3.4. Comparative Advantage with Many Goods

Question 1

Setting up the model

Answer 1

Home and Foreign now produces many goods (N goods).

Each good is assigned an individual number, from 1 to N.

aLi, where i is the number assigned to the good, shows the unit labour requirement for each good.

For example, good 5, would be aL5.

Foreign is denoted by *.

The ratio of Home’s and Foreign’s unit labour requirements is aLi / a*Li.

aLi \ aLi < aLN / aLN.

Question 2

Specialisation

Answer 2

The ratio of wage rates between Home and Foreign equals w/w*.

The rule for allocating world production is that goods will be produced wherever it is cheapest to produce them.

The cost to produce a good is equal to the unit labour requirement * wage rate.

It is cheapest to produce in home if: waLi < waLi. Or if aLi / aLi > w / w.

Question 3

Specialisation example

Answer 3

Please review the example on Google Docs 3.4.

Question 4

Determining relative wages

Answer 4

We use derived demand to calculate relative wage.

The relative derived demand for Home labour falls when the ratio of Home to Foreign wage rises:
- As Home labour becomes more expensive relative to Foreign labour, goods produced in Home also become relative more expensive, and demand for these goods falls.
- As Home wages rise, fewer goods will be produced in Home and more in Foreign, thus reducing the demand for Home labour.

Whenever we increase the wage rate of Home workers relative to that of Foreign workers, the relative demand for goods produced in Home will decline and the demand for Home labour will decline too.

Furthermore, the relative demand for Home labour will decrease abruptly whenever an increase in Home wages makes goods cheaper to produce in Foreign.

The equilibrium wage rate is determined by the intersection of the relative demand and relative supply.

Question 5

Transportation costs and nontraded goods

Answer 5

The Ricardian model predicts that countries completely specialise in production.

But, specialisation in the real economy is not this extreme:
- The existence of more than one factor of production reduces the tendency towards specialisation.
- Countries sometimes protect industries from foreign competition.
- It is costly to transport goods and services, sometimes the cost is enough to allow countries to be self-sufficient in certain sectors.

Nontraded goods arise when transport costs are too great:
- If there is no strong national cost advantage to importing goods or if transportation costs are too high.
- Services such as haircuts or the transportation of heavy materials tend to be nontraded goods.

Question 6

Empirical evidence of the Ricardian model

Answer 6

Productivity differences play an important role in international trade.

Comparative advantage (not absolute advantage) matters for trade.