1 Ch. 3: Labor Productivity and Comparative Advantage – The Ricardian Model

2 Why Do Countries Trade? Countries trade with each other because they are different from each other. Countries trade with each other because they are different from each other. Countries trade with each other because enlarging the market creates economies of scale and reduces cost per unit. Countries trade with each other because enlarging the market creates economies of scale and reduces cost per unit.

3 Comparative Advantage A person, a region, a country has comparative advantage in producing a good if the opportunity cost of producing that good is lower than others. A person, a region, a country has comparative advantage in producing a good if the opportunity cost of producing that good is lower than others. Even if a country has absolute disadvantage in every thing it produces compared to another one, it still will have comparative advantage in some goods. Even if a country has absolute disadvantage in every thing it produces compared to another one, it still will have comparative advantage in some goods.

4 Do What You Do Best; Trade for the Rest In a year, an Eastern worker can make two bikes or grow four bushels of wheat. A Westerner, however, can manage only one bushel or one bike. Each country has 100 workers, and initially both of their workforces are split evenly between the two industries. East is relatively more efficient at growing wheat, where it is four times as productive as West, than it is at making bikes, where it is only twice as productive. In other words, it has a comparative advantage in wheat. Find opportunity costs.

5 Comparative Advantage B B W W WEST EAST In a year, an Eastern worker can make two bikes or grow four bushels of wheat. A Westerner, however, can manage only one bushel or one bike. Each country has 100 workers, and initially both of their workforces are split evenly between the two industries.

6 Comparative Advantage B B W W WEST EAST East shifts 10 workers from its bicycle factories to its fields. West moves 25 workers from wheat farming into bike making,

7 Comparative Advantage B B W W WEST EAST Can we improve the standard of living even more? Suppose we have complete specialization. East produces 400 wheat and West produces 100 bicycles. Let them trade with the outside world at 1.5 wheat per bicycle

8 Relative Wages The wages of workers represent their productivity. The wages of workers represent their productivity. In autarky In autarky East workers get 4 wheat or 2 bikes. East workers get 4 wheat or 2 bikes. West workers get 1 wheat or 1 bike. West workers get 1 wheat or 1 bike. Why are East workers paid more? Are West workers exploited? Why are East workers paid more? Are West workers exploited?

9 Relative Wages Under trade 1 Bicycle = 1.5 Wheat. Under trade 1 Bicycle = 1.5 Wheat. East makes 400 wheat; each worker gets paid 4 wheat or 2.67 bikes. East makes 400 wheat; each worker gets paid 4 wheat or 2.67 bikes. West makes 100 bicycles; each worker gets paid 1 bicycle=1.5 wheat. West makes 100 bicycles; each worker gets paid 1 bicycle=1.5 wheat. Did the lower wage of West workers take all the jobs away from East workers? Did the lower wage of West workers take all the jobs away from East workers? Did trade increase the wages for both countries? Did trade increase the wages for both countries?

10 Another Example HOME: Labor required for cheese production (a LC ) is 2. Labor required for wine production (a LW ) is 4. Home has 100 units of labor. HOME: Labor required for cheese production (a LC ) is 2. Labor required for wine production (a LW ) is 4. Home has 100 units of labor. FOREIGN: Labor required for cheese production (a* LC ) is 5. Labor required for wine production (a* LW ) is 5. Foreign has 200 units of labor. FOREIGN: Labor required for cheese production (a* LC ) is 5. Labor required for wine production (a* LW ) is 5. Foreign has 200 units of labor.

11 PPF for Home and Foreign Wine Cheese Home Foreign

12 Prices Home has to use twice as much labor to produce wine compared to cheese. Therefore, wine costs twice; or cheese costs half as much. Home has to use twice as much labor to produce wine compared to cheese. Therefore, wine costs twice; or cheese costs half as much. Pc/Pw = a LC /a LW = 2/4 = ½ Pc/Pw = a LC /a LW = 2/4 = ½ Foreign uses equal amounts of labor for cheese and wine. They should cost the same. Foreign uses equal amounts of labor for cheese and wine. They should cost the same. P*c/P*w = a* LC /a* LW = 5/5 = 1 P*c/P*w = a* LC /a* LW = 5/5 = 1

