Lecture 2: One-factor

economy: The Ricardian

model
1 ntuyen@hcmiu.edu.vn

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2 Content
1. Comparative advantages
2. One-factor economy: Ricardian model
3. Trade in a one-factor world
4. Misconceptions about comparative advantage.
5. Comparative advantages with many goods

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 3 1. Comparative advantages
 Why trade?
• Differences in resources (e.g., natural resources, technology, labor, climate…)
• Economies of scale

10 millions 100,000 10 millions 30,000

 Opportunity cost: trade-off of one product given resource to produce another.

1/100
 EX: USA’s Opportunity cost of rose in term of computer is……

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 1. Comparative advantages
4

 Trade between two countries can benefit both countries if each

comparative advantage.
country exports the goods in which it has a…………..

Comparative
advantage 
lower
….
opportunity
cost

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 5 1. Comparative advantages
 However, in the real world, international production and trade are
determined in the marketplace, where the supply and demand rule.
➔To assess if trade between US and Columbia actually happens like
the statement about comparative advantage possibilities, we’ll look
at Ricardian Model (1817).

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 6 2. One-factor economy
RICARDIAN MODEL OF TRADE
 Emphasizes differences in technology across countries, reflected in
differences in the productivity of labor.
 Assume that we are dealing with an economy (which we call Home).
In this economy:
• Labor is the only factor of production (one-factor economy).
• Only two goods (say wine and cheese) are produced.
• The supply of labor is fixed in each country.
• The productivity of labor in each good is fixed.
• Perfect competition prevails in all markets.

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7
2. One-factor economy
Country Production Possibilities Frontier

The technology of Home’s economy can be

summarized by labor productivity in each
𝑎𝐿𝑊
industry, expressed in terms of the unit labor
requirement, the number of hours of labor
required to produce a pound of cheese or a
gallon of wine

𝑎𝐿𝑊 and 𝑎𝐿𝐶 : unit labor requirement of Wine and

𝑎𝐿𝐶 Cheese
Productivity: inverse of unit labor requirement
1/𝑎𝐿𝑊 and 1/𝑎𝐿𝐶 : # units of W and C produced in 1
hour
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 2. One-factor economy
8
Country Production Possibilities Frontier

L: total labor
resource

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 2. One-factor economy
9
Country Production Possibilities Frontier
 Aggregate labor endowment
constraint can be written:
𝑳 = 𝒂𝑳𝑾 ∗ 𝑸𝑾 + 𝒂𝑳𝑪 ∗ 𝑸𝑪
(𝑳- 𝒂𝑳𝑪 ∗ 𝑸𝑪 )/𝒂𝑳𝑾 = 𝑸𝑾
which summarizes the country’s
PPF
 PPF shows maximum amount of
cheese (wine) Home can
produce given any production
of wine (cheese).

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10 2. One-factor economy
Country Production Possibilities Frontier

𝐿 𝑎𝐿𝐶 Slope?
 𝑄𝑊 = − ∗ 𝑄𝐶
𝑎𝐿𝑊 𝑎𝐿𝑊

𝑎𝐿𝐶
 Opportunity cost of cheese in terms of wine is = absolute value of
𝑎𝐿𝑊
slope of PPF line.

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 11
EXAMPLE
 The economy’s total labor supply is 1,000 hours. It takes 1 hour of labor to
produce a pound of cheese and 2 hours of labor to produce a gallon of wine.
Then the total labor used in production is:
1 * pounds of cheese produced + 2 * gallons of wine produced ≤ 1000
 Questions:
• What is the opportunity cost of wine in terms of cheese?
• If we need 500 pounds of cheese and 200 gallons of wine, how many labor
supply do we need?
• Can 400 pounds of cheese and 400 gallons of wine be produced at the same
time?
• If the economy devoted all its labor to cheese production, how many pounds
of cheese are produced?
• If the economy devoted all its labor to wine production, how many gallons of
wine are produced?

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 2. One-factor economy
12
Relative prices and supply
 In a competitive economy, supply decisions are determined by the
attempts of individuals to maximize their earnings. In our simplified
economy, since labor is the only factor of production, the supply of
cheese and wine will be determined by the movement of labor to
whichever sector pays the higher wage.

