Chapter 2: Ricardian Model Flashcards
What is the ricardian model
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.
What are the ricardian model assumptions
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
What is a unit labour requirement and Labour Supply
What does it mean for labour productivtiy?
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
How to draw Ricardian PPF
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
What are workers wages? How is it linked to perfect competition
Perfect competition and workers move freely –> workers are paid a wage that is equal to the value of what they produce
Wc = Pc/Alc
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?
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
What is the relative price pc/pw?
pc/pw = Alc/Alw
Relative price of computers to widgets can be seen as the relative productivity of widgets to computers
What is absolute advantage
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
What is comparative advantage
Home’s opportunity cost of producing computers is lower than in Foreign
(Alc/Alw) < (Alc/Alw)
Compare the slope of the foreign PPF to home
What does the slope of the PPF represent?
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
Whats the difference btw autarky relative prices and world free trade price
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
What are terms of trade
terms of trade refer to the relative price of a country’s exports
With trade both terms of trade increases
What happens when the relative price of computers equals the opportunity cost in HomePC/PW =aLC/aLW <aLC/aLW,
Since wages same in both sector for home, home workers are indifferent about producing widgets or computers while foreign workers only produce widgets
Why does aLC/aLW <PC/PW <Alc/Alw
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 ).
What is the relative supply of computers
the quantity of computers supplied by all countries relative to the quantity of widgets supplied by all countries
RS = (QC + QC∗ ) / (QW + QW∗ )
Why is the world relative supply a step function, which points of the graph does it intersect
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
What is relative demand
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
How has trade helped countries in the process
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.
Show mathematically how Home is able to consume more widgets in this case
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!
What are relative wages
What determines relative wage difference across countries?
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*)
Looking at relative wages, when will country choose to produce good?
Thailand will produce good i if its relative wage is lower than its
relative productivity for good i:
