11

Ch. 3: Labor Productivity andComparative Advantage – The Ricardian Model

22

Why Do Countries Trade?Why Do Countries Trade?

Countries trade with each other because Countries trade with each other because they are different from each other.they are different from each other.

Countries trade with each other because Countries trade with each other because enlarging the market creates economies of enlarging the market creates economies of scale and reduces cost per unit.scale and reduces cost per unit.

33

Comparative AdvantageComparative AdvantageA person, a region, a country has A person, a region, a country has

comparative advantage in producing a good comparative advantage in producing a good if the if the opportunity costopportunity cost of producing that of producing that good is lower than others.good is lower than others.

Even if a country has absolute Even if a country has absolute disadvantagedisadvantage in every thing it produces compared to in every thing it produces compared to another one, it still will have comparative another one, it still will have comparative advantage in some goods.advantage in some goods.

44

Do What You Do Best; Do What You Do Best; Trade for the RestTrade for the Rest

http://www.economist.com/surveys/displaystory.cfm?story_id=E1_GDVTQQ

In a year, an Eastern worker can make two bikes or grow four bushels of wheat. A Westerner, however, can manage only one bushel or one bike. Each country has 100 workers, and initially both of their workforces are split evenly between the two industries.

East is relatively more efficient at growing wheat, where it is four times as productive as West, than it is at making bikes, where it is only twice as productive. In other words, it has a comparative advantage in wheat.

Find opportunity costs.

55

Comparative AdvantageComparative AdvantageBB

WW

WEST EAST

400

200

100

200

100

100

50

50

In a year, an Eastern worker can make two bikes or grow four bushels of wheat. A Westerner, however, can manage only one bushel or one bike. Each country has 100 workers, and initially both of their workforces are split evenly between the two industries.

66

Comparative AdvantageComparative AdvantageBB

WW

WEST EAST

400

200

100

200

100

100

50

50

East shifts 10 workers from its bicycle factories to its fields. West moves 25 workers from wheat farming into bike making,

240

80

25

75

77

Comparative AdvantageComparative AdvantageBB

WW

WEST EAST

400

200

100

200

100

100

50

50

Can we improve the standard of living even more? Suppose we have complete specialization. East produces 400 wheat and West produces 100 bicycles. Let them trade with the outside world at 1.5 wheat per bicycle.

60

60

110

235

88

Relative WagesRelative WagesThe wages of workers represent their The wages of workers represent their

productivity.productivity. In autarkyIn autarky

East workers get 4 wheat or 2 bikes.East workers get 4 wheat or 2 bikes.West workers get 1 wheat or 1 bike.West workers get 1 wheat or 1 bike.

Why are East workers paid more? Are Why are East workers paid more? Are West workers exploited?West workers exploited?

99

Relative WagesRelative WagesUnder trade 1 Bicycle = 1.5 Wheat.Under trade 1 Bicycle = 1.5 Wheat.East makes 400 wheat; each worker gets East makes 400 wheat; each worker gets

paid 4 wheat or 2.67 bikes.paid 4 wheat or 2.67 bikes.West makes 100 bicycles; each worker West makes 100 bicycles; each worker

gets paid 1 bicycle=1.5 wheat.gets paid 1 bicycle=1.5 wheat.Did the lower wage of West workers take Did the lower wage of West workers take

all the jobs away from East workers?all the jobs away from East workers?Did trade increase the wages for both Did trade increase the wages for both

countries?countries?

1010

Another ExampleAnother ExampleHOME: Labor required for cheese HOME: Labor required for cheese

production (aproduction (aLCLC) is 2. Labor required for ) is 2. Labor required for

wine production (awine production (aLWLW) is 4. Home has ) is 4. Home has

100 units of labor.100 units of labor.FOREIGN: Labor required for cheese FOREIGN: Labor required for cheese

production (a*production (a*LCLC) is 5. Labor required ) is 5. Labor required

for wine production (a*for wine production (a*LWLW) is 5. Foreign ) is 5. Foreign

has 200 units of labor.has 200 units of labor.

1111

PPF for Home and ForeignPPF for Home and ForeignWine

Cheese Cheese

25

50

40

40

Home Foreign

1212

PricesPricesHome has to use twice as much labor to Home has to use twice as much labor to

produce wine compared to cheese. produce wine compared to cheese. Therefore, wine costs twice; or cheese Therefore, wine costs twice; or cheese costs half as much.costs half as much.

Pc/Pw = aPc/Pw = aLCLC/a/aLWLW = 2/4 = ½ = 2/4 = ½Foreign uses equal amounts of labor for Foreign uses equal amounts of labor for

cheese and wine. They should cost the cheese and wine. They should cost the same.same.

