International Trade

and Investment
Lecture 2: Comparative Advantage and the Ricardian Model
Part 2
Introduction
• In the last lecture, we started to develop the Ricardian Model
• We had assumed that
• Home has a comparative advantage in production of Cheese
' /
'()% 𝑎 ,# 𝑎,# /(0%123
𝑂𝐶#$%%&% = ' < / = 𝑂𝐶#$%%&%
𝑎,- 𝑎,-
• Product and Labor markets are perfectly competitive, such that wage rates in each industry 𝑖
and country 𝑘 must equal the marginal revenue of labor:
• I.e. The wage (𝑤) a worker receives for an hour of work is equal
9
to the revenue earned : from output produced in that hour of work.

𝑃1;
𝑤1; = ;
𝑎,1
Introduction
• We had learnt that if Home and Foreign engage in free trade, relative
price of cheese must be the same in each country – i.e. that there will
be a single world relative price that applies to each country.
𝑃#' 𝑃#/ 𝑃#
' = / =𝑃
𝑃- 𝑃- -
• We concluded the last lecture with one question:
• If the countries can trade freely, what equilibrium world relative price will
prevail? And how will it be determined?
• We need to start with simple Demand and Supply analysis.
World Market Equilibrium
• Let’s assume that if the countries trade, the international markets in
Cheese and Wine will be perfectly competitive.
• Just as in any perfectly competitive market, the market equilibrium is
determined at the intersection of demand and supply curves.
• I.e. at the equilibrium price, quantity demanded = quantity supplied.
• But here, there are 2 goods and 2 countries
• how do we ensure that in the market equilibrium, both product markets clear
and the market value of each country’s exports equals its imports?
• Here we have to use the
Relative Demand and Relative Supply curves.
Relative Demand
• Relative Quantity Demanded (𝑅𝑄𝐷) is the
• Ratio of Quantity Demanded 𝑄𝐷 for one good relative to the Quantity Demanded for the other good
• Where Quantity Demanded refers to how much Buyers from both countries want to buy in total
(i.e. global quantity demanded)

𝑄𝐷#' + 𝑄𝐷#/
𝑅𝑄𝐷 = ' /
𝑄𝐷- + 𝑄𝐷-
Where 𝑄𝐷1; refers to quantity demanded for good 𝑖 = 𝐶, 𝑊 by country 𝑘 = 𝐻, 𝐹
𝑷𝑪
• Relative Demand of Cheese is the relationship between Relative Price of Cheese
𝑷𝑾
𝑸𝑫𝑯 𝑭
𝑪 K𝑸𝑫𝑪
and Relative Quantity Demanded of Cheese.
𝑸𝑫𝑯 𝑭
𝑾 K𝑸𝑫𝑾
9M
• Relative demand could also be defined in terms of Wine, i.e. the relationship between the relative price of wine
9N
𝑸𝑫𝑯 𝑭
𝑾 K𝑸𝑫𝑾
and the relative quantity demanded of wine
𝑸𝑫𝑯 𝑭
𝑪 K𝑸𝑫𝑪
Relative Demand
• Just like any normal Demand curve,
the Relative Demand Curve is downward sloping
9N
• If the World Relative Price of Cheese increases ↑ ,
9M
• that means Cheese is becoming more expensive relative to Wine
in both Home and Foreign.
• Consumers in both countries will substitute away
from Cheese 𝑄𝐷#' ↓ +𝑄𝐷#/ ↓ towards Wine 𝑄𝐷- '
↑ +𝑄𝐷- /
↑ .
• Hence if Relative Price of Cheese increases,
Relative Quantity Demanded must decrease
𝑃# 𝑄𝐷#' + 𝑄𝐷#/
↑ ⇒ ' / ↓
𝑃- 𝑄𝐷- + 𝑄𝐷-
Relative Supply
• Relative Quantity Supplied (RQS) is the
• Ratio of Quantity Supplied (𝑄𝑆) for one good
relative to the Quantity Supplied for the other good
• Where Quantity Supplied refers to how much Sellers from both countries want to sell in total
𝑄𝑆#' + 𝑄𝑆#/
𝑅𝑄𝑆 = ' /
𝑄𝑆- + 𝑄𝑆-
Where 𝑄𝑆1; refers to quantity supplied of good 𝑖 = 𝐶, 𝑊 by country 𝑘 = 𝐻, 𝐹
9N
• Relative Supply of Cheese is the relationship between Relative Price of cheese
9M
STNU KSTNV
and Relative Quantity Supplied U KST V of cheese.
STM M
• We could also defined the Relative Supply of Wine in a similar fashion, i.e. the relationship between the
U V
9M SM KSM
relative price of wine and relative quantity supplied of wine .
9N SNU K SNV
Relative Supply
• The relative supply curve will look a bit strange
9 :NU 9 :NV
• There are 2 horizontal bits (at 9 N = U
:M
and 9 N = V )
:M
M M

