L12315: International Trade
Trade and Technology:
The Ricardian Model
Reference
Robert Feenstra
3rd edition, Worth Publishers. Chapter 2.
2
Why Countries Trade ?
Reasons countries trade goods with each other include:
Differences in the technology used in each country (i.e.,
).
The proximity of countries to each other (i.e., how close they
are to one another). Examples: Canada US; EU countries.
Differences in the total amount of resources (including labor,
capital, and land) found in each country. Available resources to
produce the product in question. Geography (mountain and
to US than Mexico does.
Differences in the costs of offshoring (i.e., producing the various
parts of a good in different countries and then assembling it in a
final location). US imports unfinished and low-
from Mexico and Taiwan and process them to finished product.
3
Trade and Technology
In this section, we focus on technology differences across
countries as an explanation for trade.
This explanation is often called the Ricardian model because
it was proposed by David Ricardo.
technology
affects the wage paid to labor, such that countries with better
technologies have higher wages.
This, in turn, helps to explain how a
affects its trade pattern.
We also explain the concept of comparative advantage and
why it works as an explanation for trade patterns.
4
The Model
Model assumptions:
2 countries: home and foreign
1 factor of production: labor
2 goods: wheat and cloth
Constant marginal product of labor (MPL)
Derive:
Autarky equilibrium
International trade equilibrium
Home export supply curve
Foreign import demand curve
5
Technology
Home technology
Labor is the only factor used to produce both goods.
The Marginal Product of Labor is the extra output obtained
by using one more unit of labor.
One worker can produce either 4 bushels of wheat or 2
yards of cloth.
MPLW = 4 and MPLC = 2.
Alternatively, the production of 1 unit of wheat requires ¼
worker and the production of 1 unit of cloth requires ½
worker.
aW = 1/MPLw = 1/4 ; aC = 1/MPLc = 1/2.
(ai are called unit input coefficients)
6
Production possibilities
Home Production Possibilities Frontier (PPF)
We can use the marginal products of labor to construct
.
Assume Home is endowed with 25 workers.
If all the workers were employed in wheat, the economy
could produce (Qw = MPLw*L) =100 bushels.
If they were all employed in cloth, it could produce a
maximum of (Qc = MPLc*L) = 50 yards.
The PPF connects these two points.
7
Production possibilities
This gives us a straight line PPF which is a unique feature of
the Ricardian model.
It assumes the .
We consider the case where the marginal product of labor
is diminishing in the specific-factors model in section 3.
See the PPF for Home (when MPL is constant) in the next slide.
Figure 2.1 Home Production Possibilities
Frontier
9
Slope of PPF
The slope of the PPF can be calculated as the ratio of marginal
products of the two goods.
50 MPLC ( L ) QC
SlopePPF
100 MPLW ( L ) QW
MPLC 1
MPLW 2
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.
Demand and Indifference Curve
To attain the Autarky Equilibrium we will take the assistance
of home indifference curve.
Home Indifference Curve
actually produce? The answer depends on demand.
Demand can be represented with indifference curves.
An indifference curve shows the combinations of two
goods that the country can consume and be equally
satisfied.
11
Home preferences/ Indifference Curve
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 preferences of
an individual.
But we use indifference curves to show the preferences of an
entire economy.
12
Figure 2.2 Autarky Equilibrium at Home
The country is indifferent between A and B.
The country would be better off on U2, but
C is not feasible to produce.
U0<U1<U2
13
Autarky Equilibrium
Points A and B lie on the same indifference curve and give the
Home consumers the level of utility U1.
The highest level of Home utility on the PPF is obtained at
point A, which is the no-trade equilibrium.
Point D is also on the PPF but would give lower utility.
Point C represents a higher utility level but is off of the PPF, so
it is not attainable in the absence of international trade.
14
Autarky Equilibrium
With perfectly competitive markets, the country will
produce at its highest level of utility within the limits of the
PPF.
The highest level of utility that can be reached within the
PPF is U1 with production taking place at point A.
Key insight production point
must coincide with its consumption point.
In other words, the economy only consumes what it
produces (which is not necessarily true in an open
economy).
15
Autarky equilibrium and relative prices
Equilibrium prices and wage rate
In the wheat industry labor will be hired upto the point at which
the wage equals Pw*MPLw
In the cloth industry labor will be hired upto the point at which
the wage equals Pc*MPLc.
If we assume that labor is perfectly free to move between
industries then wage must be equalized across two industries
(otherwise labor will move to high paid industry).
