Technological di¤erences and trade equilibrium:

Ricardian Theory of Trade

Karen Helene Ulltveit-Moe

Fall 2010

Contents
1 Ricardo’s model (1817) 2
1.1 Preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.2 Technologies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.2.1 Production possibility frontier . . . . . . . . . . . . . . . . . . . 3
1.3 Autarky equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.3.1 Equilibrium conditions . . . . . . . . . . . . . . . . . . . . . . . 4
1.3.2 Solving the autarky equilibrium . . . . . . . . . . . . . . . . . . 5
1.4 Trade Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1.4.1 Solving the trade equilibrium . . . . . . . . . . . . . . . . . . . 6
1.5 The gains from trade . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
1.6 Exercise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

2 Ricardian model with a continuum of goods 12

2.1 Characteristics of the model . . . . . . . . . . . . . . . . . . . . . . . . 12
2.1.1 Technology and Production . . . . . . . . . . . . . . . . . . . . 12
2.1.2 Relative good prices . . . . . . . . . . . . . . . . . . . . . . . . 13
2.1.3 Preferences and demand . . . . . . . . . . . . . . . . . . . . . . 13
2.2 Trade equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
2.3 Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2.3.1 The e¤ect of an increase in relative size LF =LH . . . . . . . . . 16
2.3.2 The e¤ect of technological progress . . . . . . . . . . . . . . . . 18

1
1 Ricardo’s model (1817)
Ricardo’s classic model of international trade attributes trade to di¤erences in
technogoly across countries.

Di¤erences in technology give rise to di¤erences in relative costs, and are a

source of comparative advantage.

These technological di¤erences are re‡ected in di¤erences in the productivity of

labor. This model can be used also to explain wage disparities across countries.

Assumptions of the model

Labor is the only factor of production.

Only two goods (say Wine and Cloth) are produced.

The supply of labor is …xed in each country.

The productivity of labor in each good is …xed.

Perfect competition prevails in all markets.

1.1 Preferences

Suppose that preferences in each country (of the representative consumer ) are of
Cobb Douglas type. Consumer will choose consumption to maximize
I
X
i log ci
i=1

subject to the budget constraint

I
X
pi ci wn Ln
i=1

where pi is the price of good i, wn is the wage in country n, and Ln the country size.
Cobb Douglas preference implies that expenditure of good i is a constant share i of
income, ie
pi ci = i wn Ln .

For simplicity condider two goods (ie: I = 2) C and W and two countries (n=1,2)
home H and foreign F.

2
1.2 Technologies

Assume constant return to scale technologies in the production of both goods.

With only one factor of production, technology can be described in terms of the
number of workers required to produce one unit of commodity i in country n
as ain .

Labour productivity: 1=ain

We say that country H has absolute advantage in producing C if

aC C
H < aF .

We say that country H has comparative advantage in producing C if

aC
H aCF
< .
aW
H aW
F

Equivalently, 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.

1.2.1 Production possibility frontier

QW
H , the quantity of wine produced at home

QC
H , the amount of cloth produced at home

Total labor allocated to the production of wine is aW W

H QH

Total labor used in producting cloth is aC C

H QH .

Total endowment of labor for home country is LH , i.e. limits on production are
de…ned by the inequality

aC C W W
H QH + aH QH LH .

Figure 1: PPF for home; cloth on the horizontal axis and wine production on
the vertical axis. To get the PPF, we solve for the quantity of wine QW from
the above equation to get
LH aC
QW
H
H C
QH .
aW
H aW
H

3
 The opportunity cost of cloth measured in units of cloth is the slope aC W
H =aH of
the PPF.

Opportunity cost of cloth is the number of liters of wine the economy would
have to give up in order to produce one extra tonne of cloth

Perfectly competitive …rms, so the economy’s revenue function

r(p; v) = max pC C W W C C W W
n Qn + pn Qn an Qn + an Qn LH (1)
x

1.3 Autarky equilibrium

Ricardo assumed perfect competition.

Hence, constant return to scale and zero pro…ts. Therefore, goods will cost what
it costs to pay the workers who make them, i.e. marginal cost.

1.3.1 Equilibrium conditions

An equilibrium in each country is a set of commodity prices pin wage wn production

amounts Qin and consumption cin , that satistfy the following conditions:

Zero pro…t conditions: 4 complementary slackness conditions.

pC aC
H wH 0 QC
H pC aC
F wF 0 QC
F
pW aW
H wH 0 QW
H pW aW
F wF 0 QW
F

Labor market clearing conditions: 2 complementary slackness conditions for

country n.
aC C W W
H QH + aH QH LH aC C W W
F QF + aF QF LF
0 wH 0 wF

Goods market clearing conditions: 2 conditions by Walras’Laws.

QC C
H = cH = pC
C
wH LH QC C
F = cF = pC
C
wF LF
H F

4
1.3.2 Solving the autarky equilibrium

1. Prices, wages and production

From the zero pro…t conditions of wine we have

1 = wn aW
n

=) wage in the wine sector

pW
n
wn =
aW
n
) wage in the cloth sector
pC
n
wn =
aC
n

Equilibrium requires that wages are equalised across producing sectors; i.e.

Case 1: complete specialization in the cloth sector:

pC
n pW
n pC
n aC
n Ln W
C
> W
) W
> W
) QC
n = C ; Qn = 0
an an pn an an

Case 2: complete specialization in the wine sector:

pC
n pW
n pCn aCn Ln C
< ) < ) QW
n = W ; Qn = 0
aC
n aW
n p W
n aW
n a n

Case 3: diversi…ed production

pC
n pW
n pC
n aC
n Ln Ln
C
= W
) W
= W
) 0 < QW C
n < W ; 0 < Qn < C
an an pn an an an

Without trade consumers will have to buy at home; preference implies that
demand is strictly positive independent of the price, so each good will produced
at home. This means that we need all Q’s to be positive and therefore all ZPC
become equalities, and autarky equilibrium is de…ned by case 3.

5
 3.Consumption and labor allocation

Using the good market clearing conditions we have that consumption and pro-
duction of cloth is
C
QC
n = cC
n = wn Ln
pC
n
C
= Ln
aC
n

and production and consumption of wine is

C
(1 )
QW W
n = cn = wn Ln .
pW
n

C
Labor allocation: of the total labor force is making cloth and the rest wine.

1.4 Trade Equilibrium

Suppose that Home country has an absolute advantage in the production in

both sectors, but a comparative advantage in the production of C, ie

aC
H aCF
<
aW
H aW
F

Equivalently, we say that Home relative productivity in cloth is higher than it

is in wine.

1.4.1 Solving the trade equilibrium

A A
Relative autarky prices pC
H pC
F , implies that cloth is relatively cheaper
in H and wine relatively cheaper in F . Hence, we expect trade to create incen-
tive to produce more C in the Home country and then trade it for wine with
the F country.

Numeraire: In general equilibrium analysis, prices correspond to the rate at

which one commodity of factor is trade in terms of another, we need to choose
a unit of account. For this reason, let the world price of wine be the numeraire
(ie, pW = 1).

6
 A trade equilibrium in each country is a set of commodity prices pi (notice that
prices are equalized across countries so we drop the n index), wage wn produc-
tion amounts Qin and consumption cin that satistfy the following conditions:

– Zero pro…t conditions: 4 complementary slackness conditions.

pC aC
H wH 0 QC
H pC aC
F wF 0 QC
F
pW aW
H wH 0 QW
H pW aW
F wF 0 QW
F

– Labor market clearing conditions: 2 complementary slackness conditions

for country n.

aC C W W
H QH + aH QH LH aC C W W
F QF + aF QF LF
0 wH 0 wF

– World goods market clearing condition: Condition by Walras’Laws.

C C
QC C
H + QF = wH LH + wF LF = cC C
H + cF
pC pC
Three cases: complete specialization and two cases of incomplete specialization,
see Figure 2

Complete specialization

If H has comparative advantage in cloth and consumers preferences are not

skewed, H will produce only C and F will produce only W .

