CHAPTER 2
LABOR PRODUCTIVITY
COMPARATIVE ADVANTAGE
THE RICARDIAN MODEL
Copyright ? 2003 Pearson Education,Inc,Slide 1-2
Chapter Organization
? Introduction
? The Concept of Comparative Advantage
? A One-Factor Economy
? Trade in a One-Factor World
? Comparative Advantage with Many Goods
? Adding Transport Costs and Nontraded Goods
? Summary
Copyright ? 2003 Pearson Education,Inc,Slide 1-3
? Countries engage in international trade for two
basic reasons:
? They are different from each other in terms of
climate,land,capital,labor,and technology.
? They try to achieve scale economies in production.
? The Ricardian model is based on technological
differences across countries.
? These technological differences are reflected in
differences in the productivity of labor.
Introduction
Copyright ? 2003 Pearson Education,Inc,Slide 1-4
? On Valentine’s Day the U.S,demand for roses is
about 10 million roses.
? Growing roses in the U.S,in the winter is difficult.
? Heated greenhouses should be used.
? The costs for energy,capital,and labor are substantial.
? Resources for the production of roses could be used
to produce other goods,say computers.
The Concept of
Comparative Advantage
Copyright ? 2003 Pearson Education,Inc,Slide 1-5
? Opportunity Cost
? The opportunity cost of roses in terms of computers is
the number of computers that could be produced with
the same resources as a given number of roses.
? Comparative Advantage
? A country has a comparative advantage in producing a
goods if the opportunity cost of producing that goods in
terms of other goods is lower in that country than it is in
other countries.
The Concept of
Comparative Advantage
Copyright ? 2003 Pearson Education,Inc,Slide 1-6
? Suppose that in the U.S,10 million roses can be produced with
the same resources as 100,000 computers.
? Suppose also that in South America 10 million roses can be
produced with the same resources as 30,000 computers.
? This example assumes that South American workers are less
productive than U.S,workers.
The Concept of
Comparative Advantage
Copyright ? 2003 Pearson Education,Inc,Slide 1-7
? If each country specializes in the production of the
goods with lower opportunity costs,trade can be
beneficial for both countries.
? Roses have lower opportunity costs in South America.
? Computers have lower opportunity costs in the U.S.
? The benefits from trade can be seen by considering
the changes in production of roses and computers in
both countries.
The Concept of
Comparative Advantage
Copyright ? 2003 Pearson Education,Inc,Slide 1-8
Table 2-1,Hypothetical Changes in Production
The Concept of
Comparative Advantage
Copyright ? 2003 Pearson Education,Inc,Slide 1-9
? The example in Table 2-1 illustrates the principle of
comparative advantage,
? If each country exports the goods in which it has comparative
advantage (lower opportunity costs),then all countries can in
principle gain from trade.
? What determines comparative advantage?
? Answering this question would help us understand how
country differences determine the pattern of trade (which
goods a country exports).
The Concept of
Comparative Advantage
Copyright ? 2003 Pearson Education,Inc,Slide 1-10
A One-Factor Economy
? Assume that we are dealing with an economy (which
we call Home),In this economy:
? Labor is the only factor of production.
? Only two goods (say wine and cheese) are produced.
? The supply of labor is fixed in each country.
? The productivity of labor in each goods is fixed.
? Perfect competition prevails in all markets.
Copyright ? 2003 Pearson Education,Inc,Slide 1-11
? The technology of Home’s economy can be summarized by labor
productivity in each industry,expressed in terms of unit labor
requirements:
? The unit labor requirement is the number of hours of labor
required to produce one unit of output.
– Denote with aLWthe unit labor requirement for wine (e.g,if aLW = 2,
then one needs 2 hours of labor to produce one gallon of wine).
– Denote with aLC the unit labor requirement for cheese (e.g,if aLC = 1,
then one needs 1 hour of labor to produce a pound of cheese).
? The economy’s total resources are defined as L,the total labor
supply (e.g,if L = 120,then this economy is endowed with 120
hours of labor or 120 workers).
A One-Factor Economy
Copyright ? 2003 Pearson Education,Inc,Slide 1-12
? Production Possibilities
? The production possibility frontier (PPF) of an economy shows
the maximum amount of a goods (say wine) that can be produced
for any given amount of another (say cheese),and vice versa,Or
illustrates the different mixes of goods the economy can produce.
