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2
Trade and Technology: The
Ricardian Model
Readings: Chapter 2
sections 1-3
Introduction. U.S. Imports of
Snowboards
• Why do countries trade?
Chapter
2
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Introduction
Chapter
2
• This chapter explains comparative
advantage by looking at how technology
differences across countries affects trade
• This is referred to as the Ricardian model
because it was proposed by the 19th century
economist David Ricardo
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The Home Country
Chapter
2
• We will use two goods to develop a Ricardian
model of trade: Wheat and Cloth
• There are two countries, Home and Foreign.
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Road Map
Chapter
2
• Part 1. Home country, before trade
• Part 2. Home and Foreign countries, who
exports wheat and who exports cloth?
 Comparative advantage
• Part 3. Is trade “good” or “bad”?
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The Home Country
• The Home Country
Chapter
2
 We will assume that labor is the only resource
used to produce both goods
 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
 Key Assumption: Marginal Products of Labor
are fixed
 Suppose Home has 25 workers; i.e. L = 25.
Labor endowment.
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The Home Country: Summary
Chapter
2
Home
Cloth
MPL
wheat
MPL
Labor
2
4
25
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Drawing the PPF
Chapter
2
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Notes: Drawing of PPF
• Home Production Possibilities Frontier
Chapter
2
 We can use the marginal products of labor to
construct Home’s PPF.
 Assume there are 25 workers in Home.
 If all the workers were employed in wheat, the
country could produce 100 bushels
 If they were all employed in cloth they could
produce 50 yards.
 The PPF connects these two points
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Slope of PPF
Chapter
2
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Notes: PPF Slope: formular
• Showing these calculations we can see:
Chapter
2
 Labor = 25, MPLW = 4, MPLC = 2
 If Home produces wheat only, QW = MPLW* L = 25*4 = 100
 If Home produces cloth only, QC = MPLC* L = 25*2 = 50
• This gives us a straight line PPF which is a unique
feature of the Ricardian model
 Assumes marginal production of labor is constant
QC MPLC  L MPLC 1
50
SlopePPF   


100 QW MPLW  L MPLW 2
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Notes: Slope of PPF and Opportunity
Cost
Chapter
2
• The slope of the PPF can be calculated as the ratio
of marginal products of the two goods
• 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 – if we put wheat
quantity on the horizontal axis.
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Slope of PPF and Opportunity Cost
Chapter
2
• The slope of the PPF reflects the opportunity
cost of producing one more bushel of wheat
in terms of cloth
• Labor used in 1 wheat = labor used in ½
cloth; i.e. cost of 1 wheat = cost of ½ cloth
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Indifference Curves
Chapter
2
Cloth, QC
(yards)
The country is indifferent between A
and B
U0 < U1 < U2
B
A
U1
U2
U0
Wheat, QW
(bushels)
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Notes: Indifference Curves
• Home Indifference Curve
Chapter
2
 Given Home’s PPF, we still don’t know how much
Home will choose to produce
 We need information about the country’s
preferences – we need indifference curves
 A single indifference curve shows the
combinations of wheat and cloth that the country
can consume and be equally satisfied.
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Notes: Indifference Curves
Chapter
2
• Indifference curves increase in utility as the
curves move northeast.
• All points on a single indifferent curve have
the same level of utility.
• A country cannot produce outside their PPF
so, without trade, they are constrained in
their utility by the PPF.
• We use these indifference curves to show
the preferences of an entire country
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closed-economy equilibrium (Home)
Figure 2.2
Chapter
2
The country could produce at point D
but would be at a higher level of utility
at point A.
Cloth, QC
(yards)
The country is better off on U2 but
cannot produce that much
C
50
D
At point A, on U1, is the best the
country can do
B
A
U2
25
Home closed-economy
equilibrium
U1
Home PPF
U0
50
100
Wheat, QW
(bushels)
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Notes: Figure 2.2
• Home Equilibrium
Chapter
2
 Without trade, the PPF acts like a budget
constraint for the country
 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
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Wage Equation
• Wages
Chapter
2
 In competitive markets, suppose for cloth P = $2
and MPL = 4. How much are firms willing to pay?
