Chapter 2: Ricardian Model

Question 1

What is the ricardian model

Answer 1

The Ricardian model uses the concepts of opportunity cost and comparative advantage.

􏰀 The opportunity cost of producing something measures the cost of not being able to produce something else with the resources used.

Comparative Advantage
􏰀 A country has comparative advantage in producing those goods that it produces best compared with how well it produces other goods.

Question 2

What are the ricardian model assumptions

Answer 2

Two countries in the economy: Home and Foreign.

One factor of production: labor.

Constant returns to scale in production

Countries have different technology, so labor productivity varies across countries. But within each country, labor productivity is constant.

Economy produces only 2 goods

Perfect competition and workers move freely –> workers are paid a wage that is equal to the value of what they produce

Question 3

What is a unit labour requirement and Labour Supply

What does it mean for labour productivtiy?

Answer 3

Alc and Alw refers to the number of hours of labour to produce one unit of computers/widgets in home

High unit labour requirement means need many hours to produce one unit of output –> means labour productivity is low (1/Alc)

Labour Supply is the total amount of hours worked in Home and Foreign

Qc = Number of Labour Hours / Alc

ALc x QC +Alw x Qw ≤ L

Question 4

How to draw Ricardian PPF

Answer 4

Alc x Qc +Alw x Qw ≤ L

Qw (Qc) = L/Alc - Qc(Alc/Alw)

Y axis: Home production of widgets
X axis: Home production of computers
Gradient: Relative labour productivity of widgets/computers

opp cost of computers in terms of widgets is defined as number of units of widgets Home should stop producing to make one more unit of computers: Alc/Alw

Question 5

What are workers wages? How is it linked to perfect competition

Answer 5

Perfect competition and workers move freely –> workers are paid a wage that is equal to the value of what they produce

Wc = Pc/Alc

Question 6

What happens if the price of computers relative to the price of widgets exceeds the opp cost of producing computers (Pc/Pw) > (Alc/Alw)

What is the only way for firms to produce both goods?

Answer 6

Means that equilibrium wage of computers Wc>Ww

No one would be willing to work in widgets seector

The economy specializes in computers production (corner solution).

Only way is for PC/PW =aLC/aLW, thus allowing wages to be equal

Question 7

What is the relative price pc/pw?

Answer 7

pc/pw = Alc/Alw

Relative price of computers to widgets can be seen as the relative productivity of widgets to computers

Question 8

What is absolute advantage

Answer 8

This means that Home’s unit labor requirement for computers and widget production are lower than in Foreign:
aLC <aLC andaLW <aLW.

Number of unit hours in home required to produce both computers and widgets are lesser

Question 9

What is comparative advantage

Answer 9

Home’s opportunity cost of producing computers is lower than in Foreign

(Alc/Alw) < (Alc/Alw)

Question 10

Compare the slope of the foreign PPF to home

What does the slope of the PPF represent?

Answer 10

The slope of the PPF indicates the opportunity cost of computers in terms of widgets. Foreign’s PPF is steeper than Home’s PPF since the opportunity cost of computers in terms of widgets is higher in Foreign than in Home.

To produce one more unit of computers. they must stop producing more widgets in foreign than in home

Question 11

Whats the difference btw autarky relative prices and world free trade price

Answer 11

Under autarky, the relative price of computers reflects
the opportunity cost of computers in each country

PC /PW = aLC /aLW and Pc/Pw = aLC /aLW .

When Home and Foreign start to trade, Home will ship its relatively cheaper computers to Foreign and Foreign its relatively cheaper widgets to Home until the relative price with trade is the same for both countries

(PC /PW )Autarky ≤ (PC /PW )FreeTrade
≤ (PC* /PW* )Autarky

Question 12

What are terms of trade

Answer 12

terms of trade refer to the relative price of a country’s exports

With trade both terms of trade increases

Question 13

What happens when the relative price of computers equals the opportunity cost in HomePC/PW =aLC/aLW <aLC/aLW,

Answer 13

Since wages same in both sector for home, home workers are indifferent about producing widgets or computers while foreign workers only produce widgets

Question 14

Why does aLC/aLW <PC/PW <Alc/Alw

Answer 14

Home workers produce only computers (where their wages are higher);

􏰀 Foreign workers still produce only widgets (where their wages are higher):

􏰀 World relative supply of computers equals Home’s maximum computers production divided by Foreign’s maximum widget production (L/aLC ) / (L/Alw ).

Question 15

What is the relative supply of computers

Answer 15

the quantity of computers supplied by all countries relative to the quantity of widgets supplied by all countries

RS = (QC + QC∗ ) / (QW + QW∗ )

Question 16

Why is the world relative supply a step function, which points of the graph does it intersect

Answer 16

First step at relative price of computers equal to Home’s opportunity cost alc/alw

Jumps when world relative supply of computers equals Home’s maximum computers production divided by Foreign’s maximum widget production (L/aLC ) / (L/aLW )

Second step at relative price of computers equal to Foreign opp cost Alc/Alw

Question 17

What is relative demand

Answer 17

Relative demand for computers is the quantity of computers demanded in all countries relative to the quantity of widgets demanded in all countries.

As the price of computers relative to the price of widgets rise, consumers in all countries purchase less computers and more widgets

Question 18

How has trade helped countries in the process

Answer 18

The consumption possibilities frontier expand beyond the production possibility frontier when trade is allowed. With trade, world production is expanded when each country specializes in producing the good in which it has a comparative advantage.

Question 19

Show mathematically how Home is able to consume more widgets in this case

Answer 19

In autarky, quantity of widgets consumed (maximum) = L/Alw

With free trade, since Pc(world)/Pw(world) > (Alc/Alw)
Income earned from widgets for home is always more than income earned from autarky

When consumption possibilities frontiers shift out, consumers in both countries are able to reach a higher indifference curve =⇒ there are gains from trade in both countries!

Question 20

What are relative wages

What determines relative wage difference across countries?

Answer 20

Relative wages are the wages of the home country relative to the wages in the foreign country.
(W/W*)

Relative Productivity (technological) differences determine relative wage differences across countries. (1/Alw)/(1/Alw*)

Question 21

Looking at relative wages, when will country choose to produce good?

Answer 21

Thailand will produce good i if its relative wage is lower than its
relative productivity for good i: