Ricardian Model Of Comparative Advantage

Question 1

Recall the ‘No trade model’ assumptions (4)

Answer 1

Identical tech and tastes
Same relative factor endowments
Constant RTS
No distortions

Question 2

Which assumption do we relax for the Ricardian model?

Answer 2

Identical technology (since differences in tech drive changes in relative labour productivity)

Question 3

So we assume differences in technology.

What does actually this mean?

Answer 3

Goods are produced with different amounts of labour

Question 4

Ricardian model

5 Assumptions

Answer 4

Labour is the only factor

Labour productivity varies ACROSS countries, but labour productivity WITHIN the country is constant (rmb CRTS)

2 goods

Labour mobile between industries not countries

Competition allows workers to be paid a wage equal to what they produce, and allows them to work in the industry that pays the highest wage.

Question 5

aLC and aLW: hours of labour to produce one unit
So high a means low productivity

L is total number of work hours available
Qc and Qw is quantity produced

What is the production possibility frontier? (PPF)

Answer 5

aLCQc + alwQw <=L

Question 6

What is the opportunity cost of an additional cheese

Answer 6

aLC/aLW

Since an additional cheese requires aLC hours.

Which could’ve been used to produce 1/alw amount of wine.

Question 7

How can we show the opportunity cost of cheese is the slope of the PPF (equation)

Answer 7

Qw = L/aLW - (aLC/aLW)Qc

Question 8

What is wage expression for cheese and wine industry? (2)

Answer 8

Wc = Pc/aLC and Ww = Pw/aLW

Since mobile labour, they work where wages are higher.

Question 9

Using this… If Pc/alc> Pw/alw , which good is produced

Answer 9

Cheese

Question 10

Assuming convex (average>extremes) preferences,

In autarky what would consumers consume, and what happens to the market as a result?

C) What would the expression be?

Answer 10

Both wine and cheese

So relative prices must adjust so wages equal in both industries to ensure both goods are produced

C) Pc/Pw = aLc/aLw
(Relative price = opportunity cost)

Question 11

Home country is more efficient in both wine and cheese production. What is this called?

B) hows it expressed

Answer 11

Absolute advantage (as lower unit labour requirements)

aLC < aLC and aLW < aLW

Question 12

So a country can be more efficient in producing both goods (absolute advantage)

But, it will have a comparative advantage in ONLY ONE good unless..

Answer 12

Unless they are identical

(So a country can have absolute advantage for both, but will only have comparative advantage in one)

Question 13

What would PPFs look like graphically, say we assume:

aLC /aLW < aLC /aLW

Answer 13

Linear as CRS (no DMR since only one factor (labour)

And slope is opportunity cost. Since home has a lower opportunity cost, foreign PPF will be steeper (higher opportunity cost of cheese in terms of wine)

Question 14

At autarky (no trade), will the relative price of cheese to wine be higher foreign or home?

B) Upon this, is it profitable to break autarky and sell cheese to foreign, and wine from foreign to home?

C) How do we find where relative prices settle

Answer 14

Foreign, as higher opportunity cost of cheese (steeper slope of alc/alw)

B) Yes, home should export cheese, and foreign should export wine

C) RICARDIAN MODEL - TRADE IS BASED OFF RELATIVE PRICES. As to where relative price settles… we need to find world relative supply

Question 15

World relative supply of cheese expression

Answer 15

RS = Qc + Qc / Qw + Qw
(Quantity of h&f cheese / Q of h&f wine)

Question 16

Pg 13:
When will:
A)no cheese be produced

B)home be indifferent to producing either, while foreign produces wine

C)Both countries specialise (whichever good they have a comparative advantage)

D)Home produces cheese, foreign is indifferent

E)No wine produced

Answer 16

A) Pc/Pw < aLc/aLw < a*Lc/aLw
(Since opp cost is greater than the rel price for both home and foreign)

B)
Pc/Pw = aLc/aLw < a*Lc/aLw
Home is indifferent (simple) but foreign opp cost of cheese is higher, so produce other good i.e wine

C) aLc/aLw < Pc/Pw < a*Lc/aLw
Since home has lower opp cost (produce cheese) and also lower than rel price, and foreign has higher opp cost for cheese that is above rel price so no point in producing so specialise in wine.

