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LABOUR PRODUCTIVITY AND COMPARITIVE ADVANTAGE :
The Ricardian Model
Why do countries trade?
1. Because they are different from other nations.
2. Countries tend to achieve economies of scale in their production
CONCEPT OF COMPARITIVE ADVANTAGE
Whenever we produce one thing , we devote the resources which could have been used
elsewhere.This is the opportunity cost of production . Some countries are better at production of
one commodity and the other country is better at other things.
The difference in opportunity cost forms the basis of mutually beneficial trade, because it allows
each country to specialise in production of the good it has comparative advantage in production of
that good is lower in that country as compared to other countries.
A ONE FACTOR ECONOMY
Lets imagine that labour is the only factor of production there are only two goods wine and cheese .
The cost is measured as the no. of hours of labour required to produce one unit of wine or cheese .
ALw and ALc are the unit labor requirement for wine and cheese respectively total resources are L.
PRODUCTION POSSIBILITIES
Since L is fixed there is always a max amount that a country can produce and there is also a trade off.
Since labor is homogeneous therefore the first unit or the last of labor produces the exact same
amount.
Q w
Budget equation ALw.Ql +ALc. Qc ≤L
No of labor hrs/
L arm
slope=ALc/ALw
qty of wine
unit of wine
Slope is constant . Slope represents the no of gallons of
Wine the country would have to give up for a unit of
Cheese.
RELATIVE PRICES AND SUPPLY
The economy will produce what it can sell for more than as compared to its opportunity cost. Pcprice of cheeses and Pw- price of wine . If Pc/Pw > ALc/Alw then prices are high in cheese industry
and vice versa .If the above scenario is true than then country will specialize in cheese. In absence of
international trade, the country produces both goods and therefore relative prices are equal to
relative labor requirement
TRADE IN ONE FACTOR WORLD
Lets add another country to our analysis and call it a foreign country like we had all the variable
earlier for home country . the same symbols with as are for foreign country lets say home country is
better at producing cheese then
ALc/ALw < ALc*/ALw* or ALc/ALc*< ALw/ALw*
So home country has a comparative advantage in cheese.
Wine
C*/AC*w
Foreign PPF
Countries w/o trade fixed theiit relative prices on the
Basis of the ratio but with trade , trade condition
Also decide relative price
L*/ALc* cheese
RELATIVE PRICE AFTER TRADE
We have to use general equation analysis and study home and foreign market both to determine
relative prices.
Relative price of cheese Pc/Pw
A*Lc/A*Lw
RS
1
2
RD
RD is the relative dd curve and Rs is II ss curve since
home country will only produce cheese if Pc/Pw>ALc/ALw
therefore RS starts from that point
RD1
Q L/ALc / l*A*LC
Relative qty. of cheese Qc+Q*c/Qw +Q*w
If PC/Pw <AL*c/A*Lw but greater than ALc/ALw the home country will specialize in cheese and
foreign country in wine .This will happen till Pl/Pw <A*Lc/A*Lw when Pc/PW =A*Lc/A*lw then both
countries start specializing in cheese.
RD is negatively sloping coz as PC increases the dd falls coz of substitution effect.
SO if RD is crossing RS at point 1 then home country produces cheese and foreign country produces
wine .But if the relevant curve is RD’ then home country is producing both cheese and wine but
foreign country is producing only wine.
But if the 2 countries do end up specializing completely then,
Increase in relative price of cheese
Q
Q* W
T makes it specialize in cheese
F*
increase in relative price of wine makes
it specialize in wine
P
F
P*
T*
Q*
QC
GAINS FROM TRADE
Home country’s wine ( by trading ) =(1/ALc) (Pc/Pw)
So if (1/ALc) (Pc/Pw) > 1/ALw then they will gain or Pc/Pw > ALc /ALw . the same can be seen from
the above graph.
RELATIVE WAGE
The relative wage of a country’s workers is the amnt. they are paid per hour, compared with the
amount workers in another country are paid
Per hour
Home
Foreign
Cheese
ALc=1 hour/pound
A*Lc=6 hour/pound
Wine
Alw= 2 hour/gallon
A*Lw=3 hour/gallon
Lets say Pc=Pw=$12 home country specialities in cheese and they produce 1 unit of cheese in one hr
which sells for $12 therefore their wage is $12/3 =$4 hour therefore the relative wage is 3 this wage
depends upon relative price and productivity of each country.
MISCONCEPTIONS ABOUT COMPARITIVE ADVANTAGE
1. PRODUCTIVITY AND COMPETITIVENESS we don’t need absolute advantage for 2 countries to
trade Compartitive advantage leads to trade as long as the wages paid to workers are
justified by productivity
2. PAMPER LABOR ARGUMENT –in our eg- home is more productive than foreign and this is
due to the fact that foreign has much lower wages. But home is only concerned with lower
cost of wine as compared to its own whether it is due to cheaper labor or high productivity.
3. EXPLOITATION- some one might compare the wages of 2 countries and call it exploitation if
one country gets lower wage rate than the other but may end up getting even a lower wage
rate and therefore, it is better to trade than not to.
COMPARITIVE ADVANTAGE WITH MANY GOODS
2 countries- Home and foreign with one factor of production labor and producing numerous
goods numbered 1 to N so Ali is the number of labor hours required to produce ith good we
place the relative labour hours in the ascending manner so that ,
aL1/a*L1 < aL2/a*L2 <aL3/a*L3 <a*L4/aL4
SPECIALIZATION
The goods will always be produced where it is cheaper to produce them. The cost of
producing some good say ‘I’ is the unit labor requirement times the wage rate.
So, WALi <W*a*Li Implies home country is cheaper
Or
W/W* <a*Li/aLi
So all goods are compared with w/w* all the goods lower than w/w* are produced at all to
the right are produced in country.
a*Li/aLi <w/w*
All to left -produced at foreign
All to right- produced in home
Eg:
Good
Home labor
Foreign labor
Relative home
req.(aLi)
reqd(a*Li)
productivity
adv.(A*Li/aLi)
Apples
1
10
10
Bananas
5
40
8
Caviar
3
12
4
Dates
6
12
2
Enchiladas
12
9
0.75
Home country has an advantage in any good for which its relative productivity is higher than
wage.
We can assume any wage rate and see which country produce what :
For eg: w/w* =1.5 then except for enchi ladas all get produced in home.
w/w* <a*Li/Ali =produced in home
DETERMINING RELATIVE WAGE FOR MULTI GOOD
We look at relative dd of good to the implied relative dd of labor .H is derived dd since labor
is used to produce goods and services.
When wages in home Increases implies w/w* increases implies relative derived dd of labor
decreases:
1. Goods produced at home also becomes more expensive
2. As W/W* increases implies fewer goods get produced at home
Relative wage w/w*
10
8
4
2
075
RD represents world demand for home labor relative to its dd for foreign labor.
Apples
RS is relative supply of labor determined by relative sizes of home and foreign labor
Bananas
forces it is a vertical straight line
Caviar
dates
enchi ladas
Quantity of labor L/L*
ADDING TRANSPORT COSTS AND NON TRADED GOODS
Specialization in the real international economy is not that extreme because :
1. More than one factor is present which reduces the specialization countries sometime
protect industries from foreign competition
2. Countries sometime protect industries from foreign competition
3. It is expensive to transport goods
Sometimes the expense is so high that it is cheaper to produce it in the country than to
import it.The goods which are not traded at all becomes non traded goods