SNU KSNV U
,U /:XN
• Joined by a vertical bit (at U V = V ).
SM KSM ,V /:XM
• We’ll try to explain the strange shape of the Relative Supply curve
over the next few slides.
• Please remember that in this lecture, we
𝑯
had𝑭assumed that Home has a
𝒂 𝒂
comparative advantage in Cheese s.t. 𝒂𝑯𝑪 < 𝒂𝑭𝑪
𝑾 𝑾
(Very Important for the next few slides)
Relative Supply: Intuition
9N
• Recall that the relative price of Cheese is also the exchange rate of
9M
Cheese for Wine in the international product markets
– i.e. how many units of Wine can be traded for 1 unit of Cheese.
9N Z
• For example if = = 2, that means that Home can trade 1 unit of
9M [
Cheese for 2 units of Wine
9N Z
• Home can sell (give up) 1 unit of Cheese for 𝑃# = 6 and buy (obtain) = =2
9M ^
additional units of Wine with the $6 received from selling that 1 unit of Cheese.
• Home can also give up 2 units of Wine in return for gaining 1 additional unit of
Cheese.
Relative Supply: Intuition
• Suppose Relative Price of Cheese is Greater than Opp. Cost of producing Cheese.
'
𝑃# 3 𝑎,#
=2> = '
𝑃- 2 𝑎,-

• Should Home produce Cheese domestically or Import Cheese?

If Home wants to obtain 1 unit of Cheese for consumption
[
• If it produces the Cheese domestically – needs to give up units of Wine
^
• If it buys the Cheese from intl. markets – needs to give up 2 units of Wine
• Home should Produce Cheese domestically
– “Cheaper” in terms of wine to obtain Cheese by domestic production as opposed to
trading for Cheese in the international market.
Relative Supply: Intuition
• Suppose Relative Price of Cheese is Greater than Opp. Cost of producing Cheese.
'
𝑃# 3 𝑎,#
=2> = '
𝑃- 2 𝑎,-
• This implies that the Relative Price of Wine is Lower than the Opp. Cost of producing Wine.
'
𝑃- 1 2 𝑎,-
= > = '
𝑃# 2 3 𝑎,#
• Should Home produce Wine domestically or Import Wine?
If Home wants to obtain 1 unit of Wine for consumption
^
• If it produces the Wine domestically – needs to give up [ units of Wine
• If it buys the Wine from intl. markets – needs to give up ½ units of Wine
'
• Home should Import Wine and produce 𝑄𝑆- = 0 units of Wine.
Relative Supply: Intuition
• Suppose the world relative price of Cheese is greater than the opportunity
cost of producing Cheese at Home
'
𝑃# 𝑎,#
> '
𝑃- 𝑎,-

• Should Home produce Cheese domestically,

or buy it from the international market?
• Should Home produce Wine domestically,
or buy wine from international markets?
Relative Supply: Intuition
• We have seen that if the Relative Price of Cheese is Greater than Opp. Cost
of producing Cheese.
'
𝑃# 3 𝑎,#
=2> = '
𝑃- 2 𝑎,-

'
• Home should only Import Wine and produce 𝑄𝑆- = 0 units of Wine.
• But that also means that Home will specialize in the production of Cheese
,U
'
Use all 𝐿 labor hours in the production of 𝑄#' = U units of Cheese.
:XN
Relative Supply: Intuition
• In General:
• If the Relative Price of a good 𝑖 is higher than a country’s 𝑘 Opportunity
Cost of producing that good, e.g.
f
9d :Xd
> f
9e :Xe

• The country (𝑘) should produce none of other good 𝑗 𝑄𝑆h; = 0 .

