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Chapter 3

Chapter 3. Labor Productivity and Comparative Advantage: The Ricardian Model. 1. 1 .The Concept of Comparative Advantage 2 .A One-Factor Economy 3 .Trade in a One-Factor World 4 .Misconceptions about Comparative Advantage Box: Do Wages Reflect Productivity?. 2.

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Chapter 3

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  1. Chapter 3 Labor Productivity and Comparative Advantage: The Ricardian Model 1

  2. 1.The Concept of Comparative Advantage 2.A One-Factor Economy 3.Trade in a One-Factor World 4.Misconceptions about Comparative Advantage Box: Do Wages Reflect Productivity? 2

  3. 5.Comparative Advantage with Many Goods 6.Adding Transport Costs and Nontraded Goods 7.Empirical Evidence on the Ricardian Model 8.Summary 3

  4. Introduction • Countries engage in international trade for two basic reasons: • They are different from each other in terms of climate, land, capital, labor, and technology. • They try to achieve scale economies in production.

  5. Introduction • The Ricardian model is based on technological differences across countries. • These technological differences are reflected in differences in the productivity of labor.

  6. 1.The Concept of Comparative Advantage Winter Roses case : trade-off 6

  7. The Concept of Comparative Advantage • On Valentine’s Day the U.S. demand for roses is about 10 million roses. • Growing roses in the U.S. in the winter is difficult. • Heated greenhouses should be used. • The costs for energy, capital, and labor are substantial. • Resources for the production of roses could be used to produce other goods, say computers.

  8. So…Should the U.S. produce roses then anyway?

  9. Opportunity cost: The opportunity cost of a good in terms of other goods is the number of other goods that could have been produced with the resources used to produce a given number of a good.

  10. OR… • The particular amounts of each goods produced are determined by prices. • The relative price of goods X (cheese) in terms of goods Y (wine) is the amount of goods Y (wine) that can be exchanged for one unit of goods X (cheese). • Examples of relative prices: • If a price of a can of Coke is $0.5, then the relative price of Coke is the amount of $ that can be exchanged for one unit of Coke, which is 0.5. • The relative price of a $ in terms of Coke is 2 cans of Coke per dollar.

  11. The Concept of Comparative Advantage • Suppose that in the U.S. 10 million roses can be produced with the same resources as 100,000 computers. • Suppose also that in South America 10 million roses can be produced with the same resources as 30,000 computers. • This example assumes that South American workers are less productive than U.S. workers.

  12. The Concept of Comparative Advantage • If each country specializes in the production of the goods with lower opportunity costs, trade can be beneficial for both countries. • Roses have lower opportunity costs in South America. • Computers have lower opportunity costs in the U.S. • The benefits from trade can be seen by considering the changes in production of roses and computers in both countries.

  13. 1.The Concept of Comparative Advantage • Production (GDP) Welfare • Table 3-1 Hypothetical Changes in Production Million Roses Thousand Computers United States -10 +100 South America +10 -30 Total 0 +70 13

  14. 1.The Concept of Comparative Advantage • Comparative Advantage: A country has a Comparative Advantage in producing a good if the opportunity cost of producing that good in terms of other goods is lower in that country than it is in other countries. • U.S.- computer • Mexico - roses 14

  15. The example in Table 2-1 illustrates the principle of comparative advantage: • If each country exports the goods in which it has comparative advantage (lower opportunity costs), then all countries can in principle gain from trade. • What determines comparative advantage? • Answering this question would help us understand how country differences determine the pattern of trade (which goods a country exports). 15

  16. What happens in the real world? • Model explnains. (simple ----> complex)

  17. 2.A One-Factor Economy (1).Production Possibilities (2).Relative Prices and Supply RETURN 17

  18. Imagine an economy (Home) *produce two goods: Wine and Cheese *one factor of production: labor unit labor requirement: aLW, aLC *total labor supply: L RETURN 18

  19. A One-Factor Economy • The technology of Home’s economy can be summarized by labor productivity in each industry, expressed in terms of unit labor requirements: • The unit labor requirement is the number of hours of labor required to produce one unit of output. • Denote with aLWthe unit labor requirement for wine (e.g. if aLW = 2, then one needs 2 hours of labor to produce one gallon of wine). • Denote with aLC the unit labor requirement for cheese (e.g. if aLC = 1, then one needs 1 hour of labor to produce a pound of cheese).

