EC336 International Trade

Professor Natalie Chen

Labour Productivity and Comparative

Advantage:
The Ricardian Model

1
The Ricardian model
 Organisation
 Introduction
 The concept of comparative advantage
 Ricardian trade
 Misconceptions about comparative advantage
 Empirical evidence on the Ricardian model
 Summary
 Reading: Krugman, Obstfeld and Melitz, chapter 3
 Modern and formal treatment of the Ricardian model:
Jonathan Eaton and Samuel Kortum (2002), “Technology,
Geography, and Trade” Econometrica 70(5), pp. 1741-1779.
A more accessible version (available on the EC336 website):
Eaton and Kortum (2012), “Putting Ricardo to Work”
Journal of Economic Perspectives 26(2), pp. 65-90.
EC336 The Ricardian model Slide 2
 Introduction
 Why do countries engage in international trade?
There are two basic reasons:
• #1: Countries are different from each other in terms of
climate, land, capital, labour, and technology
(“neoclassical” trade theory).
• #2: Countries try to achieve scale economies in
production (“new” trade theory).
 The Ricardian model is based on technological
differences across countries (i.e., part of #1).
• Differences are reflected in the productivity of
labour.
EC336 The Ricardian model Slide 3
 Introduction

 Key concept: Comparative advantage

 This concept provides one of the most important
insights in economics.
 Unfortunately, it is often misunderstood and
misrepresented in the public debate/media.
 Learning goal: Understand comparative advantage
and refute common fallacies about international trade.

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 The Concept of Comparative Advantage

 Valentine’s Day!

 Suppose U.S. demand for roses is about 10 million roses.

 Growing roses in the U.S. in the winter is difficult.

• Heated greenhouses must be used.
• The costs for energy, capital, and labour are substantial.

 Resources for the production of roses could be used to produce

other goods, say computers.

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 Opportunity Cost and Comparative Advantage
 The opportunity cost of roses in terms of computers is the number of
computers that could be produced with the same resources as a given
number of roses.
• Example: The U.S. can produce 100,000 computers with the same
resources used to produce 10,000,000 roses.
• Mexico can produce 30,000 computers with the same resources used to
produce 10,000,000 roses.
• Therefore, the opportunity cost of producing 10,000,000 roses is
100,000 computers for the U.S. and 30,000 computers for Mexico.
 Comparative Advantage
• A country is said to have 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.
•
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This is different from an absolute advantage (see below).
The Ricardian model Slide 6
 Specialisation and Trade

 If each country specialises in the production of the

good with lower opportunity costs, trade can be
beneficial for both countries.

• Roses have lower opportunity costs in Mexico.

• 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.

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 The Concept of Comparative Advantage
Hypothetical changes in production (assuming the U.S. stops producing
roses and shifts into producing computers and Mexico stops producing
computers and shifts into producing roses)

Mexico

• Will production actually shift? That is determined in the marketplace.

Caveat: The model is simplifying. For example, there might be
substantial costs in switching production from one good to the other.
We will abstract from such costs for now.

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 The Concept of Comparative Advantage

 The previous example illustrates the principle of

comparative advantage:
• If each country exports the goods in which it has a
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 (i.e.,
which country exports which goods).

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 The Ricardian Model
 Published in 1817 by David Ricardo (1772-1823), British political
economist. One of the most important classical economists along
with Thomas Malthus and Adam Smith. Also rich businessman.
 The model’s assumptions (important):
• There are two countries in the world (Home and Foreign).
• Only two goods (say, wine and cloth) are produced.
• Labour is the only factor of production.
• Labour is not mobile across countries, but mobile across sectors.
• The supply of labour is fixed in each country.
• The productivity of labour in each good is fixed.
• Perfect competition prevails in all markets.
Notation: All variables with an asterisk refer to the Foreign country.
EC336 The Ricardian model Slide 10
 A Numerical Example

 Home labour supply is fixed at L = 120 hours of labour or

120 workers.
 The constant labour productivity is modelled with the
specification of unit labour requirements:
• The unit labour requirement is the number of hours of
labour required to produce one unit of output. For Home:
– Denote with aLW ( = 1) the unit labour requirement for wine
(one needs 1 hour of labour to produce one gallon of wine).
– Denote with aLC ( = 3) the unit labour requirement for cloth.
(one needs 3 hours of labour to produce one kg of cloth).

