EC3355: International Trade
The Ricardian model
Stijn van Weezel
Department of Economics
Royal Holloway, University of London
Last week
Size matters
I
Gravity model
I
Large economies produce more and have more to sell in export
market
Large economies generate more income and can buy more
imports
Larger trade flows if countries have large economies or are
close to each other
Describes trade flows reasonably well
Persistent effect of distance
I
I
I
Trade decreases in distance
Distance proxies for other factors that influence trade
Borders associated with trade reduction
UK imports in 2012
From first lecture
Bananas from Equador (68 Million US $)
Lamb meat from New Zealand (441 Million US $)
Oil from Kuwait (2 billion US $)
Cars from Germany (17.2 billion US $)
Turbojets from the USA (4.2 billion US $)
UK exports 2012
Mineral fuels, oils and waxes (62.7 Billion US $)
Nuclear reactors and boilers (61.8 Billion US $)
Vehicles (48.3 Billion US $)
Pharmaceutical products (27.5 Billion US $)
Today
Comparative advantage
Ricardian model
Gains from trade
Productivity
Extensions and limits
Comparative advantage
Reasons why countries trade
Proximity of countries to each other
Based on cross-country differences
I
I
Differences in amount of resources/factors of production
Countries can benefit from things they do relatively well
Based on economies of scale and product differentiation
I
Produce limited amount of goods but more efficient
Comparative advantage
Ricardos idea
Countries trade due to technological differences
Countries can always gain from trade
I
Even a country that is better at everything
Comparative advantage
Context of Ricardos idea
Time of mercantilism
I
I
Mercantilism was in favour of high tariffs
I
Focus on positive trade balance
Exports are good, imports are bad
Corn Laws in the UK
Ricardo showed that free trade could benefit all trade partners
Comparative advantage
Ricardos example
Portugal
England
Cloth (m)
Wine (L)
20
10
300
100
Portugal has an absolute advantage in producing both goods
Portugal can still benefit from trade
Comparative advantage
Ricardos example
1. England should specialise in cloth where it has a comparative
advantage
I
10 m of cloth can be traded against 150 L of wine (10
rather than produce 100 L domestically
300
20 ),
2. Portugal should specialise in wine production
I
300 L of wine will get 30 m of cloth (300
20 m at home
10
100 ),
instead of just
Comparative advantage
Ricardos example
England has a comparative advantage in producing cloth,
Portugal in producing wine
Both countries gain by specialising and trading
Comparative advantage
Main idea of the Ricardian model
Trade due to technological differences
I
Countries will benefit by specialising
I
Labour productivity
Under free trade countries will specialise
Free trade weakly benefits all participants (relative to autarky)
even if some countries are terrible at everything
Comparative advantage
Ricardian model
Basic model
2 countries: Home and Foreign
2 goods: X and Y
1 production factor: labour L
Ricardian model
Model assumptions
Supply
I
I
I
I
I
Labour is mobile across sectors
Market for labour is competitive (work in sector with higher
wages)
Supply of labour is constant
Production with constant returns to scale
Labour cannot move between countries
Demand
I
I
I
I
Consumers consume X and Y to maximise utility
Constrained by labour income
If price in one good rises, substitute other good
Under free trade: can buy goods produced anywhere
Ricardian model
Production
1. Home has L hours of labour
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One unit of x takes ax hours
One unit of y takes ay hours
2. Foreign has L hours of labour
I
I
One unit of x takes ax hours
One unit of y takes ay hours
Production probabilities frontier (PPF):
L = a x X + ay Y
L = ax X + ay Y
Ricardian model
Production possibility frontier Home and Foreign
Ricardian model
Production probability frontier
In autarky the PPF acts as a budget constraint for the country
In a perfectly competitive market the country will produce at
its highest level of utility within the limits of the PPF
Ricardian model
Relative prices under perfect competition
Under autarky we have:
px = ax w ; py = ay w pa =
ax
px
=
py
ay
px = ax w ; py = ay w pa =
Wage is given by:
w=
px
py
=
ax
ay
px
ax
=
py
ay
Ricardian model
Opportunities for trade and specialisation
In autarky the relative price of good X is higher in Home than
Foreign
ax
a
> x
ay
ay
I
Opportunity cost of X in terms of Y is higher in Home than
Foreign
Means that Home is better for producing Y and importing X
from Foreign
Ricardian model
Opportunities for trade and specialisation
ax
px
<
py
ay
I
Home specialises in Y and imports X
px
a
> x
py
ay
Foreign specialises in X and imports Y
Ricardian model
Trade patterns
Each country will export its comparative advantage good
I
I
Home will export Y
Foreign will export X
Mutual beneficial exchange implies a convergence of prices
until:
p
px
= x
py
py
Ricardian model
Three possible equilibria
1. Free trade relative price can equal Home autarky relative price
2. Free trade relative price can equal Foreign autarky relative
price
3. Free trade relative price can be strictly in between autarky