  20. Here the economy’s total resources are defined as L, the total labor supply (e.g. if L = 120, then this economy is endowed with 120 hours of labor or 120 workers).

  21. (1).Production Possibilities • Resources & tech limitations exist (sacrifice or trade-off required) • Production possibility frontier (PPF) • The production possibility frontier (PPF) of an economy shows the maximum amount of a goods (say wine) that can be produced for any given amount of another (say cheese), and vice versa. Or illustrates the different mixes of goods the economy can produce. 21

  22. The PPF of our economy is given by the following equation: • The total production are defined by the inequality aLCQC+ aLWQW < L (2-1)

  23. From our previous example, • aLC = 1 • aLW = 2, we get: QC + 2QW = 120

  24. Figure 3-1 Home’s Production possibility frontier Home wine production, QW, in gallons Absolute value of slope equals opportunity cost of cheese in terms of wine L/aLW PPF Home cheese production, QC, in pounds L/aLC RETURN 24

  25. For straight line – costant opportunity cost • 1 gallon of wine –aLW housrs required • 1 pond of cheese - aLc housrs required • So… • aLW housrs ---> aLW /aLc pond of cheese (absolute of slope) • Here “hour” means “person-hour”

  26. Opportunity Cost – How many goods could be produced? • But how many to produce respectively? • （Relative）Price——— Production

  27. (2).Relative Prices and Supply • P=w or profit=0 (market stucture) • Relative price: the price of one good in terms of the other. define: PC—the price of cheese PW—the price of wine then the hourly wage rate in cheese sector will be PC/aLC in wine sector will be PW/aLW 27

  28. Supply decisions, wage & labor movement. • If PC/PW>aLC/aLW the economy will specialize in the production of cheese; If PC/PW<aLC/aLW the economy will specialize in the production of wine. 28

  29. Opportunity Cost… • Wine: aLW /aLc • Cheese: aLc /aLw • So… • The economy will specialize in the production of cheese if the relative price of cheese exceeds its opportunity cost; vice versa.

  30. A country will produce both goods only when… • Labor theory of value: In the absence of international trade, the relative prices of goods are equal to their relative unite labor requirement. RETURN 30

  31. 3.Trade in a One-Factor World (1).Determining the Relative Price After Trade (2).The Gains from Trade (3).A Numerical Example (4).Relative Wages RETURN 31

  32. Assumptions of the model: • There are two countries in the world (Home and Foreign). • Each of the two countries produces two goods (say wine and cheese). • Labor is the only factor of production. • The supply of labor is fixed in each country. • The productivity of labor in each goods is fixed. 32

  33. Labor is not mobile across the two countries. • Perfect competition prevails in all markets. • All variables with an asterisk refer to the Foreign country. (two countries) eg.aLC < a*LC and aLW < a*LW • Absolute of slope: Absolute Advantage • eg.aLC < a*LC

  34. Comparative Advantage • Less opportunity cost-----higher productivity • Assume that aLC /aLW < a*LC /a*LW (3-2) or equivivalently, that aLC / a*LC < aLW /a*LW (3-3) • This assumption implies that the opportunity cost of cheese in terms of wine is lower in Home than it is in Foreign. • In other words, in the absence of trade, the relative price of cheese at Home is lower than the relative price of cheese at Foreign. • Home has a comparative advantage in cheese and will export it to Foreign in exchange for wine 34

  35. Absolute Advantage • A country has an absolute advantage in a production of a goods if it has a lower unit labor requirement than the foreign country in this goods. • Assume that aLC < a*LC and aLW < a*LW • This assumption implies that Home has an absolute advantage in the production of both goods. Another way to see this is to notice that Home is more productive in the production of both goods than Foreign. • Even if Home has an absolute advantage in both goods, beneficial trade is possible. • The pattern of trade will be determined by the concept of comparative advantage.