 Cost of a marginal worker to the firm = wage
 Value of a marginal worker to the firm = the value
of one more hour of production = 4 cloth x
$2/cloth = $8
 So firms are happy if w = $8
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Wage Equation
2
 Meaning in English: The value of one more
worker equals the amount of goods produced by
this worker (MPL) times the price of the good.
Chapter
• w = P*MPL
 Predictions: (1) you earn more if your
products are worth more; (2) you earn more if
you are more productive
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Ave. Wage Purdue Graduates 2011
Source: The Exponent, 2011.
Chapter
2
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Oil Boom in North Dakota and Wages
Source: “U.S. News: North Dakota Enjoys Oil Boom – But Girds for Slowdown”, by Russel Gold,
24 December 2012, The Wall Street Journal.
Chapter
2
• Oil prices
http://www.macrotrends.net/1369/crude-oilprice-history-chart
• The average wage in the energy industry in
ND = ?
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Example: A Snow-covered Paradise in Alberta
• Wood Buffalo, Alberta
Chapter
2
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Wood Buffalo: A Luxury Resort Town?
Source: “This Is the Life: Luxurious Digs On Frigid Oil Sands --- Firms in Canada Pay Well, And Steak Is on the Menu;
'Smell of Money' Beckons”, by Douglas Belkin, 5 December 2007, The Wall Street Journal, A1
Chapter
2
• Medium Single Family House: $625,000
• In and out: private airports
• Life style of residents:
 20-inch flat-screen TV, double bed
 high-speed Internet access and daily maid
service.
 Prime rib is on the Thursday dinner menu.
 The bar opens at 6 p.m., there's a yoga class at 7
• Earnings of residents:
 $100,000 for inexperienced truck drivers
 $200,000 for experienced welders
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Relative Prices at closed-economy
equilibrium
 W=P*MPL holds for both wheat and cloth
 Since labor can move freely between industries, wages
must be equalized:
Chapter
2
PW * MPLW  PC * MPLC
PW MPLC 1


PC MPLW 2
 The right had size is the slope of the PPF and the
opportunity cost of obtaining one more bushel of
wheat.
 The left hand side is the relative price of wheat.
 Value of 1 wheat = ½ value of 1 cloth
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Relative Prices and OC
Chapter
2
• The price ratio, PW/PC, always denotes the
relative price of the good in the numerator,
measured in terms of how much of the good
in the denominator must be given up.
• For the good on the horizontal axis of the
PPF picture, |PPF slope| = OC = relative
price before trade
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Real Wages Before Trade
• Real Wage = wage/price
Chapter
2
 Real wage for wheat = wage/price_of_wheat; i.e.
quantity of wheat the wage can buy
• Calculate the real wage for wheat
• Calculate the real wage for cloth
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Notes: the calculation of Real Wages
Before Trade
• Real Wages
Chapter
2
 Real wage for wheat = wage/price_of_wheat; i.e.
quantity of wheat the wage can buy
 Since Home produces both wheat and cloth,
Home wage is: w = PW*MPLW = PC*MPLC
 The real wage for wheat = w/PW = (PW*MPLW)/PW
= MPLW = 4 wheat
 The real wage for cloth = w/PC = (PC*MPLC)/PC
MPLC = 2 cloth
• Before trade, real wage = marginal product of
labor
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Real Wages Before Trade
• Before trade, real wage = marginal product of
labor
Chapter
2
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Part 1 Summary
Chapter
2
•
•
•
•
•
MPL
PPF
PPF Slope and OC
Wage Equation
Relative price before trade
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The Foreign Country: Summary
Chapter
2
Foreign
Cloth
MPL
wheat
MPL
Labor
1
1
100
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Notes: The Foreign Country in Detail
• The Foreign Country
 Foreign Production Possibilities Frontier
Chapter
2
 MPL*W = 1, MPL*C = 1
 Key Assumption: Marginal Products of Labor are
fixed
 Assume there are 100 workers available in Foreign
 If all workers were employed in wheat they could
produce 100 bushels.
 If all workers were employed in cloth they could produce
100 yards.
 The Foreign country’s PPF connects these two points.
