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2
Trade and Technology: The Ricardian Model
1
2
Determining the
Pattern of
International Trade
4
Dickinson State University
Copyright 2011 Worth Publishers International Economics Feenstra/Taylor, 2/e.
Ricardian Model
3
Prepared by:
Fernando Quijano
Reasons for Trade
Solving for
International Prices
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Introduction
Where did Shaun Whites
snowboard come from?
In 2005 the United States imported
(i.e., purchased from other countries)
$59 million of snowboards from 20
different countries.
China exported (i.e., sold to another
country) more than $18 million worth
of snowboards to the United States in
2005 and $21 million in 2009.
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Introduction
Table 2-1 shows that the value of imports to the United
States has fallen in recent years. Why does the US import
snowboards? Why so many from China?
U.S. Imports of Snowboards, 2005 and 2009
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Introduction
Reasons countries trade goods with each other
include:
Differences in the technology used in each
country (i.e., differences in each countrys ability to
manufacture products) Ricardian Model
Differences in the total amount of resources
(including labor, capital, and land) found in each
country
Differences in the costs of offshoring (i.e.,
producing the various parts of a good in different
countries and then assembling it in a final location)
The proximity of countries to each other (i.e.,
how close they are to one another)
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1 Reasons for Trade
Proximity
The closer countries are the lower the costs of
transportation. For example, the largest trading
partner of most European countries is another
European country.
Resources
A countrys resources are often collectively called
its factors of production.
natural resources (such as land and minerals)
labor (labor of various education and skill levels)
capital (machinery and structures)
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1 Reasons for Trade
Absolute Advantage
When a country has the best technology for producing a
good, it has an absolute advantage in the production of
that good.
Comparative Advantage
Absolute advantage is not a good explanation for trade
patterns. Instead, comparative advantage is the
primary explanation for trade among countries.
A country has comparative advantage in producing
those goods that it produces best compared with how
well it produces other goods.
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SIDE BAR
David Ricardo and Mercantilism
Mercantilists believed that exporting was good
because it generated gold and silver for the
national treasury and that importing was bad because it
drained gold and silver from the national treasury.
To ensure that a country exported a lot and imported
only a little, the mercantilists were in favor of high tariffs.
Ricardo was interested in showing that countries could
benefit from international trade without having to use
tariffs.
Many of the major international institutions in the world
today are founded at least in part on the idea that free
trade between countries brings gains for all trading
partners.
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2 Ricardian Model
The Home Country
To develop a Ricardian model of trade, we will use an
example with two goods:
Wheat and other grains are major exports of the
U.S. and Europe.
Many types of cloth are imported into these
countries.
To simplify our example, we will ignore the role of land
and capital and suppose that both goods are produced
with labor alone.
The Ricardian model is a one factor model.
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2 Ricardian Model
The Home Country
We will assume that labor is the only resource used to
produce both goods.
The marginal product of labor (MPL) is the extra output
obtained by using one more unit of labor.
Assume: MPLW = 4 and MPLC = 2.
Home Production Possibilities Frontier
The PPF shows all combinations of the two goods that
can be produced in the country.
Assume there are 25 workers in Home.
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2 Ricardian Model
The Home Country
Home Production Possibilities Frontier
FIGURE 2-1
The Home PPF is a
straight line between 50
yards of cloth and 100
bushels of wheat.
The slope of the PPF
equals the negative of
the opportunity cost of
wheat.
Equivalently, the
magnitude of the slope
can be expressed as the
ratio of the marginal
products of labor for the
two goods.
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2 Ricardian Model
The Home Country
Home Indifference Curve There are several ways to
represent demand in the Home economy, but we will
start by using indifference curves.
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.
Each indifference curve shows the combinations of
two goods, such as wheat and cloth, that a person
or economy can consume and be equally satisfied.