Relative Prices:
Pw*MPLw = Pc*MPLc
Pw/Pc = MPLc/MPLw = 1/2 [see slide no. 10]
The Left-had side is relative prices of wheat and the right-hand side
is the opportunity cost of wheat.
16
Foreign Economy
o
Assume one foreign worker can produce either one bushel
of wheat or one yard of cloth.
MPL*W = 1, MPL*C = 1
Since MPL*W <MPLW and MPL*C < MPLW , Foreign has an
absolute disadvantage in each good.
Assume Foreign is endowed with L* = 100 workers.
If all foreign, workers were employed in the wheat
sector, they could produce 100 bushels.
If all workers were employed in cloth sector, they
could produce a maximum of 100 yards.
17
Figure 2.3 Foreign Production Possibilities
Frontier
18
Foreign PPF
The Foreign PPF is a straight line between 100 yards of cloth
and 100 bushels of wheat.
The slope of the PPF equals the negative of the opportunity
cost of wheat, that is, the amount of cloth that must be given
up (1 yard) to obtain 1 more bushel of wheat.
19
Foreign autarky equilibrium
preferences are also represented by
indifference curves and production occurs at the point
of highest utility within the foreign PPF.
The slope of the foreign PPF is also the foreign
opportunity cost of wheat.
relative price of wheat is P*W/P*C = 1 and
W/PC = ½)
The difference in relative autarky prices shows the
comparative advantage that Home has is in wheat.
[Because if Home produce one extra unit of wheat it has to give up
only ½ units of cloth; however, Foreign has to give up one unit of
cloth.]
20
Figure 2.4 Foreign autarky equilibrium
The highest level of Foreign utility on the
PPF is obtained at point A*, which is the
no-trade equilibrium.
21
Opportunity costs (or real prices)
In an exchange economy:
Wheat Cloth
(1 Bushel) (1 Yard)
Comparative
Advantage
Home ½ Yard 2 Bushels
of Cloth of Wheat
Foreign 1 Yard 1 Bushel
of Cloth of Wheat
Comparative advantage
Comparative Advantage
A country has a comparative advantage in a good when it
has a lower opportunity cost of producing it than another
country.
From the Table we can see that Foreign has a comparative
advantage in producing cloth
of cloth is lower (1<2).
Home has a comparative advantage in producing wheat as
its opportunity cost of wheat is lower (½ <1).
23
Determining the Pattern of International Trade
Autarky price comparisons:
Relative price of cloth in Foreign is P*C/P*W = 1.
Relative price of cloth in Home is PC/PW = 2.
Foreign would want to export its cloth to Home as it can
make it for the cost of 1 and export it for more than 1 ( but
below 2 ! Why ? Think about the cost of cloth in the Home).
The opposite is true for wheat.
Home will export wheat and Foreign will export cloth.
Both countries export the good in which they have a
comparative advantage.
24
Price changes as the result of trade
How trade affects domestic prices:
As Home exports wheat, the quantity of wheat sold at
Home falls. So the price of wheat at Home is bid up. (P )
wheat in Foreign falls. (Pw* )
As Foreign exports cloth, the quantity sold in Foreign falls,
and the price in Foreign for cloth rises. (PC* )
Since foreign cloth goes home, the price of cloth at Home
falls. (PC )
25
Break!
26
Determining the Pattern of International Trade
International Trade Equilibrium
The relative price of wheat in the trade equilibrium (or the
international terms of trade) will be between the autarky
relative prices in Home and Foreign [This result has been
established by J.S. Mill (1848)].
For now we will assume the free-trade price of wheat,
PW/PC ,is 2/3. This is between the autarky price of ½ in
Home and the autarky price of 1 in Foreign. (later we will
discuss how this relative price is determined )
Given this free trade price of wheat, we can now see how
trade changes production and consumption in each
country.
27
International Trade Equilibrium
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 autarky to the trade
equilibrium affects production and consumption in
both Home and Foreign.
28
Change in Production and Consumption
Home producers of wheat can earn more than the
opportunity cost of wheat (1/2)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
good times its marginal product (if the production of
the good is positive! ).
Given the information from before, we can calculate
the wage rates in the two sectors.
29
Labor Market Condition (Home)
PW MPLW 2 4 8 When trade takes place,
1 PW/PC = 2/3
PC MPLC 3 2 6 MPLw /MPLc = 4/2
Therefore
PW MPLW PC MPLC
Wages in wheat Wages in cloth
All Home workers have an incentive to move into the wheat
sector and no cloth will be produced.