? The PPF of our economy is given by the following equation:
aLCQC + aLWQW = L (2-1)
? From our previous example,we get:
QC + 2QW = 120
A One-Factor Economy
Copyright ? 2003 Pearson Education,Inc,Slide 1-13
L/aLW
L/aLC
Figure 2-1,Home’s Production Possibility Frontier
A One-Factor Economy
Absolute value of slope equals
opportunity cost of cheese in
terms of wine
F
P
Home wine
production,QW,
in gallons
Home cheese
production,QC,
in pounds
o
Copyright ? 2003 Pearson Education,Inc,Slide 1-14
? Relative Prices and Supply
? The particular amounts of each goods produced are
determined by prices.
? The relative price of goods X (cheese) in terms of goods Y
(wine) is the amount of goods Y (wine) that can be
exchanged for one unit of goods X (cheese).
? Examples of relative prices:
– If a price of a can of Coke is $0.5,then the relative price of
Coke is the amount of $ that can be exchanged for one unit of
Coke,which is 0.5.
– The relative price of a $ in terms of Coke is 2 cans of Coke per
dollar.
A One-Factor Economy
Copyright ? 2003 Pearson Education,Inc,Slide 1-15
? Denote with PC the dollar price of cheese and with PW
the dollar price of wine,Denote with wW the dollar wage
in the wine industry and with wC the dollar wage in the
cheese industry.
? There are no profits in our one-factor model,the hourly
wage rate in the cheese sector will equal the value of
what a worker can produce in an hour,PC/aLC.The hourly
wage rate in the wine sector will be PW/aLW.
A One-Factor Economy
Copyright ? 2003 Pearson Education,Inc,Slide 1-16
? The above relations imply that if the relative price of
cheese (PC / PW ) exceeds its opportunity cost (aLC / aLW),
then the economy will specialize in the production of
cheese.Or PC/aLC>PW/aLW.
? In the absence of trade,both goods are produced,and
therefore PC / PW = aLC /aLW.
A One-Factor Economy
Copyright ? 2003 Pearson Education,Inc,Slide 1-17
Trade in a One-Factor World
? Assumptions of the model:
? There are two countries in the world (Home and Foreign).
? Each of the two countries produces two goods (say wine and
cheese).
? Labor is the only factor of production.
? The supply of labor is fixed in each country.
? The productivity of labor in each goods is fixed.
? Labor is not mobile across the two countries.
? Perfect competition prevails in all markets.
? All variables with an asterisk refer to the Foreign country.
Copyright ? 2003 Pearson Education,Inc,Slide 1-18
? Absolute Advantage
? A country has an absolute advantage in a production
of a goods if it has a lower unit labor requirement than
the foreign country in this goods.
? Assume that aLC < a*LC and aLW < a*LW
– This assumption implies that Home has an absolute
advantage in the production of both goods,Another way
to see this is to notice that Home is more productive in
the production of both goods than Foreign.
– Even if Home has an absolute advantage in both goods,
beneficial trade is possible.
? The pattern of trade will be determined by the
concept of comparative advantage.
Trade in a One-Factor World
Copyright ? 2003 Pearson Education,Inc,Slide 1-19
? Comparative Advantage
? Assume that aLC /aLW < a*LC /a*LW (2-2)
– This assumption implies that the opportunity cost of
cheese in terms of wine is lower in Home than it is in
Foreign.
– In other words,in the absence of trade,the relative price
of cheese at Home is lower than the relative price of
cheese at Foreign.
? Home has a comparative advantage in cheese and will
export it to Foreign in exchange for wine.
Trade in a One-Factor World
Copyright ? 2003 Pearson Education,Inc,Slide 1-20
F*
P*
L*/a*LW
L*/a*LC
Foreign wine
production,Q*W,
in gallons
Foreign cheese
production,Q*C,
in pounds
+1
Figure 2-2,Foreign’s Production Possibility Frontier
Trade in a One-Factor World
Copyright ? 2003 Pearson Education,Inc,Slide 1-21
? Determining the Relative Price After Trade
? What determines the relative price (e.g.,PC / PW) after
trade?
– To answer this question we have to define the relative
supply and relative demand for cheese in the world as a
whole.
