Ch. 3: The Ricardian model

Question 1

What are the two reasons that countries trade?

Answer 1

• They are different from each other
• They achieve economies of scale in production
o “If countries produce only a limited range of goods, it can produce each of these goods at a larger scale and more efficiently than if they all produced everything”

Question 2

What are “Opportunity costs”?

Answer 2

What could you have instead.

Question 3

What happens when each country specializes in a product of production?

Answer 3

The world as a whole is producing more, which makes it possible in principle to raise everyone’s standard of living.

Question 4

When does a country have comparative advantage?

Answer 4

A country has a comparative advantage in producing a good if the opportunity cost of producing that good in terms of other goods is lower in that country than it is in other countries.

Question 5

Is the following statement true: “Trade between two countries can benefit both countries if each country exports the goods in which it has a comparative advantage”?

Answer 5

This is a true statement, but NOT what actually happens in the real world.

Question 6

Which factor of production is the Ricardian solely based on?

Answer 6

The productivity of labor

Question 7

What is the unit labor requirements?

Answer 7

• Technology of Home´s economy is summarized into labor productivity, which is made into unit labor requirements.
o ULR= The number of hours of labor required to produce a pound of cheese or a gallon of wine ex. 1 hour of labor to produce 1 pound of cheese and 2 hours to produce a gallon of wine.

OBS: ULR = The inverse of productivity, which means the more cheese or wine a worker can produce in an hour, the lower ULR.

Question 8

Is there a limit on how much or what a country can produce?

Answer 8

Yes! There is always a tradeoff: To produce more of one good, the economy must sacrifice some production of another good. It is illustrated by “Production possibility frontier

Question 9

What is the Production Possibility Frontier?

Answer 9

Shows the maximum amount of wine that can be produced once the decision has been made to produce any amount of cheese and the other way around. It is determined by the limits on the resources of the economy.

Question 10

What happens to PPF if there is only one factor of production?

Answer 10

PPF is a straight line

Question 11

How are the opportunity costs if the PPF is a straight line?

Answer 11

When PPF is a straight line, the opportunity cost of a pound of cheese in terms of wine is constant.

Question 12

What is the relative price?

Answer 12

The price of one good in terms of the other.

Question 13

Is there profit to gain in a one-factor model?

Answer 13

There are NO profit in a one-factor mode, so the wage is equal to the value of what the worker can produce in an hour.

Question 14

If the absence of trade, will home then produce both goods no matter what?

Answer 14

• No, it is only if the relative price of cheese = opportunity costs.
o OC=ULR

Question 15

Who has comparative advantage in cheese if: The ratio of the labor required to produce 1 pound of cheese to that required to produce a gallon of wine is lower in home than it is in foreign?

Answer 15

Home´s relative productivity in cheese is higher than in wine –> Home has comparative advantage in cheese.

Question 16

How can absolute advantage be defined?

Answer 16

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

Question 17

What are the relative prices determined by?

Answer 17

Supply and demand.

Question 18

What does a “Partial equilibrium analysis” mean?

Answer 18

To study a single market.

Question 19

What does a “General equilibrium analysis” consider?

Answer 19

It considers the linkages between two markets.

Question 20

What happens in the relative price of cheese is equal to the opportunity costs in home?

Answer 20

Home will produce both wine and cheese.

Question 21

What is the result of trade on the price of the traded good?

Answer 21

The result of trade is that the price of a traded good relative to another good ends up in between its pre-trade levels in the two countries.

Question 22

There is a mutual gain when having international trade. It can be shown in two ways. How?

Answer 22

1. The first way to show that specialization and trade are beneficial is to think of trade as an indirect method of production.
   • Home could produce wine directly, but trade with foreign allows them to “produce” wine by producing cheese and then trade cheese for wine. It is a more efficient way of “producing”.
2. Another way to see the mutual gains from trade is to examine how trade affects each country’s possibilities for consumption.
   • In the absence of trade, consumption possibilities are the same as production possibilities.
   • With trade, each economy can consume a different mix of cheese and wine  Makes consumers better off.