13 Relative Supply of Cheese Relative supply of cheese is Qc+Q*c/Qw+Q*w. Relative supply of cheese is Qc+Q*c/Qw+Q*w. If (Pc/Pw)<1/2, Home would be better off producing wine. If (Pc/Pw)<1/2, Home would be better off producing wine. At Pc/Pw=1/2, Home is free to produce between 0 and 50 units of cheese. At Pc/Pw=1/2, Home is free to produce between 0 and 50 units of cheese. At P*c/P*w=1/2, Foreign would only produce wine. At P*c/P*w=1/2, Foreign would only produce wine. Once P*c/P*w=1, Foreign would produce between 0 and 40 units of cheese. Once P*c/P*w=1, Foreign would produce between 0 and 40 units of cheese.

14 Relative Supply of Cheese Pc/Pw 1/2 1 50/4070/20 Relative quantity of cheese Cheese/Wine

15 Relative Demand As Pc/Pw falls, more cheese would be demanded. As Pc/Pw falls, more cheese would be demanded. Suppose Demand for Cheese/Demand for Wine = Pw/Pc. Suppose Demand for Cheese/Demand for Wine = Pw/Pc. At Pc/Pw = 1, Pw/Pc = 1. At Pc/Pw = 1, Pw/Pc = 1. At Pc/Pw = ½, Pw/Pc = 2 At Pc/Pw = ½, Pw/Pc = 2

16 Relative Demand and Supply of Cheese Pc/Pw 1/2 1 50/4070/20 Relative quantity of cheese

17 Specialization and Trade If ½ < Pc/Pw < 1, then Home should specialize on cheese and Foreign should specialize on wine. If ½ < Pc/Pw < 1, then Home should specialize on cheese and Foreign should specialize on wine. WHY? WHY? Suppose Pc/Pw in our example is ¾. That is, the exchange is worth ¾ wine for 1 cheese. Suppose Pc/Pw in our example is ¾. That is, the exchange is worth ¾ wine for 1 cheese.

18 Relative Wages Suppose cheese is $7.50 and wine is $10. Suppose cheese is $7.50 and wine is $10. Home produces only cheese: 50x$7.50 = $375. Divide by 100 units of labor: $3.75. Home produces only cheese: 50x$7.50 = $375. Divide by 100 units of labor: $3.75. Foreign produces only wine: 40x$10 = $400. Divide by 200 units of labor: $2.00. Foreign produces only wine: 40x$10 = $400. Divide by 200 units of labor: $2.00. The more productive labor is paid higher wage. The more productive labor is paid higher wage.

19 Gains for Home and Foreign Wine Cheese Home Foreign 50x3/4 40x4/3

20 Misconceptions About Comparative Advantage Myth 1: Free trade is beneficial only if your country is strong enough to stand up to foreign competition. Myth 1: Free trade is beneficial only if your country is strong enough to stand up to foreign competition. Myth 2: Foreign competition is unfair and hurts other countries when it is based on low wages. Myth 2: Foreign competition is unfair and hurts other countries when it is based on low wages. Myth 3: Trade exploits a country and makes it worse off if its workers receive much lower wages than workers in other nations. Myth 3: Trade exploits a country and makes it worse off if its workers receive much lower wages than workers in other nations.

21 Myth 1: Productivity and Competitiveness Absolute disadvantage in every sector still allows a country to benefit from trade since it has comparative advantage in some industries. Absolute disadvantage in every sector still allows a country to benefit from trade since it has comparative advantage in some industries. Comparative advantage is dependent on internal opportunity costs. Comparative advantage is dependent on internal opportunity costs. Average wage in a country reflects the average productivity. Average wage in a country reflects the average productivity.

22 Myth 2: Pauper Labor Argument Wages and productivity go hand in hand. Wages and productivity go hand in hand. If the average wage in a country is low because of overall low productivity, the country still exports products to relatively higher productivity industries. If the average wage in a country is low because of overall low productivity, the country still exports products to relatively higher productivity industries. The country with the absolute advantage will not lower its own average wage by importing because it can reallocate the labor into high productivity industries and raise its own average wage. The country with the absolute advantage will not lower its own average wage by importing because it can reallocate the labor into high productivity industries and raise its own average wage.

23 Myth 3: Exploitation Refusing to buy soccer balls or clothing produced in Third World countries because the pay is criminally low may in fact condemn those poor people to a worse fate. Refusing to buy soccer balls or clothing produced in Third World countries because the pay is criminally low may in fact condemn those poor people to a worse fate. The question to ask is “What is their alternative?” The question to ask is “What is their alternative?” Third World countries are exporting goods where they are relatively efficient and productive. If those industries were to close, the average productivity would fall and the average wage would be less. Third World countries are exporting goods where they are relatively efficient and productive. If those industries were to close, the average productivity would fall and the average wage would be less.

24 Comp. Adv. With Many Goods Suppose two countries both produce automobiles, banking services, crackers, DVDs, and education. Suppose two countries both produce automobiles, banking services, crackers, DVDs, and education. Which country will be the exporter and which country will be the importer will depend on the productivity of each industry and the wage in that country. Which country will be the exporter and which country will be the importer will depend on the productivity of each industry and the wage in that country. Wages in each country will be same across the industries, assuming no skill differences required. Wages in each country will be same across the industries, assuming no skill differences required.

25 Comp. Adv. With Many Goods Average wage in Country A (w A ) is different than average wage in Country B (w B ). Average wage in Country A (w A ) is different than average wage in Country B (w B ). Average wage times the number of labor units required for one unit of output will determine the cost per industry. Average wage times the number of labor units required for one unit of output will determine the cost per industry. If the cost of an industry is lower in Country A than in Country B, Country A will export and Country B will import. If the cost of an industry is lower in Country A than in Country B, Country A will export and Country B will import.

26 Unit Labor Requirements INDUSTRY A’s Labor Requirement B’s Labor Requirement Relative A Productivity Automobiles Banking Crackers133.0 DVDs Education

27 Trade Pattern Suppose wages in A relative to B are 2.5 times higher. Suppose wages in A relative to B are 2.5 times higher. Which industries will export from A to B? Which industries will export from A to B? Crackers and DVDs. Crackers and DVDs. Which industries will export from B to A? Which industries will export from B to A? Automobiles, banking and education. Automobiles, banking and education.

28

29 US trade with Turkey

30 The Importance of Non-Tradables In theory, every good and service should be tradable. In theory, every good and service should be tradable. However, to get a haircut in Canada would cost me quite a bit in terms of transportation costs. However, to get a haircut in Canada would cost me quite a bit in terms of transportation costs. Protection also increases the costs of imports and eliminates some industries from being imported in spite of cost advantage. Protection also increases the costs of imports and eliminates some industries from being imported in spite of cost advantage.

31

32 Empirical Tests Empirical tests usually show that productivity differences adjusted for wages do show what the model predicts: higher productivity industries export, lower productivity industries import. Empirical tests usually show that productivity differences adjusted for wages do show what the model predicts: higher productivity industries export, lower productivity industries import.

33 A Test of Ricardian Model MacDougall, G.D.A., “British and American Exports: A Study Suggested by the Theory of Comparative Costs,” Economic Journal, December If productivity in US relative to UK is greater than the relative wages, then exports of US for that industry must exceed exports of UK. Wages in the US were, on average, twice the UK levels data was used. Tariffs were in force. If both US and UK face the same barriers from the rest of the world, then their exports to the rest of the world should reflect their cost advantages. If (Productivity in US)/(Productivity in UK) > (Wages in US)/(Wages in UK), then (Exports of US)/(Exports of UK) > 1.

34 Labor Productivity and Comparative Advantage Paper Machinery Glass containers Motor cars Tin cans Pig iron Radios 2 4 Linoleum Cigarettes Hosiery Footwear Coke Rayon cloth Cotton Cement Beer Woolens and Worsteds Clothing Output per US worker Output per UK worker US Exports UK Exports

35 Shortcomings of the Ricardian Model There will be total specialization. There will be total specialization. There is no income distribution effects. There is no income distribution effects. There is no role for differences in resource endowments between countries. There is no role for differences in resource endowments between countries. There is only one resource, labor. There is only one resource, labor. There is no role for economies of scale. There is no role for economies of scale.