• The Country 𝑘 should specialize in the production of that good (𝑖) and use all available
labor resources to produce that good
𝐿;
𝑄𝑆1; = ;
𝑎,1
Relative Supply: Intuition
• In General:
• If the Relative Price of a good 𝑖 is lower than a country’s 𝑘 Opportunity
Cost of producing that good, e.g.
f
9d :Xd
< f
9e :Xe

• The country (𝑘) should produce none of the good 𝑖 𝑄𝑆1; = 0 .

• The Country 𝑘 should specialize in the production of the other good (𝑗) and use all
available labor resources to produce good 𝑗
𝐿;
𝑄𝑆h; = ;
𝑎,h
 U V
:N 9N :N
Relative Supply: If U < < V
:M 9M :M
• Home will only produce Cheese
,U
𝑄𝑆#' = U
'
and 𝑄𝑆- =0
:XN

• Foreign will only produce Wine

,V
𝑄𝑆#/ = 0 and 𝑄𝑆-
/
= V
:XM

• Total Quantity Supplied of Cheese:

𝐿'
𝑄𝑆#' + 𝑄𝑆#/ = '
𝑎,#
• Total Quantity Supplied of Wine:
' /
𝐿/
𝑄𝑆- + 𝑄𝑆- = /
𝑎,-
• Relative Quantity Supplied of Cheese

𝐿'
'
𝑄𝑆#' + 𝑄𝑆#/ 𝑎,#
' / = 𝐿/
𝑄𝑆- + 𝑄𝑆-
/
𝑎,-
 U V
9N :N :N
Relative Supply: If < U < V
9M :M :M
• Home will only produce Wine
,U
𝑄𝑆#' = 0 and 𝑄𝑆-
'
= U
:XM

• Foreign will only produce Wine

,V
𝑄𝑆#/ = 0 and 𝑄𝑆-
/
= V
:XM

• Total Quantity Supplied of Cheese:

𝑄𝑆#' + 𝑄𝑆#/ = 0
• Total Quantity Supplied of Wine:
' /
𝐿' 𝐿/
𝑄𝑆- + 𝑄𝑆- = ' + / >0
𝑎,- 𝑎,-
• Relative Quantity Supplied of Cheese

𝑄𝑆#' + 𝑄𝑆#/ 0
' / = =0
𝑄𝑆- + 𝑄𝑆- 𝐿' 𝐿/
' + /
𝑎,- 𝑎,-
 U V
:N :N 9N
Relative Supply: If U < V <
:M :M 9M
• Home will only produce Cheese
,U
𝑄𝑆#' = U and
'
𝑄𝑆- =0
:XN

• Foreign will only produce Cheese

,V
𝑄𝑆#/ = V and
/
𝑄𝑆- =0
:XN

• Total Quantity Supplied of Cheese:

𝐿' 𝐿/
𝑄𝑆#' + 𝑄𝑆#/ = ' + /
𝑎,# 𝑎,#
• Total Quantity Supplied of Wine:
' /
𝑄𝑆- + 𝑄𝑆- =0
• Relative Quantity Supplied of Cheese
𝐿' 𝐿/
+
𝑄𝑆#' + 𝑄𝑆#/ 𝑎,#' /
𝑎,#
' / = 0
=∞
𝑄𝑆- + 𝑄𝑆-
Relative Supply
Relative Price of Cheese
𝑃#
𝑃-

