Chapter 3
Labor Productivity and Comparative
Advantage: The Ricardian Model
1
1.The Concept of Comparative Advantage
2.A One-Factor Economy
3.Trade in a One-Factor World
4.Misconceptions about Comparative
Advantage
Box: Do Wages Reflect Productivity?
2
5.Comparative Advantage with Many
Goods
6.Adding Transport Costs and Nontraded
Goods
7.Empirical Evidence on the Ricardian
Model
8.Summary
3
Introduction
• Countries engage in international trade for
two basic reasons:
– They are different from each other in terms of
climate, land, capital, labor, and technology.
– They try to achieve scale economies in
production.
Introduction
• The Ricardian model is based on
technological differences across countries.
– These technological differences are reflected
in differences in the productivity of labor.
1.The Concept of Comparative
Advantage
Winter Roses case : trade-off
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The Concept of
Comparative Advantage
• On Valentine’s Day the U.S. demand for roses is
about 10 million roses.
• Growing roses in the U.S. in the winter is difficult.
– Heated greenhouses should be used.
– The costs for energy, capital, and labor are substantial.
• Resources for the production of roses could be
used to produce other goods, say computers.
• So…Should the U.S. produce roses then
anyway?
• Opportunity cost:
The opportunity cost of a good in
terms of other goods is the number of
other goods that could have been
produced with the resources used to
produce a given number of a good.
– OR…
– The particular amounts of each goods
produced are determined by prices.
– The relative price of goods X (cheese) in
terms of goods Y (wine) is the amount of
goods Y (wine) that can be exchanged for one
unit of goods X (cheese).
– Examples of relative prices:
• If a price of a can of Coke is $0.5, then the
relative price of Coke is the amount of $ that
can be exchanged for one unit of Coke, which
is 0.5.
• The relative price of a $ in terms of Coke is 2
cans of Coke per dollar.
The Concept of
Comparative Advantage
• Suppose that in the U.S. 10 million roses can be
produced with the same resources as 100,000
computers.
• Suppose also that in South America 10 million
roses can be produced with the same resources
as 30,000 computers.
• This example assumes that South American
workers are less productive than U.S. workers.
The Concept of
Comparative Advantage
• If each country specializes in the production of
the goods with lower opportunity costs, trade
can be beneficial for both countries.
– Roses have lower opportunity costs in South America.
– Computers have lower opportunity costs in the U.S.
• The benefits from trade can be seen by
considering the changes in production of roses
and computers in both countries.
1.The Concept of Comparative
Advantage
• Production (GDP) Welfare
• Table 3-1
Hypothetical Changes in Production
Million Roses Thousand Computers
United States -10
+100
South America +10
-30
Total
0
+70
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1.The Concept of Comparative
Advantage
• Comparative Advantage:
A country has a Comparative Advantage in
producing a good if the opportunity cost of
producing that good in terms of other
goods is lower in that country than it is in
other countries.
• U.S.- computer
• Mexico - roses
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• The example in Table 2-1 illustrates the
principle of comparative advantage:
– If each country exports the goods in which it has
comparative advantage (lower opportunity costs),
then all countries can in principle gain from trade.
• What determines comparative advantage?
– Answering this question would help us understand
how country differences determine the pattern of trade
(which goods a country exports).
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• What happens in the real world?
• Model explnains. (simple ----> complex)
2.A One-Factor Economy
(1).Production Possibilities
(2).Relative Prices and Supply
RETURN
17
• Imagine an economy (Home)
*produce two goods: Wine and
Cheese
*one factor of production: labor
unit labor requirement: aLW, aLC
* total labor supply: L
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RETURN
A One-Factor Economy
• The technology of Home’s economy can be
summarized by labor productivity in each
industry, expressed in terms of unit labor
requirements:
– The unit labor requirement is the number of hours of
labor required to produce one unit of output.
• Denote with aLW the unit labor requirement for wine (e.g. if
aLW = 2, then one needs 2 hours of labor to produce one
gallon of wine).
• Denote with aLC the unit labor requirement for cheese (e.g. if
aLC = 1, then one needs 1 hour of labor to produce a pound of
cheese).
• Here the economy’s total resources are
defined as L, the total labor supply (e.g. if
L = 120, then this economy is endowed
with 120 hours of labor or 120 workers).
(1).Production Possibilities
• Resources & tech limitations exist (sacrifice or
trade-off required)
• Production possibility frontier (PPF)
– The production possibility frontier (PPF) of
an economy shows the maximum amount of a
goods (say wine) that can be produced for
any given amount of another (say cheese),
and vice versa. Or illustrates the different
mixes of goods the economy can produce.
