International Economics
Ricardian Model
Giuseppe Berlingieri
[Link]@[Link]
@g berlingieri
ESSEC Business School
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Outline of the Course
I Introduction to International Trade
I Classical Trade Theory: Trade Patterns & Winners/Losers
I The Ricardian Model
I The Specific-Factors Model
I The Heckscher-Ohlin Model
I Trade and Inequality
I New Trade Theory: Trade Patterns & Policy
I External Economies of Scale
I Industrial (and Trade) Policy
I Market Power and Imperfect Competition
I Firms in the Global Economy
I Heterogeneous Firms
I Multinationals, FDI and Offshoring
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Outline
Introduction
Example
Model
Empirics
Conclusion
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Introduction
I This is the oldest part of classical trade theory
I First developed by Ricardo (1817)
I Big Questions: Who trades with whom, what and how much?
I Trade is due to differences between countries (as in entire classical
trade theory)
I Here focus is on differences in technology across countries
I Implications for the impact of trade on economic welfare and policy
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Outline of this Topic
I Example of Ricardian Comparative Advantage
I The two-good Ricardian model
I Welfare effects of international trade
I Application: Historic comparative advantage
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Outline
Introduction
Example
Model
Empirics
Conclusion
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Opportunity Cost
I Key concept 1: the Opportunity Cost of producing something
measures the loss of not being able to produce something else
because resources have already been used
I Example: a limited number of workers could be employed to
produce either roses or computers
I The opportunity cost of producing computers is the amount of roses
not produced; the opportunity cost of producing roses is the amount
of computers not produced
I Workers in the U.S. can produce either 10 million roses or 100,000
computers
I Workers in Ecuador can produce either 10 million roses or 30,000
computers
I Ecuador has a lower opportunity cost of producing roses:
30,000/10million vs. 100,000/10million
I The US has a lower opportunity cost of producing computers:
10million/100,000 vs. 10million/30,000
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Comparative Advantage
I Key concept 2: a country has a Comparative Advantage in
producing a good if the opportunity cost of producing that good is
lower in the country than it is in the other country
I The U.S. has a comparative advantage in computer production
I Ecuador has a comparative advantage in rose production
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Roses vs. Computers
I Suppose initially that Ecuador produces computers and the U.S.
produces roses, and that both countries want to consume computers
and roses
I Ecuador produces 30,000 computers and the U.S. produces 10
million roses
I Can joint production be increased?
I Make Ecuador produce roses and the U.S. produce computers
I Ecuador produces 10 million roses and the U.S. produces 100,000
computers
I Joint production now consists of 10 million roses as before and
100,000 computers, i.e. 70,000 more than before
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Outline
Introduction
Example
Model
Empirics
Conclusion
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The Ricardian Model
I The simple example with roses vs. computers explains the intuition
behind the Ricardian model:
I Specialization according to comparative advantage maximizes joint
production
I As each country specializes in the good with lower opportunity cost,
joint opportunity costs are minimized
I These ideas can be formalized by constructing a simple one factor
Ricardian model
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The Ricardian Model
I Two countries, UK (home) and Portugal (foreign)
I All foreign (Portuguese) variables carry an asterisk (*)
I Two goods cheese (c) and wine (w)
I Labor is the only factor of production
I Labor is perfectly mobile between sectors, but immobile across
countries (no migration)
I What does this mean? Workers are paid the value of their marginal
productivity and work in the production of the good that pays the
higher wage.
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Consumers
I There is one representative consumer per country.
I They supply L and L∗ units of labor respectively.
I Consumer preferences are identical and homothetic.
I When are preferences homothetic?
I Is this a realistic assumption?
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Technology
I Both the UK and Portugal are assumed to have the following
constant returns to scale technologies:
Lc Lw
Qc = Qw =
ac aw
L∗c L∗w
Qc∗ = Qw∗ =
ac∗ ∗
aw
I Unit labor requirement is the number of workers (hours of work)
required to produce one unit of output. ac is the unit labor
requirement for cheese at home.
I Labor productivity is the output per worker. 1/ac is the labor
productivity for cheese at home.
I Finally, we assume that there is perfect competition in all markets.
What does this mean?
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Absolute Advantage
I Let’s assume that the labor requirements a satisfy the following
assumption:
ac∗ > aw
∗
> aw > ac
I Absolute Advantage: Home is more efficient in the production of
both goods.
I Does this imply that international trade is impossible or will only
benefit the more productive country?
