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BA 187 – International Trade

Ricardo and Comparative Advantage: The Classical Model of Trade

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Issues in International Trade

Initial attempt to understand two of the important issues in trade theory. Gains from Trade Pattern of Trade

Use insight of Adam Smith about different advantages in production across countries.

Focus on comparative, rather than absolute, advantage as source of pattern & gains from trade

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Classical Model Assumptions

Fixed endowment of labor in each country. Labor completely mobile within a country. Labor completely immobile between countries. Commodity value determined by labor content. Technology fixed but differs across countries. Prod’n costs constant, do not depend on quantity. Full employment of labor, perfect competition. No tariffs or transportation costs. Two country, two commodity world.

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Constant Cost Technology

Ricardo (1817) viewed mutual gains from trade possible based on comparative advantage.

Example above Portugal has absolute advantage in both goods, but trade still possible as England is relatively more productive in cloth than wine.

ClothCloth WineWineAutarky Autarky

PPCC/P/PWW

EnglandEngland 10 hrs/yd 12 hrs/bbl 5/6W : 1C

PortugalPortugal 8 hrs/yd 6 hrs/bbl 4/3W : 1C

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Absolute vs. Comparative Advantage

Absolute Advantage– A country has an absolute advantageabsolute advantage in good X if one

unit of labor produces more X than is produced by one unit of labor in the other country.

Comparative Advantage– A country has an comparative advantagecomparative advantage in good X if

its opportunity cost of X in terms of Y is less than in the other country

In previous example Portugal has an absolute advantage in both goods but a comparative advantage in wine.

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Opportunity Costs and Advantage Comparative advantage arises from differing

opportunity costs across countries.– With total labor fixed, producing more of one good (Cloth) means

producing less of other good (Wine).– Tradeoff is opportunity cost and differs between the two countries.

EnglandEngland – 1 more unit of cloth requires giving up 5/65/6 unit of wine.

Portugal Portugal – 1 more unit of cloth means giving up 4/34/3 units of wine.

England’s comparative advantage is producing cloth, while Portugal’s comparative advantage is in producing wine.

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Ricardian Comparative Advantage Assume each

country has 120 units of labor.

Table shows all feasible combinations of cloth and wine for each country in autarky.

EnglandEngland Labor in Labor in ClothCloth

PortugalPortugal

Wine Cloth Wine Cloth

0 12 120 hrs120 hrs 0 15

3 1/3 8 80 hrs80 hrs 6 2/3 10

6 2/3 4 40 hrs40 hrs 13 1/3 5

10 0 00 20 0

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Gains from Trade Now trade opens

with terms of tradeterms of trade equal to 1W:1C

England specializes. Produces only cloth.

England exports cloth to Portugal in exchange for imports of wine.

At least as well off as in autarky.

Same results for Portugal. Mutual gains from trade.

EnglandEngland Autarky Labor Labor in in

ClothCloth

EnglandEngland Trade at 1W : 1C1W : 1C

Wine Cloth Wine Cloth

0 12 120 hrs120 hrs 00 12

3 1/3 8 120 hrs120 hrs 44 8

6 2/3 4 120 hrs120 hrs 88 4

10 0 120 hrs120 hrs 1212 0

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Relative Wages Assume unit of cloth & unit of wine sell for $12. After trade:

– English workers specialize in cloth, receive $1.20/hr ($12 for 10 hrs work)

– Portuguese workers specialize in wine, receive $2.00/hr ($12 for 6 hours work)

Relative wageRelative wage of English workers is 60% of that of Portuguese workers.– Note English workers are:

50% as productive as Portuguese workers in wine and 80% as productive as Portuguese workers in cloth Relative wage lies between these two productivities.

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BA 187 – International Trade

Visualizing Comparative Advantage

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Visualizing Comparative Advantage Rather than rely on numerical examples can

develop model visually to demonstrate results. Technology: (Constant Costs)

– aLX = # units of labor for 1 unit of X. (a*LX for foreign)– aLY = # units of labor for 1 unit of Y. (a*LY for foreign)– aLXqX + aLYqY = Ltotal (a*LXq*X + a*LYq*Y = L*total)

Tastes:– Each country possesses community indifference curves,

UH for Home and UF for foreign.– Maximize utility subject to production constraints

determined by technology and labor endowment.

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L/aLY

L/aLX

Equilibrium in Autarky

Y

X X

YHome Foreign

AH

UH

UF

AF

L*/a*LY

L*/a*LX

aLY

aLX

aLX/ aLY < a*LX /a*LY

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Prices, Wages & Production Prices, Wages, & Production

– Let PX and PY be the price of each good.

