Chapter 3

Labor Productivity
and Comparative
Advantage: The
Ricardian Model

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Preview
1. Opportunity costs and comparative
advantage
2. The one-factor Ricardian model
3. Autarky equilibrium
4. Trade in the Ricardian model
5. Gains from trade
6. Empirical evidence

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Introduction

What are the reasons for international trade?

– Some countries simply just cannot produce
certaing goods.
– Even if they can, they only can at much higher
costs.
– Countries differ in the amount of resources they
posess.
– Consumers’ tastes are different.
– There are economies of scale in production.

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• Differences across countries lead to gains

from trade:
– differences in the productivity of labor
The Ricardian model (Chapter 3).
– differences in the quantity of available labor,
capital and other factors of production
The Heckscher-Ohlin model (Chapter 5)
– differences in tastes

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1. Comparative Advantage and
Opportunity Cost (pp.25-26)

• The Ricardian model uses the concepts of

opportunity cost and comparative
advantage.
• The opportunity cost of producing
something measures the cost of not being
able to produce something else with the
resources used.
• You have to give up or forego something in
order to get something else, both valuable.

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Example: imagine a lawyer looking for a

secretary to type documents.
– The best candidate the lawyer finds can type 5
times as fast as the lawyer him/herself could.
– The best candidate can type 0,8 times as fast
as the lawyer.

Allocate resources to where they are

relatively more productive.

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2. The One-Factor Ricardian Model (p.26)

1. Labor is the only factor of production.

2. Labor productivity varies across countries due to
differences in technology, but labor productivity in
each country is constant.
3. The supply of labor in each country is constant
and there is full employment.
4. Two goods (now wine and cheese).
5. Two countries (now Home and Foreign).
6. Identical tastes for the two countries’ consumers.
7. Perfect competition on the goods and the factor
markets.
8. Free movement of workers between industries,
but no movement across countries.
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2.1 Notation (p. 27)

• L (labor supply): total number of hours worked in

the Home country.
• QC : cheese production in pounds.
• QW : wine production in gallons.
• aLC : how many hours of labor is required to
produce a pound of cheese
• aLW : how many hours of labor is required to
produce a gallon of wine
– Unit labor requirement and labor productivity.

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 2.2 What are countries able to produce
(p.27-28)

• Define the production possibility frontier (PPF) of Home

as:
Labor used for Labor used for
cheese production wine production

Total amount of
aLCQC + aLWQW = L labor resources

Total Labor required for

Labor required for Total gallons
pounds of each gallon of
each pound of of wine
cheese wine produced
cheese produced produced
produced

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• Rearranging the equation from the previous slide

we get

QW = L/aLW - aLC/aLW∙QC

• Production Possibility Frontier works similar to the

budget or isocost line

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 QW Wine
production
in gallons

Slope = opportunity cost =

Qw(max) +1 Marginal rate of transformation=
= L/aLW –1 aLC/aLW

PPF
QC Cheese
Qc(max) = L/aLC production
in pounds

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Let us have a Foreign country too, with unit labor

requirements a*LC = 2 and a*LW = 1
QW Wine
production
in gallons

+1
L*/a*LW

–2

PPF*
QC Cheese
L*/a*LC production
in pounds
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2.3 What do countries want to consume?
(p.31)

QW Wine Tastes of the countries

production
in gallons can be demonstrated by
country indiffecence
curves (CIC).
Slope at any point is
MRS = MUC/MUW.

CIC

QC Cheese
production
in pounds

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3. Autarky equilibrium (p.28-29)

Suppose there is no trade between Home and

Foreign, each country has to produce for itself what
it wants to consume.
• How much is each country going to produce?
• How much are they going to consume?
• What are the prices going to be?
• What are the wages going to be?
• We will use Relative Supply and Relative
Demand to determine these.

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3.1 Relative Prices, Productivity and
Wages (p.29)

• PC and PW: the Home price of cheese and wine,

• WC and WW : the Home wages in the two
industries.
• What if the relative price of cheese is higher than
1? (remember: workers have same productivity in both industries)
• What if it is lower than 1?

