Trade and Technology: The Ricardian Model Readings: Chapter 2 sections 1-3 2.

Trade and Technology: The Ricardian Model

Readings: Chapter 2 sections 1-3

2

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© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Introduction. U.S. Imports of Snowboards

• Why do countries trade?

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Introduction

• This chapter explains comparative advantage by looking at how technology differences across countries affects trade

• This is referred to as the Ricardian model because it was proposed by the 19th century economist David Ricardo

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The Home Country

• We will use two goods to develop a Ricardian model of trade: Wheat and Cloth

• There are two countries, Home and Foreign.

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Road Map

• Part 1. Home country, before trade• Part 2. Home and Foreign countries, who

exports wheat and who exports cloth? Comparative advantage

• Part 3. Is trade “good” or “bad”?

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The Home Country

• The Home Country We will assume that labor is the only resource

used to produce both goods One worker can produce 4 bushels of wheat or 2

yards of cloth The Marginal Product of Labor is the extra

output obtained by using one more unit of labor MPLW = 4 and MPLC = 2

Key Assumption: Marginal Products of Labor are fixed

Suppose Home has 25 workers; i.e. = 25. Labor endowment.

L

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The Home Country: Summary

Cloth

MPL

wheat

MPL

Labor

Home 2 4 25

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Drawing the PPF

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Notes: Drawing of PPF

• Home Production Possibilities Frontier We can use the marginal products of labor to

construct Home’s PPF. Assume there are 25 workers in Home. If all the workers were employed in wheat, the

country could produce 100 bushels If they were all employed in cloth they could

produce 50 yards. The PPF connects these two points

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Slope of PPF

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Notes: PPF Slope: formular

• Showing these calculations we can see: Labor = 25, MPLW = 4, MPLC = 2

If Home produces wheat only, QW = MPLW* = 25*4 = 100

If Home produces cloth only, QC = MPLC* = 25*2 = 50

• This gives us a straight line PPF which is a unique feature of the Ricardian model Assumes marginal production of labor is constant

LL

50 1100 2

C C C

WW W

Q MPL L MPLSlopePPF

MPLQ MPL L

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Notes: Slope of PPF and Opportunity Cost

• The slope of the PPF can be calculated as the ratio of marginal products of the two goods

• The slope also equals the opportunity cost of wheat – the amount of cloth that must be given up to obtain one more unit of wheat – if we put wheat quantity on the horizontal axis.

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Slope of PPF and Opportunity Cost

• The slope of the PPF reflects the opportunity cost of producing one more bushel of wheat in terms of cloth

• Labor used in 1 wheat = labor used in ½ cloth; i.e. cost of 1 wheat = cost of ½ cloth

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Indifference Curves

A

B

U1

Wheat, QW (bushels)

Cloth, QC

(yards)The country is indifferent between A and B

U0 < U1 < U2

U2

U0

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Notes: Indifference Curves

• Home Indifference Curve Given Home’s PPF, we still don’t know how much

Home will choose to produce We need information about the country’s

preferences – we need indifference curves A single indifference curve shows the

combinations of wheat and cloth that the country can consume and be equally satisfied.

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Notes: Indifference Curves

• Indifference curves increase in utility as the curves move northeast.

• All points on a single indifferent curve have the same level of utility.

• A country cannot produce outside their PPF so, without trade, they are constrained in their utility by the PPF.

• We use these indifference curves to show the preferences of an entire country

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closed-economy equilibrium (Home)

A

BD

U1

U0

Wheat, QW (bushels)

50

U2

Cloth, QC

(yards)

C

Home PPF

The country could produce at point D but would be at a higher level of utility at point A.