– The relative supply of cheese equals the total quantity
of cheese supplied by both countries at each given
relative price divided by the total quantity of wine
supplied,(QC + Q*C )/(QW + Q*W).
– The relative demand of cheese in the world is a
similar concept.
Trade in a One-Factor World
Copyright ? 2003 Pearson Education,Inc,Slide 1-22
2
RD'
RD
1
Q'
aLC/aLW
a*LC/a*LW RS
Figure 2-3,World Relative Supply and Demand
Trade in a One-Factor World
Relative price
of cheese,PC/PW
Relative quantity
of cheese,QC + Q*C
QW + Q*W
L/aLC
L*/a*LW
Copyright ? 2003 Pearson Education,Inc,Slide 1-23
Trade in a One-Factor World
? First,the RS curve shows that there is no supply of cheese if
the world price drops below aLC/aLW.
-Assume aLC/aLW<a*LC/a*LW,,Home will specialize in the
production of cheese.
-Home will specialize in the production of wine whenever
PC/PW<aLC/aLW,or PC/aLC<PW/aLW.
-Similarly,Foreign will specialize in wine production
whenever PC/PW<a*LC/a*LW.
? Second,when the relative price of cheese,PC/PW=aLC/aLW,
Home workers are indifferent between producing cheese and
wine,We have a flat section of the supply curve,
Copyright ? 2003 Pearson Education,Inc,Slide 1-24
Trade in a One-Factor World
? Third,for PC/PW>a*LC/a*LW,both Home and Foreign
will specialize in cheese production,There will be no
wine production,so that the relative supply of cheese
will become infinite.
? Fourth,At PC/PW=a*LC/a*LW,Foreign workers are
indifferent between producing cheese and wine,We
again have a flat section of the supply curve.
? Fifth,aLC/aLW< PC/PW< a*LC/a*LW,the relative supply
of cheese is (L/aLC)/(L*/a*LW).
Copyright ? 2003 Pearson Education,Inc,Slide 1-25
? The Gains from Trade
? If countries specialize according to their
comparative advantage,they all gain from this
specialization and trade.
? We will demonstrate these gains from trade in two
ways.
? First,we can think of trade as a new way of
producing goods and services (that is,a new
technology).
Trade in a One-Factor World
Copyright ? 2003 Pearson Education,Inc,Slide 1-26
? Another way to see the gains from trade is to consider how
trade affects the consumption in each of the two countries.
? The consumption possibility frontier states the maximum
amount of consumption of a goods a country can obtain for
any given amount of the other commodity.
? In the absence of trade,the consumption possibility curve is
the same as the production possibility curve.
? Trade enlarges the consumption possibility for each of the
two countries.
Trade in a One-Factor World
Copyright ? 2003 Pearson Education,Inc,Slide 1-27
Trade in a One-Factor World
Figure 2-4,Trade Expands Consumption Possibilities
T
F
P
T *P *
F *
(a) Home (b) Foreign
Quantity
of wine,QW
Quantity
of cheese,QC
Quantity
of wine,Q*W
Quantity
of cheese,Q*C
Copyright ? 2003 Pearson Education,Inc,Slide 1-28
? Setting Up the Model
? Both countries consume and are able to produce a
large number,N,of different goods.
? Relative Wages and Specialization
? The pattern of trade will depend on the ratio of Home
to Foreign wages.
? Goods will always be produced where it is cheapest to
make them.
– For example,it will be cheaper to produce goods i in
Home if waLi < w*a*Li,or by rearranging if a*Li/aLi >
w/w*.
Comparative Advantage
with Many Goods
Copyright ? 2003 Pearson Education,Inc,Slide 1-29
Comparative Advantage
with Many Goods
Table 2-4,Home and Foreign Unit Labor Requirements
Copyright ? 2003 Pearson Education,Inc,Slide 1-30
? Which country produces which goods?
? A country has a cost advantage in any good for which
its relative productivity is higher than its relative wage.
– If,for example,w/w* = 3,Home will produce apples,
bananas,and caviar,while Foreign will produce only
dates and enchiladas.
– Both countries will gain from this specialization.
Comparative Advantage
with Many Goods
Copyright ? 2003 Pearson Education,Inc,Slide 1-31
? Determining the Relative Wage in the Multigood
Model
? To determine relative wages in a multigood economy
we must look behind the relative demand for goods
(i.e.,the relative derived demand).
