l3 Ricardo

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EC3355: International Trade

The Ricardian model

Stijn van Weezel

Department of Economics

Royal Holloway, University of London
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UK exports 2012

Mineral fuels, oils and waxes (62.7 Billion US $)

Nuclear reactors and boilers (61.8 Billion US $) Vehicles (48.3 Billion US $)

Pharmaceutical products (27.5 Billion US $)
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Comparative advantageReasons why countries trade

Proximity of countries to each other

Based on cross-country differences Differences in amount of resources/factors of production Countries can benefit from things they do relatively well

Based on economies of scale and product differentiation Produce limited amount of goods but more efficient
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Comparative advantageRicardos idea

Countries trade due to technological differences

Countries can always gain from trade Even a country that is better at everything
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Comparative advantageContext of Ricardos idea

Time of mercantilism Focus on positive trade balance Exports are good, imports are bad

Mercantilism was in favour of high tariffs Corn Laws in the UK

Ricardo showed that free trade could benefit all trade partners
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Comparative advantageRicardos example

Cloth (m) Wine (L)

Portugal 20 300England 10 100

Portugal has an absolute advantage in producing both goods

Portugal can still benefit from trade
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1. England should specialise in cloth where it has a comparativeadvantage

10 m of cloth can be traded against 150 L of wine (10

300

20),rather than produce 100 L domestically

2. Portugal should specialise in wine production 300 L of wine will get 30 m of cloth (300 10

100), instead of just

20 m at home
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England has a comparative advantage in producing cloth,Portugal in producing wine

Both countries gain by specialising and trading
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Comparative advantageMain idea of the Ricardian model

Trade due to technological differences Labour productivity

Countries will benefit by specialising Under free trade countries will specialise

Free trade weakly benefits all participants (relative to autarky)even if some countries are terrible at everything
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Comparative advantage
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Ricardian modelBasic model

2 countries: Home and Foreign

2 goods: X and Y

1 production factor: labour L
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Ricardian modelModel assumptions

Supply Labour is mobile across sectors Market for labour is competitive (work in sector with higher

wages) Supply of labour is constant Production with constant returns to scale Labour cannot move between countries

Demand Consumers consume X and Yto maximise utility Constrained by labour income If price in one good rises, substitute other good Under free trade: can buy goods produced anywhere
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Ricardian modelProduction

1. Home has L hours of labour One unit ofx takes ax hours One unit ofy takes ay hours

2. Foreign has L hours of labour

One unit ofx takes a

x hours One unit ofy takes ay hours

Production probabilities frontier (PPF):

L= axX+ayY

L =axX+a

yY
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Ricardian modelProduction possibility frontier Home and Foreign

R d d l
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Ricardian modelProduction probability frontier

In autarky the PPF acts as a budget constraint for the country

In a perfectly competitive market the country will produce atits highest level of utility within the limits of the PPF

Ri di d l
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Ricardian modelRelative prices under perfect competition

Under autarky we have:

px=axw; py=aywpa =px

py= ax

ay

px= a

xw; py=a

ywpa =

pxpy

= axay

Wage is given by:

w=px

ax= py

ay

Ri di d l
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Ricardian modelOpportunities for trade and specialisation

In autarky the relative price of good X is higher in Home thanForeign

ax

ay> ax

a

y

Opportunity cost of X in terms of Y is higher in Home thanForeign

Means that Home is better for producing Y and importing Xfrom Foreign

Ri di d l
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Ricardian modelOpportunities for trade and specialisation

px

py< ax

ay

Home specialises in Y and imports X

px

py> axay

Foreign specialises in Xand imports Y

Ri di d l
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Ricardian modelTrade patterns

Each country will export its comparative advantage good Home will export Y Foreign will export X

Mutual beneficial exchange implies a convergence of pricesuntil:

px

py= px

p

y

Rica dia odel
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Ricardian modelThree possible equilibria

1. Free trade relative price can equal Home autarky relative price

2. Free trade relative price can equal Foreign autarky relativeprice

3. Free trade relative price can be strictly in between autarkyrelative prices

Ricardian model
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Ricardian modelFree trade relative price = Home autarky relative price