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• The PPF of our economy is given by the
following equation:
• The total production are defined by
the inequality
aLCQC+ aLWQW < L
(2-1)
– From our previous example,
– aLC = 1
– aLW = 2,
we get:
QC + 2QW = 120
Figure 3-1 Home’s Production
possibility frontier
Home wine
production, QW,
in gallons
Absolute value of slope
equals opportunity cost of
cheese in terms of wine
L/aLW
PPF
L/aLC
RETURN
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Home cheese
production, QC,
in pounds
•
•
•
•
•
For straight line – costant opportunity cost
1 gallon of wine –aLW housrs required
1 pond of cheese - aLc housrs required
So…
aLW housrs ---> aLW /aLc pond of cheese
(absolute of slope)
• Here “hour” means “person-hour”
• Opportunity Cost – How many goods could
be produced?
• But how many to produce respectively?
• （Relative）Price ——— Production
(2).Relative Prices and Supply
• P=w or profit=0 (market stucture)
• Relative price: the price of one good in
terms of the other.
define: PC—the price of cheese
PW—the price of wine
then the hourly wage rate
in cheese sector will be PC/aLC
in wine sector will be PW/aLW
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• Supply decisions, wage & labor movement.
• If PC/PW>aLC/aLW
the economy will specialize in the
production of cheese;
If PC/PW<aLC/aLW
the economy will specialize in the
production of wine.
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• Opportunity Cost…
• Wine:
aLW /aLc
• Cheese: aLc /aLw
• So…
• The economy will specialize in the
production of cheese if the relative price of
cheese exceeds its opportunity cost; vice
versa.
• A country will produce both goods only when…
• Labor theory of value:
In the absence of international
trade, the relative prices of goods
are equal to their relative unite
labor requirement.
RETURN
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3.Trade in a One-Factor World
(1).Determining the Relative Price After
Trade
(2).The Gains from Trade
(3).A Numerical Example
(4).Relative Wages
RETURN
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• Assumptions of the model:
– There are two countries in the world (Home
and Foreign).
– Each of the two countries produces two goods
(say wine and cheese).
– Labor is the only factor of production.
– The supply of labor is fixed in each country.
– The productivity of labor in each goods is
fixed.
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– Labor is not mobile across the two countries.
– Perfect competition prevails in all markets.
– All variables with an asterisk refer to the
Foreign country. (two countries) eg.aLC <
a*LC and aLW < a*LW
• Absolute of slope: Absolute Advantage
• eg. aLC < a*LC
• Comparative Advantage
• Less opportunity cost-----higher productivity
– Assume that aLC /aLW < a*LC /a*LW
(3-2)
or equivivalently, that aLC / a*LC < aLW /a*LW
(3-3)
• This assumption implies that the opportunity cost
of cheese in terms of wine is lower in Home than it
is in Foreign.
• In other words, in the absence of trade, the relative
price of cheese at Home is lower than the relative
price of cheese at Foreign.
• Home has a comparative advantage in cheese
and will export it to Foreign in exchange for wine
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• Absolute Advantage
– A country has an absolute advantage in a production
of a goods if it has a lower unit labor requirement than
the foreign country in this goods.
– Assume that aLC < a*LC and aLW < a*LW
• This assumption implies that Home has an
absolute advantage in the production of both
goods. Another way to see this is to notice that
Home is more productive in the production of both
goods than Foreign.
• Even if Home has an absolute advantage in both
goods, beneficial trade is possible.
• The pattern of trade will be determined by the
concept of comparative advantage.
Questions:
1.When a country has a comparative
advantage in a good, must it also have an
absolute advantage in that good? Why or
why not?
2.When a country has an absolute
advantage in a good, must it also have a
comparative advantage in that good? Why
or why not?
RETURN
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• The above relations imply that if the relative
price of cheese (PC / PW ) exceeds its
opportunity cost (aLC / aLW), then the economy
will specialize in the production of cheese.Or
PC/aLC>PW/aLW.
• In the absence of trade, both goods are
produced, and therefore PC / PW = aLC /aLW.
• Suppose: two countries
Home: L, aLC, aLW
Foreign: L*, aLC*, aLW*
Assumption: aLC/aLW <aLC*/aLW* (2-2)
or aLC/ aLC*<aLW/ aLW* (2-3)
that is, Home has a comparative
advantage in cheese.
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Figure 3-2 Foreign’s Production
possibility frontier
Foreign wine
production, QW*,
in gallons
L*/aLW*
PF*
L*/aLC*
RETURN
39
Foreign cheese
production, QC*,
in pounds
• Partial & general equilibrium
• Determining the Relative Price After Trade
– What determines the relative price (e.g., PC / PW)
after trade?
• To answer this question we have to define the
relative supply and relative demand for cheese in the
world as a whole.
• The relative supply of cheese equals the total
quantity of cheese supplied by both countries at each
given relative price divided by the total quantity of
wine supplied, (QC + Q*C )/(QW + Q*W).