/
𝑎,#
/
Relative Supply of Cheese 𝑅𝑆
𝑎,-

'
𝑎,#
'
𝑎,-

Relative Quantity of
Cheese
𝑄#' + 𝑄#/
𝐿' ' + 𝑄/
'
𝑎,# 𝑄- -

𝐿/
/
𝑎,-
Relative Demand and Relative Supply Curves;
and Equilibrium Relative Price.
Equilibrium with Trade
• As with all competitive markets for products, the equilibrium (relative)
price is found where (relative) Supply meets (relative) Demand.
• The Equilibrium Relative Price is found at the intersection of the
Relative Supply (RS) curve and the Relative Demand (RD) curve.
• Notice that if Relative Demand for Cheese is low (e.g. RD’ in the previous slide),
U V
9N :N :N
it is possible for = U < V such that only Foreign specializes in Wine
9M :M :M
production, while Home produces both Wine and Cheese.
Equilibrium with Trade
U V
:N 9N :N
• However, it is likely that at equilibrium U < < V , and
:M 9M :M
• Home specializes in the production of Cheese (in which it has a comparative advantage);
and Export Cheese to Foreign in return for Wine.
Foreign specializes in the production of Wine (in which it has a comparative advantage);
and Export Wine to Home in return for Cheese.
• Takeaway:
The Ricardian Model of Trade predicts that each country should produce the good for which it has
a comparative advantage, and that at most only one country will produce more than one good.
U V
:N 9N :N
• For the rest of the lecture, let us assume that at equilibrium U < < V , and that each
:M 9M :M
country specializes in the production of the good for which it has a comparative advantage
(I.e. Cheese for Home and Wine for Foreign).
Gains from Trade
Without Trade
'
• Home will need 𝑎,- hours of labor to obtain 1 unit of Wine
With Trade:
How many hours of labor does Home need to get 1 unit of Wine?
• It costs 𝑃- to buy one unit of wine from Foreign
9M
• To earn 𝑃- , Home will need to sell 9N
units of Cheese to Foreign.
9M 9M '
• units of Cheese will require ⋅ 𝑎,# hours of labor.
9N 9N
Gains from Trade
With Trade (Continued):
• But since the relative price of Cheese is between the opportunity cost of Cheese
in Home and Foreign, i.e.
' /
𝑎,# 𝑃# 𝑎,#
' <𝑃 < /
𝑎,- - 𝑎,-
9M ' '
• We have ⋅ 𝑎,# < 𝑎,-
9N
9M '
• It takes Home less hours of labor to obtain Wine by importing it from Foreign ⋅ 𝑎,# than
9N
'
by producing Wine domestically (𝑎,- ).
'
• While labor hours required to obtain one unit of Cheese remains unchanged at 𝑎,# .
Gains from Trade
• The price of Wine (in terms of labor hours) has fallen with Trade for
Home, so Home has benefited from Trade!
• By similar reasoning, the price of Cheese (in terms of labor hours) can
be shown to have decreased for Foreign.
• So both countries have benefited from trade due to decreased prices
of goods.
Gains from Trade
• Alternatively, we can think of changes in the real wage rate:
the purchasing power of labor income earned in one hour of work.
• In the Home country, without Trade, we have learnt that wage rate must equal the marginal
revenue of labor, and that without trade, the wage rates must be the same across both industries
𝑃# 𝑃-
𝑤' = ' = '
𝑎,# 𝑎,-
• This implies that the purchasing power of wages (real wages) from each hour of work in the home
country must be:
lU m
• Wages from 1 Hour of labor buys = U unit of Cheese in Home without trade
9N :XN
lU m
• Wages 1 Hour of labor buys = U unit of Wine in Home without trade
9M :XM
Gains from Trade
• With Trade, the world relative price of cheese rises above Home’s opportunity cost of producing cheese (due
to import demand from Foreign)
'
𝑃# 𝑎,#
> '
𝑃- 𝑎,-
• And Home specializes in production of Cheese – so Home wages is determined only by marginal revenue of
labor in Cheese production
𝑃#
𝑤' = '
𝑎,#
• This implies that real wages in terms of purchasing power over cheese remains unchanged (i.e. wages
earned from 1 hour of work buys the same units of cheese as without trade)
𝑤' 1
= '
𝑃# 𝑎,#
Gains from Trade
• But real wages in terms of purchasing power over wine has increased (compared to no trade scenario)
𝑤' 𝑃# 1
= ' > '
𝑃- 𝑃- 𝑎,# 𝑎,-

• So Home real wages in aggregate must have increased

• i.e. even if a worker at Home buys the same amount of Cheese, he’ll be able to buy more Wine than before with trade
• in fact a worker will be able to buy more of both goods with wages from 1 hour of labor with if Home Trades with Foreign
compare to the scenario where the two countries don’t trade.