What are hourly

𝑎𝐿𝑊 = 2 𝑙𝑎𝑏𝑜𝑟 ℎ𝑜𝑢𝑟𝑠, 𝑝𝑊 = $7
wages of workers
and what they’re
gonna specialize
𝑎𝐿𝐶 = 1 𝑙𝑎𝑏𝑜𝑟 ℎ𝑜𝑢𝑟, 𝑝𝐶 = $4 producing?

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 2. One-factor economy
13 Relative prices and supply
𝑝𝑊 𝑝𝐶 𝑝𝑊 𝑎𝐿𝑊
 If > ~ > , specialize in W
𝑎𝐿𝑊 𝑎𝐿𝐶 𝑝𝐶 𝑎𝐿𝐶

𝑝𝑊 𝑝𝐶 𝑝𝑊 𝑎𝐿𝑊
 If < ~ < , specialize in C
𝑎𝐿𝑊 𝑎𝐿𝐶 𝑝𝐶 𝑎𝐿𝐶

𝑝𝑊 𝑝𝐶 𝑝𝑊 𝑎𝐿𝑊
 If = ~ = , both goods are produced, any production
𝑎𝐿𝑊 𝑎𝐿𝐶 𝑝𝐶 𝑎𝐿𝐶
on the PPF maximizes the value of revenue.
𝑝𝑊 𝑎𝐿𝑊
 NOTE: : relative price of wine; : opportunity cost of wine in terms of
𝑝𝐶 𝑎𝐿𝐶
cheese

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 2. One-factor economy
14 Relative prices and supply
𝑝𝑊 𝑎𝐿𝑊
 When no trade occurs, Home will produce both goods if = (or
𝑝𝐶 𝑎𝐿𝐶
𝑝𝐶 𝑎𝐿𝐶
= ): relative price = opportunity cost
𝑝𝑊 𝑎𝐿𝑊

➔Labor theory of value:

“In the absence of international trade

relative prices of goods relative unit labor requirements”

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 15 2. One-factor economy: with trade
 Consider 2 countries (Home & Foreign) such that
∗
𝑎𝐿𝐶 𝑎𝐿𝐶 𝑎𝐿𝐶 𝑎𝐿𝑊
< ∗  ∗ < ∗
𝑎𝐿𝑊 𝑎𝐿𝑊 𝑎𝐿𝐶 𝑎𝐿𝑊

➔Home has smaller opportunity cost of cheese than Foreign, and vice
versa ➔ Foreign has comparative advantage in …………..…, and Home
has comparative advantage in……………
 Note that country size (L and L*) and absolute productivity do not affect
the pattern of comparative advantage!
 If only 𝑎𝐿𝐶 < 𝑎𝐿𝐶
∗
, Home produce labor is more efficient than Foreign in
producing cheese ➔ Home has absolute advantage in producing
cheese. NOT COMPARATIVE ADVANTAGE (we need 4 terms to identify
comparative advantage)

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 16 2. One-factor economy: with trade
 We cannot determine pattern of trade from absolute advantage, but
need comparative advantage.
 Profitable to ship

Cheese ∗
𝑝𝐶 𝑝𝐶
Home Foreign when < ∗
𝑝𝑊 𝑝𝑊
Wine

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 Pattern of Specialization and World Relative
17
Supply
𝑝𝑐 𝑎𝐿𝑐
 If < , both countries
𝑝𝑤 𝑎𝐿𝑤
General equilibrium
analysis specialize in W (no Cheese
No trade production)
∗
𝑝𝑐 𝑎𝐿𝑐
 If > ∗ , both countries
𝑝𝑤 𝑎𝐿𝑤
specialize in C (no Wine
Trading
production)
∗
𝑝𝑐 𝑎 𝑝𝑐 𝑎𝐿𝑐
 If = 𝐿𝑐 or = ∗ , indifferent
𝑝𝑤 𝑎𝐿𝑤 𝑝𝑤 𝑎𝐿𝑤
No trade
between producing any relative
amount of 2 goods (flat RS)

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 Pattern of Specialization and World
18 Relative Supply
∗
𝑎𝐿𝑐 𝑝𝑐 𝑎𝐿𝑐
 If < < ∗ , countries specialize
𝑎𝐿𝑤 𝑝𝑤 𝑎𝐿𝑤
according to comparative advantage
(Home:cheese, Foreign:wine) with relative
𝐿/𝑎𝐿𝐶
supply of cheese is ∗ ∗
𝐿 /𝑎𝐿𝑊
 Downward slope of RD curve reflects
substitution effect.
 Equilibrium relative price of cheese:
intersections ➔ normal case is complete
specialization according to comparative
advantage (point 1).

