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Section 2: The Ricardian model

Model assumptions:
2 countries: home and foreign
1 factor of production: labor
2 goods: wheat and cloth
Constant marginal product of labor
General concepts:
Autarky equilibrium
International trade equilibrium
Home export supply curve
Foreign import demand curve


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Technology
Home technology
Labor is the only factor used to produce both goods.
One worker can produce either 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.
Notation: MPL
W
= 4 and MPL
C
= 2.
Alternatively, the production of 1 unit of wheat requires
worker and the production of 1 unit of cloth requires
worker.
Notation: a
W
= 1/4 and a
C
= 1/2.
(a
i
are called unit input coefficients)
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Production possibilities
Home Production Possibilities Frontier (PPF)
We can use the marginal products of labor to construct
Homes PPF.
Assume Home is endowed with 25 workers.
If all the workers were employed in wheat, the economy
could produce 100 bushels.
If they were all employed in cloth, it could produce a
maximum of 50 yards.
The PPF connects these two points.
Key insight: A countrys PPF is determined by its labor
productivity and its labor endowment.

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Production possibilities
Homes production data is given by:
L = 25, MPL
W
= 4, MPL
C
= 2
Maximum wheat output: Q
W
= MPL
W
(L) = 4x25 = 100
Maximum cloth output: Q
C
= MPL
C
(L) = 2x25 = 50
This gives us a straight line PPF which is a unique feature of
the Ricardian model.
It assumes the marginal products of labor are constant.
We consider the case where the marginal product of labor
is diminishing in the specific-factors model in section 3.
Slope of PPF
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 wheatthe
amount of cloth that must be given up to obtain one more
unit of wheat.

2
1
) (
) (
100
50
= =
= =
W
C
W
C
MPL
MPL
L MPL
L MPL
SlopePPF
Home PPF
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Demand
Home Indifference Curve
Given Homes PPF, how much wheat and cloth will
home actually produce? The answer depends on
demand.
Demand can be represented with indifference
curves.
An indifference curve shows the combinations of
two goods that the country can consume and be
equally satisfied.
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Home preferences
All points on an indifference curve have the
same level of utility.
Points on higher indifference curves have
higher utility.
Indifference curves are often used to show the
preferences of an individual.
But we use indifference curves to show the
preferences of an entire economy.
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Autarky (no-trade) equilibrium






The country is indifferent between A
and B.
The country would be better off on U2,
but C is not feasible to produce.
U0<U1<U2
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Autarky equilibrium
Autarky equilibrium (at home)
Without trade, the consumption opportunities are
constrained by the production opportunities.
With perfectly competitive markets, the country will
produce at its highest level of utility within the limits of the
PPF.
The highest level of utility that can be reached within the
PPF is U
1
with production taking place at point A.
Key insight: under autarky, the economys production point
must coincide with its consumption point.

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Autarky equilibrium
Equlibrium prices and wage rate
Zero profit condition in wheat (price=marginal cost):
P
W
= w a
W
(price = wage rate * labor units)
Zero profit condition in cloth (price=marginal cost):
P
C
= w a
C
(price = wage rate * labor units)
P
W
/P
C
= a
W
/a
C
= MPL
C
/MPL
W
Key insight: relative autarky prices depend only on relative
productivities and not at all on consumer preferences.

=> w= P
W
MPL
W
= P
C
MPL
C

Workers are paid a common wage which equals the value of
their marginal productivity in each sector.

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Foreign Economy
Foreign Economys production possibilities
Assume one foreign worker can produce either one
bushel of wheat or one yard of cloth.
MPL*
W
= 1, MPL*
C
= 1 (a*
W
= 1, a*
C
= 1)
Since MPL*
W
<MPL
W
and MPL*
C
< MPL
W
, Foreign has
an absolute productivity disadvantage in each good.
Assume Foreign is endowed with 100 workers.
If all foreign, workers were employed in the wheat
sector, they could produce 100 bushels.
If all workers were employed in cloth sector, they could
produce a maximum of 100 yards.
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Foreign PPF
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Foreign autarky equilibrium

Foreigns preferences are also represented by
indifference curves and production occurs at the
point of highest utility within the foreign PPF.
The slope of the foreign PPF is also the foreign
opportunity cost of wheat.
Foreigns relative price of wheat is P*
W
/P*
C
= 1 and
exceeds Homes relative price of wheat (P
W
/P
C
= )
The difference in relative autarky prices comes
from the comparative advantage that Home has in
wheat.
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Foreign autarky equilibrium
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Opportunity costs (or real prices)
Cloth
(1 Yard)
Wheat
(1 Bushel)
Home 2 Bushels
of Wheat
Yard
of Cloth
Foreign 1 Bushel
of Wheat

1 Yard
of Cloth

Comparative advantage
Comparative Advantage
A country has a comparative advantage in a good
when it has a lower opportunity cost of producing
it than another country.
From the Table we can see that Foreign has a
comparative advantage in producing cloth as
Foreigns opportunity cost of cloth is lower (1<2).
Home has a comparative advantage in producing
wheat as its opportunity cost of wheat is lower
(1/2<1).