• We can show the same holds for Foreign country workers as well.
• So both countries have benefited from trade.
Relative Wages
• Question:
If Labor Productivity at Home is higher for both Cheese and Wine,
why is Foreign sufficiently competitive in the Wine market to be able
to export Wine to Home?
• Answer: Because lower labor productivity in Foreign also implies that
wages will be lower in Foreign – which reduces the cost of wine
production in Foreign.
• To see this, let’s calculate Relative Wages in this scenario.
Relative Wages
• Since Home workers are all employed in the Cheese industry, the Home wages equal the
Home Cheese industry wages:
𝑃#
𝑤' = '
𝑎,#
• Similarly, since Foreign workers all work in the Wine industry
/
𝑃-
𝑤 = /
𝑎,-
• Relative Wages hence must be
/
𝑤 ' 𝑃# 𝑎,-
/ = ⋅ '
𝑤 𝑃- 𝑎,#
Relative Wages
U V
:XN 9N :XN
• Since U < < V , this implies that
:XM 9M :XM
' / / / /
𝑎,# 𝑎,- 𝑃# 𝑎,- 𝑎,# 𝑎,-
' ⋅ 𝑎' < 𝑃 ⋅ 𝑎' < 𝑎/ ⋅ 𝑎'
𝑎,- ,# - ,# ,- ,#
' / / /
𝑎,# 𝑎,- 𝑤 ' 𝑎,# 𝑎,-
⇒ ' ⋅ ' < /< / ⋅ '
𝑎,- 𝑎,# 𝑤 𝑎,- 𝑎,#
/ /
𝑎,- 𝑤 ' 𝑎,#
⇒ ' < /< '
𝑎,- 𝑤 𝑎,#
• The relative wage rate must be between the Home’s relative productivity in Wine (Imports for
Home) and Cheese (exports for Home) production
(i.e. relative to Foreign’s productivity in these sectors).
Relative Wages
lU
If Wages are Higher at Home than in Foreign >1 ,
lV
-How can Cheese exports from Home be competitive in international markets?
• Home has a cost advantage in Cheese production, despite higher Wages at Home the wage
difference is more than made up by Home’s even greater efficiency in Cheese production.
/
𝑤 ' 𝑎,# ' 𝑎' < 𝑤 / 𝑎/
< ' ⟹ 𝑤 ,# ,#
𝑤 / 𝑎,#
'
• Once again 𝑤 ' 𝑎,- is the cost of producing 1 unit of wine in the Home country
/
• And 𝑤 / 𝑎,# is the cost of producing 1 unit of wine in the foreign country.
• Takeaway – Every country (no matter how advanced or underdeveloped)
must have a cost advantage in at least one good:
• High wages can be offset by high productivity.
• Low productivity can be offset by low wages.
Do Wages Reflect Productivity?
• Do relative wages reflect relative productivities of the two countries?

• Evidence shows that low wages are associated with low productivity.
• Wage of most countries relative to the U.S. are proportional to their labor
productivity relative to the U.S.

• Other evidence shows that wages rise as productivity rises.

• As recently as 1975, wages in South Korea were only 5% of those of the
United States.
• As South Korea s labor productivity rose (to about half of the U.S. level by
2007), so did its wages.
Productivity and Wages

A country’s wage rate (relative to the US) is roughly proportional to the

country’s productivity (relative to the US).
Source: International Monetary Fund and The Conference Board.
Misconceptions about Comparative Advantage
Misconception 1:
Free trade is beneficial to a country only if the country is more productive than foreign
countries. Otherwise local industries will collapse in the face of foreign competition.