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2 Ricardian Model
Home Indifference Curve
FIGURE
2-2
Home Equilibrium with No Trade
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Points A and B lie on the
same indifference curve
and give the Home
consumers the level of
utility U1.
The highest level of Home
utility on the PPF is
obtained at point A, which
is the no-trade
equilibrium.
Point D is also on the PPF
but would give lower
utility.
Point C represents a
higher utility level but is
off of the PPF, so it is not
attainable in the absence
of international trade.
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2 Ricardian Model
The Home Country
Wages
In competitive markets firms hire workers up to the point
at which the hourly wage equals the value of one more
hour of production.
The value of one more hour of labor equals the amount
of goods produced in that hour (MPL) times the price of
the good.
w = P MPL for each industry.
Free mobility of labor implies wages are equal
across industries.
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2 Ricardian Model
The Home Country
Wages
We can use the equality of the wage across industries to
obtain the following equation:
PW MPLW = PC MPLC
By rearranging terms, we see that
PW/PC = MPLC/MPLW
The right-hand side of this equation is the slope of the
production possibilities frontier (the opportunity cost of
obtaining one more bushel of wheat).
The left-hand side of the equation is the relative price of
wheat.
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2 Ricardian Model
The Foreign Country
Assume a Foreign worker can produce one bushel of
wheat or one yard of cloth.
MPL*W = 1, MPL*C = 1
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.
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2 Ricardian Model
The Foreign Country
Foreign Production Possibilities Frontier
FIGURE
2-3
The Foreign PPF is a
straight line between
100 yards of cloth and
100 bushels of wheat.
The slope of the PPF
equals the negative of
the opportunity cost of
wheat, that is, the
amount of cloth that
must be given up (1
yard) to obtain 1 more
bushel of wheat.
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2 Ricardian Model
Comparative Advantage
A country has a comparative advantage in a good when it
has a lower opportunity cost of producing than another
country.
Foreign has a comparative advantage in producing cloth.
Home has a comparative advantage in producing wheat.
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2 Ricardian Model
The Foreign Country
Comparative Advantage
FIGURE
2-4
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Foreign
Equilibrium with
No Trade The
highest level of
Foreign utility on
the PPF is obtained
at point A*, which
is the no-trade
equilibrium.
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APPLICATION
Comparative Advantage in Apparel, Textiles, and Wheat
TABLE Apparel, Textiles, and Wheat in the United States and China
2 per
Sales-2 employee for the apparel and textile industries in the United
States and China, as well as bushels per hour in producing wheat.
The United States has an absolute advantage in all of these products,
but it has a comparative advantage in producing wheat.
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3 Determining the Pattern of International Trade
International Trade Equilibrium
What happens when goods are traded between Home and
Foreign?
We will see the countrys no-trade relative price
determines which product it will export and which it will
import.
The no-trade relative price equals its opportunity cost of
production.
The pattern of exports and imports will be determined by
the opportunity costs of production in each countrytheir
comparative advantage.
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3 Determining the Pattern of International Trade
International Trade Equilibrium
The relative price of cloth in Foreign is PC/PW = 1.
The relative price of cloth in Home is PC/PW = 2.
Therefore Foreign would want to export their cloth to
Homethey can make it for $1 and export it for more than
$1.
The opposite is true for wheat.
Home will export wheat and Foreign will export cloth.
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3 Determining the Pattern of International Trade
International Trade Equilibrium
How Trade Occurs
As Home exports wheat, quantity of wheat sold at
Home falls.
The price of wheat at Home is bid up.
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.
The price of cloth at Home falls.
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3 Determining the Pattern of International Trade
International Trade Equilibrium
The two countries are in an international trade
equilibrium the when relative price of cloth is the same in
the two countries.
To fully understand the international trade equilibrium, we
are interested in two issues:
Determining the relative price of cloth (or wheat) in the
trade equilibrium
Seeing how the shift from the no-trade equilibrium to the
trade equilibrium affects production and consumption in
both Home and Foreign.
