trade and technology: the ricardian model 1 reasons for trade 2 ricardian model 3 determining the...

TRADE AND TECHNOLOGY: THE RICARDIAN MODEL

1 Reasons for Trade

2Ricardian Model

3Determining the

Pattern of International Trade

4Solving for

International Prices5

Conclusions

2

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 2 of 87

Introduction

• Why does the U.S. import goods that it could easily produce itself with its great manufacturing capability?

• The first part of this book looks at the various reasons for trade: Technological differences Differences in amounts of resources Differences in costs of outsourcing The proximity of countries to each other


Introduction

• This chapter focuses on how technology differences across countries affect trade. Ricardian model proposed by the 19th century

economist David Ricardo.

• It explains how the level of a country’s technology affects wages paid to labor in a way that countries with better technology have higher wages.

• We use this to explain a country’s trade pattern—the products it exports and imports.


Reasons for Trade

1. Proximity The closer countries are the lower the costs of

transportation.

2. Resources A country can have resources that give it an edge in

the production of certain goods. A country with a lot of snow may be very good at

producing snowboards.

Resources are also called factors of production—the land, labor, and capital used to produce goods and services.


Reasons for Trade

3. Absolute Advantage When a country has the best technology for

producing a good, it has an absolute advantage in the production of that good.

4. Comparative Advantage Absolute advantage is actually not a good

explanation for trade patterns. A country has a comparative advantage in

producing those goods that it produces best compared with how well it produces other goods.

China does not have an absolute advantage compared to U.S. but is better at producing snowboards than some other goods.


Ricardian Model

• To develop a Ricardian model of trade, we will use an example with two goods: wheat and cloth. Wheat and other grains are major exports of the U.S.

and Europe. Many types of cloth are imported into these countries.

• Home will be the country exporting wheat and importing cloth.

• Assume that labor is the only factor of production.

• Note that the model has two goods and one factor of production.


Ricardian Model

• The Home Country

One worker can produce 4 bushels of wheat or 2 yards of cloth.

The Marginal Product of Labor is the extra output obtained by using one more unit of labor. MPLW = 4 and MPLC = 2.

We can use the marginal products of labor to construct Home’s Production Possibilities Frontier. The PPF shows all feasible combinations of wheat and cloth.

Assume there are 25 workers in Home.


Ricardian Model

• Using the setup, we can show: Labor = 25, MPLW = 4, MPLC = 2 QW = MPLW(L) = 25(4) = 100 QC = MPLC(L) = 25(2) = 50

• This gives us a straight line PPF which is a unique feature of the Ricardian model. It assumes the marginal products of labor are

constant.

• The slope also equals the opportunity cost of wheat—the amount of cloth that must be given up to obtain one more unit of wheat. It is the ratio of the marginal products.


Ricardian Model

Figure 2.1


Ricardian Model

• Home Indifference Curve Given Home’s PPF, how much wheat and cloth will

home actually produce. The answer depends on demand.

Demand can be represented with indifference curve. An indifference curve shows the combinations of two

goods that the country can consume and be equally satisfied.

All points on an indifference curve have the same level of utility.

Points on higher indifference curves have higher utility.


Ricardian Model

The country is indifferent between A and B

The country is better off on U2 but cannot produce that much

U0<U1<U2

Figure 2.2


Ricardian Model

• Home Equilibrium

Without trade, the PPF acts as a budget constraint for the country.

With perfectly competitive markets, the country will produce at its highest level of utility within the limits of the PPF.

In the graph, the highest level of utility that can be reached and still stay within the PPF is U1 with production at point A. Refer to this as the no-trade equilibrium.


Ricardian Model

• Opportunity Cost and Prices

The slope of the PPF reflects the opportunity of producing one more bushel of wheat.

Under perfect competition the opportunity cost of wheat should equal the price of wheat. Price reflects the opportunity cost of a good.


Ricardian Model

• Wages Determination of wages

In competitive markets firms hire workers up to the point at which the hourly wage equals the value of one more hour of production.

wage = P*MPL for each industry.

In competitive markets, labor can move freely between industries. Wages must be equal across industries.

