Ricardian theory Flashcards
Assumptions of Ricardian model
- Two countries with 2 goods (x and y) having labour for each sector.
- Labour is the only factor of production
- Quantities of labour used to produce each good for each country are uniquely given.
- Labour requirements in each country are different so axA =/= ayA =/= axB =/= ayB
- Perfect competition in each sector
- Perfect labour mobility within country but not internationally
- Tastes are internationally identical
- Free trade between countries - no barriers to trade
Utility maximisation problem
Max U = U(Cx, Cy) s.t. to two constraints:
- Cx = Qx and Cy = Qy
- Lbar = Lx + Ly
Qx = 1/ ax . Lx where Lx = axQx and Ly = ayQy
Sub Lx = axQx and Ly = ayQy into Lbar = Lx + Ly to give:
Lbar = axQx + ayQy
Qx = Lbar/ ax - (ay/ax). Qy
Lagrangian problem:
L = U(Cx, Cy) + λ1[Qx - Lbar/ ax - (ay/ax). Qy] + λ2[Cx – Qx] + λ3[Cy – Qy]
FOCs: dL/ dCx = U’Cx + λ2 = 0 dL/ dCy = U’(Cy) + λ3 = 0 dL/ dQx = λ1 – λ2 = 0 dL/ dQy = λ1.(conay/ax) – λ3 = 0 dL/ dλ1 = Qx - Lbar/ ax - (ay/ax). Qy = 0 dL/ dλ2 = Cx – Qx = 0 dL/ dλ3 = Cy – Qy = 0
Utility maximisation problem (cont’d)
U’(Cy)/ U’(Cx) = ay/ ax so that MRS = MRTS = OC = relative labour productivity.
We need to look at the assumptions when looking at the prices of producing the two goods.
Px = wx.ax
Under the assumption of perfect competition, we know there is full employment
Py = wyay
Wx = wy so that relative price: p = py/ px = wyay/ wxax = ay/ax. Thus MRS = MRTS = OC = relative labour productivity = relative price (all under autarky).
Ricardian model: under autarky
On the diagram we have the quantities Cx = Qx and Cy = Qy with the indifference curves tangental to it, point E. We have a point (reverseE!- exists and unique) where indifference curve is tangent to AB and Cx = Qx, Cy = Qy and U’(Cy)/ U’(Cx) = ay/ ax.
Now looking at the world price, pw which could be the same, less than or greater than the autarky price, which means looking at world trade situation.
Under free trade
Now we will look at the problem of specialization where there is free trade between 2 countries, A and B with the pattern of specialization.
A has CA in production of x so it will specialize in production of x and vice versa for B.
Country A exporting good x and country B exporting good y.
Assumption is that pw > p (the relative price at autarky).
If pw = p then there will be no trade.
If pw > p then PPF will move upwards from point E, resulting in the relative price of y being greater than that under autarky.
This results in consumption of y decreasing so that there is an excess supply of y which is exported. The consumption of x will conversely increase resulting in excess demand for x so need to import it. This gives a new point, Z, on the new PPF at quantities Cy’ – Cy = Qy (export) and Cx’ – Cx = Qx (import of x).
Under free trade (continued)
Profit maximising producers will shift production so that more of y is produced resulting in more y being produced, giving a new PPF (pink line) with the same slope of the green PPF because the relative prices are the same.
Producers would want to produce the maximum amount of y they can produce to profit maximize, so the PPF will keep expanding until it crosses point B, which is the maximum it can produce of good y.
There should also be an indifference curve be tangental to green PPF at point Z, parallel to the first indifference curve.
When doing this for each of the PPFs after, the indifference curves would give higher points of tangency. Thus utility increases under free trade.
Empirical testing on the Ricardian theory
Empirical evidence supports the view that Ricardian Theory provides an explanation of trade flows. This is by testing prediction that countries tend to export goods in which their productivity is relatively high.
This was confirmed by McDougal, Stern and Balassa. The same can be true for the modern empirical tests such as that of Golub and Hsieh (2000).
R^2 values are larger in the old empirical tests compared to the ones run in the modern day
Early empirical tests
Early tests were carried out by MacDougall (1951), Stern (1962) and Balassa (1963) and compared the exports of the USA and UK.
Showed that there was evidence of comparative advantages of the 2 countries narrowed at each end of the Comparative scale.
There appeared to be evidence that high productivity country gain export increase in low productivity industries, and vise versa.
In fact commodities are ranked in terms of comparative factor-productivity ratios such that it will always be true that each of a country’s export will have a higher productivity ratio (Jones, 1961).
Modern empirical tests
Golub and Hsieh (2000) based tests on the previous literature on the subject but used a larger sample of countries instead.
Generally results were shown to be favourable to Ricardian model especially with countries like Japan doing very well.
For explaining relative exports productivity was preferred to unit labour costs. For explaining bilateral exports, unit labour costs were preferred.
Overall same conclusions as the previous empirical tests which is that countries export more in industries where relative productivity is high.
However, R^2 value was shown to be lower than those of the early empirical tests.
Reasons for differences in R^2
Measurement errors in independent variables (e.g. imperfections in PPP measures used).
Common in cross-sectional analysis
There could be omitted variables.
May be due to increased flow of capital and technology transfer now compared to the past which has resulted in convergence in productive capacities across countries.
Limitations of the Ricardian theory
Does not consider other factors of production that could impact exports such as capital.
Does not explain how the comparative advantage occurs.
Does not take into account the sizes of the countries since smaller countries may be unable to meet demand by world trade.
While it predicts welfare improvements for both countries, the Ricardian model has nothing to say regarding distribution.