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3 Determining the Pattern of International Trade
International Trade Equilibrium
Change in Production and Consumption- assume PC/PW = 1
FIGURE 2-5 (1 of 3)
Home Equilibrium with Trade
With a world relative
price of wheat of 2/3,
Home production will
occur at point B.
Through international
trade, Home is able to
export each bushel of
wheat it produces in
exchange for 2/3 yard
of cloth.
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3 Determining the Pattern of International Trade
International Trade Equilibrium
Change in Production and Consumption
Home Equilibrium with Trade (continued)
FIGURE 2-5 (2 of 3)
As wheat is exported,
Home moves up the
world price line BC.
Home consumption
occurs at point C, at
the tangent
intersection with
indifference curve U2,
since this is the
highest possible
utility curve on the
world price line.
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3 Determining the Pattern of International Trade
International Trade Equilibrium
Change in Production and Consumption
FIGURE 2-5 (3 of 3)
Home Equilibrium with Trade (continued)
Given these levels of
production and
consumption, we can
see that total exports
are 60 bushels of wheat
in exchange for imports
of 40 yards of cloth and
also that Home
consumes 10 fewer
bushels of wheat and 15
more yards of cloth
relative to its pre-trade
levels.
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3 Determining the Pattern of International Trade
International Trade Equilibrium
FIGURE 2-5
(revisited)
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International Trade
Home obtains a higher
utility with international
trade than in the
absence of international
trade (U2 is higher than
U1); the finding that
Homes utility increases
with trade is our first
demonstration of the
gains from trade, by
which we mean the
ability of a country to
obtain higher utility for its
citizens under free trade
than with no trade.
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3 Determining the Pattern of International Trade
International Trade Equilibrium
Pattern of Trade and Gains from Trade
FIGURE 2-6 (1 of 2)
Foreign Equilibrium with Trade
With a world relative
price of wheat of 2/3,
Foreign production
will occur at point B*.
Through international
trade, Foreign is able
to export 2/3 yard of
cloth in exchange for
1 bushel of wheat,
moving down the
world price line.
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3 Determining the Pattern of International Trade
International Trade Equilibrium
Pattern of Trade and Gains from Trade
FIGURE 2-6 (2 of Foreign Equilibrium with Trade (continued)
2)
Foreign consumption
occurs at point C*, and
total exports are 40
yards of cloth in
exchange for imports of
60 bushels of wheat.
Relative to its pre-trade
wheat and cloth
consumption (point A*),
Foreign consumes 10
more bushels of wheat
and 10 more yards of
cloth.
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3 Determining the Pattern of International Trade
Pattern of Trade and Gains from Trade
Each country is exporting the good for which it has the
comparative advantage.
This confirms that the pattern of trade is determined
by comparative advantage.
This is the first lesson of the Ricardian model.
There are gains from trade for both countries.
This is the second lesson of the Ricardian model.
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3 Determining the Pattern of International Trade
Solving for Wages across Countries
Absolute Advantage As our example shows, wages are
determined by absolute advantage. In contrast, the pattern
of trade is determined by comparative advantage.
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3 Determining the Pattern of International Trade
Solving for Wages across Countries
As stated before, in competitive labor markets, firms will
pay workers the value of their marginal product.
Since Home produces and exports wheat, they will be
paid in terms of that goodthe real wage is MPLW = 4
bushels of wheat.
The workers sell the wheat on the world market at a
relative price of PW/PC = 2/3.
We can use this to calculate the real wage in terms of
cloth: (PW/PC)MPLW = (2/3)4 = 8/3 yards.
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3 Determining the Pattern of International Trade
Solving for Wages across Countries
We can do this for Foreign as well and summarize:
Home real wage is:
4 bushels of wheat
8/3 yards of cloth.
Foreign real wage is:
3/2 bushels of wheat
1 yard of cloth.