– Perfect competition implies wage to worker equals value of output produced, PX/aLX or PY/aLY

– Labor mobility implies: If PX/aLX > PY/aLY, or equivalently when PX/ PY >

aLX /aLY then economy produces only X.

If PX/aLX < PY/aLY, or equivalently when PX/ PY < aLX /aLY then economy produces only Y.

– In autarky, economy must produce both goods so relative prices of goods must equal their relative unit labor requirements, i.e. px = PX/ PY = aLX /aLY.

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QH

U’H

U’F

CH

CF

UF

AF

L*/a*LY

L*/a*LX

L/aLY

L/aLX

Potential Gains from Trade

Y

X X

YHome Foreign

AH

UH

QF

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QH

U’H

U’F

CH

CF

UF

AF

L*/a*LY

L*/a*LX

L/aLY

L/aLX

Equilibrium and Trade

Y

X X

YHome Foreign

AH

UH

QF

HomeImports

ForeignExports

Home Exports Foreign Imports

Equilibrium occurs at relative price that makes the two triangles equal

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Determining Terms of Trade How can we determine exactly what the relative price

will be in equilibrium with trade? Terms of trade for a country:

– Ratio of the price of its export commodity to the price of its import commodity.

– In our example, terms of trade for Home are PX/PY, and PY/PX for Foreign.

Number of analytical tools to determine the equilibrium relative price ratio with trade.

K&O focus on Relative Demand and Supply analysis.

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Relative Demand and Supply Relative analysis focuses on ratio of prices PX/PY &

ratio of total quantities (qX+ q*X)/(qY+ q*Y).

Relative Demand:– Rise in PX/PY makes X more expensive relative to Y.

– Substitution away from X towards Y, leads to downward-sloping Relative Demand Curve, RD.

Relative Supply:– If PX/PY < aLX /aLY : no Good X produced.

– If PX/PY = aLX /aLY : Home produces X as demanded.

– If a*LX /a*LY > PX/PY > aLX /aLY : Home specializes in X.

– If PX/PY > a*LX /a*LY : Both Home & Foreign produce X.

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aLX/aLY

(L/aLX)/(L*/aLY)

a*LX/a*LY RS

Relative Demand and Supply

1

RD

(qX+ q*X)/(qY + q*Y)

PX/PY

Relative Price of X

Relative Quantity of X

RD’

2

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BA 187 – International Trade

Summary of Results from the Classical Model of Trade

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Results of Trade Mutual Gains from Trade

– Trade enlarges the range of consumption choices for each nation over autarky.

Absolute vs. Comparative Advantage– Gains arise from specializing in producing goods in

which have a comparative (not absolute) advantage.

Trade & Specialization– Expect trade to lead nation to specialize in prod’n.

Relative Wages– What matters for trade is relative wage versus relative

labor productivities.

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Shortcomings of Ricardo Model Classical approach has serious shortcoming, in that it

assumes rather than explains comparative advantage. Classical model does not explain why labor productivities

differ between nations. It is these differences which are the source of comparative advantage.

Ignores how relative resource endowments change as countries grow (constant costs assumption).

Benefits of trade come from more efficient use of domestic resources through specialization. Specialization can have negative aspects if it results in a

lopsided pattern of growth within a developing country. May produce an export enclave rather than a well-balanced

economy.

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Statements to Address Productivity & Competitiveness

“Free trade is beneficial only if your country is strong enough to stand up to foreign competition.”

Pauper Labor“Foreign competition is unfair and hurts other countries when

it is based on low wages.” Exploitation

“Trade exploits a country and makes it worse off if its workers receive much lower wages than workers in other countries.”

Specialization“There cannot be distinct roles within Mercosur, with one

country producing primary products while another is industrialized” Fernando de la Rita, Presidential Candidate Argentina

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BA 187 – International Trade

Appendix: Small Country vs. Large Country Gains from Trade

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Does Trade Exploit Small Nations? Examine effects of opening trade between a large

economy and a small economy. (Think NAFTA) Is it true that the large nation will use its economic

clout to exploit the small nation? Next slide examines this case.

– SC = Small Country, LC = Large Country– Begin with both nation’s in autarky, ASC and ALC.– Open trade, change relative prices to find equilibrium

(equal trade triangles) between the countries.– Equilibrium with trade (Consumption, Production)

given by (CSC, QSC) and (CLC, QLC) Surprising results for Small vs. Large Country.

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CSC

Large/Small Country

Y

X

ASC

CLC

SC Imports

SC Exports

ULC

Small Country = SC

Large Country = LC

LC consumption point in autarchy & trade

LC Exports

LC Imports

QLC

LC production point with trade

U’SCSC consumption point

with trade

QSC

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Summary of Small vs. Large Country Small EconomySmall Economy

– Receives maximum gains available by opening trade.

– As a price-taker, it trades at the relative prices set by the large economy.