relative prices
Ricardian model
Free trade relative price = Home autarky relative price
Home will produce both goods
Foreign will only produce X
Foreign gains, Home does not
Ricardian model
Free trade relative price = Foreign autarky relative price
Foreign produces both goods
Home only Y
Home gains, foreign does not
Ricardian model
World equilibrium with incomplete specialisation
Ricardian model
Free trade relative price strictly in between autarky relative prices
Home produces only X, Foreign only Y
Both gain
Ricardian model
World equilibrium with full specialisation
Ricardian model
World equilibrium with full specialisation
Full specialisation if:
ax
ax
<p<
ay
ay
Relative supply:
X
L /ax
=
Y
L/aY
Gains from trade
Gains from trade stem from specialisation on the most
resource efficient industry and using the generated income to
buy desired goods and services
Workers benefit from trade since opening up the economy
increases the price of their exported goods
Gains from trade
Trade can be regarded as indirect method of production or
new technology
In absence of trade, country has to allocate resources to
produce all of the goods it wants to consume
With trade, country can specialise its production and trade
the products for goods it wants to consume
Trade expands consumption possibilities beyond production
possibilities
Gains from trade
Trade Possibility Frontier
Gains from trade
Welfare gains under full specialisation
Free trade create additional consumption possibilities
Instead of producing additional unit of X , Home saves ax
units of labour
ax units of labour are used to produce
Extra units of Y are sold to Foreign and import
of X
ax
ay
units of Y
py ax
px ay
> units
Productivity and wages
Determination of wages
Industry will hire workers up to the point at which wages
equal value of production
Labour is hired up to the point where w = p MPL for each
industry
Labour can move freely between industries, and will move to
highest paying industry until wage equalisation occurs
Productivity and wages
Determination of wages
pX MPLX = pY MPLY
pX
MPLY
=
pY
MPLX
I
Price ratio ppYX denotes relative price of the good in the
numerator in terms of foregone goods in the denominator
Productivity and wages
Determination of wages
Under autarky:
pxa = wax , pya = way ; pxa = w ax , pya = w ay
Full specialisation:
w=
py px
;w =
ay
ax
Relative wages:
w
py ax
=
w
px ay
Productivity and wages
Determination of wages
Productivity differences determine wage differences in the
Ricardian model
Trade is determined by comparative advantage, but wages by
absolute advantage
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A country with absolute advantage in producing a good will
enjoy a higher wage in that industry after trade
Productivity and wages
Determination of wages
Both countries have cost advantage in production
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Follows that countries with poor technology can export at
competitive prices by having low wages
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Cost of high wages can be offset by high productivity
Cost of low productivity can be offset by low wages
When technology improves, wages will rise
Ricardian model predicts that when countries engage in trade,
real wages will rise.
Empirical evidence
Trade relative to GDP South Korea 1961-2000 (Source: WDI)
Empirical evidene
Productivity and wages Korea 1961-2000 (Source: UNIDO)
Empirical evidence
World productivity and wages for 2000 (Source: UNIDO)
Empirical evidence
Hourly productivity and labour costs European Union 2012 (Source: Eurostat)
Empirical evidence
Bangladeshs relative productivity in textiles
Empirical evidence
US ratio of exports lowest in least productive sectors for 1951(From the textbook)
Extensions and limits
More than two goods
Rank all goods based on productivity
a1
a
a
< 2 < ... n
a1
a2
an
w
w in this serie
a
I Products i > w are exported by home
ai
w
I Disadvantage in terms of wages is compensated
I
Locate
in terms of productivity
by advantage
Extensions and limits
Transport costs
Proportional transport cost
Good i is not traded if:
wai < w ai < wai (1 + )
Extensions and limits
Popular misconceptions
1. Trade only helps countries that are more productive than
other countries
I
Unproductive countries benefit from free trade as they can
specialise in industries that use resources most efficiently
2. Trade with low wage countries hurts high wage countries
I
Trade benefits consumers in high wage countries by providing
cheaper products
Trade can hurt some groups in high wage countries
3. Trade hurts poor countries because low wages are needed to
allow exports
I
Situation would be worse in absence of trade
Extensions and limits
Absence of specialisation
Predicted specialisation rarely happens
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Transportation costs reduce/prevent trade (last lecture)
More than one factor of productions which reduces
specialisation tendency (next lecture)
Protectionism (after reading week)
Extensions and limits
Other limitations
What determines technological differences?
Factors such as weather
Manufacture local and avoid trade costs