D) aLc/aLw < Pc/Pw = a*Lc/aLw

E) aLc/aLw < a*Lc/aLw < Pc/Pw

Question 17

That shows relative supply in those scenarios.
Relative supply diagram pg 13

Answer 17

Y axis rel price of cheese Pc/Pw
X axis world supply Qc+Qc / Qw+Qw

Lower horizontal line marks alc/alw (home)
Top horizontal line marks alc/alw (foreign)

Vertical line is where both countries specialise entirely

Question 18

What happens to relative demand of cheese if the relative price of cheese increases

Answer 18

demand less cheese and more wine, so relative QD of cheese falls!

Question 19

What is this known as?

Answer 19

The substitution effect!! (Swapping wine for cheese since cheese becomes relatively more expensive in relation to wine

Question 20

How to find the equilibrium relative price of cheese

b) intuition of the intersection

Answer 20

Where RD and RS curves intersect

B) Intersection is where both countries specialise. (Home only cheese foreign only wine)

(So relative prices determine amount produced, and relative prices are determined by RD & RS (INTERSECTION))

Question 21

Scenario 2:
World relative price of cheese is equal to the opportunity cost of cheese at Home aLC /aLW, and less than opportunity cost of cheese in foreign

Pg 16 graph

Answer 21

This just basically means Pc/Pw = alc/alw < alc/alw

Which means home is indifferent in production. They don’t specialise in either.

Foreign just producers wine

B) graph, relative demand line falls down to alc/alw line

Question 22

So where do gains from trade come from?

Answer 22

Specialising in the good they have a comparative advantage in, and then using income generated to buy goods they desire.

Question 23

In autarky no trade, what are real wages determined by?

Answer 23

Labour productivity

Question 24

So what would real wages be

Answer 24

Since real wages determined by labour productivity (i.e paid on how much they produce)

1/al etc…

Question 25

If we introduce trade what happens to real wages

Answer 25

Real wage is unchanged in terms of the exported goods, but rise in terms of the now cheaper imported goods.

(Makes sense since gains of trade come from the imported good being cheaper, rather than benefits from exporting)

Question 26

So given this…

If home export cheese and foreign export wine… what is thieir new expressions

Answer 26

Home real wage of wine rises (since real wages rise in term of the imported good)

From 1/alw (autarky) to 1/alc (Pc/Pw) with trade
(Note: it changes from alw to alc )

Foreign real wage of cheese rises (same intuition)

From 1/a*lc to 1/alw (Pw/Pc)

Question 27

Adding a consumption possibilities curve to the standard home and foreign PPF diagrams

Answer 27

Blue line is consumption possibilities.

Can consume more because of each specialising as a result of trade (beyond autarky PPF)

Question 28

So that was Ricardian model with only 2 goods (wine and cheese)

Now consider model with multiple (n) goods produced. Indexed by i = 1,2,…N

How are the new unit labour requirements expressed?

B) where are goods produced?

Answer 28

aLi (for home)
a*LI (for foreign)

B) goods are produced wherever cheapest to produce them

Question 29

If w x aL₁ < w* x a*L₁

What country will produce good 1

Answer 29

Only home country since total wage payments are less there.

Question 30

Or equivalently, if relative productivity is higher than relative wage, good will be produced in that country.

Answer 30

Rearrange the past inequality

aL₁ / aL₁ > w/w

Question 31

What determines relative wages w/w*

Answer 31

Relative supply and relative demand for labour

If relative wages rise, relative demand falls since cost of producing increases, and so less goods produced in the country, further reducing demand for domesitc labour services

Question 32

Caviar a*li >ali = 4

A) Suppose w/w* increases from 3 to 3.99. What happens.