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Opportunity Cost
I Key concept: opportunity cost - the number of units of the other
good that the economy would have to forgo in order to produce an
additional unit of one good.
I Assumption CA also implies that Home has a comparative
advantage (=lower opportunity costs) in cheese production while
foreign has a comparative advantage in wine production.
ac∗ > aw
∗
> aw > ac
I The opportunity cost of Cheese at Home is: ac /aw < 1
I The opportunity cost of Cheese in Foreign is: ac∗ /aw
∗ > 1 > a /a
c w
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Autarkic Economy
I Production. We will now construct the production possibility
frontier (PPF) of a country: the maximum amount of a goods that
can be produced with its workers
I To mathematically derive the PPF substitute the home production
functions into Lw + Lc = L to get:
aw Qw + ac Qc = L
or
L ac
Qw = − Qc
aw aw
I The next page graphs the PPF.
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Production Possibilities Frontier
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Relative Prices and Supply
I The PPF describes what can be produced, but to determine what is
actually produced, one needs to know the equilibrium prices of goods
I We need to solve the profit maximization problem of firms. Let Pc
be the price of cheese and Pw be the price of wine
I Home wine firms maximize:
πw = Pw Qw − ωLw
subject to:
Lw
Qw = Qw ≥ 0
aw
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Firms and Wages
I The first order condition (FOC) for wine production is:
Pw
− ω = 0 Qw > 0
aw
Pw
− ω ≤ 0 Qw = 0
aw
I If there is positive wine production, Pw = ωaw , i.e. price equals
marginal costs.
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Firms and Wages
I Similarly the FOC for cheese production is:
Pc
− ω ≤ 0 and = 0 if Qc > 0
ac
I If both goods are produced in equilibrium then: Pc = ωac and
Pw = ωaw .
Pc ac
= = (−)Slope of PPF
Pw aw
I If only cheese is produced then: Pc = ωac and Pw < ωaw . So
Pc /Pw > ac /aw .
I If only wine is produced then: Pc < ωac and Pw = ωaw . So
Pc /Pw < ac /aw .
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Relative Prices
I Implication: If consumers want to consume both goods in autarky,
then market clearing implies that relative prices have to be equal to
the slope of the PPF.
I How to determine which point on the PPF is the production point of
the autarkic economy?
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Relative Prices and Demand
I Consumption. Consumers will maximize utility taking prices as
given.
I Where is the consumption point?
I What is the missing piece?
I Market clearing. Demand = Supply in all markets.
I Absolute prices are not determined.
I To work out absolute prices, we use one good as the numeraire and
set its price equal to one.
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Free Trade Equilibrium
I With free trade world prices will equilibrate world supply and
demand.
I There are several ways to find these prices:
I Excess demand curves
I Offer curves
I Drawing the world PPF
I Relative demand and supply curves
I Here we use the last approach.
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Relative Supply
I Relative supply of cheese is the quantity of cheese supplied by the
two countries together relative to the quantity of wine they jointly
supply (Qc + Qc∗ )/(Qw + Qw∗ ) at each price of cheese relative to the
price of wine Pc /Pw
I For each possible price ratio Pc /Pw , we need to determine how much
each country produces to determine the world supply. For Home:
I If Pc /Pw = ac /aw then the home country produces both goods.
I If Pc /Pw > ac /aw then the home country only produces cheese.
I If Pc /Pw < ac /aw the home country only produces wine.
I Follow a similar analysis for the foreign country and add up the home
and foreign supply for each price level.
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Supply from Countries
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World Supply
I For Pc /Pw < ac /aw < ac∗ /aw
∗ , neither Home nor Foreign produce
Cheese: Qc + Qc∗ = 0 + 0.
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World Supply
I For Pc /Pw = ac /aw < ac∗ /aw
∗ , Foreign still no Cheese: Q ∗ = 0 and
c
∗ ∗
Qw = L/aw .
I But Home can produce any Qc between 0 and L/ac .
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World Supply
I For ac∗ /aw
∗ > P /P > a /a , Foreign still no Cheese and Home
c w c w
only Cheese.
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Relative Demand
I Relative demand of cheese is the quantity of cheese jointly demanded
by both countries relative to the quantity of wine jointly demanded
by them at each price of cheese relative to the price of wine, Pc /Pw .
I As preferences are homothetic, relative demand only depends on
relative prices and not on income.
I As the price of cheese relative to the price of wine rises, consumers in
all countries tend to purchase less cheese and more wine so that the
relative quantity of cheese demanded falls
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World Demand
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Gains from Trade
I The resulting world equilibrium price lies between the autarky prices
of the home and foreign country.
