TRADE AND
TECHNOLOGY: THE
RICARDIAN MODEL
1
Reasons for Trade
2
Ricardian Model
3
Determining the Pattern of International Trade
4
Solving for
Introduction
•
Why does the U.S. import goods that it could
easily produce itself with its great manufacturing
capability?
•
The first part of this book looks at the various
reasons for trade:
Technological differences
Differences in amounts of resources
Differences in costs of outsourcing
Introduction
•
This chapter focuses on how technology
differences across countries affect trade.
Ricardian model proposed by the 19th century economist David Ricardo.
•
It explains how the level of a country’s technology
affects wages paid to labor in a way that countries
with better technology have higher wages.
•
We use this to explain a country’s
trade pattern
Reasons for Trade
1.
Proximity
The closer countries are the lower the costs of transportation.
2.
Resources
A country can have resources that give it an edge in the production of certain goods.
A country with a lot of snow may be very good at producing snowboards.
Reasons for Trade
3.
Absolute Advantage
When a country has the best technology for
producing a good, it has an absolute advantage in the production of that good.
4.
Comparative Advantage
Absolute advantage is actually not a good explanation for trade patterns.
A country has a comparative advantage in producing those goods that it produces best
compared with how well it produces other goods.
Ricardian Model
•
To develop a Ricardian model of trade, we will use
an example with two goods: wheat and cloth.
Wheat and other grains are major exports of the U.S.
and Europe.
Many types of cloth are imported into these countries.
•
Home will be the country exporting wheat and
importing cloth.
•
Assume that labor is the only factor of production.
Ricardian Model
•
The Home Country
One worker can produce 4 bushels of wheat or 2 yards of cloth.
The Marginal Product of Labor is the extra output
obtained by using one more unit of labor.
MPLW = 4 and MPLC = 2.
We can use the marginal products of labor to construct Home’s Production Possibilities Frontier.
Ricardian Model
•
Using the setup, we can show:
Labor = 25, MPLW = 4, MPLC = 2 QW = MPLW(L) = 25(4) = 100
QC = MPLC(L) = 25(2) = 50
•
This gives us a straight line PPF which is a unique
feature of the Ricardian model.
It assumes the marginal products of labor are constant.
• 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.
Ricardian Model
Ricardian Model
•
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.
All points on an indifference curve have the same level of utility.
Ricardian Model
The country is indifferent between A and B
The country is better off on U2 but cannot produce that much
U0<U1<U2
Ricardian Model
•
Home Equilibrium
Without trade, the PPF acts as a budget constraint for the country.
With perfectly competitive markets, the country will produce at its highest level of utility within the limits of the PPF.
In the graph, the highest level of utility that can be reached and still stay within the PPF is U1 with
production at point A.
Ricardian Model
•
Opportunity Cost and Prices
The slope of the PPF reflects the opportunity of producing one more bushel of wheat.
Under perfect competition the opportunity cost of wheat should equal the price of wheat.
Ricardian Model
•
Wages
Determination of 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.
wage = P*MPL for each industry.
In competitive markets, labor can move freely between industries.
Wages must be equal across industries.
Equalization of wages implies that:
This is the relative price of wheat.
Cost of wheat in terms of cloth.
W W C C
W C
C W
P MPL
P MPL
P
MPL
P
MPL
Ricardian Model
•
The Foreign Country
Assume Foreign’s technology is inferior to Home’s.
Foreign has an absolute disadvantage in producing both wheat and cloth as compared to Home.
Foreign Production Possibilities Frontier
Assume a Foreign worker can produce one bushel of wheat or one yard of cloth.
MPL*W = 1, MPL*C = 1
Ricardian Model
Ricardian Model
Cloth (1 Yard)
Wheat (1 Bushel)
Home 2 Bushels of Wheat
½ Yard of Cloth
Foreign 1 Bushel of Wheat
1 Yard of Cloth
• Comparative Advantage
Given the opportunity cost information, we can determine comparative advantages in each country for each good.
Ricardian Model
•
Comparative Advantage
A country has a comparative advantage in a good when it has a lower opportunity cost of producing than
another country.
By looking at the chart we can see that Foreign has a comparative advantage in producing cloth.
Foreign’s Opportunity cost of cloth is lower.
Home has a comparative advantage in producing wheat.
Ricardian Model
•
Equilibrium in Foreign
Foreign’s preferences can also be represented by an
indifference curve.
The no-trade relative price of wheat is P*W/P*C = 1.
The relative price exceeds Home’s no-trade relative
price of wheat: P*W/P*C = ½ .
The difference in relative prices comes from the
comparative advantage that Home has in wheat.
Ricardian Model—Foreign
APPLICATION
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.
APPLICATION
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 the absolute advantage in these products.
• 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.
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, it
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.
SIDE BAR
Can Comparative Advantage be Created?
The Case of “Icewine”
•
In general we think of a country having a
comparative advantage in a good.
Certain countries have a comparative advantage in the production of wine.
•
Can a country create a comparative advantage?
SIDE BAR
Can Comparative Advantage be Created?
The Case of “Icewine”
The Niagara Falls region of Canada began producing a product called “icewine” in 1983; it’s now made in
British Columbia, too.
The grapes are allowed to freeze on the vine before they are picked.
The unique flavor of the wine has led to a relatively high demand.
Determining the Pattern of International Trade
•
What happens now 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.
•
The no-trade relative price equals its opportunity
cost of production.
Determining the Pattern of International Trade
•
International Trade Equilibrium
Relative price of cloth in Foreign is PC/PW = 1. Relative price of cloth in Home is PC/PW = 2.