The country is better off on U2 but cannot produce that much

At point A, on U1, is the best the country can do

50

25

100

Home closed-economy equilibrium

Figure 2.2

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Notes: Figure 2.2

• Home Equilibrium Without trade, the PPF acts like a budget

constraint for the country The country will produce at its highest level of

utility within the limits of the PPF In the graph, the highest level of utility that can be

reached and still stay within the PPF is U1 with production at point A

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Wage Equation

• Wages In competitive markets, suppose for cloth P = $2

and MPL = 4. How much are firms willing to pay? Cost of a marginal worker to the firm = wage Value of a marginal worker to the firm = the value

of one more hour of production = 4 cloth x $2/cloth = $8

So firms are happy if w = $8

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Wage Equation

• w = P*MPL Meaning in English: The value of one more

worker equals the amount of goods produced by this worker (MPL) times the price of the good.

Predictions: (1) you earn more if your products are worth more; (2) you earn more if you are more productive

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Ave. Wage Purdue Graduates 2011

Source: The Exponent, 2011.

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Oil Boom in North Dakota and Wages

• Oil prices http://www.macrotrends.net/1369/crude-oil-price-history-chart

• The average wage in the energy industry in ND = ?

Source: “U.S. News: North Dakota Enjoys Oil Boom – But Girds for Slowdown”, by Russel Gold, 24 December 2012, The Wall Street Journal.

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Example: A Snow-covered Paradise in Alberta

• Wood Buffalo, Alberta

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Wood Buffalo: A Luxury Resort Town?

• Medium Single Family House: $625,000• In and out: private airports• Life style of residents:

20-inch flat-screen TV, double bed high-speed Internet access and daily maid

service. Prime rib is on the Thursday dinner menu. The bar opens at 6 p.m., there's a yoga class at 7

• Earnings of residents: $100,000 for inexperienced truck drivers $200,000 for experienced welders

Source: “This Is the Life: Luxurious Digs On Frigid Oil Sands --- Firms in Canada Pay Well, And Steak Is on the Menu; 'Smell of Money' Beckons”, by Douglas Belkin, 5 December 2007, The Wall Street Journal, A1

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Relative Prices at closed-economy equilibrium

W=P*MPL holds for both wheat and cloth Since labor can move freely between industries, wages

must be equalized:

The right had size is the slope of the PPF and the opportunity cost of obtaining one more bushel of wheat.

The left hand side is the relative price of wheat. Value of 1 wheat = ½ value of 1 cloth

* *

1

2

W W C C

W C

C W

P MPL P MPL

P MPL

P MPL

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Relative Prices and OC

• The price ratio, PW/PC, always denotes the relative price of the good in the numerator, measured in terms of how much of the good in the denominator must be given up.

• For the good on the horizontal axis of the PPF picture, |PPF slope| = OC = relative price before trade

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Real Wages Before Trade

• Real Wage = wage/price Real wage for wheat = wage/price_of_wheat; i.e.

quantity of wheat the wage can buy

• Calculate the real wage for wheat

• Calculate the real wage for cloth

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Notes: the calculation of Real Wages Before Trade

• Real Wages Real wage for wheat = wage/price_of_wheat; i.e.

quantity of wheat the wage can buy Since Home produces both wheat and cloth,

Home wage is: w = PW*MPLW = PC*MPLC

The real wage for wheat = w/PW = (PW*MPLW)/PW = MPLW = 4 wheat

The real wage for cloth = w/PC = (PC*MPLC)/PC MPLC = 2 cloth

• Before trade, real wage = marginal product of labor

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Real Wages Before Trade

• Before trade, real wage = marginal product of labor

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Part 1 Summary

• MPL• PPF• PPF Slope and OC• Wage Equation• Relative price before trade

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The Foreign Country: Summary

Cloth

MPL

wheat

MPL

Labor

Foreign 1 1 100

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Notes: The Foreign Country in Detail

• The Foreign Country Foreign Production Possibilities Frontier

MPL*W = 1, MPL*C = 1

Key Assumption: Marginal Products of Labor are fixed

Assume there are 100 workers available in Foreign If all workers were employed in wheat they could

produce 100 bushels. If all workers were employed in cloth they could produce

100 yards. The Foreign country’s PPF connects these two points.