? The relative demand for Home labor depends
negatively on the ratio of Home to Foreign wages.
Comparative Advantage
with Many Goods
Copyright ? 2003 Pearson Education,Inc,Slide 1-32
3
10
Apples
8 Bananas
4 Caviar
2
Dates
0.75
Enchiladas
RD
Comparative Advantage
with Many Goods
Figure 2-5,Determination of Relative Wages
RS
Relative wage
Rate,w/w*
Relative quantity
of labor,L/L*
Copyright ? 2003 Pearson Education,Inc,Slide 1-33
Adding Transport Costs
and Nontraded Goods
? There are three main reasons why specialization in
the real international economy is not extreme:
? The existence of more than one factor of production.
? Countries sometimes protect industries from foreign
competition.
? It is costly to transport goods and services.
? The result of introducing transport costs makes some
goods nontraded.
? In some cases transportation is virtually impossible.
? Example,Services such as haircuts and auto repair
cannot be traded internationally.
Copyright ? 2003 Pearson Education,Inc,Slide 1-34
Summary
? We examined the Ricardian model,the simplest
model that shows how differences between countries
give rise to trade and gains from trade.
? In this model,labor is the only factor of production
and countries differ only in the productivity of labor
in different industries.
? In the Ricardian model,a country will export that
commodity in which it has comparative (as opposed to
absolute) labor productivity advantage.
Copyright ? 2003 Pearson Education,Inc,Slide 1-35
? The fact that trade benefits a country can be shown in
either of two ways:
? We can think of trade as an indirect method of
production.
? We can show that trade enlarges a country’s
consumption possibilities.
? The distribution of the gains from trade depends on
the relative prices of the goods countries produce.
Summary
Copyright ? 2003 Pearson Education,Inc,Slide 1-36
? Extending the one-factor,two-good model to a world
of many commodities makes it possible to illustrate
that transportation costs can give rise to the existence
of nontraded goods.
? The basic prediction of the Ricardian model-that
countries will tend to export goods in which they
have relatively high productivity- has been confirmed
by a number of studies.
Summary
LABOR PRODUCTIVITY
COMPARATIVE ADVANTAGE
THE RICARDIAN MODEL
Copyright ? 2003 Pearson Education,Inc,Slide 1-2
Chapter Organization
? Introduction
? The Concept of Comparative Advantage
? A One-Factor Economy
? Trade in a One-Factor World
? Comparative Advantage with Many Goods
? Adding Transport Costs and Nontraded Goods
? Summary
Copyright ? 2003 Pearson Education,Inc,Slide 1-3
? Countries engage in international trade for two
basic reasons:
? They are different from each other in terms of
climate,land,capital,labor,and technology.
? They try to achieve scale economies in production.
? The Ricardian model is based on technological
differences across countries.
? These technological differences are reflected in
differences in the productivity of labor.
Introduction
Copyright ? 2003 Pearson Education,Inc,Slide 1-4
? On Valentine’s Day the U.S,demand for roses is
about 10 million roses.
? Growing roses in the U.S,in the winter is difficult.
? Heated greenhouses should be used.
? The costs for energy,capital,and labor are substantial.
? Resources for the production of roses could be used
to produce other goods,say computers.
The Concept of
Comparative Advantage
Copyright ? 2003 Pearson Education,Inc,Slide 1-5
? Opportunity Cost
? The opportunity cost of roses in terms of computers is
the number of computers that could be produced with
the same resources as a given number of roses.
? Comparative Advantage
? A country has a comparative advantage in producing a
goods if the opportunity cost of producing that goods in
terms of other goods is lower in that country than it is in
other countries.
The Concept of
Comparative Advantage
Copyright ? 2003 Pearson Education,Inc,Slide 1-6
? Suppose that in the U.S,10 million roses can be produced with
the same resources as 100,000 computers.
? Suppose also that in South America 10 million roses can be
produced with the same resources as 30,000 computers.
? This example assumes that South American workers are less
productive than U.S,workers.
The Concept of
Comparative Advantage
Copyright ? 2003 Pearson Education,Inc,Slide 1-7
? If each country specializes in the production of the
goods with lower opportunity costs,trade can be
beneficial for both countries.