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 Production Possibility Frontier
 The production possibility frontier (PPF) of an
economy shows the maximum amount of a good (say,
wine) that can be produced for any given amount of
another (say cloth), and vice versa.
• The PPF of our economy is given by the following
equation:
aLCQC + aLWQW = L
• In our example, the PPF is:
3QC + QW = 120

EC336 The Ricardian model Slide 12

 Home’s Production Possibility Frontier

QW

Absolute value of PPF slope equals the

120 = L/aLW opportunity cost of cloth in terms of wine:
a LC / aLW = 3

3QC + QW = 120
QC
40 = L/aLC

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 Relative Prices
 The particular amounts of each good produced are
determined by prices.
 The relative price of good X (cloth) in terms of good Y
(wine) is the amount of good Y that can be exchanged
for one unit of good X.
 Examples of relative prices:
• If a price of a can of Coke is £1 and the price of a box of
chocolates is £2, the relative price of Coke is the
amount of chocolates that can be exchanged for one unit
of Coke, which is 1/2 = PCoke/Pchocolates.
• The relative price of a box of chocolates is 2 =
Pchocolates/PCoke, i.e., we can get 2 cans of Coke in
exchange for a box of chocolate.
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 Perfect Competition

 Let PC be the price of cloth and PW the price of wine.

Denote with wW the wage in the wine industry and with
wC the wage in the cloth industry. Since labour is mobile
across industries, it follows wW= wC= w.
 Then under perfect competition, the non-negative
profit condition implies (price equals marginal cost):
• If PW < aLW wW, then there is no wine production.
• If PW = aLW wW, then there is wine production.
• If PC < aLC wC, then there is no cloth production.
• If PC = aLC wC, then there is cloth production.
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 Relative Prices and Trade

 In the absence of trade, both goods are produced and

therefore PC / PW = aLC /aLW. Why?

 The previous relations imply that if the relative price of

cloth (PC / PW ) exceeds its opportunity cost (aLC / aLW),
then the economy will specialise in the production of
cloth.

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 Ricardian Trade
 A country has an absolute advantage in the production of a
good if it has a lower unit labour requirement than the other
country in this good.
• Assume that aLC < a*LC and aLW < a*LW
– i.e., Home has an absolute advantage in the production of both
goods. Another way to see this is that Home workers need
fewer hours than Foreign workers to produce each good.
– Even if Home has an absolute advantage in both goods,
beneficial trade is possible.
 But the pattern of trade will be determined by comparative
advantage, not by absolute advantage.
EC336 The Ricardian model Slide 17
 Example
Home Foreign

Wine unit labour requirement aLW=1 a*LW =2

Cloth unit labour requirement aLC =3 a*LC =10
Labour endowment L = 120 L* =100

 Home has an absolute advantage both for wine and for cloth because
aLC < a*LC and aLW < a*LW

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 Production Possibility Frontiers
Foreign PPF Home PPF

Q*W QW

120 = L/aLW

50 = L*/a*LW

10 = L*/a*LC Q*C 40 = L/aLC QC

Note that aLC/aLW = 3 and a*LC /a*LW = 5, i.e., the opportunity cost
of cloth in terms of wine is lower in Home.
EC336 The Ricardian model Slide 19
 Comparative Advantage and Trade

 This example shows that in the absence of trade, the relative

price of cloth is lower in Home than in Foreign:
PC / PW = aLC /aLW = 3 in Home
P*C / P*W = a*LC /a*LW = 5 in Foreign
 Therefore, Home has a comparative advantage in cloth and will
export it to Foreign in exchange of wine.
• Note that in the absence of trade both countries have domestic
prices, whereas after trade there should be one common free-trade
price.

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 The Relative Price after Trade
 What determines the relative price (PC / PW) after trade?
• We have to define the relative supply and relative demand
for cloth in the world as a whole.
• The relative supply of cloth equals the total quantity of
cloth 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 cloth in the world follows a
similar concept.
• The relative price after trade should typically lie between
the relative prices of each country before trade.

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 World Relative Supply and Demand

Relative price
of cloth, PC/PW

5 = a*LC/a*LW RS

RD
2
3 = aLC/aLW

RD'

Q' L/aLC Relative quantity

L*/a*LW of cloth, QC + Q*C
Q W + Q *W
EC336 The Ricardian model Slide 22
 World Relative Supply and Demand

 At point 1, the RD curve intersects the RS curve. The relative price of cloth
is between the two countries’ pre-trade prices. In this case, each country
specialises in the production of the good in which it has a comparative
advantage (Home produces only cloth, Foreign produces only wine).
 Another possible outcome is point 2. In that case the relative price of cloth
is equal to its opportunity cost in Home. Home does not need to specialise.
 At point 2, Home actually produces both cloth and wine because the
amount Q’ is less than it would be if Home were completely specialised in
cloth production. But Foreign specialises in wine production.
 Thus: if a country does specialise, it specialises in the good in which it has
a comparative advantage.
 One-line summary: “Do what you do best and trade for the rest.”

