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Ricardian ModelRicardian Model
A lesson in Comparative Advantage
Mercantilism: 17th and 18th CenturyMercantilism: 17th and 18th Century
Trade was considered as a “Zero-Sum Game”
It was viewed a means to accumulate Gold & Silver
• Exports were encouraged
• Imports were discouraged
End of 18th Century: Major Shift in ParadigmEnd of 18th Century: Major Shift in Paradigm
David Hume, 1752, “It is not the quantity of Gold & Silver that a nation holds that matter, rather it is the quality of goods & services that the gold and silver can buy.”
Adam Smith’s Absolute Income Hypothesis, 1776Adam Smith’s Absolute Income Hypothesis, 1776
Trade is not a zero-sum game
Both economies can benefit if each specializes in the product in which it has
absolute advantage.
A country is said to have absolute advantage in the product which can be produced at a lower labor cost compared to its trading partners.
Wine Cheese
England 2 8
Portugal 8 2
Labor Hour RequirementLabor Hour Requirement
Absolute AdvantageAbsolute Advantage
The number in the table shows the amount of labor hours needed to produce each unit of the product in question.
England has absolute advantage in Wine
Portugal has absolute advantage in Cheese
Wine Cheese
England 10 5
Portugal 8 2
Production of Wine and CheeseProduction of Wine and CheeseExample 2:
Who has absolute advantage in Wine?
Who has absolute advantage in Cheese?
Can these countries benefit from trade and specialization?
The number in the table shows the amount of labor hours needed to produce each unit of the product in question.
David Ricardo, 1817: Theory of Comparative AdvantageDavid Ricardo, 1817: Theory of Comparative Advantage
The direction of Trade and Specialization should not be determined on the basis of absolute cost but should depend on comparative cost or opportunity cost.
A country is said to have comparative advantage in the commodity which can be produced in that country at a lower opportunity cost.
Wine Cheese
England 10 5
Portugal 8 2
Production of Wine and CheeseProduction of Wine and CheeseExample 2:
In England, 1 Wine = 2 Cheese
In Portugal, 1 Wine = 4 Cheese & 1 Cheese = ¼ Wine
& 1 Cheese = ½ Wine
2 ch ½ wi
¼ wi4 ch
International Exchange Rate, 1 Wine = 3 Cheese
In Portugal, 1 Wine = ¼ Cheese
The number in the table shows the amount of labor hours needed to produce each unit of the product in question.
Ricardian Model: Formal ExpositionRicardian Model: Formal ExpositionSimplifying Assumptions:
1. Perfect Competition prevails both in the product and factor market.
2. Each Country has a fixed endowment of resources. Resources are internally mobile but
can not move internationally.
3. Fixed technology and only one input (L) needed for the production of the goods in question. Constant Returns to Scale prevails.
4. There is zero transportation cost and product produced are homogeneous.
X Y
Country A 5 10
Country B 8 2
X YCountry A aLX aLY
Country B bLX bLY
In Country A:
In Country B:
The Opportunity cost of X =LY
LX
a
a
The Opportunity cost of X =LY
LX
b
b
5/10 = ½
8/2 = 4
X Y
Country A 5 10
Country B 8 2
X Y
Country A aLX aLY
Country B bLX bLY
Total Supply of Labor in Country A = LA = 60
aLX.X + aLY.Y = LA
The resource Constraint that the country faces is,-
X Y
Country A 5 10
Country B 8 2
X Y
Country A aLX aLY
Country B bLX bLY
Total Supply of Labor in Country A = LA = 60
Given this supply, what is the maximum amount of X country A can produce?
LX
A
a
L12
5
60
LY
A
a
L6
10
60
Y
Country A: Production Possibility Frontier (PPF)Country A: Production Possibility Frontier (PPF)
Y
X1 2 3 4 5 6 7 8
9
1
2
3
45
6
7
8
10
9 10 110
1112
12 13 14 15 16
LA/aLY
LA/aLX
The absolute value of the slope of the PPF:
The equation of the PPF is,- aLX.X + aLY.Y = LA
LY
LX
a
a
X
Y
d
d= Opportunity Cost of X
= Marginal Rate of Transformation (MRT)
Lets now look at the relative price of the two products.