With trade, Home will specialize in wheat production; Foreign
specialize in cloth production.
30
Terms of trade and increased consumption
opportunities
Home can export wheat at the international relative prices
(or terms of trade) of 2/3.
For each bushel of wheat it exports, it gets 2/3 yards of
cloth in return.
The world price line (or terms of trade line) shows the
range of consumption possibilities that the country can
achieve by specializing in wheat and trading it.
International trade allows to separate production (point B)
from consumption (point C).
31
Enhanced consumption opportunities
The new world price, PW /PC = 2/3, shows us
the new range of consumption possibilities.
Cloth, QC (yards)
For any point on the world price line, such as
D, Home can consume X units of wheat, and
then exchange the rest (100-X) with the foreign
for cloth consumption.
50
Home has better consumption opportunities
when trade is allowed.
Trade: (100-X)*(2/3) D
World price line (terms of trade
Autarky: (100-X)*(1/2) line), slope = 2/3
Home production
X 100 Wheat, QW (bushels)
32
Enhanced consumption opportunities
The new world price, PW /PC =
Cloth, QC (yards) 2/3, shows us the new range of
consumption possibilities
The country can now achieve a
higher utility with the new
50
consumption possibilities
World price line (terms of trade
U2 line), slope = 2/3
25 A
U1 Home production
50 100 Wheat, QW (bushels)
33
Free trade equilibrium (Home)
Home produces 100 bushels but
consumes only 40, so it exports 60.
Cloth, QC (yards)
Home produces 0 yards of cloth but
consumes 40, so it imports 40.
Home consumption
50
40 C World price line (terms of trade
U2 line), slope = 2/3
25 A
Home imports 40
yards of cloth U1 Home production
40 50
50 100
100 Wheat, QW (bushels)
Home exports 60 bushels of wheat
34
Terms of trade
exports and imports are equal when valued in the same
units. [60*2/3 = 40]
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.
Now consider Foreign.
35
Free trade equilibrium (Foreign)
With a world relative prices of
wheat equals 2/3, foreign
production will occur at point B*
and consumption at C*.
= Home exports of wheat
36
Figure 2.6 Foreign Equilibrium with Trade
With a world relative price of wheat of 2/3, Foreign
production will occur at point B*.
Through international trade, Foreign is able to export 2/3
yard of cloth in exchange for 1 bushel of wheat, moving
down the world price line B*C*.
Foreign consumption occurs at point C*, and total
exports are 40 yards of cloth in exchange for imports of 60
bushels of wheat.
Relative to its pre-trade wheat and cloth consumption
(point A*), Foreign consumes 10 more bushels of wheat
and 10 more yards of cloth.
37
Comparative advantage and
the gains from trade
Each country exports the good where it has a comparative
advantage. This confirms that the pattern of trade is
determined by comparative advantage.
There are gains from trade for the home and the foreign
economy
The gains from trade can be captured in several ways:
Each country reaches a higher utility level (utilitarian
formulation).
Each country enlarges its consumption opportunities
(utility free formulation).
Workers receive higher real wages.
38
Real wages in the trade equilibrium
As stated before, in competitive labor markets, firms will
pay workers the value of their marginal product.
Since Home produces and exports wheat, workers can be
thought of being paid in wheat. As 1 unit of labor produces
4 bushels of wheat, the real wage of home workers is
MPLW (= 4 bushels of wheat).
Workers can sell wheat on the world market at a relative
price of PW/PC = 2/3.
We can use this to calculate their real wage in terms of
cloth: (PW/PC)MPLW = (2/3)4 = 8/3 yards.
Through trade, 1 unit of labor is able to buy 8/3 yards.
39
Real wages in the trade equilibrium
Home real wage is
4 bushels of wheat or
8/3 yards of cloth (> 2, the autarky level)
Foreign real wage is
1 yard of cloth or
3/2 bushels of wheat (>1, the autarky level)
(since(PC/PW) MPL*C = (3/2)1 = 3/2)
Trade leads to an increase in real wages in both countries,
but the real wages do not converge.
Home workers earn a higher real wage than foreign workers
because of their absolute productivity advantage in both
sectors.
40
Key insight: Real wages in the trade equilibrium
Wages are determined by absolute advantage and trade is
determined by comparative advantage.