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Foreign PPF
Chapter
2
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closed-economy equilibrium (Foreign)
Cloth, (yards)
Chapter
2
Figure 2.4
100
A*
50
Foreign before-trade
equilibrium
Foreign PPF
50
100
Wheat , (bushels)
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Notes: Figure 2.4
• Equilibrium in Foreign
Chapter
2
 Foreign’s preferences can also be represented by
indifference curves
 Economy produces at the point of highest utility
for the country within the PPF constraint
 |The slope of the PPF| = the opportunity cost of
wheat = the before-trade relative price of wheat,
P*W/P*C = 1
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Pattern of Trade
Chapter
2
• Which country exports wheat and which
country exports cloth?
• Assume: no trade cost
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Absolute Advantage = Higher MPL
Summary of Home and Foreign
MPL, Cloth
(Yard/worker)
Chapter
2
MPL, wheat
Labor
(Bushel/worker)
Home
2
4
25
Foreign
1
1
100
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Notes: Absolute Advantage
• Absolute advantage = higher MPL
Chapter
2
 Foreign’s technology is inferior to Home’s
 Home has an absolute advantage in both wheat
and cloth as compared to Foreign
 Clearly, Home can’t export both wheat and cloth
when trade opens up.
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Comparative Advantage = Lower OC
Summary of Home and Foreign
MPL, Cloth
(Yard/worker)
Chapter
2
MPL, wheat
Labor
(Bushel/worker)
Home
2
4
25
Foreign
1
1
100
OC of wheat in Home = ??
OC of wheat in Foreign = ??
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Table of Opportunity Cost
Chapter
2
Opportunity Costs for Goods in Home
and Foreign
Cloth (Yard)
Wheat
(Bushel)
Home
2 wheat
½ cloth
Foreign
1 wheat
1 cloth
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Notes: OC Table
• Comparative Advantage = Lower Opportunity
Cost
Chapter
2
 Remember a country has a comparative
advantage in a good when it has a lower
opportunity cost of producing that good
 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
 Home’s opportunity cost of wheat is lower
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Why does comparative advantage drive trade
patterns?
• Because OC = relative prices before trade
Chapter
2
Wheat
(Bushel)
Home
½ cloth
Foreign
1 cloth
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Notes: Relative Price Table
• Why does Home export wheat?
Chapter
2
 Relative price of wheat in Home is PW/PC = 1/2
 Relative price of wheat in Foreign is PW*/PC* = 1
 Therefore Home would want to export their wheat
to Foreign – they can make it for 0.50 cloth and
export it for 1 cloth!
• The opposite is true for cloth
 Home will export wheat and Foreign will export
cloth
 Both countries export the good for which they
have the comparative advantage
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Comparative Advantage in Apparel,
Textiles, and Wheat
APPLICATION
Chapter
2
• US 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
US with a 1999 sales of $1.6 billion
• Sales per employee were therefore $92,000
• This is the average for all US apparel producers
• Textiles are even more productive with annual sales
per employee of $140,000 in the US
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Comparative Advantage in Apparel, Textile and Wheat
APPLICATION
• Table 2.2
Chapter
2
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Equilibrium with trade
Chapter
2
• The relative price of wheat in the trade
equilibrium will be between the before-trade
prices in the two countries
• For now lets assume the free-trade price,
PWT/PCT = 2/3. This is between the price of
½ in Home and 1 in Foreign.
• We can now take this price and see how
trade changes production and consumption
in each country
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Notes: Equilibrium with trade
• How prices change after trade
Chapter
2
 As Home exports wheat, quantity of wheat sold at
Home falls
 The price of wheat at Home goes up
 More wheat goes into Foreign’s market
 The price of wheat in Foreign falls
 For the same reason, as Foreign exports cloth,
the quantity sold in Foreign falls. Therefore, the
price in Foreign for cloth rises, and the price of
cloth in Home falls.
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Notes: Equilibrium with trade
• Trade Equilibrium
Chapter
2
 Two countries are in a trade equilibrium when the
relative price of wheat is the same in the two
countries – this means the relative price of cloth is
also the same in both countries.
