2

Trade and Technology:

The Ricardian Model
1. Reasons for Trade
2. Ricardian Model
3. Determining the Pattern of International Trade
4. Understanding the impact of trade on production and
consumption

1
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 Introduction

Where did Shaun White’s

snowboard come from?
• In 2005 the United States
imported (i.e., purchased from
other countries) $59 million of
snowboards from 20 different
countries.
• China exported (i.e., sold to
another country) more than $18
million worth of snowboards to the
Doug Pensinger/Getty Images United States in 2005 and $21
million in 2009.
2
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Introduction
Table 2-1 shows that the value of imports to the United States has
fallen in recent years and, in snowboards at least, has become more
focused on exports from China and Taiwan.
U.S. Imports of Snowboards, 2005 and 2009

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Introduction

This pattern raises the question:

With all the manufacturing capability in the United States,

why does it purchase snowboards from these countries at
all instead of producing them domestically?

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Another example: Apparel, Textiles, and Wheat in the
United States and China

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.

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Another example: Apparel, Textiles, and Wheat in the United
States and China

Textiles are even more productive with annual sales per

employee of $140,000 in the U.S. 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.

For wheat, the U.S. produces 27.5 bushels per hour of labor.
China produces only 0.1 bushel per hour of labor.
The U.S. is thus 275 times as productive in wheat.

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Table 2.2 Apparel, Textiles, and Wheat in the United States
and China

The U.S. exports wheat to China and imports apparel

and textiles from China.

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Introduction

Reasons countries trade goods with each other

include:
■ Differences in the technology used in each country
(i.e., differences in each country’s ability to
manufacture products)

■ Differences in the total amount of resources

(including labor, capital, and land) found in each
country
■ The proximity of countries to each other (i.e., how
close they are to one another)

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Introduction

In this chapter, we focus on technology differences

across countries as an explanation for trade, called the
Ricardian model.

• The Ricardian model explains how the level of a

country’s technology affects its trade pattern.

• It also explains the concept of comparative

advantage and why it works as an explanation for
trade patterns.

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 SIDE BAR
David Ricardo and Mercantilism

• Mercantilists believed that exporting was good

because it generated gold and importing was bad
Bettman/Corbis
because it drained gold from the national treasury.
• Mercantilists were in favor of high tariffs to ensure high
exports and low imports.
• Ricardo showed that countries could benefit from
international trade without having to use tariffs.
• Today, many of the worlds major international institutions
were founded at least in part on the idea that free trade
between countries brings gains for all trading partners.

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2 Ricardian Model

The Home Country

To develop a Ricardian model of trade, we will use an

example with two goods:
• Wheat and other grains are major exports of the
U.S. and Europe.
• Many types of cloth are imported into these
countries.
To simplify our example, we will ignore the role of land
and capital and suppose that both goods are produced
with labor alone.

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2 Ricardian Model

The Home Country

We will assume that labor is the only resource used to
produce both goods.
The marginal product of labor (MPL) is the extra output
obtained by using one more unit of labor.
In Home, one worker produces 4 bushels of wheat, so
MPLW = 4.

Alternatively, one worker can produce 2 yards of cloth, so

MPLC = 2.

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2 Ricardian Model

The Home Country

Home Production Possibilities Frontier

Using the marginal products for producing wheat and cloth,
we can graph Home’s production possibilities frontier
(PPF).
Assume there are 25 workers in Home. If all the workers
were employed in wheat, the country could produce 100
bushels. If they were all employed in cloth they could
produce 50 yards. The PPF connects these two points.
The slope of the PPF is also the opportunity cost of
wheat, the amount of cloth that must be given up to obtain
one more unit of wheat.

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2 Ricardian Model

The Home Country

Home Production Possibilities Frontier
FIGURE 2-1

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2 Ricardian Model

The Home Country

Home Production Possibilities Frontier
FIGURE 2-1

The Home PPF is a

straight line between
50 yards of cloth and
100 bushels of wheat.
The slope of the PPF
equals the negative of
the opportunity cost of
wheat. That is, ½ yard
of cloth must be given
up in order to produce
one more bushel of
wheat.

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2 Ricardian Model

The Home Country

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 goods that the country can consume and be
equally satisfied.

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2 Ricardian Model

The Home Country

Home Indifference Curve

• Indifference curves are often used to show the
preferences of an individual.
• Each indifference curve shows the combinations of two
goods, such as wheat and cloth, that a person or
economy can consume and be equally satisfied.
• All points on an indifference curve have the same level
of utility.
• Points on higher indifference curves have higher utility.