B) what if w/w* increases to 4.01

Answer 32

Home still produces, (as ali/ali > w/w) , but demand for caviar falls and labour falls as relative wage rises

B) now relative wages>relative productivity in home for caviar, so caviar industry moves to foreign, causing DISCRETE (complete) drop in demand for home labour

Question 33

Graph to show relative wage determination (pg 27)

Answer 33

RS is vertical (since it demonstrates the discrete drop once a industry fully moves to foreign - caviar in this instance)

Relative wage on Y axis w/w*
Relative quantitity of labour on X axis L/L*

Question 34

Recap: For multiple good models - what determines comparative advantage

Answer 34

Cost advantage - good is produced in the country where it is cheapest (either from productivity or wage differentials)

(This is only for multiple goods, whereas 2 goods model is based on different relative prices in countries (relative prices equal opportunity costs in that country) pg13

Question 35

Misleading predictions of the Ricardian model overall

Answer 35

Degree of specialisation - countries irl do not fully specialise

Income distribution within countries. (It assumes everyone is better off… if this is the case, there should be no opposition to trade; which there is.

Resource differences (some may have better production conditions, or actual goods may differ too)

E.O.S

Question 36

Comparative advantage is the whole concept of this model.

Why is testing comparative advantage hard IRL (3)

Answer 36

The principle version is too weak to test in real world (real world obviously more than 2 countries and goods)

Latent variable problem: requires knowledge of autarky prices which are often not directly observable

Periods of autarky rare (so hard to get autarky prices)

Question 37

So how to proceed upon these issues?

Deardorff: How to solve problem 1 (principle version too weak as simple like 2 countries, 2 goods)

Answer 37

States an economy’s net export vector at autarky prices is negative. (Value of exports should not exceed value of imports)

It should be negative since it means it is exporting the good they have a lower opportunity cost (relative price) of, while importing goods that are relatively expensive to produce domestically (that have a high autarky price) thus creating gains from trade!

Question 38

Criticism of Deardorff’s intuition

Answer 38

Problem 2 and 3 still prevail (latent variable problem and periods of autarky rare)

Question 39

How to address problem 1-3.

Answer 39

Model determinants of autarky prices and substitute this model in.

Eval:
hard to do
tests become joint test of CA (whether CA actually holds) and structure (is it well specified)

Question 40

If pA is autarky prices and t is net export vector

How to express

Answer 40

pA < t < 0

(Since t is negative rmb…)

Question 41

Key Problem

Answer 41

Impossible to observe pA and t at the same time (problem 2: latent variable issue)

Since you can’t be in autarky and also have net exports where export value <import value cos that means trade!

Question 42

If observable why is pA powerful

Answer 42

It is a sufficient statistic for all supply and demand features of the economy

Question 43

But Pa is so rarely observed.

Bernhofen and Brown observe a near case. Where

Answer 43

Japan was a near closed economy in 1858 before trade was forced upon by the USA in 1859.

Question 44

Findings using the graphical result

Answer 44

Upward sloping, symbolising Japan exported goods with a lower opp cost (relative price) i.e they had a comparative advantage in,

And imported goods that had a higher autarky price

Which allowed for gains from trade, aligning with CA theory.

Question 45

One misleading prediction: complete specialisation

Answer 45

Not true, countries produce a wide variety.

The model predicts there is a good is not produced (due to comparative disadvantage), there’s a latent variable problem. You can’t observe its relative labour cost of production if it isn’t produced, so direct validation of comparative advantage is unachievable.

Question 46

Issues with relative labour costs itself w/w*

Answer 46

Not really comparable across countries

Question 47

Criticisms of model (2)

Answer 47

Testing CA (3 problems)

One factor model is too simple - goods are produced with multiple inputs in reality

Doesn’t say where relative labour costs come from (just assumes exogenous), no reason why one is more productive than another.

Question 48

Does studies support CA

Answer 48

MacDouggal yes :
Under theory, should export in sectors where relative labour productivity> relative wage. This we as true for 20/25 cases.

Other ones find similar results…

Eval:
Very simple specification, ignores transport costs, product differentiation, single factor of production etc.