 This is because we assume there is no trade cost
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Pattern of Production
Opportunity Costs in Home and
Foreign
Chapter
2
Cloth (Yard)
Home
2 wheat
Wheat
(Bushel)
½ cloth
Foreign
1 wheat
1 cloth
PWT/PCT = 2/3.
Home exports wheat. How many wheat does Home make?
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Complete specialization
P MPLW  2  4  8
      1
P MPLC  3  2  6
Therefore
T
W
T
C
Chapter
2
PWT MPLW  PCT MPLC
Wages Wheat  Wages Cloth
• 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
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Summary Part 2
• Absolute advantage
• Comparative advantage
Chapter
2
 OC = relative price before trade
• Trade equilibrium
• Free-trade price
• Complete specialization
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Is trade good or bad: Home
Chapter
2
PWT/PCT = 2/3.
Home exports wheat
Cloth, QC
(yards)
50
A
Home closed-economy
equilibrium
25
U1
Home PPF
50
100
Wheat, QW
(bushels)
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Consumption possibility frontier
Chapter
2
• With free trade, what choices does Home
country have for consumption? i.e. what is
Home country’s “budget line”?
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Consumption Possibility Frontier (CPF), Home
•The new world price, PWT /PCT =
2/3, shows us the new range of
consumption possibilities
Cloth, QC (yards)
Chapter
2
•The country can now achieve a
higher utility with the new
consumption possibilities
50
CPF, Slope = –2/3
A
25
U2
U1
Home production
B
50
100
Wheat , QW
(bushels)
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Is trade good or bad: Foreign
Chapter
2
Cloth, (yards)
Foreign PPF
PWT/PCT = 2/3.
Foreign exports cloth
100
A*
Foreign closed-economy equilibrium
U0
100
Wheat, (bushels)
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CPF, Foreign
Chapter
2
Foreign production
Cloth, (yards)
100
•The new world price, PWT /PCT =
2/3, shows us the new range of
consumption possibilities
•The country can now achieve a
higher utility with the new
consumption possibilities
B*
Foreign consumption
C*
60
U1
World price line,
Slope = –2/3
U0
60
100
Wheat, (bushels)
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Notes: Gains from Trade
• Gains from trade for BOTH countries!
Chapter
2
 Under the new production, each country
specializes fully in the good for which they have
the comparative advantage
 They then export some of their production and
import some of the other good from the other
country
 Home specializes in wheat and Foreign
specializes in cloth
 The new indifference curves show the new
consumption points.
 The difference between production and
consumption give us trade patterns
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Gains from Trade: intuition
• International Trade
Chapter
2
 Trade allows both countries to engage in
consumption possibilities they did not have before
trade
 This is a demonstration of gains from trade
 Intuition: trade increases the choices a
country can make (the PPF remains available
after trade); both countries gain because they
help each other out.
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Trade is Balanced: Foreign
Foreign produces 0 wheat but consumes 60
so imports equal 60.
Chapter
2
Foreign production
Cloth, (yards)
Foreign produces 100 cloth but consumes
only 60 so exports equal 40
100
Foreign exports
40 yards of cloth
B*
Foreign consumption
C*
60
U1
World price line,
Slope = –2/3
U0
60
100
Wheat, (bushels)
Foreign imports 60 bushels of wheat
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Trade is Balanced: Home
Home produces 100 wheat but consumes
only 40 so exports equal 60
Cloth, QC (yards)
Home produces 0 cloth but consumes 40 so
imports equal 40.
Chapter
2
Home consumption
50
C
40
U2
Home imports 40
yards of cloth
World price line, Slope = –2/3
U1
Home production
B
40
100
Wheat , QW
(bushels)
Home exports 60 bushels of wheat
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Notes: Trade is Balanced
• Trade is the difference between domestic
production and consumption
Chapter
2
 Quantity of exports = quantity of production –
quantity of consumption
 Quantity of imports = quantity of consumption –
quantity of production
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Trade and Wages
Chapter
2
• How do wages change after trade for Home
and Foreign?
• Under free trade, which country has a higher
wage?
 Wages actually differ – they are determined by
absolute advantage – not comparative advantage
• Real wages: = wage/price.
