Eng Ricardo

1 Klaus Desmet y Jos Riera

RICARDIAN MODEL


1. INTRODUCTION


Classical models of trade emphasize that trade is based on differences between countries. Examples: Spain (sunny weather and nice beaches) exports tourism to Germany. United States (technologically advanced) exports high-tech goods to the rest of the world. Canada (forests) exports wood products. Classical model emphasize two types of differences.

Technological differences (as in the example of United States): Ricardian model. Factor endowment differences (as in the examples of Spain and Canada): Heckscher-

Ohlin model.

Classical Models of Trade


Countries trade to take advantage of their differences. If countries were identical, there would be no point in trading. The differences that matter for trade are relative differences. Example: Suppose the US is technologically more advanced than Mexico in all sectors. In that case we could think that the US would produce and export goods in all sectors. But if so, what would Mexico produce? What would the US import? In practice, the US will specialize in those sectors in which its advantage is largest and

Mexico will specialize in those sectors in which its disadvantage is smallest.

Lessons: Relative (or comparative) advantage determines the patterns of trade. You do not need to be the best in anything to take advantage of trade.

Classical Models and Comparative Advantage


Assumptions: Perfect competition 2 countries 2 sectors 1 factor of production (labor)

Ricardian Model


2. ROAD MAP


Theory Closed Economy. Open Economy:

Comparative Advantage Gains from Trade: Graphical Analysis Relative Demand and Supply with an Application to Countries of Different Sizes

Exercises

Graphical and Numerical Applications of Ricardian Models.

Road Map


3. THEORY LECTURE


3.1. CLOSED ECONOMY (AUTARKY)


Domestic Country: Spain Data Unit labor requirement (number of workers to produce one unit of a good):

aLV (wine) = 1 aLT (textile) = 2

Number of workers:

L = 100 Observations Linear technology. Unit labor requirement is the inverse of labor productivity.

Spain


Closed Economy

QV

- aLT/aLV

QT

L/aLV =100

L/aLT =50

Production possibility frontier

Slope: Opportunity cost of textile in terms of wine. Productivity of wine / productivity of textile Production cost of textile / Production cost of wine


Production

QV

QT

L/aLV =100

L/aLT =50

If pT / pV = aLT / aLV

If Spain produces both goods, pT / pV = aLT / aLV = 2 (interior solution). If pT / pV > aLT / aLV, the relative price of textile is higher than the relative cost, so that no

one will produce wine (corner solution: complete specialization in textile). Si pT / pV < aLT / aLV, the relative price of textile is lower than the relative cost, so that no

one will produce textile (corner solution: complete specialization in wine).

If pT / pV < aLT / aLV

If pT / pV > aLT / aLV


Consumption

QV

QT

L/aLV =100

L/aLT =50

Consumers maximize utility subject to budget constraint.

In a closed economy, the budget constraint (consumption possibility frontier) coincides with the production possibility frontier.

Without trade, consumption must equal production.


Spain & India

WINE TEXTILE WORKERS

SPAIN 1 2 100

INDIA 10 5 1000


Spain & India

QV

- aLT/aLV

QT

L/aLV

=100

L/aLT =50

- a*LT/a*LV Q*T

L*/a*LT =200

Q*V

L*/a*LV

=100 pT / pV = aLT / aLV = 2

p*T / p*V = a*LT / a*LV = 1/2

We now focus only on the relative prices under autarky.

From these relative prices we will determine the comparative advantage of each country and the pattern of trade.

SPAIN INDIA


3.2. OPEN ECONOMY (FREE TRADE)


Under autarky: pT / pV = 2 (Spain) and p*T / p*V = 1/2 (India) Textile is relatively cheaper in India. India will gain if by producing more textile, exporting the additional production to Spain, and importing wine in exchange. Example: 10 Indian workers leave the wine industry to go produce textiles Production

- 1 unit of wine + 2 units of textile

Exports the additional production of textile to Spain - 2 units of textile

Imports wine from Spain (price in Spain is pT / pV = 2) + 4 units of wine

Total effect: + 3 units of wine Conclusion: India gains from trade (it consumes the same quantity of textile and can have 3 more units of wine)

Gains from Trade: Intuition


Spain is 10 times more productive in the production of wine. 2.5 times more productive in the production of textile. Therefore, Spain has ABSOLUTE ADVANTAGE in both sectors. To determine absolute advantage, we compare productivity sector by sector. That is, we need to compare the numbers column by column.

Absolute Advantage WINE TEXTILE

SPAIN 1 2

INDIA 10 5


The absolute advantage of Spain is higher in wine. Therefore, Spain has COMPARATIVE (or RELATIVE) ADVANTAGE in wine and India has COMPARATIVE (or RELATIVE) ADVANTAGE in textile. To determine COMPARATIVE ADVANTAGE we need to compare the relative productivity of one country in one sector with the relative productivity of that country in the other sector.

a*LV / aLV > a*LT / aLT 10 / 1 > 5 / 2

Another way to determine comparative advantage is

aLT / aLV > a*LT / a*LV pT / pV > p*T / p*V

Thus, Spain has comparative advantage in the production of wine, and India in the production of textile. India specializes in textile because its relative price is smaller.

Comparative (or Relative) Advantage WINE TEXTILE

SPAIN 1 2

INDIA 10 5


Relative prices in autarky: pT / pV = 2 (Spain) and p*T / p*V = 1/2 (India) Trade: Spain exports wine and India exports textile. Effects on prices: Demand for Spanish wine raises (exports) and demand for Spanish textiles falls (imports). Relative price of wine raises in Spain. Relative price of textiles falls in Spain. The opposite happens in India. Prices converge (if there are no barriers to trade).