In this case we have

pC = aC
H wH 0 < QC
H pC < aC
F wF 0 = QC
F
1 < aW
H wH 0 = QW
H 1 = aW
F wF 0 < QW
F

Cloth will be produced in Home because the cost of producing it in country H

is lower than producing it in country F , i.e.:

wH aC C
H < wF aF

Wine will be produced in Foreign because the cost of producing it in country F

is lower than producing it in country H, i.e.:

aW W
F wF < aH wH

7
 To …nd pC we have to use the labor market condition (or PPF) since we know
that
aC C
H QH = LH aC C
F QF LF .

Now use the world market equilibrium to …nd the demand for C in the world
as (why?1 )
LH LF
QC
H =
C
C
+ C W .
aH p aF

Using the labor market condition at home (aC C

H QH = LH ) andrearranging terms
we solve for pC
C
LF =aW
pC = C
F
.
1 LH =aC
H

Notice that the relative price of C is bigger, 1) the higher consumers’preferences

for cloth, 2) the bigger the labor force in the cloth importing country F relative
to country H, 3) the larger the relative productivity of producing cloth in the
H relative to the production of wine in F:

Relative wages re‡ects absolute technological di¤ erences

pC
wH = ,
aC
H
1
wF = .
aW
F

The …nal step is to check that there are no pro…ts in the sectors that are produc-
ing zero quantities. That is 1 aW
H wH and p
C aC
F wF . Using the equilibrium
conditions derived above we need to check that
C
LF aW
F
C
,
1 LC aW
H
C
LF aC
F
C
.
1 LC aC
H

The …rst condition checks that there pC is high enough so H workers in the C
sectors do not have incentives to move to the W sector. Likewise, make sure
that the relative price of W is low so they do not have incentive to make their
own cloth.
1
Hint: Recall the properties of the Cobb Douglas preferences.

8
1.5 The gains from trade

If countries specialize according to their comparative advantage, they all gain

from this specialization and trade.

We demonstrate these gains from trade in two ways

– trade as a new way of producing goods and services (that is, a new tech-
nology)
– trade as means to raise consumption in each of the two countries.

Method 1:

Recall that H has specialized in C. Home could produce wine directly, but
trade with F allows it to produce (or obtain) W by producing cloth and then
trade it for W . Consider two alternative ways to use one unit of labor at H.
First, it could produce 1=aW
H units of wine. Alternatively, it could produce
1=aC C
H units of cloth and trade it for P =P
W (recall, the relative barter price

measure exhange units of wine by one units of cloth) gallons of wine, so you
can obtain 1=aC C W
H (P =P ) units of wine. Therefore, you obtain more wine
producing indirectly than directly as long as
1 1
C
(P C =P W ) > W ,
aH aH

but this is exactly what they obtain by trading with country F (why?).

An example:

aC W C W C
H = 1; aH = 2; aF = 6; aF = 3; P =P
W
= 12=12 = 1

Home has an absolute advantage in production in both sectors

Home has an absolute advantage in Cloth production

pC pC
Relative autarky prices for cheese: H
F
PH
= 21 ; PFF = 2 ) free trade prices must
F
1
satisfy 2 < P C =P W < 2

Home uses: 1 hour to produce 1/2 litre of wine or 1 piece of cloth

9
 Foreign uses 1 hour to produce 1/3 litre wine or 1/6 piece of cloth

Trade as an indirect production: 1 hour at Home gives 1 piece of cloth, exported

to Foreign allows for import of 1 litre of wine; double what we would have got
at home for giving up the same amount of cloth.
pC pW
Wages: wH = H
aC
= 12; wF = F
aW
= 4 ) re‡ects relative absolute productivity
H F
di¤erences

Method 2:

The consumption possibility frontier states the maximum amount of consump-

tion of a good 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, see Figure 3

10
1.6 Exercise

Suppose that two countries H and F produce cheese and wine with the following
worker requirements:

Cloth (tonne) Wine (per gallon) Total labor force

Home aC
H =5 aW
H =3 LH
Foreign aC
F =6 aW
F =9 LF

Assume LH = LF = 100 workers. Preferences are Cobb Douglas with cheese

having a share 3=4.

a. Which country has absolute advantage and which has comparative advantage.

b. Draw the production possibility frontier (PPF) for each country

c. Please state the autarky equilibrium conditions in both countries.

d. Solve for the equilibrium prices and quantities when countries are not allowed
to trade. Where the relative price of cheese is greater? Why?

e. State the trade equilibrium conditions.

f. Now suppose that countries are allowed to trade. Compute the world relative
price of cheese and relative wages. Which is bigger?

g. Explain the pattern of trade using the PPFs for both countries.

h. Show that both countries bene…t from trade.

11
2 Ricardian model with a continuum of goods
Dornbush, Fisher and Samuelson (1977) consider the case of trade in a Ricardian
model between two countries with many commodities.

