3.2. Trade in a One-Factor World: The Ricardian Model

Question 1

Foreign (a new country)

Answer 1

Produces wine and cheese too.

aLW: unit labour requirements of Foreign wine production.
aLC: unit labour requirements of Foreign cheese production.

Question 2

Absolute advantage in the Ricardian model

Answer 2

When one country can produce a unit of a good with less labour than another country, we say that the first country has an absolute advantage in producing that good.

If aLC < a*LC, Home is more efficient at producing cheese than Foreign. Home holds the absolute advantage.

But, we need to consider the comparative advantage.

Question 3

Comparative advantage in the Ricardian model

Answer 3

If aLC/aLW < aLC/aLW, Home has a comparative advantage in cheese production, as its opportunity cost of producing cheese, in terms of wine, is less than Foreign’s opportunity cost.

When Home increases cheese production, they reduce wine production by less than Foreign would.

This means that Foreign’s PPF would be steeper, as their opportunity cost of cheese, in terms of wine, is higher.

Question 4

Determining relative prices after trading occurs

Answer 4

We should consider the relative supply and demand.

This is equal to Qc+Qc / Qw+Qw.

Consider how the relative price can affect whether people trade on Google Doc 3.2.

Question 5

Numerical example of trade in the Ricardian model

Answer 5

Complete the numerical example of trade in the Ricardian model found in Google Doc 3.2.

Question 6

Gains from trade

Answer 6

Indirect production:
- Home can produce wine directly, but if it chooses to trade with Foreign, it allows Home to focus on producing cheese (which it is more efficient at).
- Home can use their resources more efficiently.
- The opportunity cost of cheese, in terms of wine, is 0.5 gallons. The relative price of cheese after trade is 1. So, instead of using two hours of labour to produce one gallon of wine, Home can use that labour to produce two pounds of cheese and trade that for two gallons of win

Expand PPF:
- When there is no trade, consumption possibilities are the same as production possibilities.
- Once trade is allowed, each economy can consume a different mix of cheese and wine from the mix it produces.
- In all cases, trade enlarges the range of choice and therefore makes residents better off.

Question 7

Relative wages

Answer 7

Relative wages are the wages of Home relative to the wages of Foreign.

Pc: £12 / pound.
Pw: £12 / gallon.

Home wage: 12/1 = £12 / hour.
Foreign wage: 12/3 = £4 / hour.

Relative wage of Home workers: 12/4=3.

Both countries have a cost advantage in production:
- High wages can be offset by high productivity.
- Low productivity can be offset by low wages.

Review the numerical example on Google Doc 3.2.

We see that as Foreign workers have a wage that is only one third that of Home, Foreign can gain a cost advantage in wine production, despite low productivity.

Also, as Home workers have productivity that is six times that of Foreign, Home is able to gain a cost advantage in cheese production, depsite high wages.