(pT / pV)A = 2 (pT / pV)FT (p*T / p*V)A = 1/2

The new relative price is called the international relative price or the relative price under free trade.

Price Convergence


Gains from Trade

QV

- (pLT/pLV)A

QT

100

50 Q*T 200

Q*V

100

Assume (pT / pV)FT = 1. Spain (completely) specializes in wine production and India (completely) specializes in textiles. Both countries gain from trade: budget constraints shift upwards and consumption is on a higher indifference

curve.

SPAIN INDIA

- (pLT/pLV)LC - (p*LT/p*LV)A - (pLT/pLV)LC

Production and Consumption (autarky)

Production and Consumption (autarky)

Production (free trade)

Consumption (free trade)

Production (free trade)

Consumption (free trade)


Spain Trade increases the price of the good it exports (wine). It jumps from (pV / pT)A = 1/2 to

(pV / pT)FT = 1. The relative price of a countrys exports is called its terms of trade. An increase (or improvement) in the terms of trade explains the gains from trade. For each

unit of wine that Spain exports, it now receives more textiles.

India As in Spain, its terms of trade improve: the relative price of textile increases from (p*T /

p*V)A = 1/2 to (pT / pV)LC = 1. It is not a coincidence that the terms of trade improve in both countries: it is precisely because the relative price of wine (textile) rises in Spain (India) that Spain (India) exports wine (textiles).

Relative Prices and Gains from Trade


Wage in Spain: w = pV / aLV = pV / 1

Wage in India: w* = pT / a*LT = pT / 5

Relative wage in Spain: w / w* = pv a*LT / pT aLV = 5

India can be competitive in textile production (even though it has lower productivity) because c*T = w* a*LT < w aLT. That is equivalent to: w / w* (=5) > a*LT /aLT (=2.5). Spanish productivity (in textiles) is 2.5 times higher than in India but Spanish wages are 5 times higher.

Similarly, even though Spanish wages are higher (5 times), Spanish wine is competitive,

because it is much more productive (10 times).

To determine competiveness, we cannot look only at productivity or only at wages. Instead, what matters are production costs. Production costs are wages divided by productivity.

Wages, productivity and costs


In the theory lecture, we have seen that the free trade relative price will be inside a band

(pT / pV)A = 2 (pT / pV)LC (p*T / p*V)A = 1/2 However, which price will appear in equilibrium depends on the relative supply and

demand.

We will now draw the relative supply and demand and determine the free trade relative price.

Relative Demand and Supply


Relative Demand and Supply

PT/PV

QT +QT*/Qv +Qv* L*/ aLT*

aLT*/aLV* = 1/2

aLT/aLV = 2

L/ aLV

RS

RD

(PT/PV)LC

= 2


Size Matters: Big vs Small Countries

WINE TEXTILE WORKERS

SPAIN 1 2 100

INDIA 10 5 10

Let us reduce the number of Indian workers from 1000 to 10. There is no other change.


RS/RD for Countries with Different Size

PT/PV

QT +QT*/Qv +Qv* L*/ aLT*

aLT*/aLV* = 1/2

aLT/aLV = 2

L/ aLV

OR

DR

(PT/PV)LC =

= 0.02


All gains from trade go to the small country (India).

Terms of trade do not change in Spain. That is the reason why Spanish welfare does not change.

Small countries have more incentives to open up to trade.

In the data there exists a negative relationship between country size and openness to trade. As the UE gets bigger, it has less incentives to open up to third countries.

Gains from Trade with Countries of Different Size


Trade with More than Two Goods

SPAIN INDIA RELATIVE PRODUCTIVITY

CARS 2 5 2.5

COMPUTERS 1 10 10

PLANES 8 16 2

CARPETS 4 5 1.25 Each good is produced where it is cheaper to do so.

Good i is produced in Spain if w aLi < w* a*Li

w/w* < a*Li / aLi

Spain produces good i if its relative wage is lower than its relative productivity in

good i.


Trade with More than Two Goods

Chain of comparative advantage

10 > 2.5 > 2 > 1.25 Computers Cars Planes Carpets

Spain produces the good(s) to the left and India the good(s) to the right.

Assume w/w* = 3.

In this case, Spain produces computers and India the other goods.

The threshold good depends on the relative wage (The relative wage depends on the relative productivity, the relative demand, and the relative supply of workers).


Transportation Costs


Keep assuming w/w* = 3.

Let us introduce transport costs between countries. These costs add 100% to the production costs.

For example, importing a car from India requires 5 workers for production and 5 for shipping (that is, 10 workers).

Without transportation costs, Spain imported cars from India. What happens now? Price of Spanish car= Production cost = 2 w Price of Indian car to be sold in Spain = Production + Transportation costs = 10 w*

The relative wage in Spain (= 3) is lower than the relative productivity (=5). Thus, Spain

stops importing cars from India. Cars become non-traded.


Transportation Costs


If we solve the rest of the exercise, we will find that

Spain exports computers. India exports carpets. Cars and planes become non-traded.

What matters is not the absolute transportation costs but the transportation costs relative to the production cost. Cement is very costly to transport (it is heavy and cheap, so the transport cost relative to the price is high). Diamonds are very cheap to transport (they are very expensive and transport costs are relatively small).


4. EXERCISES


Problem Set

See Problem Set Ricardian Model

Eng Ricardo

Documents

Transcript of Eng Ricardo