Equalization of wages implies that:

This is the relative price of wheat. Cost of wheat in terms of cloth.

W W C C

W C

C W

P MPL P MPL

P MPLP MPL


Ricardian Model

• The Foreign Country Assume Foreign’s technology is inferior to Home’s.

Foreign has an absolute disadvantage in producing both wheat and cloth as compared to Home.

Foreign Production Possibilities Frontier Assume a Foreign worker can produce one bushel of

wheat or one yard of cloth. MPL*W = 1, MPL*C = 1

Assume there are 100 workers available in Foreign.


Ricardian Model

Figure 2.3


Ricardian Model

Cloth

(1 Yard)

Wheat

(1 Bushel)

Home 2 Bushels

of Wheat

½ Yard

of Cloth

Foreign 1 Bushel

of Wheat

1 Yard

of Cloth

• Comparative Advantage Given the opportunity cost information, we can determine

comparative advantages in each country for each good.

• The table below shows the opportunity cost of each good for both countries:


Ricardian Model

• Comparative Advantage A country has a comparative advantage in a good when

it has a lower opportunity cost of producing than another country.

By looking at the chart we can see that Foreign has a comparative advantage in producing cloth. Foreign’s Opportunity cost of cloth is lower.

Home has a comparative advantage in producing wheat. Home’s opportunity cost of wheat is lower.


Ricardian Model

• Equilibrium in Foreign Foreign’s preferences can also be represented by an

indifference curve.

The no-trade relative price of wheat is P*W/P*C = 1.

The relative price exceeds Home’s no-trade relative price of wheat: P*W/P*C = ½ .

The difference in relative prices comes from the comparative advantage that Home has in wheat.

Shortly, we will show how these differences can form the basis for trade.


Ricardian Model—Foreign

Figure 2.4

APPLICATION


Comparative Advantage in Apparel, Textiles, and Wheat

• U.S. Textile and apparel industries face intense import competition.

• Burlington Industries announced in January 1999 it would reduce production capacity by 25% due to increased imports from Asia.

• After layoffs they employed 17,400 persons in the U.S. with sales of $1.6 billion in 1999.

• Sales per employee were therefore $92,000.• This is the average for all U.S. apparel producers.• Textiles are even more productive with annual sales per

employee of $140,000 in the U.S.

APPLICATION



• In China, however, sales per employee are only $13,500 in apparel and $9,000 in textiles.

• The U.S. is 7 times more productive in apparel and 16 times more productive in textiles.

• So the U.S. has the absolute advantage in these products.• For wheat, the U.S. produces 27.5 bushels per hour of

labor.• China produces only 0.1 bushel per hour of labor.• The U.S. is thus 275 times as productive in wheat.• It thus has the absolute advantage in wheat.

APPLICATION



• Since the absolute advantage in wheat for the U.S. is even greater than in apparel and textiles, it has the comparative advantage in wheat.

• China has the comparative advantage in apparel and textiles because its productive disadvantage relative to the U.S. is less than in wheat.

• This explains why the U.S. imports apparel and textiles from China despite higher productivity in the U.S.

SIDE BAR


Can Comparative Advantage be Created? The Case of “Icewine”

• In general we think of a country having a comparative advantage in a good. Certain countries have a comparative advantage in the

production of wine.

• Can a country create a comparative advantage? Areas that get very cold are not good wine producers

because the vines get too cold.

SIDE BAR


Can Comparative Advantage be Created? The Case of “Icewine”

The Niagara Falls region of Canada began producing a product called “icewine” in 1983; it’s now made in British Columbia, too.

The grapes are allowed to freeze on the vine before they are picked.

The unique flavor of the wine has led to a relatively high demand.

This has created a comparative advantage in a certain type of wine, even though Canada does not have the advantage in traditional wine production.


Determining the Pattern of International Trade

• What happens now when goods are traded between Home and Foreign?

• We will see the country’s no-trade relative price determines which product it will export and which it will import.

• The no-trade relative price equals its opportunity cost of production. Therefore, the pattern of exports and imports will be

determined by the opportunity costs of production in each country—their comparative advantage.