  36. Questions: 1.When a country has a comparative advantage in a good, must it also have an absolute advantage in that good? Why or why not? 2.When a country has an absolute advantage in a good, must it also have a comparative advantage in that good? Why or why not? RETURN 36

  37. The above relations imply that if the relative price of cheese (PC / PW ) exceeds its opportunity cost (aLC / aLW), then the economy will specialize in the production of cheese.Or PC/aLC>PW/aLW. • In the absence of trade, both goods are produced, and therefore PC / PW = aLC /aLW.

  38. Suppose: two countries Home: L, aLC, aLW Foreign: L*, aLC*, aLW* Assumption: aLC/aLW <aLC*/aLW* (2-2) or aLC/aLC*<aLW/aLW* (2-3) that is, Home has a comparative advantage in cheese. 38

  39. Figure 3-2 Foreign’s Production possibility frontier Foreign wine production, QW*, in gallons L*/aLW* PF* Foreign cheese production, QC*, in pounds L*/aLC* RETURN 39

  40. Partial & general equilibrium • Determining the Relative Price After Trade • What determines the relative price (e.g., PC / PW) after trade? • To answer this question we have to define the relative supply and relative demand for cheese in the world as a whole. • The relative supply of cheese equals the total quantity of cheese supplied by both countries at each given relative price divided by the total quantity of wine supplied, (QC+ Q*C)/(QW+ Q*W). • The relative demand of cheese in the world is a similar concept.

  41. RS-relative supply curve • RD-relative demand curve • World general equi. price - intersection • RD-downward slope (substitution effect) • RS- a “step” with flat sections linked by a vertical section

  42. (1).Determining the Relative Price After Trade Figure 3-3 World Relative Supply and Demand PC/PW aLC*/aLW* RS 1 RD″ 2 aLC/aLW RD RD′ Q′ L/aLC QC+QC* L*/aLw* Qw+Qw* 42

  43. First,the RS curve shows that there is no supply of cheese if the world price drops below aLC/aLW. -Assume aLC/aLW<a*LC/a*LW, Home will specialize in the production of cheese. -Home will specialize in the production of wine whenever PC/PW<aLC/aLW.(P=W) -Similarly,Foreign will specialize in wine production whenever PC/PW<a*LC/a*LW. • Second,when the relative price of cheese, PC/PW=aLC/aLW, Home workers are indifferent between producing cheese and wine. We have a flat section of the supply curve. 43

  44. Third, for PC/PW>a*LC/a*LW, both Home and Foreign will specialize in cheese production. There will be no wine production, so that the relative supply of cheese will become infinite. • Fourth, At PC/PW=a*LC/a*LW, Foreign workers are indifferent between producing cheese and wine. We again have a flat section of the supply curve. • Fifth, aLC/aLW< PC/PW< a*LC/a*LW, the relative supply of cheese is (L/aLC)/(L*/a*LW). 44

  45. The outcome with specalization – price converge inbetween pre-trade levels. • Another effect: PPF.

  46. Figure 3-4 Trade Expands Consumption Possibilities QW QW* F* T P F P* T* QC QC* (b) Foreign (a) Home 46

  47. (2).The Gains from Trade Specialization Indirect method of production (as long as: (1/aLC)(PC/PW)>1/aLW Or PC/PW>aLC/aLW ) Change the possibilities for consumption (figure 2-4) RETURN 47

  48. The Gains from Trade • If countries specialize according to their comparative advantage, they all gain from this specialization and trade. • We will demonstrate these gains from trade in two ways. • First, we can think of trade as a new way of producing goods and services (that is, a new technology).

  49. Another way to see the gains from trade is to consider how trade affects the consumption in each of the two countries. • The consumption possibility frontier states the maximum amount of consumption of a goods a country can obtain for any given amount of the other commodity. • In the absence of trade, the consumption possibility curve is the same as the production possibility curve. • Trade enlarges the consumption possibility for each of the two countries.

  50. (3).A Numerical Example Table 3-2 Unite Labor Requirements Cheese Wine Home aLC=1 hour per pound aLW=2 hours per gallon aLW*=3 hours per gallon Foreign aLC*=6 hours per pound Assumption: world equi. price=1 • aLC /aLW = 1/2 < a*LC /a*LW = 2 RETURN 50

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