trade_ch2

TRADE AND 1

2

TRADE AND

TECHNOLOGY: THE

RICARDIAN MODEL

1Ricardian Model

2Determining the

Pattern of International Trade

3Solving for

International Prices4

Conclusions

Chapter Outline

• Reasons for Trade� Absolute Advantage

� Comparative Advantage

• Ricardian Model� The Home Country

� The Foreign Country

2 of 87© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

• Determining the Pattern of International Trade� International Trade Equilibrium

� Solving for Wages Across Countries

• Solving for International Prices� Home Export Supply Curve

� Foreign Import Demand Curve

� International Trade Equilibrium

Learning Objectives

• Distinguish between absolute and comparative advantage

• Understand the Ricardian model

• Understand the no-trade equilibrium using each country’s PPF and Indifference Curve

• Understand the trade equilibrium

� how the pattern of international trade is determined


� how the pattern of international trade is determined

� how to solve for prices and wages across countries

� how to derive the export supply curve and the import demand curve

� Understand the international trade equilibrium

� Understand how to determine a country’s terms of trade and how they affect that country

Introduction

• We focus on how technology differences across countries affect trade.

• This is referred to as the Ricardian model because it was 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.

Comparative advantage

• When a country has the best technology for producing a good, it has an absolute advantage in the production of that good.� Absolute advantage is actually not a good explanation

for trade patterns.

• Comparative advantage is the primary


• Comparative advantage is the primary explanation for trade among countries.� A country has a comparative advantage in producing

those goods that it produces best compared with how well it produces other goods.

� Comparative advantage = what a country produces a good compared with how well it produces other goods

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


• Home will be the country exporting wheat and importing cloth.

Ricardian Model

• The Home Country

� We will assume that labor is the only resource used to produce both goods.

� One worker can produce 4 bushels of wheat or 2 yards of cloth.

� The Marginal Product of Labor is the extra output


� The Marginal Product of Labor is the extra output obtained by using one more unit of labor.

� MPLW = 4 and MPLC = 2.

Ricardian Model

• Home Production Possibilities Frontier

� We can use the marginal products of labor to construct Home’s PPF.

� Assume there are 25 workers in Home.

� If all the workers were employed in wheat, the country could produce 100 bushels.


could produce 100 bushels.

� If they were all employed in cloth they could produce 50 yards.

� The PPF connects these two points.

Ricardian Model

• Showing these calculations we can see:� 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.


feature of the Ricardian model.� It assumes the marginal products of labor are constant.

� There are no diminishing returns because the model ignores the use of other resources.

Ricardian Model

• The slope of the PPF can be calculated as the ratio of marginal products of the two goods.

• 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.

)(50 LMPL


2

1

)(

)(

100

50

−=−=

=−=

W

C

W

C

MPL

MPL

LMPL

LMPLSlopePPF

Ricardian Model

Figure 2.1


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


� An indifference curve shows the combinations of two goods that the country can consume and be equally satisfied.

Ricardian Model

• All points on an indifference curve have the same level of utility.

• Points on higher indifference curves have higher utility.

• Indifference curves are often used to show the


• Indifference curves are often used to show the preferences of an individual.

• But we use indifference curves to show the preferences of an entire country.

Ricardian Model

The country is indifferent between A and B

The country is better off on U2 but cannot produce that much

U0<U1<U2

Figure 2.2


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.


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.

Ricardian Model

• Home Equilibrium

� Point A is the no-trade equilibrium.

� The country can reach point A its own production.

� The assumption of perfect competition will assure the country ends up at the highest level of utility possible.


Ricardian Model

The country could produce at point D but would be at a higher level of utility at point A.

At point A, on U1, is the best the country can do

Figure 2.2


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.


� Price reflects the opportunity cost of a good.

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.

� The value of one more hour of labor equals the amount of goods produced in that hour (MPL) times the price of the good.


goods produced in that hour (MPL) times the price of the good.

� Labor hired up to the point where wage equals P*MPL for each industry.

� In competitive markets, labor can move freely between industries.

� Labor will move to the higher paid industry.

� This will continue until there is equalization of wages between industries.

Ricardian Model

� The equalization of wages will give us the following:� The right hand side is the slope of the PPF and the opportunity

cost of obtaining one more bushel of wheat.

� The left hand side is the relative price of wheat.

W W C CP MPL P MPL⋅ = ⋅


W W C C

W C

C W

P MPL P MPL

P MPL

P MPL

⋅ = ⋅

=

Ricardian Model

• The price ratio, PW/PC, always denotes the relative price of the good in the numerator, measured in terms of how much of the good in the denominator must be given up.

• The slope of the PPF equals the relative price of


wheat, the good on the horizontal axis.

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.


Ricardian Model

• The Foreign Country

� 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.


� Assume there are 100 workers available in Foreign.

� If all workers were employed in wheat they could produce 100 bushels.

� If all workers were employed in cloth they could produce 100 yards.

Ricardian Model

Figure 2.3


Ricardian Model

• Comparative Advantage

� Given the information we have gathered, we can begin to talk about the opportunity cost of production of each good in each country.

� Given the opportunity cost information, we can determine comparative advantages in each country for


determine comparative advantages in each country for each good.

Ricardian Model

Opportunity Costs for Goods in Home and Foreign

Cloth

(1 Yard)

Wheat

(1 Bushel)


(1 Yard) (1 Bushel)

Home 2 Bushels

of Wheat

½ Yard

of Cloth

Foreign 1 Bushel

of Wheat

1 Yard

of Cloth

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.


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.

Ricardian Model

• Equilibrium in Foreign

� Foreign’s preferences can also be represented by an indifference curve.

� Its economy produces at the point of highest utility for the country within the PPF constraint.