P*c/P*w = a*P*c/P*w = a*LCLC/a*/a*LWLW = 5/5 = 1 = 5/5 = 1

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Relative Supply of CheeseRelative Supply of CheeseRelative supply of cheese is Relative supply of cheese is

Qc+Q*c/Qw+Q*w.Qc+Q*c/Qw+Q*w. If (Pc/Pw)<1/2, Home would be better off If (Pc/Pw)<1/2, Home would be better off

producing wine.producing wine.At Pc/Pw=1/2, Home is free to produce At Pc/Pw=1/2, Home is free to produce

between 0 and 50 units of cheese.between 0 and 50 units of cheese.At P*c/P*w=1/2, Foreign would only At P*c/P*w=1/2, Foreign would only

produce wine.produce wine.Once P*c/P*w=1, Foreign would produce Once P*c/P*w=1, Foreign would produce

between 0 and 40 units of cheese.between 0 and 40 units of cheese.

1414

Relative Supply of CheeseRelative Supply of CheesePc/Pw

1/2

1

50/40 70/20

Relative quantity of cheese

Cheese/Wine

1515

Relative DemandRelative DemandAs Pc/Pw falls, more cheese would be As Pc/Pw falls, more cheese would be

demanded.demanded.Suppose Demand for Cheese/Demand Suppose Demand for Cheese/Demand

for Wine = Pw/Pc.for Wine = Pw/Pc.At Pc/Pw = 1, Pw/Pc = 1.At Pc/Pw = 1, Pw/Pc = 1.At Pc/Pw = ½, Pw/Pc = 2At Pc/Pw = ½, Pw/Pc = 2

1616

Relative Demand and Supply of Relative Demand and Supply of CheeseCheese

Pc/Pw

1/2

1

50/40 70/20

Relative quantity of cheese

1717

Specialization and TradeSpecialization and Trade

If ½ < Pc/Pw < 1, then Home should If ½ < Pc/Pw < 1, then Home should specialize on cheese and Foreign specialize on cheese and Foreign should specialize on wine.should specialize on wine.

WHY?WHY?Suppose Pc/Pw in our example is ¾. Suppose Pc/Pw in our example is ¾.

That is, the exchange is worth ¾ wine That is, the exchange is worth ¾ wine for 1 cheese.for 1 cheese.

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Relative WagesRelative Wages

Suppose cheese is $7.50 and wine is $10.Suppose cheese is $7.50 and wine is $10.Home produces only cheese: 50x$7.50 = Home produces only cheese: 50x$7.50 =

$375. Divide by 100 units of labor: $3.75.$375. Divide by 100 units of labor: $3.75.Foreign produces only wine: 40x$10 = Foreign produces only wine: 40x$10 =

$400. Divide by 200 units of labor: $2.00.$400. Divide by 200 units of labor: $2.00.The more productive labor is paid higher The more productive labor is paid higher

wage.wage.

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Gains for Home and ForeignGains for Home and ForeignWine

Cheese

25

50

40

40

Home Foreign50x3/4

40x4/3

2020

Misconceptions About Misconceptions About Comparative AdvantageComparative Advantage

Myth 1Myth 1: Free trade is beneficial only if your : Free trade is beneficial only if your country is strong enough to stand up to foreign country is strong enough to stand up to foreign competition.competition.

Myth 2Myth 2: Foreign competition is unfair and hurts : Foreign competition is unfair and hurts other countries when it is based on low other countries when it is based on low wages.wages.

Myth 3Myth 3: Trade exploits a country and makes it : Trade exploits a country and makes it worse off if its workers receive much lower worse off if its workers receive much lower wages than workers in other nations.wages than workers in other nations.

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Myth 1: Productivity and Myth 1: Productivity and CompetitivenessCompetitiveness

Absolute disadvantage in every sector still Absolute disadvantage in every sector still allows a country to benefit from trade since it allows a country to benefit from trade since it has comparative advantage in some has comparative advantage in some industries.industries.

Comparative advantage is dependent on Comparative advantage is dependent on internal opportunity costs.internal opportunity costs.

Average wage in a country reflects the Average wage in a country reflects the average productivity.average productivity.

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Myth 2: Pauper Labor ArgumentMyth 2: Pauper Labor ArgumentWages and productivity go hand in hand.Wages and productivity go hand in hand. If the average wage in a country is low If the average wage in a country is low

because of overall low productivity, the because of overall low productivity, the country still exports products to relatively country still exports products to relatively higher productivity industries.higher productivity industries.

The country with the absolute advantage will The country with the absolute advantage will not lower its own average wage by importing not lower its own average wage by importing because it can reallocate the labor into high because it can reallocate the labor into high productivity industries and raise its own productivity industries and raise its own average wage.average wage.

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Myth 3: ExploitationMyth 3: Exploitation Refusing to buy soccer balls or clothing produced in Refusing to buy soccer balls or clothing produced in

Third World countries because the pay is criminally Third World countries because the pay is criminally low may in fact condemn those poor people to a low may in fact condemn those poor people to a worse fate.worse fate.

