Chapter 3 - Labour Productivity and Comparative Advantage, The Ricardian Model

Why do countries engage in international trade?

1. Because they are different from one another. 2. To achieve economies of scale in production.

What is comparative advantage?

A country has a comparative in the production of a good if the opportunity cost of producing that good is lower in that country than it is in other countries.

What is a production possibility frontier?

A diagram showing the trade-offs in production. Any economy has limited resources, so there are limits on what it can produce, and there are always trade-offs: to produce more of one good or service too have to sacrifice production of another.

What is the Ricardian model?

A model of international trade which is based solely on international differences in the productivity of labour.

Why does international trade produce this increase in world output?

Because it allows each country to specialise in producing the good in which it has a comparative advantage.

How are gains from trade derived?

Consider two alternative ways of using an hour of labour: Home could use the labour directly to produce 1/aLW gallons of wine. Alternatively, home could use the hour to produce 1/aLC pounds of cheese, which is then traded for wine, with each pound trading for PC/PW gallons. Our original hour of labour yields (1/aLC)(PC/PW) gallons of wine. This will become more wine than the hour could have produced directly as long as: (1/aLC)(PC/PW) > 1/aLW or PC/PW > aLC/aLW In international equilibrium if neither country produces both goods we must have PC/PW > aLC/aLW, which shows that home can "produce" wine more efficiently by making cheese and trading it than by producing it directly.

What is the effect of this convergence of relative prices?

Each country specialises in the production of that good in which it has the relatively lower unit labour requirement.

What is general equilibrium analysis?

Takes account of the linkages between the two markets. this is needed for International trade analysis.

What happens in the absence of international trade?

Home would have to produce both goods for itself. But, it will only produce both goods if the relative price if cheese is just equal to its opportunity cost. Since the opportunity cost equals the ratio of unit labour requirements in cheese and wine, we can summarise the determination of prices in the absence of international trade with a simple labour theory of value: In the absence of international trade, the relative prices of goods are equal to their relative unit labour requirements.

How does a country end up with a cost advantage?

If the relative wage is between the relative productivities. E.g. a lower wage rate means foreign has a cost advantage in wine even though it has a 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.

What is another way of seeing the gains from trade?

In the absence of trade, consumption possibilities are the same production possibilities PF and P*F*. Once trade is allowed, each country can consume a different mix of cheese and wine from the mix it produces. Home's consumption possibilities are indicated by the coloured line TF, while foreign's consumption possibilities are shown by T*F*. In each case trade has enlarged the range of choice and therefore it must make residents of each country better off.

What does the PPF do?

It illustrates the different mixes of goods the economy can produce. However, to determine what the economy will actually produce, we need to look at prices - specifically, we need to look at the relative price of the economy's two goods, that is, the price of one good in terms of the other.

How are an economy's total resources defined?

L, the total labour requirement.

What is unit labour requirement the inverse of?

Labour productivity. The more of a good a worker produces in an hour (higher productivity), the lower the unit labour requirement.

What are the common misconceptions about comparative advantage?

Myth 1: free trade is beneficial only if your country is strong enough to stand up to foreign competition. - This fails to understand comparative advantage. The competitive advantage of an industry depends not only on its productivity relative to the foreign industry, but also on the domestic wage rate relative to the foreign rate. Myth 2: foreign competition is unfair and hurts other countries when it is based on low wages. This is referred as the Pauper labor argument. - All that matters to home is that it is cheaper in terms of its own labour for home to produce cheese and trade it for wine than to produce wine for itself. Myth 3: Trade exploits a country and makes it worse off if its workers receive much lower wages than workers in other nations. - Need to ask whether these workers would be worse off exporting goods based on low wages than they would be if they refused to enter into such demeaning trade. What is the alternative? - To deny them the ability to export and trade might well condemn them to even deeper poverty.

Show the world supply and demand for cheese relative to wine as functions of the price of cheese relative to that of wine.

See sheet.

What is the hourly wage in the cheese sector and in the wine sector.

See sheet.

When will wages in the cheese sector or wine sector be higher?

See sheet.

What assumption do we make in the model of trade in a one-factor world?

See sheet. In words, we assume that the ratio of the labour required to produce a pound of cheese that is required to produce a gallon of wine is lower in home than it is in foreign. Briefly, we say that Home's relative productivity is higher in cheese than it is in wine. Therefore, Home has a comparative advantage in cheese.

Show the effect of a rise in the relative price of cheese on a PPF.

See sheet. The rise in the relative price of cheese in home will lead home to specialise in the production of cheese, producing at point F. The fall in the relative price of cheese in foreign will lead foreign to specialise in the production of wine, producing at point F*.

How do we define the unit labour requirement of cheese and wine?

See sheet?

How will supply of goofs be determined in a one-factor (labour) economy?

Supply decisions are determined by the attempts of individuals to maximise their earnings. In labour's case, the supply of goods will be determined by the movement of labour to the sector which pays the higher wage.

What is special about the RS curve and how can we derive it?