The only way a country with poor technology (and thus
low productivity) can export at a price others are willing to
pay is by having low wages. (think about Chinese exports).
As a country develops better technologies, its wages will rise.
Workers become better off by receiving higher wages.
As countries engage in trade, the Ricardian model predicts
that their real wages will rise.
41
Application 1: Labor productivity and wages
Labor productivity can be measured by the value-added per
hour in manufacturing.
Value-added is the difference between sales revenue in an industry
and the costs of intermediate inputs.
Equals the payments to labor and capital in an industry.
The Ricardian model ignores capital so we can measure labor
productivity as value-added divided by the number of hours worked,
or value-added per hour.
The next figures show value-added per hour in manufacturing
for several countries.
Countries with higher labor productivity pay higher wages, just as the
Ricardian model predicts.
42
Application 1: Labor productivity and wages
Labor Productivity and Wages, 2001
Source: U.S. Department of Labor, Bureau of Labor Statistics
43
Figure 2.7 Labor Productivity and Wages, 2001
Labor productivity is measured by value-added per hour of
work and can be compared with the wages paid in
manufacturing in various countries.
The general ranking of countries from highest to lowest in
terms of labor productivity is the same as the ranking in terms
of wages: countries with higher labor productivity pay higher
wages, just as the Ricardian model predicts.
44
Application 1: Labor productivity and wages
Source: U.S. Department of Labor, Bureau of Labor Statistics.
45
Figure 2.8
Labor Productivity and Wages over Time
The trends in labor productivity and wages can also be
graphed over time.
The general upward movement in labor productivity is
matched by upward movements in wages, as predicted by the
Ricardian model.
46
Application 2: Comparative advantage in
apparel, textiles, and wheat
U.S. Textile and apparel industries face intense import
competition.
Burlington Industries announced in January 1999 it would
reduce production capacity by 25% due to increased imports
from Asia.
After layoffs they employed 17,400 persons in the U.S. with
sales of $1.6 billion in 1999.
Sales per employee were therefore $92,000.
This is the average for all U.S. apparel producers.
Textiles are even more productive with annual sales per
employee of $140,000 in the U.S.
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Application 2: Comparative advantage in apparel,
textiles and wheat
In China, however, sales per employee are only $13,500 in
apparel and $9,000 in textiles.
The U.S. is 7 times more productive in apparel and 16 times
more productive in textiles.
So the U.S. has an absolute productivity advantage in these
industries.
In the wheat sector, the U.S. produces 27.5 bushels of wheat
per hour of labor.
China produces only 0.1 bushels of wheat per hour of labor.
So the US has also an absolute productivity advantage in wheat.
But it is 275 times more productive in wheat than China.
48
Application 2: Comparative advantage in apparel,
textiles, and wheat
So, US has comparative advantage in wheat production and China
has comparative advantage in Apparel and Textile production.
49
Application 2: Comparative advantage in apparel,
textiles and wheat
Since the absolute advantage in wheat for the U.S. is even
greater than in apparel and textiles, the US has a comparative
advantage in the production of wheat.
China has a comparative advantage in apparel and textiles
because its productive disadvantage relative to the U.S. is less
than in wheat.
This explains why the U.S. imports apparel and textiles from
China despite its higher productivity.
This also explains why the US is an exporter of wheat.
50
International equilibrium: Determination of the
terms of trade
In the previous analysis we assumed that the relative price of wheat, or
the terms of trade was given by 2/3. Now we investigate what determines
the terms of trade.
The terms of trade is determined by export supply and import demand.
There are two international markets for wheat and cloth. But since only
relative prices matter, it is sufficient to look only at the international
equilibrium in one market. So we can just focus on the export supply and
import demand in the wheat market.
According to , which is a key general equilibrium insight, if the
international market for wheat is in equilibrium, then the market for cloth
has to be in equilibrium also.
export supply = excess supply (domestic supply - domestic demand)
import demand = excess demand (domestic demand - domestic supply)
51
Home export supply curve
Derivation of the Home export supply curve
The home excess supply of wheat Xw (horizontal axis) will depend on
the relative price of wheat Pw/Pc (vertical axis).
At Pw/Pc=2/3, Xw=60 (=100-
At Pw/Pc=1/2, Xw=0 (=50-
equilibrium
However, if Pw/Pc=1/2 and trade is allowed, workers earn the same
wage in wheat and cloth and production can be at any point between
A and B on the Home PPF => Xw can take any value between 0 and 50
(horizontal segment).