? Roses have lower opportunity costs in South America.
? Computers have lower opportunity costs in the U.S.
? The benefits from trade can be seen by considering
the changes in production of roses and computers in
both countries.
The Concept of
Comparative Advantage
Copyright ? 2003 Pearson Education,Inc,Slide 1-8
Table 2-1,Hypothetical Changes in Production
The Concept of
Comparative Advantage
Copyright ? 2003 Pearson Education,Inc,Slide 1-9
? The example in Table 2-1 illustrates the principle of
comparative advantage,
? If each country exports the goods in which it has comparative
advantage (lower opportunity costs),then all countries can in
principle gain from trade.
? What determines comparative advantage?
? Answering this question would help us understand how
country differences determine the pattern of trade (which
goods a country exports).
The Concept of
Comparative Advantage
Copyright ? 2003 Pearson Education,Inc,Slide 1-10
A One-Factor Economy
? Assume that we are dealing with an economy (which
we call Home),In this economy:
? Labor is the only factor of production.
? Only two goods (say wine and cheese) are produced.
? The supply of labor is fixed in each country.
? The productivity of labor in each goods is fixed.
? Perfect competition prevails in all markets.
Copyright ? 2003 Pearson Education,Inc,Slide 1-11
? The technology of Home’s economy can be summarized by labor
productivity in each industry,expressed in terms of unit labor
requirements:
? The unit labor requirement is the number of hours of labor
required to produce one unit of output.
– Denote with aLWthe unit labor requirement for wine (e.g,if aLW = 2,
then one needs 2 hours of labor to produce one gallon of wine).
– Denote with aLC the unit labor requirement for cheese (e.g,if aLC = 1,
then one needs 1 hour of labor to produce a pound of cheese).
? The economy’s total resources are defined as L,the total labor
supply (e.g,if L = 120,then this economy is endowed with 120
hours of labor or 120 workers).
A One-Factor Economy
Copyright ? 2003 Pearson Education,Inc,Slide 1-12
? Production Possibilities
? The production possibility frontier (PPF) of an economy shows
the maximum amount of a goods (say wine) that can be produced
for any given amount of another (say cheese),and vice versa,Or
illustrates the different mixes of goods the economy can produce.
? The PPF of our economy is given by the following equation:
aLCQC + aLWQW = L (2-1)
? From our previous example,we get:
QC + 2QW = 120
A One-Factor Economy
Copyright ? 2003 Pearson Education,Inc,Slide 1-13
L/aLW
L/aLC
Figure 2-1,Home’s Production Possibility Frontier
A One-Factor Economy
Absolute value of slope equals
opportunity cost of cheese in
terms of wine
F
P
Home wine
production,QW,
in gallons
Home cheese
production,QC,
in pounds
o
Copyright ? 2003 Pearson Education,Inc,Slide 1-14
? Relative Prices and Supply
? The particular amounts of each goods produced are
determined by prices.
? The relative price of goods X (cheese) in terms of goods Y
(wine) is the amount of goods Y (wine) that can be
exchanged for one unit of goods X (cheese).
? Examples of relative prices:
– If a price of a can of Coke is $0.5,then the relative price of
Coke is the amount of $ that can be exchanged for one unit of
Coke,which is 0.5.
– The relative price of a $ in terms of Coke is 2 cans of Coke per
dollar.
A One-Factor Economy
Copyright ? 2003 Pearson Education,Inc,Slide 1-15
? Denote with PC the dollar price of cheese and with PW
the dollar price of wine,Denote with wW the dollar wage
in the wine industry and with wC the dollar wage in the
cheese industry.
? There are no profits in our one-factor model,the hourly
wage rate in the cheese sector will equal the value of
what a worker can produce in an hour,PC/aLC.The hourly
wage rate in the wine sector will be PW/aLW.
A One-Factor Economy
Copyright ? 2003 Pearson Education,Inc,Slide 1-16
? The above relations imply that if the relative price of
cheese (PC / PW ) exceeds its opportunity cost (aLC / aLW),
then the economy will specialize in the production of
cheese.Or PC/aLC>PW/aLW.
? In the absence of trade,both goods are produced,and
therefore PC / PW = aLC /aLW.