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 The Gains from Trade

 If countries specialise (i.e., produce only one of the two

goods) according to their comparative advantage, they all
gain from this specialisation by engaging in mutual 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, trade can be interpreted as a
new production technology because it allows you to
purchase goods that are produced more efficiently.

EC336 The Ricardian model Slide 24

 Numerical Example
 Suppose that the world relative price of cloth is PC/PW = 4 (determined
by exogenous relative demand).
 Without trade, Home can use 1 hour of labour to produce 1 gallon of
wine. Can it do better by specialising in cloth and trading cloth with
Foreign for wine?
 With trade, Home can use 1 hour labour to produce 1/3 kg of cloth,
sell this to Foreign and obtain
(1/3)x(4) = 4/3 gallons of wine!
 Without trade, Foreign can use 1 hour of labour to produce 1/10 kg of
cloth.
 With trade, Foreign can use 1 hour of labour to produce 1/2 gallons of
wine, sell this to Home and obtain
(1/2)x(1/4) = 1/8 kg of cloth!
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 Gains From Trade

• 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 good that a country can
obtain for any given amount of the other commodity.
• In the absence of trade, the consumption possibility
frontier is the same as the production possibility frontier.
• Trade enlarges the consumption possibility frontier for
each of the two countries.

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 A Numerical Example
 Suppose PC/PW = 4. The following table describes
the technology of the two countries (same table as
before):

Home Foreign

Wine unit labour requirement aLW=1 a*LW =2

Cloth unit labour requirement aLC =3 a*LC =10

Labour endowment L = 120 L* =100

EC336 The Ricardian model Slide 27

 Gains from Trade
Foreign PPF Home PPF

Q*W QW
160

120 = L/aLW

50 = L*/a*LW

10 = L*/a*LC 12.5 Q*C 40 = L/aLC QC

Red: Consumption possibility frontier with trade

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 Relative Wages
 Because of the technological differences between the two countries,
trade in goods does not make the wages equal across the two
countries.
 A country with an absolute advantage in both goods will enjoy a
higher wage. A numerical example:
• Assume that PC = £24 and that PW = £6 such that PC / PW = 4 as in
our previous example.
• Since Home specialises in cloth after trade, its wage will be
(1/aLC)PC = (1/3)£24 = £8.
• Since Foreign specialises in wine after trade, its wage will be
(1/a*LW) PW = (1/2)£6 = £3.
• Therefore, the relative wage of Home will be 8/3>1.
• Thus, the country with the higher absolute advantage will enjoy a
higher wage after trade.
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 Comparative Advantage Is More
Powerful Than You Think
 Specialization and trade also apply to you and your
personal life.
 Douglas Irwin (“Free Trade Under Fire”, Princeton
University Press 2009, chapter 2):
 “The traditional case for free trade is based on the
gains from specialization and exchange. These gains
are easily understood at the level of the individual.
Most people do not produce for themselves even a
fraction of the goods they consume.”

EC336 The Ricardian model Slide 30

  “Rather, we earn an income by specializing in certain
activities and then using our earnings to purchase
various goods and services – food, clothing, housing,
health care – produced by others. In essence, we
‘export’ the goods and services that we produce with
our own labor and ‘import’ the goods and services
produced by others that we wish to consume. This
division of labor enables us to increase our
consumption beyond that which would be possible if
we tried to be self-sufficient and produce everything
for ourselves.”
EC336 The Ricardian model Slide 31
Digression: Is growing your own food good for the
environment? “Math lessons for locavores”

 Most people buy their food from the supermarket or

some other store. You can interpret this is a trade
(even if the transaction is purely domestic and not
international – the same theory applies).
 Instead, we could possibly grow some of it ourselves
in our gardens, as encouraged by the local food
movement. Is this a good idea (leaving aside issues of
food quality, taste, leisure preferences etc.)?
 An economic argument would have to assess the role
of transportation costs – and comparative advantage!
EC336 The Ricardian model Slide 32
  Although this might be counterintuitive, it is not clear
whether growing your own food is good for the
environment.
 See “Math lessons for locavores” by Stephen
Budiansky, New York Times, August 19, 2010,
available here:
[Link]
[Link]?_r=1