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 Equilibrium Trade Price
19

 However, incomplete specialization is

also possible where
𝑝𝑐 𝑎𝐿𝑐
= (point A)
𝑝𝑤 𝑎𝐿𝑤 B
∗
𝑝𝑐 𝑎𝐿𝑐
or = ∗ (point B)
𝑝𝑤 𝑎𝐿𝑤
 This is most likely to happen when one
country is very large (in terms of size or A
productivity) relative to the other
 The bigger country will then be
incompletely specialized (producing
both goods).

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 20
Constructing the World PPF
 Consider the following
example: W W
➢ Home:
L = 1200, 𝑎𝐿𝐶 = 6,
𝑎𝐿𝑊 = 6
➢ Foreign:
L = 400, 𝑎𝐿𝐶
∗
= 4,
∗
𝑎𝐿𝑊 =1

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21 Constructing the World PPF
W
W

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 22 Gains from trade
 International trade allows
Home and Foreign to
consume more than it can
produce ➔ gain from
trade.
 If countries specialize
according to their
comparative advantage,
they all gain from this
specialization and trade.
 TF, T*F*: consumption
possibility line
 PF, P*F*: production
possibility line

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 23
Gains from trade: numerical example

 The previous numerical example implies that:

aLC / aLW = 1/2 < a*LC / a*LW = 2
In world equilibrium, the relative price of cheese must lie between these values.
Assume that Pc/PW = 1 gallon of wine per pound of cheese.
 Both countries will specialize and gain from this specialization.
Consider Home, which can transform wine to cheese by either producing it internally
or by producing cheese and then trading the cheese for wine.

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 Gains from trade: numerical example
24

 Home can use one hour of labor to produce 1/aLW = 1/2 gallon of
wine if it does not trade.
 Alternatively, it can use one hour of labor to produce 1/aLC = 1
pound of cheese, sell this amount to Foreign, and obtain 1 gallon of
wine (better).

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 25
Productivity and Wages

Competitive labor and output markets

 Firms pay workers the value of their marginal product:
 If C is produced, workers in C sector are paid 𝑤𝐶 = 𝑝𝐶 /𝑎𝐿𝐶
 If W is produced, workers in W sector are paid 𝑤𝑊 = 𝑝𝑊 /𝑎𝐿𝑊
 With just one production factor, this is equivalent to marginal cost pricing
 As workers can freely move to sector with higher wage (this is the long
run), then must have w = 𝑤𝐶 = 𝑤𝑊 whenever both C and W are produced
 This implies 𝑝𝐶 /𝑝𝑊 = 𝑎𝐿𝐶 /𝑎𝐿𝑊 whenever both C and W are produced
 If country is specialized in good i = {C , W } then wages are w = 𝑝𝑖 /𝑎𝐿𝑖

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 26
Relative Wages
 The relative wage of a country’s workers is the amount they are paid per
hour, compared with the amount workers in another country are paid per
hour.
 Assume that 2 countries are open to trade at the relative price pT
 ... and both countries are completely specialized (in C for Home, in W for
Foreign): 𝑎𝐿𝐶 /𝑎𝐿𝑊 < 𝑝𝑇 < 𝑎𝐿𝐶
∗ ∗
/𝑎𝐿𝑊
𝑇 𝑇
𝑝𝐶 𝑝𝑊
 Then w = 𝑎𝑛𝑑 𝑤∗ = ∗
𝑎𝐿𝐶 𝑎𝐿𝑊

 Because there are technological differences between the two countries,

trade in goods does not make the wages equal across the two countries.
 A country with absolute advantage in both goods will enjoy a higher wage
after trade.

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 27 Relative Wages

This can be illustrated with the help of a numerical example:

Assume that PC = $12 and that PW = $12. Therefore, we have PC / PW = 1
as in our previous example.
Since Home specializes in cheese after trade, its wage will be (1/aLC)PC
= ( 1/1)$12 = $12.
Since Foreign specializes in wine after trade, its wage will be (1/a*LW) PW
= (1/3)$12 = $4.
Therefore the relative wage of Home will be $12/$4 = 3.
Thus, the country with the higher absolute advantage will enjoy a
higher wage after trade (Home in this case).