The RS curve is a "step" with flat sections linked by a vertical section. The RS curve shows that there would be no supply of cheese if the world price of cheese dropped below aLC/aLW (home's opportunity cost of cheese production) - this is already below Foreign's opportunity cost of cheese production, so there will therefore be no world cheese production at prices below this. When the relative price of cheese PC/PW is exactly equal to the opportunity cost of cheese production aLC/aLW, workers in home can earn exactly the same amount in cheese production as wine production. So, home will be willing to produce any amount of the two goods, producing a flat section to the supply curve. If PC/PW is above aLC/aLW, home will specialise in the production of cheese. As long as PC/PW < a*LC/a*LW, however, foreign will continue to specialise in producing wine. When home specialises in cheese production, it produces L/aLC pounds. When foreign specialises in wine production, it produces L*/a*LW gallons. So, for any relative price of cheese between aLC/aLW and a*LC/a*LW, the relative supply of cheese is: (L/aLC)/(L*/a*LW). At PC/PW = a*LC/a*LW, foreign workers are indifferent between producing cheese and wine. So, we have another flat section of the curve. Finally, for PC/PW > a*LC/a*LW, both home and foreign will specialise in cheese production. There will be no wine production and the relative supply of cheese will become infinite.

What is the relative wage of a country's workers?

The amount they are paid per hour, compared with the amount workers in another country are paid per hour.

How do we derive the relative demand curve?

The downward slope of the RD represents substitution effects. As the relative price of cheese rises, consumers will tend to purchase less cheese and more wine, so the relative demand for cheese falls.

What is a crucial proposition that we can therefore derive?

The economy will specialise in the production of cheese if the relative price of cheese exceeds its opportunity cost in terms of wine; it will specialise in the production of wine if the relative price of cheese is less than its opportunity cost in terms of wine.

What is the equilibrium relative price of cheese determined by?

The intersection of the relative supply and relative demand curves. On def 27's diagram: RD intersects RS at point 1, when the relative price of cheese is between the two country's preterite prices. In this case, each country specialises in the production of the good in which it has a comparative advantage: home in cheese and foreign in wine. RD' intersects the RS curve on the first horizontal section of RS. At point 2, the world relative price of cheese after trade is aLC/aLW, the same as the opportunity cost of cheese in terms of wine in Home. If the relative price of cheese is equal to its opportunity cost in home, home need not specialise in producing either cheese or wine, and home may be producing both some wine and some cheese - this is inferred from the fact that the relative supply of cheese (point Q') on horizontal axis is less than it would be if home were completely specialised. Since PC/PW is below the opportunity cost of cheese in terms of wine in foreign, it does not specialise completely in producing wine. It therefore remains true that if a country does specialise, it does so in the good in which it has a comparative advantage.

What is the relative supply and demand?

The number of pounds of cheese supplied or demanded divided by the number of gallons of wine supplied or demanded.

What is true when the PPF is a straight line?

The opportunity cost of a unit of one good in terms of another is constant. In the case of wine and cheese, to produce another pound of cheese would require aLC person-hours. Each of these person hours would have been able to produce 1/aLW gallons of wine. Therefore, the opportunity cost of cheese in terms of wine is aLC/aLW. This opportunity cost is equal to the absolute value of the slope of the PPF.

What does a difference in opportunity costs offer?

The possibility of a mutually beneficial rearrangement of world production. The rearrangement of world production might increase the size of the economic pie. Because the world as a whole produces more, it is possible to raise everyone's standard of living.

What is opportunity cost?

This describes trade-offs. For example, the opportunity cost of roses in terms of computers is the number of computers that could have been produced with the resources used to produce a given number of roses.

What is the unit labour requirement? What does this express?

This is a measurement of labour productivity. The number of hours of labour required to produce a certain measurement of a good, e.g. the number of hours of labour required to produce a pound of cheese.

What is partial equilibrium analysis?

To study a single market.

When can trade benefit two countries?

When each country exports the good in which it has a comparative advantage.

What is an absolute advantage?

When one country is able to produce a unit of a good with less labour than another country. We cannot determine the pattern of trade from absolute advantage alone.

What does the PPF of a country look like if there is only one factor of production? Derive this line and draw.

When there is only one FOP, the PPF of a country is simply a straight line. See sheet.

Does the Ricardian Model fit the real world?

YES. There are misconceptions, though: - Predicts an extreme degree of specialisation that we do not observe in the real world. - assumes away effects of International trade on the distribution of income within countries, and thus predicts that countries as a whole will always Gain from trade (in practice, international trade has strong effects on income distribution). - Ricardian model allows for no role for differences in resources among countries as a cause of trade, which leaves it unable to explain large trade flows between appareltly similar nations. In spite of these failings, the basic prediction that countries tend to export those goods in which their productivity is relatively higher has been strongly confirmed by a number of studies over the years. Difficult to measure in the modern economy as many don't even produce products that they have a comparative disadvantage for, so there are no figures to back this up, e.g. airplanes.

What is the opportunity cost of cheese in terms of wine?

aLC/aLW.