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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