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Foreign PPF

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closed-economy equilibrium (Foreign)

A*

50 100 Wheat , (bushels)

Cloth, (yards)

100

Foreign before-trade equilibrium

Foreign PPF

50

Figure 2.4

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Notes: Figure 2.4

• Equilibrium in Foreign Foreign’s preferences can also be represented by

indifference curves Economy produces at the point of highest utility

for the country within the PPF constraint |The slope of the PPF| = the opportunity cost of

wheat = the before-trade relative price of wheat, P*W/P*C = 1

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Pattern of Trade

• Which country exports wheat and which country exports cloth?

• Assume: no trade cost

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Absolute Advantage = Higher MPL

Summary of Home and Foreign

MPL, Cloth (Yard/worker)

MPL, wheat (Bushel/worker)

Labor

Home 2 4 25

Foreign 1 1 100

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Notes: Absolute Advantage

• Absolute advantage = higher MPL Foreign’s technology is inferior to Home’s Home has an absolute advantage in both wheat

and cloth as compared to Foreign Clearly, Home can’t export both wheat and cloth

when trade opens up.

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Comparative Advantage = Lower OC

Summary of Home and Foreign

MPL, Cloth (Yard/worker)

MPL, wheat (Bushel/worker)

Labor

Home 2 4 25

Foreign 1 1 100

OC of wheat in Home = ?? OC of wheat in Foreign = ??

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Table of Opportunity Cost

Cloth (Yard)

Wheat (Bushel)

Home 2 wheat ½ cloth

Foreign 1 wheat 1 cloth

Opportunity Costs for Goods in Home and Foreign

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Notes: OC Table

• Comparative Advantage = Lower Opportunity Cost Remember a country has a comparative

advantage in a good when it has a lower opportunity cost of producing that good

By looking at the chart we can see that Foreign has a comparative advantage in producing cloth Foreign’s Opportunity cost of cloth is lower

Home has a comparative advantage in producing wheat Home’s opportunity cost of wheat is lower

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Why does comparative advantage drive trade patterns?

• Because OC = relative prices before trade

Wheat (Bushel)

Home ½ cloth

Foreign 1 cloth

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Notes: Relative Price Table

• Why does Home export wheat? Relative price of wheat in Home is PW/PC = 1/2

Relative price of wheat in Foreign is PW*/PC

* = 1

Therefore Home would want to export their wheat to Foreign – they can make it for 0.50 cloth and export it for 1 cloth!

• The opposite is true for cloth Home will export wheat and Foreign will export

cloth Both countries export the good for which they

have the comparative advantage

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APPLICATION

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Comparative Advantage in Apparel, Textiles, and Wheat

• US Textile and apparel industries face intense import competition

• Burlington Industries announced in January 1999 it would reduce production capacity by 25% due to increased imports from Asia

• After layoffs they employed 17,400 persons in the US with a 1999 sales of $1.6 billion

• Sales per employee were therefore $92,000• This is the average for all US apparel producers• Textiles are even more productive with annual sales

per employee of $140,000 in the US

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Comparative Advantage in Apparel, Textile and Wheat

• Table 2.2

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Equilibrium with trade

• The relative price of wheat in the trade equilibrium will be between the before-trade prices in the two countries

• For now lets assume the free-trade price, PW

T/PCT = 2/3. This is between the price of ½

in Home and 1 in Foreign.• We can now take this price and see how

trade changes production and consumption in each country

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Notes: Equilibrium with trade

• How prices change after trade As Home exports wheat, quantity of wheat sold at

Home falls The price of wheat at Home goes up More wheat goes into Foreign’s market The price of wheat in Foreign falls For the same reason, as Foreign exports cloth,

the quantity sold in Foreign falls. Therefore, the price in Foreign for cloth rises, and the price of cloth in Home falls.

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Notes: Equilibrium with trade

• Trade Equilibrium Two countries are in a trade equilibrium when the

relative price of wheat is the same in the two countries – this means the relative price of cloth is also the same in both countries.

