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Dr. Mitchell/ECO 329/lecnot2.doc
Ricardian Model
Why do countries trade?
Often explained by comparative advantage.
Comparative Advantage
Definition: Whenever one producer can produce a good at a lower opportunity cost than
another producer can.
Sources of Comparative Advantage
Different Production Functions
This is the basis for the Ricardian model.
Countries are assumed to have different knowledge about how to produce goods.
Different Relative Factor Prices
This is the basis for the Heckscher-Ohlin model.
Labor is relatively more expensive (compared to capital) in some countries, so that the
opportunity cost of making goods that use relatively a lot of labor is higher in those
countries.
Assumptions of the Ricardian Model
Perfect competition
This implies price equals marginal cost
Resources
Fixed in quantity (this is a static model)
Fully employed
Technology
Assumed fixed (because it is a static model)
Shared among the firms within a country but not shared across countries.
Zero Transportation Costs
Factor Mobility
Factors of production are mobile between industries within a country but cannot move
between countries
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Dr. Mitchell/ECO 329/lecnot2.doc
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For the simplest form of the model
2 Countries, Home and Foreign
1 Factor of production, labor, which is homogeneous.
2 Goods, X and Y
The Economy in Autarky
Production
In order to see the PPF we need to know resources and technology.
Labor endowment for Home = 100
# of units of L needed to produce one unit of X = 2
# of units of L needed to produce one unit of Y = 5
If Home produces all X it makes 100/2 units of X. Likewise for Y.
Y
20
Slope = - aLX /aLY
50
X
Slope of the PPF
The marginal rate of transformation, which is the amount of good Y which must be
foregone to get one more unit of X.
What is the intuition behind the constant slope?
What determines relative prices and the combination of goods that is
produced and consumed?
Tastes and preferences of each household.
Income of each household.
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International Trade
Add a similar country Foreign
Labor endowment for Foreign = 120
# of units of L needed to produce one unit of X= 3
# of units of L needed to produce one unit of Y = 4
Y
30
40
X
If foreign produces both goods in autarky then the relative price of X to Y will be equal
to 3/4.
Home is willing to export X (import Y) if the world relative price of X is greater than 2/5.
Home is willing to export Y (import X) if the world relative price of X is less than 2/5.
Foreign is willing to export X (import Y) if the world relative price of X is greater than
3/4.
Foreign is willing to export Y (import X) if the world relative price of X is less than 3/4.
So Home will export X and Foreign will export Y if the world relative price of X is
between 2/5 and 3/4.
Suppose it turns out to be equal to 1/2.
Y
Foreign
Y
Home
30
25
20
50
X
40
60
X
Note: The quantity of X exported by Home must equal the quantity of X imported by
Foreign. (Similar for Y.)
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Results of Trade
Countries produce different bundles than they consume.
The "world" trading price is the same in each country.
The world price defines a country's Consumption Possibilities Frontier (CPF).
The CPF is unambiguously larger with trade than in autarky.
Gains from trade come from two sources. (a) Even if same production point, still a larger
CPF and (b) producing more of the good in which you have a CA will further enlarge the
CPF.
The CPF is largest in the model when the country completely specializes in producing the
good it produces relatively cheaper than the other country.
Under what conditions are there benefits from trade?
Any time autarky relative prices are different.
Any time the PPFs have different slopes (and no "corner solutions").
Any time the ratios of the labor requirements are different.
Note these are all equivalent statements.
Note the relative sizes of the countries do not matter (small countries are more likely to
specialize while the large country doesn't).
What about absolute advantage?
Absolute advantage is when one producer uses fewer resources to produce a good.
AA does not determine trade flows, CA does.
Even if one country has an AA in both goods, there can still be gains from trade for both.
Example: Home as before, but Foreign uses 1 unit of labor to make 1 unit of X, 1 unit of
labor to make 1 unit of Y.
What determines standard of living?
Labor productivity determines the standard of living or real wage. With trade, workers
earn the world value of the goods they make.