A One-Factor Economy
Copyright ? 2003 Pearson Education,Inc,Slide 1-17
Trade in a One-Factor World
? Assumptions of the model:
? There are two countries in the world (Home and Foreign).
? Each of the two countries produces two goods (say wine and
cheese).
? Labor is the only factor of production.
? The supply of labor is fixed in each country.
? The productivity of labor in each goods is fixed.
? Labor is not mobile across the two countries.
? Perfect competition prevails in all markets.
? All variables with an asterisk refer to the Foreign country.
Copyright ? 2003 Pearson Education,Inc,Slide 1-18
? Absolute Advantage
? A country has an absolute advantage in a production
of a goods if it has a lower unit labor requirement than
the foreign country in this goods.
? Assume that aLC < a*LC and aLW < a*LW
– This assumption implies that Home has an absolute
advantage in the production of both goods,Another way
to see this is to notice that Home is more productive in
the production of both goods than Foreign.
– Even if Home has an absolute advantage in both goods,
beneficial trade is possible.
? The pattern of trade will be determined by the
concept of comparative advantage.
Trade in a One-Factor World
Copyright ? 2003 Pearson Education,Inc,Slide 1-19
? Comparative Advantage
? Assume that aLC /aLW < a*LC /a*LW (2-2)
– This assumption implies that the opportunity cost of
cheese in terms of wine is lower in Home than it is in
Foreign.
– In other words,in the absence of trade,the relative price
of cheese at Home is lower than the relative price of
cheese at Foreign.
? Home has a comparative advantage in cheese and will
export it to Foreign in exchange for wine.
Trade in a One-Factor World
Copyright ? 2003 Pearson Education,Inc,Slide 1-20
F*
P*
L*/a*LW
L*/a*LC
Foreign wine
production,Q*W,
in gallons
Foreign cheese
production,Q*C,
in pounds
+1
Figure 2-2,Foreign’s Production Possibility Frontier
Trade in a One-Factor World
Copyright ? 2003 Pearson Education,Inc,Slide 1-21
? Determining the Relative Price After Trade
? What determines the relative price (e.g.,PC / PW) after
trade?
– To answer this question we have to define the relative
supply and relative demand for cheese in the world as a
whole.
– The relative supply of cheese equals the total quantity
of cheese supplied by both countries at each given
relative price divided by the total quantity of wine
supplied,(QC + Q*C )/(QW + Q*W).
– The relative demand of cheese in the world is a
similar concept.
Trade in a One-Factor World
Copyright ? 2003 Pearson Education,Inc,Slide 1-22
2
RD'
RD
1
Q'
aLC/aLW
a*LC/a*LW RS
Figure 2-3,World Relative Supply and Demand
Trade in a One-Factor World
Relative price
of cheese,PC/PW
Relative quantity
of cheese,QC + Q*C
QW + Q*W
L/aLC
L*/a*LW
Copyright ? 2003 Pearson Education,Inc,Slide 1-23
Trade in a One-Factor World
? First,the RS curve shows that there is no supply of cheese if
the world price drops below aLC/aLW.
-Assume aLC/aLW<a*LC/a*LW,,Home will specialize in the
production of cheese.
-Home will specialize in the production of wine whenever
PC/PW<aLC/aLW,or PC/aLC<PW/aLW.
-Similarly,Foreign will specialize in wine production
whenever PC/PW<a*LC/a*LW.
? Second,when the relative price of cheese,PC/PW=aLC/aLW,
Home workers are indifferent between producing cheese and
wine,We have a flat section of the supply curve,
Copyright ? 2003 Pearson Education,Inc,Slide 1-24
Trade in a One-Factor World
? Third,for PC/PW>a*LC/a*LW,both Home and Foreign
will specialize in cheese production,There will be no
wine production,so that the relative supply of cheese
will become infinite.
? Fourth,At PC/PW=a*LC/a*LW,Foreign workers are
indifferent between producing cheese and wine,We
again have a flat section of the supply curve.
? Fifth,aLC/aLW< PC/PW< a*LC/a*LW,the relative supply
of cheese is (L/aLC)/(L*/a*LW).
Copyright ? 2003 Pearson Education,Inc,Slide 1-25
? The Gains from Trade
? If countries specialize according to their
comparative advantage,they all gain from this
specialization and trade.
? We will demonstrate these gains from trade in two
ways.