I This implies that both countries will gain from trade.
I Gains from trade come from specialization according to comparative
advantage.
I Domestic workers earn a higher income from cheese production
because the relative price of cheese they face increases with trade with
respect to autarky
I Foreign workers earn a higher income from wine production because
the relative price of wine they face increases with trade relative to
autarky
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Gains from Trade
I Trade can be seen as a technological improvement:
I Think of trade as an indirect method of production or a new
technology that converts cheese into wine or vice-versa
I Without the technology, a country has to allocate resources to
produce all of the goods that it wants to consume
I With the technology, a country can specialize its production and trade
(“convert”) the products for the goods that it wants to consume
I To see this consider the following graph of the consumption
possibilities in the home and foreign country under free trade:
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Trade Expands the Consumption Set
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Where do the gains come from?
I Note that both countries gain from trade even though home is more
efficient in the production of both goods!
I The reason is that differences in productivity across the two
countries is reflected in differences in wage levels.
I If demand was equal to RD 0 only the foreign country gains from
trade and the home country is indifferent.
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Demand Shift
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Relative Wages
I Relative wages are the wages of the domestic country relative to the
wages in the foreign country
I Although the Ricardian model predicts that prices equalize across
countries after trade, it does not predict that wages will do the same
I Productivity (technological) differences determine wage differences in
the Ricardian model:
I The home wage relative to the foreign wage will settle in between the
ratio of how much better Home is at making cheese and how much
better it is at making wine compared to Foreign.
I Relative wages cause Home to have a cost advantage in only cheese
and Foreign to have a cost advantage in only wine.
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Relative Wages
I Assume the following unit labour requirements:
Wine Cheese
England 2 1
Portugal 3 6
I Suppose that Pc = A
C12/kg and Pw = A
C12/bottle.
I The relative wage lies between the ratio of the productivities in each
industry.
I Since domestic workers specialize in cheese production, their hourly
wages will be: Pc /ac = A
C12/1 = A C12
I Since foreign workers specialize in wine production, their hourly wages
will be: Pw /aw∗ = A
C12/3 = AC4
I The relative wage of domestic workers is therefore AC12/A C4 = 3
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Relative Wages
I These relationships imply that both countries have a cost
advantage in production.
I High wages can be offset by high productivity.
I Low productivity can be offset by low wages.
I In Home, producing 1kg of cheese costs 12A
C (one worker paid
A C (six paid A
C12/hr) but would have cost 24A C 4/hr) in Foreign.
I In Foreign, producing one bottle of wine costs 12A
C (three workers
paid A
C4/hr) but would have cost 24A C (two paid AC12/hr) in Home.
I Because foreign workers have a wage that is only 1/3 the wage of
domestic workers, they are able to attain a cost advantage in wine
production, despite low productivity.
I Because domestic workers have a productivity that is 6 times that of
foreign workers in cheese production, they are able to attain a cost
advantage in cheese production, despite high wages.
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Misconceptions About Comparative Advantage
1. Free trade is beneficial only if a country is more productive than
foreign countries.
I Unproductive country benefits from free trade by avoiding the high
costs for goods that it would otherwise have to produce domestically.
I The benefits of free trade depend on comparative advantage, not
absolute advantage!
2. Free trade with countries that pay low wages hurts high wage
countries.
3. Free trade exploits less productive countries.
I While labor standards in some countries are less than exemplary
compared to Western standards, they are so with or without trade.
I Consumers benefit from free trade by having access to cheaply
(efficiently) produced goods.
I Producers/workers benefit from having higher profits/wages, higher
compared to the alternative.
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Outline
Introduction
Example
Model
Empirics
Conclusion
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Empirical Evidence: Balassa 1963
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Empirical Evidence: Golub and Hsieh 2000
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Empirical Problems
I Latent Productivity: If a country does not have a CA, then it will not
produce that good.
I Multi-country world predictions from the Ricardian model are less
clear.
I Alternative hypothesis: Which other theories predict this
relationship?
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Outline
Introduction
Example
Model
Empirics
Conclusion
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Conclusion
I The Ricardian model is the first classical trade theory model that we
encounter.
I In the model, differences in technology are the cause of comparative
advantage.
I Comparative advantage and not absolute advantage is key to gains
from trade.
I The model provides a basic framework for thinking about the effects
of trade on production, real wages and world prices.
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