This is because we assume there is no trade cost

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Pattern of Production

PWT/PC

T = 2/3.Home exports wheat. How many wheat does Home make?

Cloth (Yard) Wheat (Bushel)

Home 2 wheat ½ cloth

Foreign 1 wheat 1 cloth

Opportunity Costs in Home and Foreign

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Complete specialization

• Home’s workers will want to work in wheat and no cloth will be produced

• With trade, Home will be fully specialized in wheat production

ClothWagesWheatWages

MPLPMPLP

Therefore

MPLP

MPLP

CTCW

TW

CTC

WTW

1

6

8

2

4

3

2

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Summary Part 2

• Absolute advantage• Comparative advantage

OC = relative price before trade

• Trade equilibrium• Free-trade price• Complete specialization

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Is trade good or bad: Home

A

U1

Wheat, QW (bushels)

50

Cloth, QC

(yards)

Home PPF

PWT/PC

T = 2/3.Home exports wheat

50

25

100

Home closed-economy equilibrium

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Consumption possibility frontier

• With free trade, what choices does Home country have for consumption? i.e. what is Home country’s “budget line”?

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Consumption Possibility Frontier (CPF), Home

U2

CPF, Slope = –2/3

U1

A

50 100 Wheat , QW (bushels)

Cloth, QC (yards)

B

Home production

50

25

•The new world price, PWT

/PCT =

2/3, shows us the new range of consumption possibilities

•The country can now achieve a higher utility with the new consumption possibilities

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Is trade good or bad: Foreign

Foreign PPF

100 Wheat, (bushels)

Cloth, (yards)

100

U0

Foreign closed-economy equilibriumA*

PWT/PC

T = 2/3.Foreign exports cloth

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CPF, Foreign

Foreign production

C*

Foreign consumption

60 100 Wheat, (bushels)

Cloth, (yards)

100

60

B*

World price line, Slope = –2/3

U0

U1

•The new world price, PWT

/PCT =

2/3, shows us the new range of consumption possibilities

•The country can now achieve a higher utility with the new consumption possibilities

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Notes: Gains from Trade

• Gains from trade for BOTH countries! Under the new production, each country

specializes fully in the good for which they have the comparative advantage

They then export some of their production and import some of the other good from the other country

Home specializes in wheat and Foreign specializes in cloth

The new indifference curves show the new consumption points.

The difference between production and consumption give us trade patterns

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Gains from Trade: intuition

• International Trade Trade allows both countries to engage in

consumption possibilities they did not have before trade

This is a demonstration of gains from trade Intuition: trade increases the choices a

country can make (the PPF remains available after trade); both countries gain because they help each other out.

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Trade is Balanced: Foreign

Foreign production

C*

Foreign consumptionForeign exports 40 yards of cloth

Foreign imports 60 bushels of wheat

60 100 Wheat, (bushels)

Cloth, (yards)

100

60

B*


U0

U1

Foreign produces 0 wheat but consumes 60 so imports equal 60.

Foreign produces 100 cloth but consumes only 60 so exports equal 40

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Trade is Balanced: Home

Home consumption

Home production

Home imports 40 yards of cloth

Home exports 60 bushels of wheat

U1

40 100 Wheat , QW (bushels)

Cloth, QC (yards)

C

B

U2


50

40

Home produces 100 wheat but consumes only 40 so exports equal 60

Home produces 0 cloth but consumes 40 so imports equal 40.

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Notes: Trade is Balanced

• Trade is the difference between domestic production and consumption Quantity of exports = quantity of production –

quantity of consumption Quantity of imports = quantity of consumption –

quantity of production

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Trade and Wages

• How do wages change after trade for Home and Foreign?

• Under free trade, which country has a higher wage? Wages actually differ – they are determined by

absolute advantage – not comparative advantage

• Real wages: = wage/price.

