clothing produced in
Third World countries because the pay is criminally
low may in fact condemn those poor people to a
worse fate.
The question to ask is “What is their alternative?”
Third World countries are exporting goods where
they are relatively efficient and productive. If those
industries were to close, the average productivity
would fall and the average wage would be less.
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Comp. Adv. With Many Goods
Suppose two countries both produce
automobiles, banking services, crackers,
DVDs, and education.
 Which country will be the exporter and which
country will be the importer will depend on the
productivity of each industry and the wage in
that country.
 Wages in each country will be same across
the industries, assuming no skill differences
required.

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Comp. Adv. With Many Goods
Average wage in Country A (wA) is different
than average wage in Country B (wB).
 Average wage times the number of labor
units required for one unit of output will
determine the cost per industry.
 If the cost of an industry is lower in Country
A than in Country B, Country A will export
and Country B will import.

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Unit Labor Requirements
INDUSTRY A’s Labor
B’s Labor
Relative A
Requirement Requirement Productivity
Automobiles 150
250
1.6
Banking
25
50
2.0
Crackers
1
3
3.0
DVDs
10
50
5.0
Education
25
30
1.2
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Trade Pattern
Suppose wages in A relative to B are 2.5
times higher.
 Which industries will export from A to B?



Crackers and DVDs.
Which industries will export from B to A?

Automobiles, banking and education.
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http://stats.bls.gov/news.release/prod4.nr0.htm
28
US trade with Turkey
http://censtats.census.gov/cgi-bin/sitc/sitcCty.pl
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The Importance of Non-Tradables
In theory, every good and service should be
tradable.
 However, to get a haircut in Canada would
cost me quite a bit in terms of transportation
costs.
 Protection also increases the costs of
imports and eliminates some industries from
being imported in spite of cost advantage.

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Empirical Tests

Empirical tests usually show that
productivity differences adjusted for
wages do show what the model
predicts: higher productivity industries
export, lower productivity industries
import.
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A Test of Ricardian Model
• MacDougall, G.D.A., “British and American Exports: A
Study Suggested by the Theory of Comparative Costs,”
Economic Journal, December 1951.
• If productivity in US relative to UK is greater than the
relative wages, then exports of US for that industry must
exceed exports of UK. Wages in the US were, on average,
twice the UK levels.
• 1937 data was used. Tariffs were in force. If both US and
UK face the same barriers from the rest of the world, then
their exports to the rest of the world should reflect their
cost advantages.
• If (Productivity in US)/(Productivity in UK) > (Wages in
US)/(Wages in UK), then (Exports of US)/(Exports of
UK) > 1.
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Labor Productivity and
Comparative Advantage
Output per US worker
Output per UK worker
Tin cans
4
Pig iron
Radios
Motor cars
Machinery
2
Paper
Glass
containers
Beer
Cotton
Woolens and
Worsteds
Clothing Cement
0.05
0.1
CokeHosiery Linoleum
RayonFootwear Cigarettes
cloth
US Exports
UK Exports
0.25
0.5
1.0
2.0 4.0
8.0
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Shortcomings of the
Ricardian Model
•
•
•
•
•
There will be total specialization.
There is no income distribution effects.
There is no role for differences in
resource endowments between
countries.
There is only one resource, labor.
There is no role for economies of
scale.
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