– Completely specializes in good for which it has the comparative advantage.

Large EconomyLarge Economy– Receives no gains from trade with small nation.

– No change in its production constraint.

– Produces both goods after trade, though more of good in which it has comparative advantage.

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BA 187 – International Trade

Extensions to the Classical Model of Trade

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Adding Money to Ricardo

So far have dealt with trade in terms of barter of one good for another.

How to move to monetary economy? Domestic value of good found as PX = W•aLX

Link economies through exchange rate.e = # units of foreign currency per unit domestic currency

Put price of good in common terms (foreign currency)

– Domestic Country: PPXX = a = aLX LX ••WW••ee

– Foreign Country: P*P*XX = a* = a*LX LX ••W*W*

Trade occurs based on differences in money prices

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Example of Money & Ricardo

Assume Exchange Rate of 1 escudo:£1– Cheaper to buy cloth in England, buy wine in Portugal.– Consistent with relative labor efficiency ( ½ < ¾ ) – Terms of trade for England PCloth/PWine = 1/2.4– If trade not balanced, then specie flows to country with

trade surplus. Raises prices & wages, offsets trade.

Wage/hrWage/hrLabor req. Labor req. for Clothfor Cloth

Price of Price of ClothCloth

Labor req. Labor req. for Winefor Wine

Price of Price of WineWine

EnglandEngland £1 /hr 1 hrs/yd £1 3 hrs/bbl £3

PortugalPortugal 0.6 esc./hr 2 hrs/yd 1.2 esc. 4 hrs/bbl 2.4 esc.

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The Export Condition Monetized version of Classical trade model.

– Country exports any product it can produce most inexpensively, given wage rate & exchange rate.

Export ConditionExport Condition– Cost conditions necessary for country to export a good.

PPXX = a = aLXLX W e W e << a*a*LXLX W* = P* W* = P*X X

oror a*a*LXLX/ / aaLXLX > > We/W* We/W*

– In a monetized world, ability to export depends not only on relative labor efficiency but also on relative wage rates and the exchange rate.

– Establishes limits on wage rates and/or exchange rate for trade to take place between countries.

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Wage and Exchange Rate Limits Trade in a two-good, two country world requires each country produce

one good more cheaply. This imposes limits on wage rates & exchange rates for trade to occur.

Wage Rate LimitsWage Rate Limits (assumes e = £1:1escudo)

– In previous example, England loses export market in cloth if English wage rises to £1.2/hr or higher.

– England gains export market in wine if it wage falls to £0.8/hr or lower.

Exchange Rate LimitsExchange Rate Limits (assumes wages fixed)

– Similar logic dictates that at if EXR rise to 1.2 esc/£1 or higher England loses export market in cloth.

– England gains export market in wine if it EXR falls to 0.8esc./ £ 1 or lower.

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Trade in Multi-Commodity World

Pattern of trade in multi-commodity world depends on relative labor requirements versus ratio of relative wages.

Also can see effects of change in exchange rate or relative wages on the pattern of trade.

Finally trade flows equalized by changes in relative wage rates due to flows of gold or exchange rate changes.

Cloth Wine Bread

Relative Wages Cheese Tools Pots

a*LC/aLC > a*Lw/aLw > a*LB/aLB > [We/W*] [We/W*] > a*LCh/aLCh > a*LT/aLT > a*LP/aLP

Home Exports Home Imports

Foreign Imports Foreign Exports

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Effects of Change in Relative Wages

Increase in Home wage rate, decrease in Foreign wage rate, or rise in exchange rate (home currency more valuable)

Makes home country goods more expensive, reduces the number of goods exported by the home country.

Again any imbalance in trade flows will be equalized by changes in relative wage rates due to flows of gold or exchange rate changes.

Cloth Wine

Relative Wages Bread Cheese Tools Pots

a*LC/aLC > a*Lw/aLw > [We/W*] [We/W*] > a*LB/aLB > a*LCh/aLCh > a*LT/aLT > a*LP/aLP

Home Exports Home Imports

Foreign Imports Foreign Exports

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Determining the Relative Wage

Relative Quantity of Labor

L/L*

Relative Wage , We/W*

Wine

Bread

Cheese

Tools

RD

RD = Relative Derived Demand for labor

RS

RS = Relative Supply of labor, L/L*

(We/W*)eq

Clotha*LC/aLC

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Evidence on Comparative Advantage MacDougall (1951)

– Looked at ratio of labor productivity US vs. UK plotted against export volume ratio, US vs. UK.

– Found that higher relative productivity for US vs. UK associated with higher export volume for US vs. UK in that industry.

– In addition found that relative productivity above relative wage associated with higher export volume.

– Similar results obtained by Balassa(1963) and Stern (1962)