� The slope of the PPF is the opportunity cost of


� The slope of the PPF is the opportunity cost of wheat.

� 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.

Ricardian Model—Foreign

Figure 2.4


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.


• 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.


than $1.

� The opposite is true for wheat.

� Home will export wheat and Foreign will export cloth.

� Both countries export the good for which they have the comparative advantage.


• 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.


� The price of wheat in Foreign falls.

� As Foreign exports cloth, the quantity sold in Foreign falls, and the price in Foreign for cloth rises.

� The price of cloth at Home falls.



� 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.



� The relative price of wheat in the trade equilibrium will be between the no-trade price in the two countries.

� For now we will assume the free-trade price of PW/PC is 2/3. This is between the price of ½ in Home and 1 in Foreign.


Foreign.

� We can now take this price and see how trade changes production and consumption in each country.


• Change in Production and Consumption

� Home producers of wheat can earn more than the opportunity cost of wheat by selling it to Foreign.

� Home will therefore shift labor resources toward the production of wheat and increase its production.

� Remember wages are calculated by the price of the


� Remember wages are calculated by the price of the good times its marginal product.

� Given the information from before, we can calculate the ratio of wages in the two industries.


2 4 81

3 2 6

W W

C C

W W C C

P MPL

P MPL

Therefore

P MPL P MPL

= = >

>


• 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.

W W C C

Wages in wheat Wages in cloth>


• 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


� 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.


Cloth, QC (yards)

50

• The new world price, PW/PC = 2/3, shows us the new range of consumption possibilities

• The country can now achieve a higher utility with the new consumption possibilities


U2

World price line, Slope = –2/3

U1

A

50 100 Wheat, QW (bushels)

B

Home production

25


Home consumption

Cloth, QC (yards)

50

Home produces 100 bushels but consumes only 40, so exports equal 60

Home produces 0 yards of cloth but consumes 40, so imports equal 40.

Figure 2.5


Home imports 40 yards of cloth

Home exports 60 bushels of wheat

A

B

Home production

25

C40 World price line, Slope = –2/3U2

U1

50 100 Wheat, QW (bushels)100 5040


• 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.


� 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.

� Home exports 60 bushels of wheat; multiplying this by the price of wheat in terms of cloth, 2/3, gives 40. This equals the amount of cloth that is imported.


equals the amount of cloth that is imported.

� Now consider Foreign. Conditions there are shown in

figure 2-6.


Figure 2.6




� 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.


� 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.



� 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.


converge.

� They are determined by absolute advantage, not comparative advantage.


• 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.


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.


• 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


� 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.


• 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


at a price others are willing to pay is by having low wages.

• As a country develops better technology, its wages will rise.� Workers become better off through receiving higher

wages.

� As countries engage in trade, the Ricardian model predicts that their real wages will rise.

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.


• 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.


• Home Export Supply Curve

� We can use the information we gathered from before to derive an 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 X-axis.


axis.

� We saw before a relative price of 2/3 related to exports of 60 bushels.� The first point on the export supply curve: the horizontal

distance from point B to C in figure 2-9(a) and point C’ in figure 2-9(b).


• To derive other points on the export supply curve we look at the no-trade equilibrium.

� When the relative price of wheat is ½, Home exports of wheat are zero (no-trade equilibrium). � Point A and A’ in figure 2.9

� For the 3rd point, we keep the relative price of wheat at


� For the 3rd point, we keep the relative price of wheat at ½.� At this price, Home could export some wheat in exchange for

cloth.

� Production could shift from A to any other place on the PPF.

• Workers are willing to shift between industries as the wages are the same.


• If we assume that all workers have moved into wheat production.

• With the relative price of ½, consumption is still at point A and the difference between A and B is the amount of wheat that Home is exporting.


� At the relative price of ½, with wheat exports of 50, gives another point on the Home export supply curve: B’.



Figure 2.9


• 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.

� This leads to all the export levels between A’ and B’.


� This leads to all the export levels between A’ and B’.

� At prices above ½, production is the same but consumption changes, rising above point A.


• 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


� 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.



Figure 2.10



� 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


� 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.

Figure 2.11




• 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.


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.

Conclusions

• The Ricardian model was devised to respond to the mercantilist idea that exports are good and imports are bad.

• David Ricardo found this was not true and considered an example where trade between two


countries was balanced.

• The pattern of trade is determined by comparative advantage, and both countries gain from trade.

• The Ricardian model is presented with only one factor of production—labor.

Conclusions

• Because wages depend on the marginal products of labor in each country, we conclude that wages are determined by absolute advantage.

� Country with better technology will be able to pay higher wages.

• In addition, wages depend on the prices prevailing


• In addition, wages depend on the prices prevailing on world markets for the goods exported by each country.

• The terms of trade is the price of a country’s exports divided by the price of its imports.

Conclusions

• Because we assume that labor is the only resource, the PPF in the Ricardian model is a straight line.

� This leads to the export supply and import demand curves each have a flat segment.

• The gains from trade become much more


• The gains from trade become much more complicated when we allow for more realistic assumptions using several factors of production.

� We will discuss this in future chapters.

Key Points

1. A country has comparative advantage in producing a good when the opportunity cost of producing the goods is lower than the opportunity cost of producing the good in another country.


2. The pattern of trade between countries is determined by comparative advantage.

3. All countries experience gains from trade.

Key Points

4. The level of wages in each country is determined by its absolute advantage, that is, by the amount the country can produce with its labor.

5. The equilibrium price of a good on the world market is determined where the export supply of one country equals the import demand of the


one country equals the import demand of the other country.

6. A country’s terms of trade, the price of its export good divided by the price of its import good, affect how well off a country is from trade.

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trade_ch2