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Lecture 6: Ricardo model: Relative wages and productivity

Lecture 6: Ricardo model: Relative wages and productivity. ECO 324F. Structure. Wages and productivity Limitations of Ricardo Model Empirical evidence Readings Ch 1 & 2 of Krugman and Obstfeld Golub, S. 1998. Does trade with low wage economies hurt American workers ?

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Lecture 6: Ricardo model: Relative wages and productivity

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  1. Lecture 6: Ricardo model: Relative wages and productivity ECO 324F

  2. Structure Wages and productivity Limitations of Ricardo Model Empirical evidence Readings Ch 1 & 2 of Krugman and Obstfeld Golub, S. 1998. Does trade with low wage economies hurt American workers? Edwards, L & Golub, S. 2003. South Africa’s international cost competitiveness: A sectoral analysis. Krugman. P. Ricardo’s difficult idea

  3. Question Can South Africa compete against China where wages are between 5 and 10 times lower? Will trade force down SA workers wages down to those of China? Some views: “Companies that produce goods in foreign countries to take advantage of cheap labor should not be permitted to dictate the wages paid to American workers” “Impose a tax or tariff on goods brought into this country equal to the wage difference” Quotes cited in Golub (1998) What are your views on this? Can the Ricardo model provide any insight into this?

  4. Discussion • Golub (1998) • Wages are determined by absolute advantage • Trade is determined by comparative advantage • What is cost of product? • Cost = Price = wage/MPL

  5. SA vs DEVELOPED Countries 0.6 0.5 0.4 0.3 0.2 0.1 0 1970-79 1980-89 1990-94 1995-98 wages productivity South African cost competitiveness Source: Edwards and Golub (2003)

  6. SA against DEVELOPING Countries 3.5 3 2.5 2 1.5 1 0.5 0 1970-79 1980-89 1990-94 1995-98 wages productivity South African cost competitiveness Source: Edwards and Golub (2003)

  7. Lets use the Ricardo model to compare relative wages and relative productivity under trade

  8. Data recap marginal products of labour per working hour Industry Home Foreign X (coffee) ah = 1 af = 1/6 Y (cloth) bh = 1/2 bf = 1/3 When: 1/2 < PX/PY < 2 : Home specializes in X & Foreign specializes in Y Other insights? Home: 6 times as productive in X (MPLXH/MPLXF) Home: 1.5 times as productive in Y (MPLYH/MPLYF)

  9. Relative wages New world price ratio P* = 1 Assume: price of X = R 30 = price of Y What is the wage in each country? Wage = MPL * Price Home: WH = MPLX *PriceX = 1*R30 = R30 Foreign: WF = MPLY *PriceY = 1/3*R30 = R10 Relative wage: WH/WF = R30/R10 = 3

  10. Relative wage = 3 Relative productivity in Y = 1.5 Relative productivity in X = 6 Lets plot relative wages & relative productivity Relative wage is between productivity ratios: Each country has Cost Advantage in production Home: in X: 6 times more efficient but only 3 times more expensive Foreign: in Y: 1.5 times less efficient but 3 times cheaper Solution: Each product gets produced where it is the cheapest to produce!

  11. Sub-conclusion Trade is dependent on the relationship between relative wages and relative productivity Export products where Relative wage < relative productivity Import products where Relative wage > Relative productivity

  12. Relative wage = 3 Relative productivity in Y = 1.5 Relative productivity in X = 6 What happens if P* rises Assume Px rises to R60, i.e. P* rises to 2 Home: WH = MPLX *PriceX = 1*R60 = R60 Foreign: WF = MPLY *PriceY = 1/3*R30 = R10 Relative wages (WH/WF) rise to 6 As shown using graphs, an improvement in TOT raises a country’s relative wage

  13. What happens if productivity rises? Is rapid technological progress in China a threat to welfare in South Africa? Assume Px = PY = R30, i.e. P* =1 Let productivty of H triple. Home: WH = MPLX *PriceX = 3*R30 = R90 Foreign: WF = MPLY *PriceY = 1/3*R30 = R10 Relative wages (WH/WF) rise to 9 IS that the final effect?