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Real Wages Before Trade: Home

• Before trade, real wage = marginal product of labor since Home makes both wheat and cloth The real wage for wheat = MPLW = 4 wheat

The real wage for cloth = MPLC = 2 cloth

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Real Wages After Trade: Home

• Solving for Real Wages Across Countries Since Home produces and exports wheat,

Home wage is: w = PWT*MPLW

The real wage for wheat = w/PWT =

(PWT*MPLW)/PW

T = MPLW = 4 wheat. Same as before trade

The real wage for cloth = w/PCT = (PW

T*MPLW)/PCT

=(PWT/PC

T)*MPLW = (2/3)*4 = 8/3 cloth. Higher than before trade.

• Trade increases real wage for cloth! Same intuition as gains from trade.

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Terms of Trade

• The real wage for cloth =(PWT/PC

T)*MPLW

• The Terms of Trade for Home = PWT/PC

T

An increase in PWT or a fall in PC

T will raise Home’s terms of trade

An increase in the terms of trade is good for a country They earn more for its exports They pay less for their imports Home real wage for cloth is higher

In general, the price of a country’s exports divided by the price of its imports.

Foreign’s Terms of Trade = PCT/PW

T

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Real Wages Before Trade: Foreign

• Before trade, real wage = marginal product of labor since Foreign makes both wheat and cloth The real wage for wheat = MPLW

* = 1 wheat

The real wage for cloth = MPLC* = 1 cloth

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Real Wages After Trade: Foreign

• Solving for Wages Across Countries Since Foreign produces and exports cloth,

Foreign wage is: w* = PCT

*MPLC*

The real wage for cloth = w*/PCT = (PC

T*MPLC*)/PC

T = MPLC

* = 1 cloth, same as before trade

The real wage for wheat = w*/PWT =

(PCT*MPLC

*)/PWT = (PC

T/PWT)*MPLC

* = (3/2)*1 = 3/2 wheat, higher than before trade

• Again, free trade increases real wages!

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Comparing Wages Across Countries

• Summarizing Home real wage is

4 bushels of wheat 8/3 yards of cloth

Foreign real wage is 3/2 bushels of wheat 1 yard of cloth

The ratio Home_wage/Foreign_wage = 8/3, so Foreign workers earn less

What is the intuition for this?

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Comparing Wage Across Countries

• What determines w/w*? Since Home produces and exports wheat,

Home wage is: w = PWT*MPLW

Since Foreign produces and exports cloth, Foreign wage is: w* = PC

T *MPLC

*

* * *

2 4 8( )( )

3 1 3

T TW W W WT TC C C C

P MPL P MPL

P MPL P MPL

ww

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Summary: Comparing Wages Across Countries

• Home_wage/Foreign_wage depends on Home country’s TOT and absolute advantage

• So comparative advantage gives you trade patterns, and absolute advantage gives you high wages

• The intuition: the only way a country with poor technology can export at a price others are willing to pay is by having low wages.

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Predictions

• Prediction: In a given year, the countries that have better

technology should have higher wages (i.e. comparing across countries)

Over time, as a given country develops better technology, its wages will rise (i.e. looking at changes for a given country)

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APPLICATION

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Labor Productivity and Wages for 2001

• Figure 2.7

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Notes: Figure 2.7.

• Labor productivity can be measured by the value-added per hour in manufacturing Value-added is the difference between sales revenue in an

industry and the costs of intermediate inputs Equals the payments to labor and capital in an industry. The Ricardian model ignores capital so we can measure

labor productivity as value-added divided by the number of hours worked, or value-added per hour

• Figure 2.7 shows value added per hour in manufacturing for several countries Countries with higher labor productivity pay higher wages,

just as the Ricardian model predicts

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Figure 2.8. Labor Productivity and Wage Over Time

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Notes: Figure 2.8.

• We can also see the connection between productivity and wages over time

• Figure 2.8 shows the general upward movement in labor productivity is matched by upward movement in wages This is also predicted by the Ricardian Model

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Summary Part 3

• CPF• Trade is balanced• Real wages

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Trade and Technology: The Ricardian Model Readings: Chapter 2 sections 1-3 2.

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