2.1 Characteristics of the model

2.1.1 Technology and Production

Each good is indexed z 2 [0; 1] : Function an (z) gives input of labour required
in country n to produce one unit of good z; n = H; F; a0 (z) > 0

Unit labor requirement in the two countries are aH (z) and aF (z). Let us de…ne
the function A(z) = aF (z)=aH (z).

Order the good so that A0 (z) < 0, that is, the comparative advantage of country
H declines as z increases.

Let wH and wF be the wages in each country measured in any common unit.
De…ne ! = wH =wF .

NOTE: in the two-good model relative wages can be determined using informa-
tion on labor requirement and prices, since we know – based on relative labor
requirement – how country will specialize. With more than two goods, wages
have to be calculated in a di¤erent way. We need to look behind the relative
demand for goods to the implied relative demand for labor.

We kwow that the H country will produce all goods for which the unit cost is
the lowest. That is, good z will be produce by H if

aH (z)wH aF (z)wF

or equivalently, H has a comparative advantage in z if

! A(z).

H will produce goods in 0 z z whereas F will produce goods in the interval

z z 1.

12
2.1.2 Relative good prices

The structure of relative prices are determined by the minimum cost condition.

Consider the relative price of two goods produced by H. Their relative prices
can be written as
p(z) wH aH (z)
= (2)
p(z 0 ) wH aH (z 0 )
aH (z)
=
aH (z 0 )
which is the ratio of unit labor costs.

Terms of trade: The relative price of good z produced in Home in terms of a

good produced in Foreign, z 00 , is
p(z) wH aH (z)
= (3)
p(z 00 ) wF aH (z 00 )
!aH (z)
=
aH (z 00 )

2.1.3 Preferences and demand

We will maintain the usual identical homothetic preference assumption in the

two countries.

In a continuum of goods our consumer problem is written as follows:2

Z 1
max (z) log cn (z)dz
0

subject to the budget constraint

Z 1
p(z)cn (z) wn Ln = Yn
0

where p(z) is the price of good z, wn is the wage in country n, Ln the country
size and Yn is by de…nition total income (or total output).

Cobb Douglas preference implies that expenditure of good z is a constant share

z of income, ie
p(z)c(z) = (z)wn Ln
2
R1
Notice that CRS implies 0
(i) = 1.

13
 so that the share of expenditure on the good relative to total income is

p(z)c(z)
(z) = .
wn Ln

Notice that there is no country index here. Both countries have the same pref-
erences.

De…ne the fraction of expenditure in each country for goods produced by country
H as Z z
'(z) = (z)dz
0
with '0 (z) = (z).

This is the fraction of each country’s income spent on H produced goods. It

implies that the fraction spent on F produced goods is 1 '(z).

2.2 Trade equilibrium

To solve for the equilibrium we need to factor market clearing and good markets
clearing.

We provide two alternative ways of close the model. First, notice that world
demand must be equal to total output, which equals world labor income (recall
that we only have labor as an input):

CW = YW = YH + YF = wH LH + wF LF .

Therefore, clearing the H good market requires domestic labor income equal to
world spending on goods produced in H,

wH LH = '(z)(wH LH + wF LF )

where the LHS represents the world demand of H goods.

Solving for ! = wH =wF we have

'(z) LF
! = ,
1'(z) LH
LF
= B z; .
LH

14
 Interpretation of the B (schedule): If the range of domestically produced goods
were to increase (a rise in z) for a constant ! then the demand for domestic
labor (goods) would increase and the demand for F labor would fall. A rise in
the relative demand for H goods increase the relative wage (recall that relative
supply is …xed and there is not labor mobility).

An alternative representation is trade balance. This states that imports must

be equal to exports in a balanced two country world economy. That is, Home
country value of imports must be equal to Home country value of exports.

(1 '(z))YH = '(z)YF ,
| {z } | {z }
imports of F-goods exp orts of H-goods
(1 '(z))wH LH = '(z)wF LF .

On this interpretation, the B schedule is upward sloping because an increase in

the range of good produced by H (keeping ! constant) lowers H imports and
raises exports. This trade imbalance is corrected by an increase in the relative
wage that raises import demand and reduce export to restore the balance.

The equilibrium of factor and goods market

To de…ne the equilibrium for this economy recall the two equilibrium conditions

First, the upward sloping demand schedule:

LF
! = B z; .
LH

and also the downward sloping supply schedule:

! = A(z),

As seen in the …gure, the intersectiuon pins down values for z and !.