• International Trade Equilibrium Relative price of cloth in Foreign is PC/PW = 1. Relative price of cloth in Home is PC/PW = 2. Therefore Foreign would want to export their cloth to

Home—they can make it for $1 and export it for more than $1.

• How Trade Occurs As Home exports wheat, quantity of wheat sold at

Home falls. The price of wheat at Home is bid up.

More wheat goes into Foreign’s market. The price of wheat in Foreign falls.

Similar logic applies to cloth.



• International Trade Equilibrium Two countries are in a trade equilibrium when:

the relative price of each good is the same in the two countries

the amount of each good that the countries want to trade is equal

In understanding the trade equilibrium we need to do two things: Determine the relative price of wheat or cloth in the trade

equilibrium. See how the shift from the no-trade equilibrium to the

trade equilibrium affects production and consumption in both Home and Foreign.



• International Trade Equilibrium

The relative price of wheat in the trade equilibrium will be between the no-trade price in the two countries. Assume the free-trade price of PW/PC is 2/3.

We can now take this price and see how trade changes production and consumption in each country.

Home producers of wheat can earn more than the opportunity cost of wheat by selling it to Foreign.

We can show this with our wage equations.



• Home’s workers will want to work in wheat and no cloth will be produced.

• With trade, Home will be fully specialized in wheat production.

2 4 81

3 2 6W W

C C

W W C C

P MPLP MPL

Therefore

P MPL P MPL

Wages in wheat Wages in cloth



• International Trade Home can export wheat at the international relative

price of 2/3. For each bushel of wheat it exports, it gets 2/3 yards of

cloth in return. In figure 2.5 we trace this out to get a new price line

showing the world price. The world price line shows the range of consumption

possibilities that a country can achieve by specializing in one good and trading.

Remember: this is only a consumption possibility because production is still constrained by the PPF.



U2

World price line, Slope = –2/3

U1

A

50 100 Wheat, QW (bushels)

Cloth, QC (yards)

B

Home production

50

25

• The new world price, PW/PC = 2/3, shows us the new range of consumption possibilities

• The country can now achieve a higher utility with the new consumption possibilities



Home imports 40 yards of cloth

Home exports 60 bushels of wheat

Home consumption

A

B

Home production

25

C40 World price line, Slope = –2/3 U2

U1

50 100 Wheat, QW (bushels)

Cloth, QC (yards)

50

100

Home produces 100 bushels but consumes only 40, so exports equal 60

50

Home produces 0 yards of cloth but consumes 40, so imports equal 40.

40



• International Trade

Trade allows a country to engage in consumption possibilities it did not have before trade.

We can see this as Home can now be on a higher indifference curve with trade than they were without it.

This is the first demonstration of gains from trade.

• Pattern of Trade and Gains from Trade

From figure 2.5, we can also see that Home’s exports and imports are equal when valued in the same units. Trade is balanced.



Figure 2.6




Each country is exporting the good for which it has the comparative advantage.

This confirms that the pattern of trade is determined by comparative advantage. This is the first lesson of the Ricardian model.

There are gains from trade for both countries. This is the second lesson of the Ricardian model. It refutes the notion that free trade benefits one country while

harming the other.




However, we have not yet determined the level of wages across countries.

Relative prices converge. Do wages?

Wages do rise in each country, but they do not converge. (Important political implications)

They are determined by absolute advantage, not comparative advantage.



• Solving for Wages Across Countries As stated before, in competitive labor markets, firms will

pay workers the value of their marginal product. Since Home produces and exports wheat, they will be

paid in terms of that good—the real wage is MPLW = 4 bushels of wheat.

The workers sell the wheat on the world market at a relative price of PW/PC = 2/3.

We can use this to calculate the real wage in terms of cloth: (PW/PC)MPLW = (2/3)4 = 8/3 yards.



• Solving for Wages Across Countries We can do this for Foreign as well and summarize: Home real wage is

4 bushels of wheat 8/3 yards of cloth

Foreign real wage is 3/2 bushels of wheat 1 yard of cloth

Foreign workers earn less than Home workers as measured by their ability to purchase either good. This fact reflects Home’s absolute advantage in the production

of both goods.