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2 Ricardian Model
Home Indifference Curve

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2 Ricardian Model
Home Indifference Curve
FIGURE 2-2 Home Equilibrium with No Trade

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.

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2 Ricardian Model

The Home Country

Opportunity Cost and Prices

Under perfect competition, the opportunity cost of wheat

should equal the relative price of wheat (i.e., price of
wheat relative to price of cloth, PW/PC ) in the no-trade
equilibrium.

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2 Ricardian Model

The Home Country

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.
• In the wheat industry, the wage equals PW • MPLW
• In the cloth industry, the wage equals PC • MPLC

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2 Ricardian Model

The Home Country

Wages
• In equilibrium, wage rates must be the same across
industries:
PW • MPLW = PC • MPLC

By rearranging terms, we see that

PW/PC = MPLC/MPLW

• The right-hand side of this equation is the opportunity

cost of obtaining one more bushel of wheat.
• The left-hand side of the equation is the relative price
of wheat in the no-trade equilibrium.

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2 Ricardian Model

The Foreign Country

• 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.
• If all workers were employed in wheat they could
produce 100 bushels.
• If all workers were employed in cloth they could
produce 100 yards.

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2 Ricardian Model

The Foreign Country

Foreign Production Possibilities Frontier
FIGURE 2-3

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, 1 yard of
cloth must be given up
to obtain 1 more
bushel of wheat.

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2 Ricardian Model

The Foreign Country

FIGURE 2-4

Foreign
Equilibrium with
No Trade
The highest level of
Foreign utility on
the PPF is obtained
at point A*, which is
the no-trade
equilibrium.

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 2 Ricardian Model

Comparative Advantage
Home country: MPLW = 4, MPLC = 2
Foreign country: MPL*W = 1, MPL*C = 1

The opportunity cost of producing wheat

Home country: MPLC / MPLW = 2/4 = ½ yard of cloth
Foreign country: MPL*C / MPL*W = 1/1 =1 yard of cloth

Thus, MPLC / MPLW < MPL*C / MPL*W . That is, Home has a
lower opportunity cost of producing wheat.
A country has a comparative advantage in a good when it has
a lower opportunity cost of producing than another country.
So we say that the Home has a comparative advantage in
producing wheat.
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 2 Ricardian Model

Comparative Advantage

By looking at the chart we can see that

• Foreign has a comparative advantage in producing cloth.
• Home has a comparative advantage in producing wheat.

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2 Ricardian Model

Comparative Advantage

An alternative approach to identifying the pattern of

comparative advantage:
Home country: MPLW = 4, MPLC = 2
Foreign country: MPL*W = 1, MPL*C = 1

Thus, MPLC / MPL*C = 2/1 = 2

MPLW / MPL*W = 4/1 = 4

That is, although Home has productivity advantages in both

products, the productivity advantage is even greater in
wheat. Thus, Home has a comparative advantage in wheat.

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APPLICATION: 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 U.S. has the comparative advantage in wheat.
China has the comparative advantage in apparel and textiles because its
productive disadvantage relative to the U.S. is less than in wheat.
As will be shown below, the pattern of comparative advantage determines
why the U.S. imports apparel and textiles from China despite higher
productivity in the U.S.

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3 Determining the Pattern of International Trade

International Trade Equilibrium

What happens 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.

Since the no-trade relative price equals its opportunity cost

of production, the pattern of exports and imports will be
determined by the opportunity costs of production in
each country—their comparative advantage.

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3 Determining the Pattern of International Trade

International Trade Equilibrium

• The no-trade relative price of wheat in Home is PW/PC =

½ and in Foreign is P*W/P*C = 1.
• Because the relative price of wheat is lower in Home and
higher in Foreign, Home will export wheat to Foreign.

• The no-trade relative price of cloth in Home is PC/PW=2

and in Foreign is P*C/P*W=1.
• Because the relative price of cloth is lower in Foreign and
higher in Home, Foreign will export cloth to Home.
• Both countries export the good for which they have the
comparative advantage.

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3 Determining the Pattern of International Trade

Absolute 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 not a good explanation for
trade patterns.
Comparative Advantage
• Instead, comparative advantage is the primary
explanation for trade among countries.
• A country has comparative advantage in producing
those goods that it produces best compared with how
well it produces other goods.
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3 Determining the Pattern of International Trade

International Trade Equilibrium

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.
• In the trade equilibrium, the price of wheat will converge in
the two countries.
• As Foreign exports cloth, the quantity sold in Foreign falls,
and the price in Foreign for cloth rises.
• More cloth goes into Home’s market. The price of cloth at
Home falls.
• In the trade equilibrium, the price of cloth will converge in
the two countries.