? First,we can think of trade as a new way of
producing goods and services (that is,a new
technology).
Trade in a One-Factor World
Copyright ? 2003 Pearson Education,Inc,Slide 1-26
? Another way to see the gains from trade is to consider how
trade affects the consumption in each of the two countries.
? The consumption possibility frontier states the maximum
amount of consumption of a goods a country can obtain for
any given amount of the other commodity.
? In the absence of trade,the consumption possibility curve is
the same as the production possibility curve.
? Trade enlarges the consumption possibility for each of the
two countries.
Trade in a One-Factor World
Copyright ? 2003 Pearson Education,Inc,Slide 1-27
Trade in a One-Factor World
Figure 2-4,Trade Expands Consumption Possibilities
T
F
P
T *P *
F *
(a) Home (b) Foreign
Quantity
of wine,QW
Quantity
of cheese,QC
Quantity
of wine,Q*W
Quantity
of cheese,Q*C
Copyright ? 2003 Pearson Education,Inc,Slide 1-28
? Setting Up the Model
? Both countries consume and are able to produce a
large number,N,of different goods.
? Relative Wages and Specialization
? The pattern of trade will depend on the ratio of Home
to Foreign wages.
? Goods will always be produced where it is cheapest to
make them.
– For example,it will be cheaper to produce goods i in
Home if waLi < w*a*Li,or by rearranging if a*Li/aLi >
w/w*.
Comparative Advantage
with Many Goods
Copyright ? 2003 Pearson Education,Inc,Slide 1-29
Comparative Advantage
with Many Goods
Table 2-4,Home and Foreign Unit Labor Requirements
Copyright ? 2003 Pearson Education,Inc,Slide 1-30
? Which country produces which goods?
? A country has a cost advantage in any good for which
its relative productivity is higher than its relative wage.
– If,for example,w/w* = 3,Home will produce apples,
bananas,and caviar,while Foreign will produce only
dates and enchiladas.
– Both countries will gain from this specialization.
Comparative Advantage
with Many Goods
Copyright ? 2003 Pearson Education,Inc,Slide 1-31
? Determining the Relative Wage in the Multigood
Model
? To determine relative wages in a multigood economy
we must look behind the relative demand for goods
(i.e.,the relative derived demand).
? The relative demand for Home labor depends
negatively on the ratio of Home to Foreign wages.
Comparative Advantage
with Many Goods
Copyright ? 2003 Pearson Education,Inc,Slide 1-32
3
10
Apples
8 Bananas
4 Caviar
2
Dates
0.75
Enchiladas
RD
Comparative Advantage
with Many Goods
Figure 2-5,Determination of Relative Wages
RS
Relative wage
Rate,w/w*
Relative quantity
of labor,L/L*
Copyright ? 2003 Pearson Education,Inc,Slide 1-33
Adding Transport Costs
and Nontraded Goods
? There are three main reasons why specialization in
the real international economy is not extreme:
? The existence of more than one factor of production.
? Countries sometimes protect industries from foreign
competition.
? It is costly to transport goods and services.
? The result of introducing transport costs makes some
goods nontraded.
? In some cases transportation is virtually impossible.
? Example,Services such as haircuts and auto repair
cannot be traded internationally.
Copyright ? 2003 Pearson Education,Inc,Slide 1-34
Summary
? We examined the Ricardian model,the simplest
model that shows how differences between countries
give rise to trade and gains from trade.
? In this model,labor is the only factor of production
and countries differ only in the productivity of labor
in different industries.
? In the Ricardian model,a country will export that
commodity in which it has comparative (as opposed to
absolute) labor productivity advantage.
Copyright ? 2003 Pearson Education,Inc,Slide 1-35
? The fact that trade benefits a country can be shown in
either of two ways:
? We can think of trade as an indirect method of
production.
? We can show that trade enlarges a country’s
consumption possibilities.
? The distribution of the gains from trade depends on
the relative prices of the goods countries produce.
Summary
Copyright ? 2003 Pearson Education,Inc,Slide 1-36
? Extending the one-factor,two-good model to a world
of many commodities makes it possible to illustrate
that transportation costs can give rise to the existence
of nontraded goods.
? The basic prediction of the Ricardian model-that
countries will tend to export goods in which they
have relatively high productivity- has been confirmed
by a number of studies.
Summary