• Wages are determined by absolute advantage and trade is determined by comparative advantage.

• This should make sense. The only way a country with poor technology can export

at a price others are willing to pay is by having low wages.

• As a country develops better technology, its wages will rise. (Compare to autarky wages) Workers become better off through receiving higher

wages. As countries engage in trade, the Ricardian model

predicts that their real wages will rise.



• We can see this in the real world Per capita income in China in 1978 was estimated at

$925. In 2000, per capita income in China had risen to $3750. Per capita income in India more than doubled from

$1180 in 1978 to $2480 in 2000. It is strongly believed that the opportunity for these

countries to engage in international trade has been crucial in raising their standard of living.

APPLICATION


Labor Productivity and Wages

• Labor productivity can be measured by the value-added per hour in manufacturing. Value-added is the difference between sales revenue in an

industry and the costs of intermediate inputs. Equals the payments to labor and capital in an industry. The Ricardian model ignores capital so we can measure labor

productivity as value-added divided by the number of hours worked, or value-added per hour.

• Figure 2.7 shows value-added per hour in manufacturing for several countries. Countries with higher labor productivity pay higher wages, just as

the Ricardian model predicts.

APPLICATION



Figure 2.7: Labor Productivity and Wages, 2001

APPLICATION



• We can also see the connection between productivity and wages over time.

• Figure 2.8 shows that the general upward movement in labor productivity is matched by upward movement in wages. This is also predicted by the Ricardian Model.

APPLICATION



Figure 2.8


Solving for International Prices

• In the previous analysis we assumed the world price of wheat was 2/3.

• In reality world price is determined by a market for exports and imports.

• We will derive a Home export supply curve. Shows the amount it wants to export at various relative

prices.

• Similarly we will derive a Foreign import demand curve. Shows the amount of wheat that it will import at various

relative prices.



• Home Export Supply Curve The export supply curve will have the relative price of

wheat on the Y-axis and the amount of wheat on the X-axis.

We use the information in figure 2.9 to derive the curve. Compare production and consumption at each relative price. When Pw/Pc=1/2, Exports=0. When Pw/Pc=2/3, Exports=60.

• The flat portion of the export supply curve is a special feature of the Ricardian model. The PPF is a straight line. Production can occur anywhere along the PPF as

workers shift between industries.



Figure 2.9



• Foreign Import Demand We can use a similar analysis to construct the import

demand for wheat in figure 2.10. At the world relative price of 2/3, Foreign imports 60

bushels of wheat, C* and C*’. The no-trade equilibrium in Foreign, with a relative price

of 1, is zero imports, A* and A*’. Production can shift from point A, at a price of 1, as

workers move between industries: If workers all shift to cloth. Foreign imports 50 bushels of wheat, B* and B*’.

This gives us the import demand curve.



Figure 2.10



• International Trade Equilibrium We need to put the Home export supply together with

the Foreign import demand. The exports from Home come from the excess

domestic supply. The imports to Foreign come from the excess domestic

demand. This is the World market for wheat (figure 2.11):

Equilibrium price of 2/3 and trade of 60 bushels of wheat. This is the amount that clears the world market. Desired sales of Home equal the desired purchases by

Foreign.


Figure 2.11




• The Terms of Trade The price of a country’s exports divided by the price of

its imports. For Home, PW/PC is their terms of trade.

An increase in PW or a fall in PC will raise Home’s terms of trade.

An increase in the terms of trade is good for a country: it makes it better off. A country will earn more for its exports. A country will pay less for its imports.

For Foreign, PC/PW is the terms of trade and a higher relative price for cloth makes it better off.

APPLICATION


The Terms of Trade for Primary Commodities

• Latin American economist Raúl Prebisch and British economist Hans Singer each put forward the hypothesis that the price of primary commodities would decline over time relative to the price of manufactured goods.

• Primary commodities are often exported by developing countries, so their terms of trade would decline over time.

• Empirical evidence for this theory is mixed.

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