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 Misconceptions About Comparative
28 Advantage
 Productivity and Competitiveness
➢ Myth 1: Free trade is beneficial only if a country is strong enough to withstand
foreign competition.
- This argument fails to recognize that trade is based on comparative not
absolute advantage.
 The Pauper Labor Argument
➢ Myth 2: Foreign competition is unfair and hurts other countries when it is based
on low wages.
- Again in our example Foreign has lower wages but still benefits from trade.
 Exploitation
➢ Myth 3: Trade makes the workers worse off in countries with lower wages.
- In the absence of trade these workers would be worse off.
- Denying the opportunity to export is to condemn poor people to continue to
be poor.

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 COMPARATIVE ADVANTAGE WITH MANY
29
GOODS
 N different goods: i = 1 .. N (potentially traded)
𝑎𝐿𝑖 : Home’s unit labor requirement for good i
∗
𝑎𝐿𝑖 : Foreign’s unit labor requirement for good i
 Relabel the goods so that the lower the number, the lower the ratio of
Home’s unit labor requirement to Foreign’s:
𝑎𝐿1 𝑎𝐿2 𝑎𝐿3 𝑎𝐿𝑁
∗ < ∗ < ∗ <⋯< ∗
𝑎𝐿1 𝑎𝐿2 𝑎𝐿3 𝑎𝐿𝑁
 The pattern of trade depends on relative wage between Home & Foreign.
 If home produces i then 𝑤 = 𝑝𝑖 /𝑎𝐿𝑖
 If foreign produces i then 𝑤 ∗ = 𝑝𝑖∗ /𝑎𝐿𝑖
∗

 In a free-trade equilibrium, 𝑝𝑖 = 𝑝𝑖∗ = 𝑝𝑖𝑇 for all i

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 COMPARATIVE ADVANTAGE WITH MANY
30
GOODS
 Goods will be produced where it’s cheapest to make them.
Cost at home = waLi ; Cost at Foreign = w ∗ a∗Li .
𝒂∗𝑳𝒊 𝒘
➔Better to produce i at Home when waLi < w ∗ a∗Li  >
𝒂𝑳𝒊 𝒘∗
∗
𝑎𝐿𝑖
 Any goods for which > 𝑤/𝑤 ∗ will be produced in Home
𝑎𝐿𝑖
∗
𝑎𝐿𝑖
 Any goods for which < 𝑤/𝑤 ∗ will be produced in Foreign
𝑎𝐿𝑖

 Which country produces which goods depends on the ratio of Home and
Foreign wage rates.

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 31
EXAMPLE

 Assume relative wage rate between Home & Foreign is 3 (w/w*)

 Produce at Home? …………………………………………..
 Produce in Foreign?………………………………………..

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 COMPARATIVE ADVANTAGE WITH
32 MANY GOODS
 Both countries will gain from this specialization.
 Home has higher productivity in Dates, but why it should be produced in
Foreign? (Misconception 1)
Home unit labor Foreign unit labor
requirement requirement
6 12
4

Cheaper to produce in Foreign due to w/w*=3

Home’s high relative wage!

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 33 Relative wage in Multigood model
 To determine relative wages in a multigood economy we must look behind
the relative demand for goods (i.e., the relative derived demand).
 The relative demand for Home labor depends negatively on the ratio of
Home to Foreign wages.

𝐷𝐿 𝑤 Why?
𝐷𝐿∗ 𝑤∗

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34 Relative wage in Multigood model

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 Adding Transport Costs and Nontraded
35 Goods
 There are three main reasons why specialization in the real international
economy is not extreme:
• The existence of more than one factor of production.
• Countries sometimes protect industries from foreign competition.
• It is costly to transport goods and services.
 The result of introducing transport costs makes some goods nontraded.
 In some cases transportation is virtually impossible.
• Example: Services such as haircuts and auto repair cannot be traded
internationally.

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 36 Exercise 1
Home has 1,200 units of labor available. It can produce two goods, apples
and bananas. The unit labor requirement in apple production is 3, while in
banana production it is 2.
a. Graph Home’s production possibility frontier.
b. What is the opportunity cost of apples in terms of bananas?
c. In the absence of trade, what would the price of apples in terms of
bananas be? Why?

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 37 Exercise 2
Home is as described in problem 1. There is now also another country,
Foreign, with a labor force of 800. Foreign’s unit labor requirement in apple
production is 5, while in banana production it is 1.

a. Graph Foreign’s production possibility frontier.

b. Construct the world relative supply curve.

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