Foreign workers earn less than Home workers as
measured by their ability to purchase either good.
This fact reflects Homes absolute advantage in the
production of both goods.
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APPLICATION
Labor Productivity and Wages
FIGURE
2-7
Labor Productivity and Wages, 2001 Labor productivity is
measured by value-added per hour of work and can be
compared with the wages paid in manufacturing in various
countries.
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APPLICATION
Labor Productivity and Wages
FIGURE
2-8
The trends in labor productivity and wages can also be graphed over
time. The general upward movement in labor productivity is matched
by upward movements in wages, as predicted by the Ricardian model.
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APPLICATION
Labor Productivity and Wages
FIGURE 2-8
(continued)
The trends in labor productivity and wages can also be graphed over
time. The general upward movement in labor productivity is matched
by upward movements in wages, as predicted by the Ricardian model.
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4 Solving for International Prices
Home Export Supply Curve
FIGURE 2-9 (1 of 2)
Home Export Supply Panel (a) repeats Figure 2-5 showing the trade
equilibrium for Home with production at point B and consumption at
point C.
Panel (b) shows the Home export supply of wheat.
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4 Solving for International Prices
Home Export Supply Curve
FIGURE 2-9 (2 of 2)
Home Export Supply (continued) For relative prices above 1/2, Home
exports more than 50 bushels, along the segment B C. For example, at
the relative price of 2/3, Home exports 60 bushels of wheat.
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4 Solving for International Prices
Foreign Import Demand Curve
FIGURE 2-10 (1 of 2)
Foreign Import Demand Panel (a) repeats Figure 2-6.
Panel (b) shows Foreign import demand for wheat. When the relative
price of wheat is 1, Foreign will import any amount of wheat between 0
and 50 bushels, along the segment A*B* of the Foreign import demand
curve.
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4 Solving for International Prices
Foreign Import Demand Curve
FIGURE 2-10 (2 of 2)
Foreign Import Demand (continued) For relative prices below 1, Foreign
imports more than 50 bushels, along the segment B*C*. For example,
at the relative price of 2/3, Foreign imports 60 bushels of wheat.
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4 Solving for International Prices
International Trade Equilibrium
FIGURE 211
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World Market for
Wheat Putting
together the Home
export supply curve
and the Foreign import
demand curve for
wheat,
the world equilibrium
is established at point
C, where the relative
price of wheat is 2/3.
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4 Solving for International Prices
International Trade Equilibrium
The Terms of Trade The price of a countrys exports
divided by the price of its imports is called the terms of
trade.
Because Home exports wheat, (PW /PC) is its terms of
trade.
Foreign exports cloth, so (PW /PC) is its terms of trade.
In this case, having a higher price for cloth (Foreigns
export) or a lower price for wheat (Foreigns import)
would make the Foreign country better off.
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APPLICATION
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.
Support for Hypothesis:
As people/countries become richer, they spend a smaller share of
their income on food
For mineral products, industrialized countries continually find
substitutes in the production of manufactured products.
Evidence against Hypothesis:
Technological progress in manufactured goods can certainly lead to a
fall in the price of these goods as they become easier to produce.
At least for oil, the cartel restricting prices has caused an increase in
the terms of trade for oil-exporting countries.
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APPLICATION
The Terms of Trade for Primary Commodities
FIGURE 2-12
(panel a)
Relative Price of Primary Commodities Shown here are the
prices of various primary commodities relative to an overall
manufacturing price, from 1900 to 1998. The relative prices of
some primary commodities have fallen over time (panel a)
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APPLICATION
The Terms of Trade for Primary Commodities
FIGURE 2-12
(panel b)
Relative Price of Primary Commodities whereas other
commodities have had rising relative prices (panel b)
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APPLICATION
The Terms of Trade for Primary Commodities
FIGURE 2-12
(panel c)
Relative Price of Primary Commodities Other commodity prices show
no consistent trend over time (panel c).
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