Notice that this equilibrium depends on 1) technology parameters, A( ), 2)

tastes '( ) and 3) relative size, LF =LH .

Quantities qH (z) and qF (z) and labor employment can be determined from the
demand structure and unit labor requirements.

15
 To see this, let us normalize the …rst good price at home to one. Using the price
equation 2 we can compute any price p(z) for z < z.

Then, having the relative wage we can compute the price for goods produced in
F using the price equation 3.

With all prices p(z) we compute the wage at home wH = p(z)=aH (z) and the
same for wF :

Finally, demand conditions will determined consumption and production as

follows
(z)wH LH
cH (z) =
p(z)
(z)
qH (z) = [wH LH + wF LF ]
p(z)

Figure 4, Equilibrium in the DFS model

2.3 Analysis

Having determined the relative wage and the pattern of specialization z we move on
to perform comparative statics experiments.

2.3.1 The e¤ect of an increase in relative size LF =LH

Consider the e¤ect of an increase in the relative size of the rest of the world

Equilibrium e¤ect

First, notice that of the two equations, only the B schedule is a function of
LF =LH . Hence, the B(:) curve shift upward in proportion to the change in
relative size.

As a result, the relative equilibrium wage raises and reduces the range of goods
produced domestically.

Intuition: at the initial equilibrium, the relative increase in foreign labor creates
an excess labor supply(more workers), and an excess demand at home(they
demand more H goods).

16
 This translates into a trade surplus, since for the home country there is more
and cheaper labor to produce its goods and this implies more exports.

To eliminate the trade surplus, we need an increase in the relative wage and an
increase in the unit labor cost.

The increase in the relative unit labor cost, implies a loss for marginal industries,
and therefore a reduction in the range of goods is needed as an adjustment.

Figure 5. The e¤ect of an increase in LF =LH in the DFS model

Welfare implications

Foreign and home wages remain constant in terms of their own goods. This is
because the zero pro…t condition implies

p(z) = aH (z)wH

and the technological coe¢ cients have not changed. In other words, purchasing
power of Home-produced goods remains constant.

Home real wage in terms of the goods that F produces rises. To see this, notice
that for good z > z we have the zero pro…t condition p(z) = aF (z)wF holds
before and after the change. Therefore, the condition
0
wH wH
>
wF0 wF

implies that
0
wH 0
wH wH wH
0
= 0
> =
p(z) aF (z)wF (z) aF (z)wF (z) p(z)
which implies that Home’s real wage must rise in terms of Foreign products.

A similar argument can be used to show that foreign real wages must fall in
terms of the initial goods produced at home, z < z 0 which production still
remains at home.

Now consider the industries that the Home country loses to Foreign competition,
that is when z 2 (z 0 ; z).

17
 These goods can be produced more cheaply in Foreign than in Home, so p(z) =
wF0 aF (z) < wH
0 a (z) which implies
H

0
wH 1 wH
> =
p(z)0 aH (z) p(z)

That is home real wage rises in terms of those goods that have become imports,
because the foreign costs are lower than domestic costs.

Similarly, it must be true that

wF0 1 wF0
= <
p(z)0 aF (z) p(z)
for foreign new export’s goods. Foreign’s real wage in terms of these goods has
fallen enough to make Foreign the lowest-cost production location.

This conclusion is rather striking: a rise in F relative labor supply lower its real
wage and improves Home’s. Surprisingly, H is better o¤ besides the migration
of industries from Home to Foreign.

Summarizing, this example shows that a rise in relative Foreign labor force
lowers its own real wage and raises Home’s. This means that Home is better o¤
and Foreign is worse o¤ (per unit of labor) despite the migration of industries
from home to foreign.

This goes back to Krugman’s remark that there is not connection between the
international competition, that the ability of countries to undercut rivals in the
international market, and the wellbeing of their citizens.

2.3.2 The e¤ect of technological progress

Consider a uniform reduction in F unit labor requirement aF (z).

Equilibrium and welfare e¤ects of the technological change

gives downward shift of the A schedule.

reduced range of products produced in h

trade de…cit

18
 reduced relative wages in h which restores trade balance

improved terms of trade of country h

increased real income, i.e. welfare in both country h and f.

see Figure 6

19