ALX
AX .waP A
LYAY .waP
Under Perfect Competition:
So the relative price of the two products will be
LY
LXA
LY
ALX
AY
AX
a
a
wa
wa
P
P
.
.
The absolute value of the slope of the PPF:
The equation of the PPF is,- aLX.X + aLY.Y = LA
LY
LX
a
a
X
Y
d
d= Opportunity Cost of X
= Marginal Rate of Transformation (MRT)
AY
AX
P
P
Country A: Production & Consumption in AutarkyCountry A: Production & Consumption in Autarky
Y
X1 2 3 4 5 6 7 8
9
1
2
3
45
6
7
8
10
9 10 110
1112
12 13 14 15 16
LA/aLY
LA/aLX
X Y
Country A 5 10
Country B 8 2
X Y
Country A aLX aLY
Country B bLX bLY
Total Supply of Labor in Country B = LB = 16
bLX.X + bLY.Y = LB
The resource Constraint that the country faces is,-
X Y
Country A 5 10
Country B 8 2
X Y
Country A aLX aLY
Country B bLX bLY
Total Supply of Labor in Country B = LB = 16
Given this supply, what is the maximum amount of X country B can produce?
LX
B
b
L2
8
16
LY
B
b
L8
2
16
Y
Country B: Production & Consumption under AutarkyCountry B: Production & Consumption under Autarky
Y
X1 2 3 4 5 6 7 8
9
1
2
3
45
6
7
8
10
9 10 110
1112
12 13 14 15 16
LB/b
LY
LB/bLX
The absolute value of the slope of the PPF:
The equation of the PPF is,- bLX.X + bLY.Y = LB
LY
LX
b
b
X
Y
d
d= Opportunity Cost of X
= Marginal Rate of Transformation (MRT)
BY
BX
P
P
For Country B:
Direction of Trade and Specialization:
If, (aLX/aLY)<(bLX/bLY), as has been shown in our numerical example, then Country A should completely specialize in the production of X.
If the above is true then, by construction it will also be true that, (bLY/bLX)<(aLY/aLX), and Country B should completely specialize in the production of Y.
The international price ratio has to be between the two domestic price ratios. In other words,-
LY
LXBY
BX
ttY
ttX
AY
AX
LY
LX
b
b
P
P
P
P
P
P
a
a
Int Price Ratio
Country A: Free Trade EquilibriumCountry A: Free Trade Equilibrium
Y
X1 2 3 4 5 6 7 8
9
1
2
3
45
6
7
8
10
9 10 110
1112
12 13 14 15 16
LA/aLY
LA/aLX
TradeTriangle
Exports
Imp
ort
s
Country B: Free Trade EquilibriumCountry B: Free Trade Equilibrium
Y
X1 2 3 4 5 6 7 8
9
1
2
3
45
6
7
8
10
9 10 110
1112
12 13 14 15 16
LB/b
LY
LB/bLX
TradeTriangle
Exp
ort
s
Imports
Figure 8a: What Does a Country Gain from Exchange?
Figure 8b: What Does a Country Gain from Exchange and
Specialization?
Figure 8: What Does a Country Gain from Exchange and
Specialization?
Figure 9: Domestic Markets for Goods X and Y in Autarky under Constant Costs
Figure 9a: Domestic Market for Good X in Autarky under Constant
Costs
Figure 9b: Domestic Market for Good Y in Autarky under Constant
Costs
Figure 9c: Domestic Market for Good X in Autarky under Constant
Costs
Figure 9d: Domestic Market for Good Y in Autarky under Constant
Costs
Figure 10: International Markets for Goods X and Y under Constant
Costs
Figure 11: Does Relative Labor Productivity Really Affect Export
Performance?
Table 4: Value-Added per Hour Worked In Manufacturing, 1950-1990 (U.S.=100)
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