Home will produce both goods

Foreign will only produce X

Foreign gains, Home does not


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Ricardian model


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Ricardian modelWorld equilibrium with incomplete specialisation

Ricardian model


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Ricardian modelFree trade relative price strictly in between autarky relative prices

Home produces only X, Foreign only Y Both gain

Ricardian model
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Ricardian modelWorld equilibrium with full specialisation

Ricardian model
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Ricardian modelWorld equilibrium with full specialisation

Full specialisation if:

axa

y


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Gains from trade

Gains from trade stem from specialisation on the mostresource efficient industry and using the generated income to

buy desired goods and services Workers benefit from trade since opening up the economy

increases the price of their exported goods

Gains from trade


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Gains from trade

Trade can be regarded as indirect method of production ornew technology

In absence of trade, country has to allocate resources to

produce all of the goods it wants to consume With trade, country can specialise its production and trade

the products for goods it wants to consume

Trade expands consumption possibilities beyond productionpossibilities

Gains from trade
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Gains from tradeTrade Possibility Frontier

Gains from trade
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Welfare gains under full specialisation

Free trade create additional consumption possibilities

Instead of producing additional unit ofX, Home saves ax

units of labour axunits of labour are used to produce

axay

units ofY

Extra units ofYare sold to Foreign and import pypx

axay

> unitsof X

Productivity and wages
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y gDetermination of wages

Industry will hire workers up to the point at which wagesequal value of production

Labour is hired up to the point where w=pMPL for eachindustry

Labour can move freely between industries, and will move tohighest paying industry until wage equalisation occurs

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pXMPLX=pYMPLY

pXpY

= MPLYMPLX

Price ratio pXpY

denotes relative price of the good in the

numerator in terms of foregone goods in the denominator

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Under autarky:

pax=wax, pay=way; p

ax =w

ax, pay =w

ay

Full specialisation:

w= py

ay;w =

px

ax

Relative wages:

ww

= py

px

axay

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Determination of wages

Productivity differences determine wage differences in theRicardian model

Trade is determined by comparative advantage, but wages byabsolute advantage

A country with absolute advantage in producing a good willenjoy a higher wage in that industry after trade
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Empirical evidence


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Trade relative to GDP South Korea 1961-2000 (Source: WDI)

Empirical evidene
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Productivity and wages Korea 1961-2000 (Source: UNIDO)

Empirical evidence
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World productivity and wages for 2000 (Source: UNIDO)

Empirical evidence
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Hourly productivity and labour costs European Union 2012 (Source: Eurostat)

Empirical evidence
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Bangladeshs relative productivity in textiles

Empirical evidenceUS f l l d f (F h b k)
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US ratio of exports lowest in least productive sectors for 1951(From the textbook)

Extensions and limitsM h d
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More than two goods

Rank all goods based on productivity

a1a1

< a2a2

< ...anan

Locate ww

in this serie

Products a

i

ai> w

ware exported by home

Disadvantage in terms of wages is compensated by advantagein terms of productivity

Extensions and limitsT t t
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Transport costs

Proportional transport cost

Good i is not traded if:

wai


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Popular misconceptions

1. Trade only helps countries that are more productive thanother countries

Unproductive countries benefit from free trade as they canspecialise in industries that use resources most efficiently

2. Trade with low wage countries hurts high wage countries Trade benefits consumers in high wage countries by providing

cheaper products Trade can hurt some groups in high wage countries

3. Trade hurts poor countries because low wages are needed toallow exports Situation would be worse in absence of trade

Extensions and limitsAbsence of specialisation


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Absence of specialisation

Predicted specialisation rarely happens Transportation costs reduce/prevent trade (last lecture) More than one factor of productions which reduces

specialisation tendency (next lecture) Protectionism (after reading week)

Extensions and limitsOther limitations
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Other limitations

What determines technological differences?

Factors such as weather Manufacture local and avoid trade costs
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Documents

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