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• Because workers like high wages, they will work in

the industry that pays the higher wage.
• Since we have perfect competition on the products
and the factor market
WC = VMPLC = PC∙MPLC = PC ∙ 1/aLC = PC /aLC
and
WW = VMPLW = PW∙MPLW = PW ∙ 1/aLW = PW /aLW

In equilibrium, wages are equal in both industries

PC /PW = aLC/aLW
So realtive prices reflect
relative productivity
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3.2 Relative supply (p.28)

PC/PW PC/PW
relative relative price
price of of Cheese
Cheese
RS*
2

RS
1

QC/QW QC/QW
relative relative
quantity of quantity of
Cheese Cheese

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• If the home country wants to consume both wine

and cheese (in the absence of international trade),
relative prices must adjust so that wages are
equal in the wine and cheese industries.
– If PC /aLC = PW /aLW workers will have no incentive to work
solely in the cheese industry or the wine industry, so that
production of both goods can occur.
– Production (and consumption) of both goods occurs when
the relative price of a good equals the opportunity cost of
producing that good:
PC /PW = aLC /aLW

The relative prices are independent of

what the country wants to consume

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3.3 Relative Demand (p.31)

Productivity determines relative prices.

Tastes determine relative quantities.
Optimal choice based on production
possibilities (PPF) and consumption
preferences (CIC).

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In the optimum:
MRT = MRS
QW Wine aLC/aLW = MUC/MUW.
production
in gallons Where relative price of
cheese is higher (in
Foreign) relative quantity of
L*/a*LW cheese is lower.

L/aLW

CIC

PPF* PPF
QC Cheese
L*/a*LC L/aLC production
in pounds

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 What if the Home relative
PC/PW
price of cheese goes up?
relative
price of
Cheese

RD = RD*
QC/QW
relative
quantity of
Cheese

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3.4 Equilibrium without trade

PC/PW
relative price
of Cheese

RS*
The country with 2
the higher
opportunity cost will
have higher relative
1
price and lower
RS
relative quantity.
RD = RD*
QC/QW
relative
quantity of
Cheese

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4. Trade in the Ricardian Model (p.30-33)

• Labor productivity determines domestic prices

(and consumption)
• Differences in domestic prices give rise to
trade.
• Even if a country is the most (or least) efficient
producer of all goods, it still can benefit from
trade.

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QW Wine
production Q: Who has comparative advantage
in gallons
in cheese production?
A: The country having lower
opportunity cost
L*/a*LW
aLC/aLW < a*LC/a*LW
L/aLW
…which also means
aLC/a*LC < aLW/a*LW
…and
PC /PW < PC /PW*
PPF* PPF
QC Cheese
L*/a* LC L/aLC production
in pounds

PPF biased toward cheese or wine

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 4.1 World relative supply and demand
(p.31-32)

PC/PW
relative price
of Cheese
• If PC/PW < 1
RSW
Home: only W
2 Foreign: only W
• If PC/PW > 2
(PC/PW)W
Home: only C
1 Foreign: only C
• If 1 < PC/PW < 2
Home: only C
RDW = RD = RD*
Foreign: only W
(L/aLC+0 ) / (QC+Q*C )/(QW +Q*W)
(0+L*/a*LW) relative quantity of
Cheese

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4.2 Effects of trade (p.32-34)

QW Wine
production
in gallons

IMW

CIC

PPF
QC Cheese
production
EXC in pounds

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• In Home:
– Relative price of cheese rises
– Wages in cheese rise above wages in wine
– Full specialization in cheese
– Budget line becomes steeper
– Consumption differs from production
– Export the good in which it has comparative
advantage
– Import the good in which it has comparative
disadvantage
– Increased welfare

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• In Foreign:
– Relative price of wine rises
– Wages in wine rise above wages
QW Wine
production in cheese
in gallons – Full specialization in wine
– Budget line becomes flatter
– Consumption differs from
production
EX*W – Export the good in which it has
comparative advantage
CIC – Import the good in which it has
comparative disadvantage
– Increased welfare
PPF*
QC Cheese
production
IM* C in pounds

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5. Gains From Trade (p.34-36)

• Gains from trade come from using resources more

efficiently
• Domestic workers earn higher income in both
countries
• Consumption possibilities expand beyond the
production possibility frontier.
• Think of trade as an indirect method of production
that converts cheese into wine or vice versa.
• With trade, a country can specialize its production
and exchange for the mix of goods that it wants to
consume.
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6. Empirical evidences supporting

the Ricardian model (p.37-40)

• Do countries export those goods in which their

productivity is relatively high?

• The ratio of U.S. to British exports in 1951

compared to the ratio of U.S. to British labor
productivity in 26 manufacturing industries
suggests yes.

• At this time the U.S. had an absolute advantage in

all 26 industries, yet the ratio of exports was low
in the least productive sectors of the U.S.

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Fig. 3-6: Productivity and Exports

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• Do relative wages reflect relative productivities of

the two countries?
• Evidence shows that low wages are associated with
low productivity.
– Wage of most countries relative to the U.S. is similar to
their productivity relative to the U.S.

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Productivity and Wages

Source: International Monetary Fund, Bureau of Labor Statistics, and The Conference
Board
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