Question 23

What is the relative wage?

Answer 23

The amount the workers are paid per hour, compared with the amount workers in another country are paid per hour.

Question 24

There are 3 misconceptions about trade. What are they?

Answer 24

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

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

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

Question 25

Why is the following myth not true: Myth 1: Free trade is beneficial only if your country is strong enough to stand up to foreign competition?

Answer 25

Here they failed to understand the essential point of Ricardo´s model: Gains from trade depend on comparative rather than absolute advantage.

Question 26

What does the comparative advantage depend on?

Answer 26

The competitive advantage of an industry depends not only on its productivity relative to the foreign industry, but also on the domestic wage rate relative to the foreign wage rate.

Question 27

Why is the following myth not true: Myth 2: Foreign competition is unfair and hurts other countries when it is based on low wages?

Answer 27

• It does not matter if the low cost is due to high productivity or low wages.
• Of course, it is not attractive to base your trade on low wages, but it is false that you can only trade if you have high wages!

Question 28

Why is the following myth not true: Myth 3: Trade exploits a country and makes it worse off if its workers receive much lower wages than workers in other nations?

Answer 28

Here the point is not to ask whether low-wage workers deserve to be paid more but to ask whether they and their country are worse off exporting goods based on their low wages that they would be if they were in the absence of trade. So, what would the alternative be?
• In the example, foreign workers are paid less than home. If foreign refused to trade, their real wage would be even lower. Their purchasing power of a worker´s hourly wage would fall from 1/3 to 1/6 pound of cheese.

Question 29

Comparative advantage with many goods: What happens if the wage rates = the ULR?

Answer 29

The good is produced in both countries.

Question 30

How did we determine the relative wage in the two-good model?

Answer 30

1. Calculating home wages in terms of cheese and foreign wages in terms of wine.
2. Used the price of cheese relative to that of wine to deduce the ratio of the two countries wage rates.

Question 31

How do we determine who produces what in a many-good model?

Answer 31

• It can only be determined after we know the relative wage rate.
• We must look behind the relative demand for goods to the implied relative demand for labor. It is a derived demand, that comes from the demand for goods produced with each country´s labor.

Question 32

The relative derived demand for Home labor will fall when the ratio of Home to Foreign wages rises. Why is that?

Answer 32

• There are two reasons:
o As Home labor becomes more expensive relative to Foreign labor, goods produced in Home also become relatively more expensive, and world demand for these goods falls.
o As Home wages rise, fewer goods will be produced in Home and more in Foreign, further reducing the demand for Home labor.

Question 33

Why are the specialization of production in the real world not so extreme as described in the Ricardian model?

Answer 33

1. The existence of more than one factor of production reduces the tendency toward specialization (as we will see in Chapters 4 and 5).
2. Countries sometimes protect industries from foreign competition (discussed at length in Chapters 9 through 12).
3. It is costly to transport goods and services; in some cases, the cost of transportation is enough to lead countries into self-sufficiency in certain sectors.

Question 34

What are nontraded goods?

Answer 34

Goods that each country will produce for itself because transport costs make it unbeneficial to import and export.

Question 35

Where does the Ricardian model make misleading predictions?

Answer 35

• With nontraded goods
• It does not include the distribution of income within countries, so it always assumes that the country as a whole gain from trade.
• It states that there are no differences in resources among countries.
• It does not include economy of scale as a cause of trade, which makes the Ricardian model unable to explain why there are large trade between similar nations.

However, the basic prediction of the Ricardian model—that countries should tend to export those goods in which their productivity is relatively high—has been strongly confirmed by a number of studies over the years.

Question 36

What are the two principal implications of the Ricardian model that are supported by the evidence?

Answer 36

• That productivity differences play an important role in international trade
• It is comparative rather than absolute advantage that matters