International Trade and Comparative Advantage Three reasons for trade : (1) Cross country differences in supply (different technologies, different industrial organization, etc.) (2) Cross country differences in demand (difference preferences) (3) Exploiting Economies of Scale

Comparative Advantage: The Ricardian Model Assumptions : (1) One factor (2) Differences in labor productivity across countries (3) Two goods (4) Two countries (5) Constant returns to scale Main idea : Countries engage in trade because they are different from each other in relative labor productivity.

The Ricardian Model Two goods: W (wine), C (cheese) Unit labor requirement (# of hours of labor per one unit of output) :

The Ricardian Model Two goods: W (wine), C (cheese). Unit labor requirements (# of hours of labor per one unit of output): Production possibility frontiers:

= opportunity costs of producing one extra unit of C in terms of output forgone in the W industry. Wages, prices and output: If An Equilibrium Price Configuration

The Two Countries H F Country H has a comparative advantage in the production of C. Country F has a comparative advantage in the production of W.

Determining the Relative Price: 3 Relative Supply RD” 1 2 RD = Relative Demand RD’ Relative world quantity of C (in terms of W) Point (1): H Completely specializes in C, Country F in W. Point (2): F completely specializes in W, H produces both C & W.

Relative Wages At 1: Labor productivity ratio in the export industries Factors terms of trade Goods terms of trade At 2:

Gains From Trade We show that the Specialization in Production and Trade are beneficial to both countries. Assume that the equilibrium is at point (1). (a) H can produce W directly: one hour produces Units of W. (b) H can produce C , and then trade C for W: an “indirect” method of production. One hour produces units of C to get through trade units of W.

Thus, compare to But at point (1) Therefore,

Since H benefits F can produce C directly: one hour Or “indirectly”