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ricardian - Noember 8 2006 Notes on Ricardian model These...

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Noember 8, 2006 Notes on Ricardian model These notes describe the Ricardian model, and explain the meaning of the following terms: opportunity cost, comparative advantage, and absolute advantage. The model illustrates the source of gains from trade in a general equilibrium model, i.e. one in which factors of production move across sec- tors. We begin by describing a single economy ("Home") in autarchy. We then see how production and consumption — and thus, welfare — change as a consequence of opening up to trade with the Rest of World (ROW). I will describe this model using speci fi c numerical values, for clarity. The description of the economy requires a description of technology, mar- ket structure and "tastes". The technology tells you what is technically feasible. The market structure tells you how producers and consumers be- have; "tastes" tell you the relation between consumption and welfare. Technology: There are two commodities, beer and soyburgers, produced using a single input, labor. A unit of beer ( B ) requires one unit of labor and a unit of soyburger ( S ) requires 2 units of labor. Labor can move from one sector to another. There are 100 units of labor available. (You can de fi ne units any way you want. For example, you can think of a unit of beer as a keg, and a unit of labor as a year’s worth of a person’s working time.) The production constraint is 1 B s + 2 S s = 100 (1) (The superscript s denotes supply, or production.) Figure 1 illustrates the production constraint. For example, the economy is capable of producing 50 units of soyburger or 100 units of beer, or at any point on the line shown in the fi gure. Market structure: Firms hire workers to produce products, which fi rms sell in the market place. Firms are perfectly competitive. In equilibrium — i.e. where there is no incentive for fi rms to enter or leave a sector, and no incentive for workers to move from one sector to another, pro fi ts (in each sector) are non-positive, and the wage is the same in both sectors. Why must pro fi ts be non-positive in equilibrium? If any fi rm was making pro fi ts, other fi rms would enter the sector. In order to produce, these other fi rms would hire labor, thus increasing the total demand for labor and driving 1
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up the wage. In addition, the new fi rms’ increased production increases supply, causing price of the product to fall. The result of this entry would be a fall in pro fi ts. In equilibrium pro fi ts are not positive. If the pro fi t from
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