Technology&Trade - The Ricardian Model

With Trade

- A country can specialise its production and exchange for the mix of goods that it wants to consume. - Consumption possibilities expand beyond the PPF when trade is allowed. - Domestic workers earn a higher income from cheese production because the relative price of cheese increases with trade. - Foreign workers earn a higher income from wine production because the relative price of cheese decreases with trade (making cheese cheaper) and the relative price of wine increases with trade.

If the relative price of cheese equals the Opportunity cost of cheese in Home countries:

- Domestic workers are indifferent about producing wine or cheese (wage when producing wine is the same as wage when producing cheese). - Foreign workers produce only wine. - Relative supply of cheese will be a flat section between zero and the maximum Home supply of cheese.

If the relative price of cheese settles in between the Opportunity cost of cheese:

- Domestic workers produce only cheese (where their wages are higher). - Foreign workers still produce only wine (where their wages are higher). - World Relative supply of cheese equals Home's maximum cheese production divided by Foreign maximum wine production.

If the relative price of cheese equals the Opportunity cost of cheese in the Foreign Country:

- Foreign workers are indifferent about producing wine or cheese (wage when producing wine is the same as wage when producing cheese). - Domestic workers produce only cheese. - Relative supply will be a flat section.

Assumptions of the One - Factor Ricardian Model

- Labour is the only factor of production. - Labour productivity varies across countries due to differences in technology, but labour productivity in each country is constant. - The supply of labour in each country is constant. - There are two goods (e.g. Wine and Cheese). - There are two countries (Home and Foreign). - Competition allows workers to be paid a wage equal to the value of what they produce and allows them to work in the industry that pays the highest wage.

If the relative price of cheese falls below the Opportunity cost of cheese in both countries:

- No cheese would be produced. - Domestic and Foreign workers would be willing to produce only wine - where the wage is higher. - Relative supply of Cheese = 0.

If the relative price of cheese rises above the Opportunity cost of cheese in both Countries:

- No wine is produced. - Domestic and Foreign workers are only willing to produce cheese (where the wage is higher).

Comparative Advantage

A country has comparative advantage in producing a good if the opportunity cost of producing that good is lower than other countries. Opportunity cost of producing something measure the cost of NOT being able to produce something else with resources used.

Without Trade

A country must allocate resources to produce all the goods that it wants to consume.

Production Possibility Frontier (PPF)

A graphical illustration that shows the maximum quantity of a good that can be produced for a fixed amount of resources. Alc(Qc) + Alw(Qw) <(or equal to) L

If the home country has a comparative advantage in the production of a god (cheese) whose PPF is steeper?

As Foreign's relative unit of labour requirement in cheese is higher than Home's (therefore needs to give up more wine to produce cheese), Foreign's PPF is STEEPER.

Gains From Trade

Comes from specialising in the type of production which uses resources most efficiently, and using the income generated from that production to buy the goods and services that countries desire.

The Ricardian Model

Examines the differences in the productivity of labour (due to its differences in technology) between countries.

Due to competition in the labour and goods markets

Hourly wages of cheese makers will equal the value of the cheese produced in an hour: Wc = Pc/ Alc Hourly wages of wine makers will equal the value of the wine produced in an hour: Ww = Pw/Alw

Why do nations trade?

In general it is due to the differences across countries: cheaper labor, cost companies more to make it on their own, opportunity cost, etc. Trade my also arise due to the Economies of scaled (larger scale of production is more efficient).

Does having absolute advantage guarantee a country should export a good?

NO, not absolute advantage, COMPARATIVE ADVANTAGE determines the pattern of trade. Alc/Alw < A*lc/A*lw = Opportunity cost of Home country producing cheese is less than Foreign therefore it is more efficient.

Opportunity Cost

Of a good, is how much of one good a country must stop producing in order to make one more unit of another good. Alc/Alw - In this example, the opportunity cost of cheese is how many gallons of wine, the home country must stop producing in order to make one more pound of cheese.

World Relative Supply and Demand, Equilibrium price, Point 1 (lower relative price of cheese) and Point 2 shows 2 Possible outcomes.

Point 1: Home produces only cheese while foreign produces only wine. Point 2: Home produces both cheese and wine, while foreign produces only wine

What the economy will actually produce, what should we look at?

Price

World Relative Supply and demand

The RD and RD' curves show that the demand for cheese relative to wine is a decreasing function of the price of cheese relative to that of wine. Whilst the RS curve shows that the supply of cheese relative to wine is an increasing function of the same relative price.

Absolute Advantage

The ability of a country to produce a unit of a good with less labour than another country, using the same amount of resources. Alc < A*lc - the Home country is more efficient than the Foreign in producing cheese.

Specialisation

The production of a limited range of goods by individuals, firms, regions or countries.

If the Price of cheese relative to the Price of wine is less than the opportunity cost of producing cheese: Pc/Pw < Alc/Alw

Then the wage paid in cheese will be less than the wage in wine: Wc = Pc/Alc < Pw/Alw = Ww. Workers will make only wine and the economy specialises in wine.

If the Price of cheese relative to the Price of wine equals the opportunity cost of producing cheese: Pc/Pw = Alc/Alw

Then the wage paid in cheese will equal the wage in wine: Wc = Pc/Alc = Pw/Alw = Ww. Workers will be willing to make both wine and cheese.

If the Price of cheese relative to the Price of wine exceeds the opportunity cost of producing cheese: Pc/Pw > Alc/Alw

Then the wage paid when making cheese will exceed the wage in wine: Wc = Pc/Alc > Pw/Alw = Ww. Workers will make only cheese and the economy will specialise in cheese production.