The flat portion of the export supply curve is a special feature of the
Ricardian model.
Export supply Xw will increase in Pw/Pc (domestic production will stay
the same = 100, but domestic consumption will fall).
52
Home export supply curve
53
Home export supply curve
54
Foreign import demand curve
Derivation of the Foreign import demand curve
The foreign excess demand for wheat Mw (horizontal axis) will also
depend on the relative price of wheat Pw/Pc (vertical axis).
At Pw/Pc=2/3, Mw=60 (=60-
At Pw/Pc=1, Mw=0 (=50-
equilibrium
However, if Pw/Pc=1 and trade is allowed, workers earn the same
wage in wheat and cloth and production can be at any point between
A* and B* on the Foreign PPF => Mw can take any value between 0
and 50 (horizontal segment).
The flat portion of the import demand curve is also a special feature of
the Ricardian model.
Import demand Mw will decrease in Pw/Pc (domestic production will
stay the same, but domestic consumption will fall).
55
Foreign import demand curve
56
Foreign import demand curve
57
International trade equilibrium
58
Figure 2.11: World Market for Wheat
Putting together the Home export supply curve and the
Foreign import demand curve for wheat, the world
equilibrium is established at point C
price of wheat is .
At this price, Home exports of 60 bushels just equal
Foreign imports of wheat.
59
International trade equilibrium
The export supply and import demand curves are both general
equilibrium concepts. If international prices change, this will affect the
behavior of producers and consumers in the wheat and cloth market.
The export supply curve captures the behavior of producers and
consumers in the exporting country (i.e. home, the exporter of wheat).
The import demand curve captures the behavior of producers and
consumers in the importing country (i.e. foreign, the importer of wheat).
At the international equilibrium price all markets are balanced.
Because only relative prices matter for producers and consumers, we
that if there are 2 markets, if the first market is in equilibrium than the
second market must also be in equilibrium.
The analysis has also demonstrated that the market clearing
international price must lie between the autarky prices (i.e. 1<2/3<2).
60
Terms of trade and the distribution of the gains
from trade
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
An increase in the terms of trade is welfare improving since
the country will either earn more from its exports or
the country will pay less for its imports.
Although both countries will benefit from international trade, the
terms of trade will determine how the gains from trade are distributed
across countries.
Changes in the terms of trade have different welfare effects on
exporting and importing countries (see Application 3).
61
Application 3: The Terms of Trade for Primary
Commodities
Latin American economist Raúl Prebisch and British economist Hans Singer
each put forward the hypothesis that the price of primary commodities
would decline over time relative to the price of manufactured goods
(Prebisch-Singer Hypothesis).
Since primary commodities are often exported by developing countries
whereas industrial countries export manufactured goods, this hypothesis
has received quite a bit of attention regarding the distribution of the gains
from trade between developing and industrialized countries.
Arguments for the hypothesis:
As countries become richer, they spend a smaller share of their
income on food.
As world income grows, demand for food falls relative to the demand
for manufactured goods. Therefore, the price of agricultural products
can also be expected to fall relative to manufactured goods.
62
Application 3: The Terms of Trade for Primary
Commodities
Arguments for the hypothesis (continued):
For mineral products, industrialized countries continually find
substitutes in the production of manufactured products.
The substitution away from mineral products is a form of technological
progress, and as it proceeds, can lead to a fall in the price of raw
materials.
Arguments against the hypothesis:
Technological progress in manufactured goods can certainly lead to a
fall in the price of these goods as they become easier to produce.
This is a fall in terms of trade for industrialized countries rather than
developing countries.
terms of trade for oil-exporting countries.
The long-term evidence (1900-2000) is mixed.
63
The long-term evidence
(price of primary relative to manufactured goods)
64
Key insights
The Ricardian model is about the reallocation of a single factor, labor, across
alternative uses.
It is comparative (productivity) advantage, not absolute (productivity)
advantage, which matters for the direction of specialization and the
realization of the gains from trade.
Absolute productivity advantage determines wage rates.
Gains from trade can be captured in three different ways: increase in utility,
increase in consumption opportunities or increase in real wages.
Since the gains from trade are at the country level, the gains are aggregate
conflict about the gains from trade in the Ricardian framework.
The distribution of the gains from trade (across countries) depends on the
terms of trade.
Changes in the terms of trade will have different welfare effects.
To analyze potential domestic conflict from international trade, we need to
relax the one factor assumption. This leads to the specific-factors model.
(next lecture)
65