• Our example shows this to be false:

Foreign is less productive than Home in every good.
• Competitiveness of an industry with free trade do not depend on absolute advantage (higher
efficiency of production), rather they depend on comparative advantage (lower opportunity
costs)
• Even though Foreign is less productive in all goods, it must have a comparative advantage in
some good (Wine), so Foreign must have a cost advantage in at least one good
• Even less productive countries will have exports that are internationally competitive,
because wages will be lower in less productive countries.
Misconceptions about Comparative Advantage
Misconception 2:
Free trade with countries that pay low wages hurts high wage countries
• This belief seems to come from the idea that low wages in developing countries give
exports from low wage countries an unfair cost advantage.
• Our example shows this to be false:
Even though wages are higher at Home than in Foreign,
Home still benefited from Trade.
• Home imports Wine from Foreign because buying Wine from Foreign is cheaper
than producing Wine domestically.
• It doesn’t matter why Wine from Foreign is cheaper
• What matters is that prices of all goods in Home is either left unchanged or
lowered by free trade – which increases purchasing power of Home workers.
Misconceptions about Comparative Advantage
Misconception 3:
Free trade exploits workers in low-wage developing countries
and make these workers worse off.
• While labor standards in some developing countries are worse compared to
Western standards, this is the case with or without trade.
• The question is not whether workers in developing countries deserve better
working conditions (they do), but whether these workers are better off with Free
Trade or without trade.
• Recall that less efficient Foreign benefit from free trade because:
• Workers in Foreign benefit from free trade by having access to cheaply
produced goods (lower price of Cheese)
• Producers/workers benefit from having higher profits/wages
—higher compared to the alternative of no trade.
Transportation Costs and Non-traded Goods
• The Ricardian model predicts that countries completely specialize in production.
• But this rarely happens for three main reasons:
1. More than one factor of production reduces the tendency for specialization
(Next Topic).
2. Protectionist Trade Policies (Future Lecture).
3. High Transportation costs between countries make trade more difficult and
less profitable, reducing or preventing trade. This may cause different
countries to produce the same good or service.
Empirical Evidence for the Ricardian Model (1 of 3)

• The Ricardian Model predicts that each country exports goods for which it
has a comparative advantage – for which it has a lower opportunity cost.
• Do countries export those goods in which their productivity is relatively high?
• The ratio of U.S. to British exports in 1951 compared to the ratio of U.S. to
British labor productivity in 26 manufacturing industries suggests yes.
• At this time the U.S. had an absolute advantage in all 26 industries, yet the
ratio of exports was low in the least productive sectors of the U.S.
Figure 3.6 Productivity and Exports

A comparative study showed that U.S. exports were high relative to

British exports in industries in which the United States had high
relative labor productivity. Each dot represents a different industry.
Empirical Evidence (2 of 3)
• A very poor country like Bangladesh can have comparative advantage in clothing
despite being less productive in clothing than other countries such as China because it
is even less productive compared to China in other sectors.
• Average Productivity (output per worker) across all sectors in Bangladesh
is only 28 percent of China’s.
• In the Apparel sector specifically, productivity in Bangladesh was about 77 percent
of China’s, creating strong comparative advantage in apparel for Bangladesh.
• Because the opportunity cost of apparel manufacturing is lower for
Bangladesh (i.e. shifting one Bangladeshi worker away from a less productive
sector towards apparel manufacturing will only result in a small decrease in
the other industry’s output)
Table 3.3 Bangladesh versus China, 2011

Blank Bangladeshi Output per Bangladeshi exports

Worker as % of China as a % of China
All industries 28.5 1.0
Apparel 77 15.5

Source: McKinsey and Company, “Bangladesh’s ready-made garments

industry: The challenge of growth,” 2012; UN Monthly Bulletin of
Statistics.
Empirical Evidence (3 of 3)
• The main implications of the Ricardian model are well supported by
empirical evidence:
• productivity differences play an important role in international trade
• comparative advantage (not absolute advantage) matters for trade