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Determining the Pattern of International Trade
Autarky price comparisons:
Relative price of cloth in Foreign is P*
C
/P*
W
= 1.
Relative price of cloth in Home is P
C
/P
W
= 2.
Foreign would want to export its cloth to Homeas it can
make it for the cost of 1 and export it for more than 1.
The opposite is true for wheat.
Home will export wheat and Foreign will export cloth.
Both countries export the good in which they have a
comparative advantage.
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Price changes as the result of trade
How trade affects domestic prices:
As Home exports wheat, the quantity of wheat sold at
Home falls. So the price of wheat at Home is bid up.
Since more wheat goes into Foreigns market, the price of
wheat in Foreign falls.
As Foreign exports cloth, the quantity sold in Foreign falls,
and the price in Foreign for cloth rises.
Since foreign cloth goes home, the price of cloth at Home
falls.
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Determining the Pattern of International Trade
International Trade Equilibrium
The relative price of wheat in the trade equilibrium (or the
international terms of trade) will be between the autarky
relative prices in Home and Foreign [This result has been
established by J.S. Mill (1848), see section 1 lecture notes].
For now we will assume the free-trade price of wheat,
P
W
/P
C
,is 2/3. This is between the autarky price of in
Home and the autarky price of 1 in Foreign.
Given this free trade price of wheat, we can now see how
trade changes production and consumption in each
country.
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International Trade Equilibrium
Two countries are in a trade equilibrium when:
the relative price of each good is the same in the two
countries
the amount of each good that the countries want to
trade is equal
In understanding the trade equilibrium we need to do
two things:
Determine the relative price of wheat or cloth in the
trade equilibrium.
See how the shift from the autarky to the trade
equilibrium affects production and consumption in
both Home and Foreign.
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Change in Production and Consumption
Home producers of wheat can earn more than the
opportunity cost of wheat by selling it to Foreign.
Home will therefore shift labor resources toward
the production of wheat and increase its
production.
Remember wages are calculated by the price of
the good times its marginal product.
Given the information from before, we can
calculate the wage rates in the two sectors.
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Labor Market Condition (Home)
All Home workers have an incentive to move into the
wheat sector and no cloth will be produced.
With trade, Home will be fully specialized in wheat
production.
2 4 8
1
3 2 6
W W
C C
W W C C
P MPL
P MPL
Therefore
P MPL P MPL
Wages in wheat Wages in cloth
| || |
= = >
| |
\ .\ .
>
>
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Terms of trade and increased consumption
opportunities
Home can export wheat at the international
relative price (or terms of trade) of 2/3.
For each bushel of wheat it exports, it gets 2/3
yards of cloth in return.
The world price line (or terms of trade line) shows
the range of consumption possibilities that the
country can achieve by specializing in wheat and
trading it.
International trade allows to separate production
(point B) from consumption (point C).
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Enhanced consumption opportunities
U
2



World price line (terms of trade
line), slope = 2/3
U
1



A




50 100 Wheat, Q
W
(bushels)
Cloth, Q
C
(yards)
B
Home production
50
25
The new world price, P
W
/P
C
=
2/3, shows us the new range of
consumption possibilities
The country can now achieve a
higher utility with the new
consumption possibilities
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Free trade equilibrium (Home)
Home imports 40
yards of cloth
Home exports 60 bushels of wheat
Home consumption
A




B
Home production
25
C




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World price line (terms of trade
line), slope = 2/3
U
2

U
1



50 100 Wheat, Q
W
(bushels)
Cloth, Q
C
(yards)
50
100
Home produces 100 bushels but
consumes only 40, so it exports 60
50
Home produces 0 yards of cloth but
consumes 40, so it imports 40.
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Terms of trade
From the previous figure we can also see that
Homes exports and imports are equal when
valued in the same units.
Home exports 60 bushels of wheat; multiplying
this by the price of wheat in terms of cloth, 2/3,
gives 40. This equals the amount of cloth that is
imported.
Now consider Foreign.

