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Labour Productivity and Comparative Advantage: Ricardian Model

Labour Productivity and Comparative Advantage: Ricardian Model. Why countries engage in trade? (i) Countries are different from each other (ii) Specialization and economies of scale in production A one-factor economy → Home: Labour: Two goods (Wine and Cheese)

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Labour Productivity and Comparative Advantage: Ricardian Model

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  1. Labour Productivity and Comparative Advantage: Ricardian Model • Why countries engage in trade? (i) Countries are different from each other (ii) Specialization and economies of scale in production • A one-factor economy→ Home: Labour: Two goods (Wine and Cheese) • Technology: labour productivity in each industry (unit labour requirement) – no. of hours of labour required to produce a pound of cheese or a gallon of wine alw = unit labour requirements in wine alc = unit labour requirements in cheese L = total labour supply or resources alcQc + alwQw ≤ L (Qc, Qw = production of Cheese, Wine) • Trade-offs and PPF

  2. Ricardian Model • Opportunity cost: no. of gallons of wine the economy would have to give up in order to produce an extra pound of cheese - To produce another pound of cheese would require alc person-hours. Each of this hours in turn could have been used to produce (1/ alw) gallons of wine - The opportunity cost of Cheese = (alc / alw) = slope of PPF • Relative supply is determined by movement of labour to whichever sector pays the higher wages • Hourly wage in Cheese: (Pc / alc) = value of what a worker can produce in one hour (zero profit assumption) • Hourly wage in Wine: (Pw / alw) • Wages in Cheese will be higher if (Pc / Pw ) > (alc / alw) …..(1) • Wages in Wine will be higher if (Pc / Pw ) < (alc / alw) ….. . (2)

  3. Ricardian Model • The economy will specialize in Cheese if: (1) • The economy will specialize in Wine if: (2) • Both goods will be produced if: (Pc / Pw ) = (alc / alw) • Simple labour theory of value: In the absence of international trade, the relative prices of goods are equal to their relative unit labour requirements • Trade in a one factor world: Home and Foreign • Assume: (alc / alw) < (alc*/ alw *) → Home has a comparative advantage in Cheese • alc < alc*→ Home has absolute advantage in Cheese • Comparative advantage, not absolute advantage, is the basis for trade

  4. Ricardian Model • Home (autarky): (Pc / Pw ) = (alc / alw) • Foreign (autarky): (Pc*/ Pw *) = (alc */ alw *) • Trade opening: (Pc*/ Pw *) > (Pc / Pw ) → it is profitable to export cheese from Home to Foreign and to import Wine from Foreign to Home → until (Pc*/ Pw *) = (Pc / Pw ) • General equilibrium (relative supply and relative demand) analysis to determine the relative prices after trade opening No. of pounds of cheese demanded (supplied) / No. of gallons of wine demanded (supplied) • World general equilibrium → relative demand = relative supply • If world relative price (Pct/ Pwt) < (alc / alw) → world supply of cheese is zero Home will not produce cheese because relative price of cheese is less than the opportunity cost of producing Cheese Foreign also will not produce cheese by the assumption that (alc / alw) < (alc*/ alw *)

  5. Ricardian Model • (Pct/ Pwt) = (alc / alw) → Workers in Home will be indifferent • (Pct/ Pwt) > (alc / alw) → Home will specialize in the production of Cheese • As long as (Pct/ Pwt) <(alc*/ alw*) → Foreign will specialize in Wine • Home will produce (L / alc) of Cheese: Foreign (L* / al*w) of Wine • For any relative price of cheese between (alc / alw) and (alc*/ alw*) , the relative supply of cheese is: (L / alc) / (L* / al*w) • (Pct/ Pwt) = (alc*/ alw*) → Foreign workers are indifferent • (Pct/ Pwt) > (alc*/ alw*) → No wine production by both Home and Foreign • Equilibrium by the intersection of relative demand and relative supply curves

  6. Ricardian Model • When there is complete specialization, the result of trade is that the world relative price ends up somewhere in between the pre trade levels in the two countries • Each country specializes in the production of that good in which it has the relatively lower unit labor requirement • Both countries derive gains from trade. How? • Two alternative ways of using an hour of labor: (i) Home could use the hour directly to produce (1/ alw) gallons of wine, (ii) Home could use the hour to produce (1/ alc ) pounds of Cheese. • Cheese could then be trade for wine with each pound trading for (Pc / Pw ) gallons, so our original hour of labor yields (1/ alc) (Pc / Pw ) gallons of wine • This will be more wine than the hour could have produced directly as long as (1/ alc) (Pct/ Pwt) > (1/ alw) or (Pct/ Pwt) > (alc / alw), which is true in equilibrium when neither country produces both the goods

  7. Ricardian Model • Gains from trade: trade enlarges the range of choice for consumers • Consumption possibilities are the same as production possibilities in autarky • Trade enlarges the consumption possibilities • Numerical example: Home has absolute advantage in both the industries • (Pct/ Pwt) must lie between the opportunity costs of cheese in the two countries • (alc / alw) = ½ (alc*/ alw*) = 6 / 3 = 2 • (Pct/ Pwt) must lie between ½ and 2 • Assume (Pct/ Pwt) = 1 → a pound of cheese trades for a gallon of wine

  8. Numerical example

  9. Ricardian Model • It takes only a half as many person hours in Home to produce a pound of Cheese as it takes to produce a gallon of wine (1 versus 2) • Home workers can earn more by producing cheese • Home will specialize in Cheese • Foreign will specialize in Wine • Gains from trade: In direct production, an hour of Home labor produces only ½ gallon of wine. The same hour could be used to produce 1 pound of cheese which can then be traded for 1 gallon of wine • Foreign could use 1 hour of labor to produce 1/6 pound of cheese. The same hour could be used to produce 1/3 gallon of Wine which can then be traded for 1/3 pound of cheese

  10. Ricardian Model • Relative wages: Home workers earn the value of 1 pound of Cheese per hour – Foreign workers earn the value of 1/3 of a gallon of wine per hour • Assume, Pc = Pw = $12 → Home workers will earn $12 per hour – Foreign workers will earn $4 per hour • The relative wage of Home workers = 12/4 = $3 • Because of lower wage rate, Foreign has a cost advantage in Wine, even though it has lower productivity • Home has a cost advantage in Cheese despite its higher wage rate, because the higher wage is more than offset by its higher productivity

  11. Misconceptions about comparative advantage • Myth 1: The pauper labor argument: Foreign competition is unfair and hurts other countries when it is based on low wages • Whether the low cost of wine produced in Foreign is due to high productivity or low wages does not matter • Myth 2: Exploitation: Trade exploits a country and makes it worse off if its workers receive much lower wages than workers in other nations • Are the workers worse off exporting goods based on low wages than they would be if they refuse to enter into trade: what is the alternative • Trade raises the real wage of workers • Myth 3: Trade Pessimism: Freetrade is beneficial only if your country is strong enough to stand up to foreign competition

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