The question to ask is “What is their alternative?”The question to ask is “What is their alternative?” Third World countries are exporting goods where Third World countries are exporting goods where

they are relatively efficient and productive. If those they are relatively efficient and productive. If those industries were to close, the average productivity industries were to close, the average productivity would fall and the average wage would be less.would fall and the average wage would be less.

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Comp. Adv. With Many GoodsComp. Adv. With Many GoodsSuppose two countries both produce Suppose two countries both produce

automobiles, banking services, crackers, automobiles, banking services, crackers, DVDs, and education.DVDs, and education.

Which country will be the exporter and which Which country will be the exporter and which country will be the importer will depend on the country will be the importer will depend on the productivity of each industry and the wage in productivity of each industry and the wage in that country.that country.

Wages in each country will be same across Wages in each country will be same across the industries, assuming no skill differences the industries, assuming no skill differences required. required.

2525

Comp. Adv. With Many GoodsComp. Adv. With Many GoodsAverage wage in Country A (wAverage wage in Country A (wAA) is different ) is different

than average wage in Country B (wthan average wage in Country B (wBB).).Average wage times the number of labor Average wage times the number of labor

units required for one unit of output will units required for one unit of output will determine the cost per industry.determine the cost per industry.

If the cost of an industry is lower in Country If the cost of an industry is lower in Country A than in Country B, Country A will export A than in Country B, Country A will export and Country B will import.and Country B will import.

2626

Unit Labor RequirementsUnit Labor RequirementsINDUSTRYINDUSTRY A’s Labor A’s Labor

RequirementRequirementB’s Labor B’s Labor RequirementRequirement

Relative A Relative A ProductivityProductivity

AutomobilesAutomobiles 150150 250250 1.61.6

BankingBanking 2525 5050 2.02.0

CrackersCrackers 11 33 3.03.0

DVDsDVDs 1010 5050 5.05.0

EducationEducation 2525 3030 1.21.2

2727

Trade PatternTrade PatternSuppose wages in A relative to B are 2.5 Suppose wages in A relative to B are 2.5

times higher.times higher.Which industries will export from A to B?Which industries will export from A to B?

Crackers and DVDs.Crackers and DVDs.Which industries will export from B to A?Which industries will export from B to A?

Automobiles, banking and education.Automobiles, banking and education.

2828http://stats.bls.gov/news.release/prod4.nr0.htm

2929

US trade with Turkey

http://censtats.census.gov/cgi-bin/sitc/sitcCty.pl

3030

The Importance of Non-TradablesThe Importance of Non-Tradables

In theory, every good and service should be In theory, every good and service should be tradable.tradable.

However, to get a haircut in Canada would However, to get a haircut in Canada would cost me quite a bit in terms of transportation cost me quite a bit in terms of transportation costs.costs.

Protection also increases the costs of Protection also increases the costs of imports and eliminates some industries from imports and eliminates some industries from being imported in spite of cost advantage.being imported in spite of cost advantage.

3131

3232

Empirical TestsEmpirical TestsEmpirical tests usually show that Empirical tests usually show that

productivity differences adjusted for productivity differences adjusted for wages do show what the model wages do show what the model predicts: higher productivity industries predicts: higher productivity industries export, lower productivity industries export, lower productivity industries import.import.

3333

A Test of Ricardian Model• MacDougall, G.D.A., “British and American Exports: A

Study Suggested by the Theory of Comparative Costs,” Economic Journal, December 1951.

• If productivity in US relative to UK is greater than the relative wages, then exports of US for that industry must exceed exports of UK. Wages in the US were, on average, twice the UK levels.

• 1937 data was used. Tariffs were in force. If both US and UK face the same barriers from the rest of the world, then their exports to the rest of the world should reflect their cost advantages.

• If (Productivity in US)/(Productivity in UK) > (Wages in US)/(Wages in UK), then (Exports of US)/(Exports of UK) > 1.

3434

Labor Productivity and Comparative Advantage

0.05 0.1 0.25 0.5 1.0 2.0 4.0 8.0

Paper

MachineryGlasscontainers

Motor cars

Tin cans

Pig ironRadios

2

4

Linoleum

CigarettesHosiery

Footwear

Coke

Rayoncloth

Cotton

Cement

Beer

Woolens andWorsteds

Clothing

Output per US workerOutput per UK worker

US ExportsUK Exports

3535

Shortcomings of the Shortcomings of the Ricardian ModelRicardian Model

• There will be total specialization.There will be total specialization.• There is no income distribution effects.There is no income distribution effects.• There is no role for differences in There is no role for differences in

resource endowments between resource endowments between countries.countries.

• There is only one resource, labor.There is only one resource, labor.• There is no role for economies of There is no role for economies of

scale.scale.