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Free trade equilibrium (Foreign)
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Comparative advantage and the gains from
trade
Each country exports the good where it has a comparative
advantage. This confirms that the pattern of trade is
determined by comparative advantage.
There are gains from trade for the home and the foreign
economy
The gains from trade can be captured in several ways:
Each country reaches a higher utility level (utilitarian
formulation).
Each country enlarges its consumption opportunities
(utility free formulation).
Workers receive higher real wages.

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Real wages in the trade equilibrium
As stated before, in competitive labor markets, firms will
pay workers the value of their marginal product.
Since Home produces and exports wheat, workers can be
thought of being paid in wheat. As 1 unit of labor produces
4 bushels of wheat, the real wage of home workers is
MPL
W
(= 4 bushels of wheat).
Workers can sell wheat on the world market at a relative
price of P
W
/P
C
= 2/3.
We can use this to calculate their real wage in terms of
cloth: (P
W
/P
C
)MPL
W
= (2/3)4 = 8/3 yards.
Through trade, 1 unit of labor is able to buy 8/3 yards.
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Real wages in the trade equilibrium
Home real wage is
4 bushels of wheat or
8/3 yards of cloth (> 2, the autarky level)
Foreign real wage is
1 yard of cloth or
3/2 bushels of wheat (>1, the autarky level)
(since(P
C
/P
W
) MPL*
C
= (3/2)1 = 3/2)
Trade leads to an increase in real wages in both countries,
but the real wages do not converge.
Home workers earn a higher real wage than foreign workers
because of their absolute productivity advantage.
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Key insight: Real wages in the trade equilibrium
Wages are determined by absolute advantage and trade is
determined by comparative advantage.
The only way a country with poor technology can export at
a price others are willing to pay is by having low wages.
As a country develops better technologies, its wages will rise.
Workers become better off by receiving higher wages.
As countries engage in trade, the Ricardian model predicts
that their real wages will rise.
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Application 1: Labor productivity and wages
Labor productivity can be measured by the value-added 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.
The next figures show 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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Application 1: Labor productivity and wages
Labor Productivity and Wages, 2001
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Application 1: Labor productivity and wages
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Application 2: Comparative advantage in apparel,
textiles, and wheat
U.S. 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 U.S. with
sales of $1.6 billion in 1999.
Sales per employee were therefore $92,000.
This is the average for all U.S. apparel producers.
Textiles are even more productive with annual sales per
employee of $140,000 in the U.S.
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Application 2: Comparative advantage in apparel,
textiles and wheat
In China, however, sales per employee are only $13,500 in
apparel and $9,000 in textiles.
The U.S. is 7 times more productive in apparel and 16 times
more productive in textiles.
So the U.S. has an absolute productivity advantage in these
industries.
In the wheat sector, the U.S. produces 27.5 bushels of wheat
per hour of labor.
China produces only 0.1 bushels of wheat per hour of labor.
So the US has also an absolute productivity advantage in wheat.
But it is 275 times more productive in wheat than China.

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Application 2: Comparative advantage in apparel,
textiles, and wheat
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Application 2: Comparative advantage in apparel,
textiles and wheat
Since the absolute advantage in wheat for the U.S. is
even greater than in apparel and textiles, the US has a
comparative advantage in the production of wheat.
China has a comparative advantage in apparel and
textiles because its productive disadvantage relative to
the U.S. is less than in wheat.
This explains why the U.S. imports apparel and textiles
from China despite its higher productivity.
The also explains why the US is an exporter of wheat.
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International equilibrium: Determination of
the terms of trade
In the previous analysis we assumed that the relative price of wheat, or
the terms of trade was given by 2/3. Now we investigate what determines
the terms of trade.
The terms of trade is determined by export supply and import demand.
There are two international markets for wheat and cloth. But since only
relative prices matter, it is sufficient to look only at the international
equilibrium in one market. So we can just focus on the export supply and
import demand in the wheat market.
According to Walras law, which is a key general equilibrium insight, if the
international market for wheat is in equilibrium, then the market for cloth
has to be in equilibrium also.
export supply = excess supply (domestic supply - domestic demand)
import demand = excess demand (domestic demand - domestic supply)

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Home export supply curve
Derivation of the Home export supply curve
The home excess supply of wheat Xw (horizontal axis) will depend on
the relative price of wheat Pw/Pc (vertical axis).
At Pw/Pc=2/3, Xw=60 (=100-40). (points C and C)
At Pw/Pc=1/2, Xw=0 (=50-50) (points A and A) which is the autarky
equilibrium
However, if Pw/Pc=1/2 and trade is allowed, workers earn the same
wage in wheat and cloth and production can be at any point between
A and B on the Home PPF => Xw can take any value between 0 and 50
(horizontal segment).
The flat portion of the export supply curve is a special feature of the
Ricardian model.
Export supply Xw will increase in Pw/Pc (domestic production will stay
the same, but domestic consumption will fall).