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3 Determining the Pattern of International Trade

International Trade Equilibrium

The two countries are in an international trade
equilibrium when the relative price of wheat is the same
in the two countries. (This means that the relative price of
cloth is also the same in both countries.)
To fully understand the international trade equilibrium, we
are interested in two issues:
• Determining the relative price of wheat (or cloth) in the
trade equilibrium
• Seeing how the shift from the no-trade equilibrium to the
trade equilibrium affects production and consumption in
both Home and Foreign.

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 3 Determining the Pattern of International Trade

International Trade Equilibrium

The no-trade relative price of wheat is ½ yard of cloth in Home

and 1 yard of cloth in Foreign.
The relative price of wheat in the trade equilibrium will be
between the no-trade prices in the two countries.
For now we will assume the free-trade price of PW/PC is 2/3.

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

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 3 Determining the Pattern of International Trade

International Trade Equilibrium

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.

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 3 Determining the Pattern of International Trade

International Trade Equilibrium

Change in Production and Consumption

• 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
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 engaging in international trade.
 Remember: this is only a consumption possibility because
production is still constrained by the PPF.

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3 Determining the Pattern of International Trade

International Trade Equilibrium

Change in Production and Consumption
FIGURE 2-5 (1 of 3) Home Equilibrium with Trade

With a world relative

price of wheat of 2/3,
Home production will
occur at point B.
Through international
trade, Home is able to
export each bushel of
wheat it produces in
exchange for 2/3 yard of
cloth.

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3 Determining the Pattern of International Trade

International Trade Equilibrium

Change in Production and Consumption
FIGURE 2-5 (2 of 3) Home Equilibrium with Trade (continued)

As wheat is exported,
Home moves up the
world price line BC.
Home consumption
occurs at point C, at
the tangent intersection
with indifference curve
U2, since this is the
highest possible utility
curve on the world
price line.

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3 Determining the Pattern of International Trade

International Trade Equilibrium

Change in Production and Consumption
FIGURE 2-5 (3 of 3) Home Equilibrium with Trade (continued)

Given these levels of

production and
consumption, we can
see that total exports
are 60 bushels of
wheat in exchange for
imports of 40 yards of
cloth and also that
Home consumes 10
fewer bushels of wheat
and 15 more yards of
cloth relative to its pre-
trade levels.

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3 Determining the Pattern of International Trade

International Trade Equilibrium

FIGURE 2-5 (revisited) International Trade
Home obtains a higher
utility with international
trade than in the
absence of international
trade (U2 is higher than
U1); the finding that
Home’s utility increases
with trade is our first
demonstration of the
gains from trade, by
which we mean the
ability of a country to
obtain higher utility for its
citizens under free trade
than with no trade.
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3 Determining the Pattern of International Trade

International Trade Equilibrium

Pattern of Trade and Gains from Trade
FIGURE 2-6 (1 of 2) 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.

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3 Determining the Pattern of International Trade

International Trade Equilibrium

Pattern of Trade and Gains from Trade
FIGURE 2-6 (2 of 2) Foreign Equilibrium with Trade (continued)

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.

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3 Determining the Pattern of International Trade

Pattern of Trade and Gains from Trade

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.

There are gains from trade for both countries.

• This is the second lesson of the Ricardian model.

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3 Determining the Pattern of International Trade

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.
• 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.

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3 Determining the Pattern of International Trade

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:
• 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.

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APPLICATION
Labor Productivity and Wages
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.

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APPLICATION
Labor Productivity and Wages
FIGURE 2-8

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.
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APPLICATION
Labor Productivity and Wages
FIGURE 2-8 (continued)

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.

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The Terms of Trade

The price of a country’s exports divided by the price of its

imports is called the terms of trade.
• Because Home exports wheat, (PW /PC) is its terms of trade.
• In this case, having a higher price for wheat (Home’s export)
or a lower price for cloth (Home’s import) would make the
Home country better off.

• Foreign exports cloth, so (PC /PW) is its terms of trade.

• In this case, having a higher price for cloth (Foreign’s
export) or a lower price for wheat (Foreign’s import) would
make the Foreign country better off.

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