• The relative demand of cheese in the world is a
similar concept.
• RS-relative supply curve
• RD-relative demand curve
• World general equi. price - intersection
• RD-downward slope (substitution effect)
• RS- a “step” with flat sections linked by a
vertical section
(1).Determining the Relative
Price After Trade
Figure 3-3 World Relative Supply and Demand
PC/PW
aLC*/aLW*
RS
1
aLC/aLW
RD″
2
RD
RD′
Q′ L/aLC
L*/aLw*
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QC+QC*
Qw+Qw*
• First,the RS curve shows that there is no supply
of cheese if the world price drops below aLC/aLW.
-Assume aLC/aLW<a*LC/a*LW, Home will
specialize in the production of cheese.
-Home will specialize in the production of wine
whenever PC/PW<aLC/aLW.(P=W)
-Similarly,Foreign will specialize in wine
production whenever PC/PW<a*LC/a*LW.
• Second,when the relative price of cheese,
PC/PW=aLC/aLW, Home workers are indifferent
between producing cheese and wine. We have
a flat section of the supply curve.
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• Third, for PC/PW>a*LC/a*LW, both Home and
Foreign will specialize in cheese production.
There will be no wine production, so that the
relative supply of cheese will become infinite.
• Fourth, At PC/PW=a*LC/a*LW, Foreign workers
are indifferent between producing cheese and
wine. We again have a flat section of the
supply curve.
• Fifth, aLC/aLW< PC/PW< a*LC/a*LW, the relative
supply of cheese is (L/aLC)/(L*/a*LW).
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• The outcome with specalization – price
converge inbetween pre-trade levels.
• Another effect: PPF.
Figure 3-4 Trade Expands
Consumption Possibilities
QW *
QW
F*
T
P
F
P*
T*
QC*
QC
(b) Foreign
(a) Home
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(2).The Gains from Trade
Specialization
Indirect method of
production (as long
as:
(1/aLC)(PC/PW)>1/aLW
Or PC/PW>aLC/aLW )
Change the
possibilities for
consumption
(figure 2-4)
RETURN
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• The Gains from Trade
– If countries specialize according to their
comparative advantage, they all gain from this
specialization and trade.
– We will demonstrate these gains from trade in
two ways.
– First, we can think of trade as a new way of
producing goods and services (that is, a new
technology).
– Another way to see the gains from trade is to
consider how trade affects the consumption in
each of the two countries.
– The consumption possibility frontier states the
maximum amount of consumption of a goods
a country can obtain for any given amount of
the other commodity.
– In the absence of trade, the consumption
possibility curve is the same as the production
possibility curve.
– Trade enlarges the consumption possibility for
each of the two countries.
(3).A Numerical Example
Table 3-2 Unite Labor Requirements
Home
Cheese
Wine
aLC=1 hour per pound
aLW=2 hours per gallon
Foreign aLC*=6 hours per pound aLW*=3 hours per gallon
Assumption: world equi. price=1
• aLC /aLW = 1/2 < a*LC /a*LW = 2
50
RETURN
• Questions:
• To specialize and trade, or to produce
directly?
• What are the gains?
(4).Relative Wages
• Relative wages are the wages of the
domestic country relative to the wages in the
foreign country.
• Productivity (technological) differences
determine wage differences in the Ricardian
model.
--A country with absolute advantage in producing a
good will enjoy a higher wage in that industry after
trade.
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A Numeral Example
• Suppose that PC = $12/kg and PW = $12/gallon
• Since domestic workers specialize in cheese
production after trade, their hourly wages will be
(1/aLC)PC = (1/1)$12 = $12
• Since foreign workers specialize in wine
production after trade, their hourly wages will be
(1/a*LW)PW = (1/3)$12 = $4
• The relative wage of domestic workers is
therefore
$12/$4 = 3
• The relative wage lies between the ratio of
the productivities in each industry.
• These relationships imply that both
countries have a cost advantage in
production.
– The cost of high wages can be offset by high
productivity.
– The cost of low productivity can be offset by
low wages.
• In this case…
• Foreign has a cost advantage in wine.
(lower productivity though)
• Home has a cost advantage in
cheese.(higher wage though)
4.Misconceptions about
Comparative Advantage
(1).Productivity and Competitiveness
(2).The Pauper Labor Argument
(3).Exploitation
RETURN
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(1).Productivity and
Competitiveness
Myth 1: Free trade is beneficial only
if your country is strong enough to
stand up to foreign competition
relative productivity
relative wage rate
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(2).The Pauper Labor Argument
Myth 2: Foreign competition is unfair
and hurts other countries when it
is based on low wages.
The Pauper Labor Argument
RETURN
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(3).Exploitation
Myth 3: Trade exploits a country and
makes it worse off if its workers
receive much lower wages than
workers in other nations.
RETURN
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