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Export supply curve (Home)
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Foreign import demand curve
Derivation of the Foreign import demand curve
The foreign excess demand for wheat Mw (horizontal axis) will also
depend on the relative price of wheat Pw/Pc (vertical axis).
At Pw/Pc=2/3, Mw=60 (=60-0) (points C* and C*)
At Pw/Pc=1/2, Mw=0 (=50-50) (points A* and A*) which is the
autarky equilibrium
However, if Pw/Pc=1/2 and trade is allowed, workers earn the same
wage in wheat and cloth and production can be at any point between
A* and B* on the Foreign PPF => Mw can take any value between 0
and 50 (horizontal segment).
The flat portion of the import demand curve is also a special feature of
the Ricardian model.
Import demand Mw will decrease in Pw/Pc (domestic production will
stay the same, but domestic consumption will fall).

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Import demand curve (Foreign)
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International trade equilibrium
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International trade equilibrium
The export supply and import demand curves are both general
equilibrium concepts. If international prices change, this will affect the
behavior of producers and consumers in the wheat and cloth market.
The export supply curve captures the behavior of producers and
consumers in the home country (i.e. the exporter of wheat).
The import demand curve captures the behavior of producers and
consumers in the foreign country (i.e. the importer of wheat).
At the international equilibrium price all markets are balanced.
Because only relative prices matter for producers and consumers, we
only needed to focus on the market for one good. Walras law implies
that if there are 2 markets, if the first market is in equilibrium than the
second market must also be in equilibrium.
The analysis has also demonstrated that the market clearing
international price must lie between the autarky prices (i.e. 1<2/3<2).

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Terms of trade and the distribution of the
gains from trade
The terms of trade is defined as the price of a countrys exports
divided by the price of its imports.
For Home, P
W
/P
C
is their terms of trade.
An increase in P
W
or a fall in P
C
will raise Homes terms of trade.
An increase in the terms of trade is welfare improving since
the country will either earn more from its exports or
the country will pay less for its imports.
Although both countries will benefit from international trade, the
terms of trade will determine how the gains from trade are distributed
across countries.
Changes in the terms of trade have different welfare effects on
exporting and importing countries (see Application 3).
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Application 3: The Terms of Trade for Primary
Commodities
Latin American economist Ral Prebisch and British economist Hans Singer
each put forward the hypothesis that the price of primary commodities
would decline over time relative to the price of manufactured goods
(Prebisch-Singer Hypothesis).
Since primary commodities are often exported by developing countries
whereas industrial countries export manufactured goods, this hypothesis
has received quite a bit of attention regarding the distribution of the gains
from trade between developing and industrialized countries.
Arguments for the hypothesis:
As countries become richer, they spend a smaller share of their
income on food.
As world income grows, demand for food falls relative to the demand
for manufactured goods. Therefore, the price of agricultural products
can also be expected to fall relative to manufactured goods.

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Application 3: The Terms of Trade for Primary
Commodities
Arguments for the hypothesis (continued):
For mineral products, industrialized countries continually find
substitutes in the production of manufactured products.
The substitution away from mineral products is a form of technological
progress, and as it proceeds, can lead to a fall in the price of raw
materials.
Arguments against the hypothesis:
Technological progress in manufactured goods can certainly lead to a
fall in the price of these goods as they become easier to produce.
This is a fall in terms of trade for industrialized countries rather than
developing countries.
In the case of oil, OPECs cartel pricing has caused an increase in the
terms of trade for oil-exporting countries.
The long-term evidence (1900-2000) is mixed.

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The long-term evidence
(price of primary relative to manufactured goods)
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Key insights
The Ricardian model is about the reallocation of a single factor, labor,
across alternative uses.
It is comparative (productivity) advantage, not absolute (productivity)
advantage, which matters for the direction of specialization and the
realization of the gains from trade.
Absolute productivity advantage determines wage rates.
Gains from trade can be captured in three different ways: increase in
utility, increase in consumption opportunities or increase in real wages.
Since the gains from trade are at the country level, the gains are
aggregate gains. Because of the one factor assumption, there cant be
any domestic conflict about the gains from trade in the Ricardian
framework.
The distribution of the gains from trade depends on the terms of trade.
Changes in the terms of trade will have different welfare effects.
To analyze potential domestic conflict from international trade, we need
to relax the one factor assumption. This leads to the specific-factors
model.

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