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 Misconceptions about
Comparative Advantage
 Productivity and Competitiveness
• Myth 1: Free trade is beneficial only if a country is strong enough
to withstand foreign competition.
– This is probably the most common misconception.
– This argument fails to recognise that trade is based on comparative
advantage, not on absolute advantage.
– In our example Home has an absolute advantage in both goods. This
implies that Foreign has an absolute disadvantage in both goods, but
Foreign still gains from trade (and so does Home).
– Possible reason for misconception: People tend to think of the world as
a one-good scenario, for example: “If A is better than B at making
cloth, then B will not be able to compete.” In that world, absolute
advantage would indeed be crucial. However, there are two goods in
the Ricardian model (cloth and wine) so that comparative advantage
becomes crucial. [The comparative advantage logic extends to a world
EC336
with multiple goods.] The Ricardian model Slide 34
 Misconceptions about
Comparative Advantage
 The Pauper Labour Argument
• Myth 2: Foreign competition is unfair and hurts rich
countries when it is based on low wages in foreign
countries.
– This is a favourite argument of trade unions seeking
protection from foreign competition. They fear that
foreign imports will impoverish domestic workers by
lowering their purchasing power.
– In our example Foreign has lower wages but Home still
benefits from trade. The purchasing power of Home
workers is increased by trade.

EC336 The Ricardian model Slide 35

 Misconceptions about
Comparative Advantage
 Exploitation
• Myth 3: Trade exploits a poor country and makes its
workers worse off if they receive much lower wages
than elsewhere.
– This is a favourite argument by some people in the ‘anti-
globalisation’ movement.
– In the absence of trade these workers would be worse off
because they could consume fewer goods.
– The question here is not to ask whether low-wage workers in
poor countries deserve to be paid more. The question is
whether they are worse off exporting goods or not trading at
all.
– Denying the opportunity to export can be to condemn poor
people to continue to be poor.
EC336 The Ricardian model Slide 36
 “Ricardo’s difficult idea”

 Read Paul Krugman (“Ricardo’s difficult idea”) on

why comparative advantage is so difficult to
understand even for very smart and well-educated
people (unless they happen to have an economics
background)
[Link]
 Also Douglas Irwin on “Ricardo and comparative
advantage at 200” [Link]
and-comparative-advantage-200
EC336 The Ricardian model Slide 37
 Empirical Evidence on the Ricardian Model
Average Worker Productivity and Average Wages
(This is cross-sectional evidence, i.e., across countries.)

Germany

Japan

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 More Cross-Sectional Evidence

Source: Feenstra and Taylor textbook, Figure 2-7. Data for 2001.
Productivity is measured by value-added per hour of work.

EC336 The Ricardian model Slide 39

 More Time Series Evidence

Source: Feenstra and Taylor textbook, Figure 2-8. Data for 1973-2001.
Productivity is measured by value-added per hour of work.
EC336 The Ricardian model Slide 40
 Empirical Evidence
on the Ricardian Model
Productivity and Exports
Bottom line: Trade depends on comparative, not on absolute advantage.

EC336 The Ricardian model Slide 41

 Adding Transport Costs
and Nontraded Goods
 There are three main reasons why specialisation in the real
international economy is not extreme:
• The existence of more than one factor of production.
• Countries sometimes protect industries from foreign
competition.
• It is costly to transport goods and services/other trade barriers.
 The result of introducing transport costs makes some goods
nontraded so that specialisation is no longer possible.
 In some cases transportation is virtually impossible.
• Example: Services such as haircuts and car repair cannot be
traded internationally.
 But the main insights of comparative advantage stay the same.

EC336 The Ricardian model Slide 42

 Summary
 The Ricardian model is the simplest model that shows how
differences between countries give rise to trade and gains
from trade.
 Labour is the only factor of production and countries differ
only in the productivity of labour in different industries.
 In the Ricardian model, a country will export that
commodity in which it has a comparative (not absolute)
labour productivity advantage.
 The fact that trade benefits a country can be shown in either
of two ways:
• trade as an indirect method of production.
• trade enlarges a country’s consumption possibilities.
EC336 The Ricardian model Slide 43
 Summary

 The distribution of the gains from trade depends on the

relative prices of the goods that countries produce.
 The basic prediction of the Ricardian model - that
countries will tend to export goods in which they have
relatively high productivity - has been confirmed by a
large number of studies.
 Extending the one-factor, two-good model to a world of
many commodities makes it possible to illustrate that
transportation costs can give rise to the existence of
nontraded goods.

EC336 The Ricardian model Slide 44

 Next Topic

 Resources, comparative advantage and income

distribution: the Heckscher-Ohlin model

EC336 The Ricardian model Slide 45

 Suggested Reading

 Great as an introduction: Adams (2008) provides an

easy-to-read overview of many topics we cover in the
lectures. He discusses the current states of trade
integration, financial integration and migration as
well as the Ricardian theory vs. Heckscher-Ohlin
theory. He speculates on what a truly globalised
world would ultimately look like.
 Reference: Adams, F. Gerard, 2008. Globalisation -
From Heckscher-Ohlin to the New Economic
Geography. World Economics 9(2), pp. 153-174.
Available on the EC336 website.
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