Therefore Foreign would want to export their cloth to Home—they can make it for $1 and export it for more than $1.
•
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.
Determining the Pattern of International Trade
•
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.
Determining the Pattern of International Trade
•
International Trade Equilibrium
The relative price of wheat in the trade equilibrium will be between the no-trade price in the two countries.
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.
Home producers of wheat can earn more than the opportunity cost of wheat by selling it to Foreign.
Determining the Pattern of International Trade
•
Home’s workers will want to work in wheat and no
cloth will be produced.
•
With trade, Home will be fully specialized in wheat
production.
2
4
8
1
3
2
6
W W
C C
W W C C
P MPL
P MPL
Therefore
P MPL
P MPL
Wages in wheat Wages in cloth
Determining the Pattern of International Trade
•
International Trade
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 trading.
Remember: this is only a consumption possibility because
Determining the Pattern of International Trade
U2
World price line, Slope = –2/3
U1 A
50 100 Wheat, QW (bushels) Cloth, QC (yards)
B
Home production 50
25
• The new world price, PW/PC = 2/3, shows us the new range of consumption possibilities
• The country can now achieve a higher utility with the new
Determining the Pattern of International Trade
Home imports 40 yards of cloth
Home consumption A B Home production 25 C
40 World price line,
Slope = –2/3
U2
U1
50 100 Wheat, QW (bushels) Cloth, QC (yards)
50
100
Home produces 100 bushels but
consumes only 40, so exports equal 60
50
Home produces 0 yards of cloth but consumes 40, so imports equal 40.
Determining the Pattern of International Trade
•
International Trade
Trade allows a country to engage in consumption possibilities it did not have before trade.
We can see this as Home can now be on a higher
indifference curve with trade than they were without it.
This is the first demonstration of gains from trade.
•
Pattern of Trade and Gains from Trade
From figure 2.5, we can also see that Home’s exports and imports are equal when valued in the same units.
Determining the Pattern of International Trade
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.
It refutes the notion that free trade benefits one country while
Determining the Pattern of International Trade
•
Pattern of Trade and Gains from Trade
However, we have not yet determined the level of wages across countries.
Relative prices converge. Do wages?
Wages do rise in each country, but they do not converge. (Important political implications)
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.
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.
Determining the Pattern of International Trade
•
Wages are determined by absolute advantage
and trade is determined by comparative
advantage.
•
This should make sense.
The only way a country with poor technology can export at a price others are willing to pay is by having low
wages.
•
As a country develops better technology, its
wages will rise. (Compare to autarky wages)
Workers become better off through receiving higher wages.
Determining the Pattern of International Trade
•
We can see this in the real world
Per capita income in China in 1978 was estimated at $925.
In 2000, per capita income in China had risen to $3750.
Per capita income in India more than doubled from $1180 in 1978 to $2480 in 2000.
APPLICATION
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.
• Figure 2.7 shows value-added per hour in manufacturing for several countries.
APPLICATION
Labor Productivity and Wages
APPLICATION
Labor Productivity and Wages
•
We can also see the connection between
productivity and wages over time.
•
Figure 2.8 shows that the general upward
movement in labor productivity is matched by
upward movement in wages.
APPLICATION
Labor Productivity and Wages
Solving for International Prices
•
In the previous analysis we assumed the world
price of wheat was 2/3.
•
In reality world price is determined by a market for
exports and imports.
•
We will derive a Home export supply curve.
Shows the amount it wants to export at various relative prices.
•
Similarly we will derive a Foreign import demand
curve.
Solving for International Prices
•
Home Export Supply Curve
The export supply curve will have the relative price of
wheat on the Y-axis and the amount of wheat on the X-axis.
We use the information in figure 2.9 to derive the curve.
Compare production and consumption at each relative price.
When Pw/Pc=1/2, Exports=0.
When Pw/Pc=2/3, Exports=60.
•
The flat portion of the export supply curve is a
special feature of the Ricardian model.
Solving for International Prices
Solving for International Prices
•
Foreign Import Demand
We can use a similar analysis to construct the import demand for wheat in figure 2.10.
At the world relative price of 2/3, Foreign imports 60 bushels of wheat, C* and C*’.
The no-trade equilibrium in Foreign, with a relative price of 1, is zero imports, A* and A*’.
Production can shift from point A, at a price of 1, as workers move between industries:
If workers all shift to cloth.
Solving for International Prices
Solving for International Prices
•
International Trade Equilibrium
We need to put the Home export supply together with the Foreign import demand.
The exports from Home come from the excess domestic supply.
The imports to Foreign come from the excess domestic demand.
This is the World market for wheat (figure 2.11):
Equilibrium price of 2/3 and trade of 60 bushels of wheat.
This is the amount that clears the world market.
Figure 2.11
Solving for International Prices
•
The Terms of Trade
The price of a country’s exports 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 will raise Home’s terms of trade.
An increase in the terms of trade is good for a country: it makes it better off.
A country will earn more for its exports.
A country will pay less for its imports.
APPLICATION
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.
•
Primary commodities are often exported by
developing countries, so their terms of trade
would decline over time.
questions
• (1) which country has absolute advantage in wine? In cheese?
(2) Which country has comparative advantage in wine? In cheese?
(3). Graph each country’s PPF. Use indifference curve to show the no-trade equilibrium (label as point A) for each country. (Suppose Home country consumes 4 million pounds of
cheese and Foreign country consumes 6 pounds of cheese) (4) When trade is opened between Home and Foreign country,