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Real Wages Before Trade: Home
Chapter
2
• Before trade, real wage = marginal product of
labor since Home makes both wheat and
cloth
 The real wage for wheat = MPLW = 4 wheat
 The real wage for cloth = MPLC = 2 cloth
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Real Wages After Trade: Home
• Solving for Real Wages Across Countries
Chapter
2
 Since Home produces and exports wheat,
Home wage is: w = PWT*MPLW
 The real wage for wheat = w/PWT =
(PWT*MPLW)/PWT = MPLW = 4 wheat. Same as
before trade
 The real wage for cloth = w/PCT =
(PWT*MPLW)/PCT =(PWT/PCT)*MPLW = (2/3)*4 = 8/3
cloth. Higher than before trade.
• Trade increases real wage for cloth! Same
intuition as gains from trade.
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Terms of Trade
• The real wage for cloth =(PWT/PCT)*MPLW
• The Terms of Trade for Home = PWT/PCT
Chapter
2
 An increase in PWT or a fall in PCT will raise
Home’s terms of trade
 An increase in the terms of trade is good for a
country
 They earn more for its exports
 They pay less for their imports
 Home real wage for cloth is higher
 In general, the price of a country’s exports divided
by the price of its imports.
 Foreign’s Terms of Trade = PCT/PWT
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Real Wages Before Trade: Foreign
Chapter
2
• Before trade, real wage = marginal product of
labor since Foreign makes both wheat and
cloth
 The real wage for wheat = MPLW* = 1 wheat
 The real wage for cloth = MPLC* = 1 cloth
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Real Wages After Trade: Foreign
• Solving for Wages Across Countries
Chapter
2
 Since Foreign produces and exports cloth,
Foreign wage is: w* = PCT *MPLC*
 The real wage for cloth = w*/PCT =
(PCT*MPLC*)/PCT = MPLC* = 1 cloth, same as
before trade
 The real wage for wheat = w*/PWT =
(PCT*MPLC*)/PWT = (PCT/PWT)*MPLC* = (3/2)*1 =
3/2 wheat, higher than before trade
• Again, free trade increases real wages!
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Comparing Wages Across Countries
• Summarizing
2
 4 bushels of wheat
 8/3 yards of cloth
Chapter
 Home real wage is
 Foreign real wage is
 3/2 bushels of wheat
 1 yard of cloth
 The ratio Home_wage/Foreign_wage = 8/3, so
Foreign workers earn less
 What is the intuition for this?
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Comparing Wage Across Countries
• What determines w/w*?
Chapter
2
 Since Home produces and exports wheat,
Home wage is: w = PWT*MPLW
 Since Foreign produces and exports cloth,
Foreign wage is: w* = PCT *MPLC*
w  P MPL
w P MPL
*
T
W
T
C
W
*
C
PWT MPLW
2 4 8
 ( T )(
)  
*
PC MPLC
3 1 3
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Summary: Comparing Wages Across
Countries
Chapter
2
• Home_wage/Foreign_wage depends on
Home country’s TOT and absolute
advantage
• So comparative advantage gives you trade
patterns, and absolute advantage gives you
high wages
• The intuition: the only way a country with
poor technology can export at a price others
are willing to pay is by having low wages.
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Predictions
2
 In a given year, the countries that have better
technology should have higher wages (i.e.
comparing across countries)
Chapter
• Prediction:
 Over time, as a given country develops better
technology, its wages will rise (i.e. looking at
changes for a given country)
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Labor Productivity and Wages for 2001
APPLICATION
• Figure 2.7
Chapter
2
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Notes: Figure 2.7.
APPLICATION
Chapter
2
• Labor productivity can be measured by the valueadded 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
 Countries with higher labor productivity pay higher wages,
just as the Ricardian model predicts
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Figure 2.8. Labor Productivity and Wage Over Time
APPLICATION
Chapter
2
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Notes: Figure 2.8.
APPLICATION
Chapter
2
• We can also see the connection between
productivity and wages over time
• Figure 2.8 shows the general upward
movement in labor productivity is matched by
upward movement in wages
 This is also predicted by the Ricardian Model
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Summary Part 3
Chapter
2
• CPF
• Trade is balanced
• Real wages
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