  14. Do the results change if we introduce Multiple Goods? marginal products of labour per working hour Industry Home Foreign Rel Prod X (coffee) ah = 1 af = 1/6 6 Y (cloth) bh = 1/2 bf = 1/3 1.5 Z (apples) 10 1 1 W (leather) 1 1 1 Order these by tatios of industries' productivities: MPL1H/MPL1F < MPL2H/MPL2F < … < MPLnH/MPLnF And plot on the relative w and relative productivity scale

  15. 1.5 10 1 6 Relative productivity in W (leather) Relative productivity in Y (cloth) Relative productivity in X (coffee) Relative productivity in Z (apples) Increasing relative productivity of Home If relative wage (WH/WF) lie here, then Home exports coffee and apples and imports cloth and leather If relative wages (WH/WF) fall to here, then Home exports coffee, apples and cloth and imports leather Multiple Goods model Relative wage = WH/WF

  16. Sub-conclusions The competitiveness of an industry depends not only on relative wages but also on relative productivity Relative wages generally follow relative productivity Export products where relative productivity > relative wages Declining terms of trade (Pexport/Pimport) negatively affect relative wages

  17. Limitations of model What are the limitations of model? Model assumes full specialization What are the sources of labour productivity? Capital? Need to include other factors of production What about transport costs? Income distribution: Model predicts that all factors gain Cannot explain intra-industry trade

  18. Transport costs Transport costs: Home: Px = R 30 Py = R 60 Foreign: Py = R 30 Home imports Y from Foreign But: if transport cost = 110% of Py (foreign) Imported Y costs: R30 + (R30 *110%) = R63 Imported Y is more expensive than Home Y Py (foreign) = R63 > R60 (Home Y) Outcome: Home will not import Y from foreign and rather produce Y itself Y becomes a NONTRADED GOOD like hair-cuts

  19. Relative productivity in W (leather) Relative productivity in Y (cloth) Relative productivity in X (coffee) Relative productivity in Z (apples) Non-tradable products Schematic: Transport costs Relative wage = WH/WF With transport costs goods at the margin no longer become profitable to trade

  20. Empirical evidence Is there any support for the Ricardo model? i.e. Does it predict trade flows? Read Golub, S. 1998. Does trade with low wage economies hurt American workers? Edwards, L & Golub, S. 2003. South Africa’s international cost competitiveness: A sectoral analysis.

  21. Does SA cost competitiveness affect exports? 1970-79 1980-89 3.00 2.00 1.80 2.50 1.60 1.40 2.00 1.20 RULC 1.50 RULC 1.00 0.80 1.00 0.60 0.40 0.50 0.20 0.00 0.00 0 500 1000 1500 2000 2500 3000 3500 0 500 1000 1500 2000 2500 3000 3500 4000 Real exports (R million) Real exports (R million) 1990-98 1990-98 2.00 2.00 1.80 1.80 1.60 1.60 1.40 1.40 1.20 1.20 RULC 1.00 RULC 1.00 0.80 0.80 0.60 0.60 0.40 0.40 0.20 0.20 0.00 0.00 0 1000 2000 3000 4000 5000 6000 7000 0.00 0.10 0.20 0.30 0.40 0.50 0.60 Real exports (R million) Exports/Output

  22. Does SA cost competitiveness affect exports? Source: Edwards and Golub (2003)

  23. Conclusion International competitiveness • SA competitive, as measured by RULC, in most sectors vis-à-vis developed countries, but not developing countries • SA competitiveness improved during the 1990s • but improvement substantially reflects the large depreciation of the rand against other currencies • No clear pattern of competitiveness at the sectoral level over time Effect of competitiveness on exports • South African exports respond strongly to labor cost competitiveness (relative wages and relative productivity) (particularly L-intensive) • Growth in exports during the 1990s in large measure due to improved relative unit labor costs

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