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Chapter Outline
Reasons for Trade
Absolute Advantage Comparative Advantage
Ricardian Model
The Home Country The Foreign Country
Learning Objectives
Distinguish between absolute and comparative advantage Understand the Ricardian model Understand the no-trade equilibrium using each countrys PPF and Indifference Curve Understand the trade equilibrium how the pattern of international trade is determined how to solve for prices and wages across countries how to derive the export supply curve and the import demand curve Understand the international trade equilibrium Understand how to determine a countrys terms of trade and how they affect that country
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Introduction
We focus on how technology differences across countries affect trade. This is referred to as the Ricardian model because it was proposed by the 19th century economist David Ricardo. It explains how the level of a countrys technology affects wages paid to labor in a way that countries with better technology have higher wages. We use this to explain a countrys trade patternthe products it exports and imports.
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Comparative advantage
When a country has the best technology for producing a good, it has an absolute advantage in the production of that good.
Absolute advantage is actually not a good explanation for trade patterns.
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Ricardian Model
To develop a Ricardian model of trade, we will use an example with two goods: wheat and cloth.
Wheat and other grains are major exports of the U.S. and Europe. Many types of cloth are imported into these countries.
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Ricardian Model
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.
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Ricardian Model
Home Production Possibilities Frontier
We can use the marginal products of labor to construct Homes 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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Ricardian Model
Showing these calculations we can see:
Labor = 25, MPLW = 4, MPLC = 2 QW = MPLW(L) = 25(4) = 100 QC = MPLC(L) = 25(2) = 50
This gives us a straight line PPF which is a unique feature of the Ricardian model.
It assumes the marginal products of labor are constant. There are no diminishing returns because the model ignores the use of other resources.
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Ricardian Model
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 wheatthe amount of cloth that must be given up to obtain one more unit of wheat.
Ricardian Model
Figure 2.1
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Ricardian Model
Home Indifference Curve
Given Homes PPF, how much wheat and cloth will home actually produce. The answer depends on demand. Demand can be represented with indifference curve. An indifference curve shows the combinations of two goods that the country can consume and be equally satisfied.
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Ricardian Model
All points on an indifference curve have the same level of utility. Points on higher indifference curves have higher utility. Indifference curves are often used to show the preferences of an individual. But we use indifference curves to show the preferences of an entire country.
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Ricardian Model
Figure 2.2
The country is indifferent between A and B The country is better off on U2 but cannot produce that much U0<U1<U2
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Ricardian Model
Home Equilibrium
Without trade, the PPF acts as a budget constraint for the country. With perfectly competitive markets, 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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Ricardian Model
Home Equilibrium
Point A is the no-trade equilibrium. The country can reach point A its own production. The assumption of perfect competition will assure the country ends up at the highest level of utility possible.
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Ricardian Model
Figure 2.2
The country could produce at point D but would be at a higher level of utility at point A. At point A, on U1, is the best the country can do
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Ricardian Model
Opportunity Cost and Prices
The slope of the PPF reflects the opportunity of producing one more bushel of wheat. Under perfect competition the opportunity cost of wheat should equal the price of wheat.
Price reflects the opportunity cost of a good.
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Ricardian Model
Wages
Determination of wages
In competitive markets firms hire workers up to the point at which the hourly wage equals the value of one more hour of production. The value of one more hour of labor equals the amount of goods produced in that hour (MPL) times the price of the good. Labor hired up to the point where wage equals P*MPL for each industry.
In competitive markets, labor can move freely between industries. Labor will move to the higher paid industry. This will continue until there is equalization of wages between industries.
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Ricardian Model
The equalization of wages will give us the following:
The right hand side 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.
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Ricardian Model
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. The slope of the PPF equals the relative price of wheat, the good on the horizontal axis.
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Ricardian Model
The Foreign Country
Assume Foreigns technology is inferior to Homes. Foreign has an absolute disadvantage in producing both wheat and cloth as compared to Home.
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Ricardian Model
The Foreign Country
Foreign Production Possibilities Frontier
Assume a Foreign worker can produce one bushel of wheat or one yard of cloth. MPL*W = 1, MPL*C = 1 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.
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Ricardian Model
Figure 2.3
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Ricardian Model
Comparative Advantage
Given the information we have gathered, we can begin to talk about the opportunity cost of production of each good in each country. Given the opportunity cost information, we can determine comparative advantages in each country for each good.
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Ricardian Model
Opportunity Costs for Goods in Home and Foreign Cloth (1 Yard) Home 2 Bushels of Wheat 1 Bushel of Wheat Wheat (1 Bushel) Yard of Cloth 1 Yard of Cloth
Foreign
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Ricardian Model
Comparative Advantage
A country has a comparative advantage in a good when it has a lower opportunity cost of producing than another country. By looking at the chart we can see that Foreign has a comparative advantage in producing cloth.
Foreigns Opportunity cost of cloth is lower.
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Ricardian Model
Equilibrium in Foreign
Foreigns preferences can also be represented by an indifference curve. Its economy produces at the point of highest utility for the country within the PPF constraint. The slope of the PPF is the opportunity cost of wheat. The no-trade relative price of wheat is P*W/P*C = 1. The relative price exceeds Homes no-trade relative price of wheat: P*W/P*C > . The difference in relative prices comes from the comparative advantage that Home has in wheat.
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Ricardian ModelForeign
Figure 2.4
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Cloth, QC (yards)
50
U2 25 A
U1 B
50 100
Home production
Wheat, QW (bushels)
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Home produces 100 bushels but consumes only 40, so exports equal 60 Home produces 0 yards of cloth but consumes 40, so imports equal 40.
Home consumption
50 40 C
U1 B 40 50 50
100 100
Home production
Wheat, QW (bushels)
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Foreign workers earn less than Home workers as measured by their ability to purchase either good.
This fact reflects Homes absolute advantage in the production of both goods.
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Figure 2.9
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Figure 2.10
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For Foreign, PC/PW is the terms of trade and a higher relative price for cloth makes it better off.
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Conclusions
The Ricardian model was devised to respond to the mercantilist idea that exports are good and imports are bad. David Ricardo found this was not true and considered an example where trade between two countries was balanced. The pattern of trade is determined by comparative advantage, and both countries gain from trade. The Ricardian model is presented with only one factor of productionlabor.
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Conclusions
Because wages depend on the marginal products of labor in each country, we conclude that wages are determined by absolute advantage.
Country with better technology will be able to pay higher wages.
In addition, wages depend on the prices prevailing on world markets for the goods exported by each country. The terms of trade is the price of a countrys exports divided by the price of its imports.
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Conclusions
Because we assume that labor is the only resource, the PPF in the Ricardian model is a straight line.
This leads to the export supply and import demand curves each have a flat segment.
The gains from trade become much more complicated when we allow for more realistic assumptions using several factors of production.
We will discuss this in future chapters.
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Key Points
1. A country has comparative advantage in producing a good when the opportunity cost of producing the goods is lower than the opportunity cost of producing the good in another country. 2. The pattern of trade between countries is determined by comparative advantage. 3. All countries experience gains from trade.
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Key Points
4. The level of wages in each country is determined by its absolute advantage, that is, by the amount the country can produce with its labor. 5. The equilibrium price of a good on the world market is determined where the export supply of one country equals the import demand of the other country. 6. A countrys terms of trade, the price of its export good divided by the price of its import good, affect how well off a country is from trade.
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