1. 1 Ricardian Model INTERNATIONAL ECONOMICS, ECO 486 JDE notes to supplement the text. David Ricardo April 18, 1772 — September 11, 1823

2. 2 Learning Objectives Understand five more assumptions Determine and understand comparative and absolute advantage Find international trade equilibrium Explain gains from trade Derive range of wages that will permit trade

3. 3 Learning Objectives Understand five more assumptions Determine and understand comparative and absolute advantage Find international trade equilibrium Explain gains from trade Derive range of wages that will permit trade

4. 4 Assumptions #8 -- Factors of production cannot move between countries #9 -- There are no barriers to trade in goods.

5. 5 Assumptions #10 #10 -- Exports must pay for imports Assumptions 8-10 apply to both the Classical and HO Models Assumptions 11 & 12 apply only to Classical Model

6. 6 Assumptions #11 -- Labor is the only relevant factor of production in terms of productivity analysis or costs of production. #12 -- Production exhibits constant returns to scale, CRS, between labor and output. –If both inputs, K & L, are doubled, output doubles –Implies Linear PPF and complete specialization

7. 7 Ricardian Theorem A country exports that good which has higher comparative factor productivity and imports the commodity which has lower comparative factor productivity than the other country. –Page 48, Ravendra N. Batra, Studies in the Pure Theory of International Trade

8. 8 Differing technologies and resource endowments Labor productivity Country ACountry B Soybeans4 (kg./hr.)1 (kg./hr.) Textiles2 (m./hr.)1.5 (m./hr.) Labor endowment 1000 (hr./yr.)800 (hr./yr.)

9. 9 Differing Opportunity Costs Opportunity Costs Country ACountry B Soybeans (m./kg.) Textiles (kg./m.)

10. 10 Differing Opportunity Costs Opportunity Costs Country ACountry B Soybeans (m./kg.) 2/4 = ½ = 0.5(m./kg.) 1.5/1 = 1.5(m./kg.) Textiles (kg./m.) 4/2 = 2 (kg./m.) 1/1.5 = 2/3 = 0.67 (kg./m.)

11. 11 Production possibility frontiers: (a) country A; (b) country B.

12. 12 Autarky Given perfect competition, 1.P = MC 2.Autarky price of S (on x-axis) equals slope of PPF 3.Resource payments correspond to their productivity

13. 13 Pretrade equilibriums: (a) country A; (b) country B.

14. 14 Learning Objectives Understand five more assumptions Determine and understand comparative and absolute advantage Find international trade equilibrium Explain gains from trade Derive range of wages that will permit trade

15. 15 Absolute Advantage Compare one good across countries. Country with greater output per labor hour has an absolute advantage in that good.

16. 16 Comparative Advantage Calculate opportunity costs. Compare one good across countries. Country with lower opportunity cost has a comparative advantage in that good.

17. 17 Which Advantage? Absolute advantage is a special case. Comparative advantage is the general case.

18. 18 Learning Objectives Understand five more assumptions Determine and understand comparative and absolute advantage Find international trade equilibrium Explain gains from trade Derive range of wages that will permit trade

19. 19 Terms of Trade Once trade begins, an international equilibrium results Results in one world price for a good

20. 20 Terms of Trade Once trade begins, an international equilibrium results Results in one world price for a good –called the terms of trade –between the two autarky prices –determined by reciprocal demand

21. 21 International Trade Equilibrium Complete specialization in Comparative Advantage good CIC & ToT tangent at consumption point Congruent trade triangles imply balanced trade

22. 22 Posttrade equilibriums: (a) country A; (b) country B.

23. 23 Learning Objectives Understand five more assumptions Determine and understand comparative and absolute advantage Find international trade equilibrium Explain gains from trade Derive range of wages that will permit trade

24. 24 Gains From Trade More of both goods attainable GDP increases at pre-trade prices Higher CIC is attainable

25. 25 Gains From Trade More of both goods attainable GDP increases at pre-trade prices Higher CIC is attainable CIC can isolate two sources of gain: –production (gains from specialization) –consumption (trade price better than autarky price)

26. 26 The gains from trade (country A).

27. 27 Country A’s trading equilibrium.

28. 28 Learning Objectives Understand five more assumptions Determine and understand comparative and absolute advantage Find international trade equilibrium Explain gains from trade Derive range of wages that will permit trade

29. 29 Exchange Rates State exchange rate, E, in US dollars per UK pound – say $2/£ A good will be imported if its foreign pre- trade price (x E) is less than the domestic price  P S < E x P S *

30. 30 Buy Low... Trade requires  P S < E x P S *  P T > E x P T *  autarky prices  Home (A) has comparative advantage in S  Foreign (B) has comparative advantage in T

31. 31 Perfect Competition Review (Product & Resource Markets) P X = MC for a good, X MC = w/MPP L (Labor, L, is only var. input) w=MRP L =(MR) MPP L =(P) MPP L =VMP L

32. 32 Perfect Competition Review (Product & Resource Markets) P X = MC for a good, X MC = w/MPP L (Labor, L, is only var. input) w=MRP L =(MR) MPP L =(P) MPP L =VMP L MRP L = Marginal Revenue Product MR = Marginal Revenue; MPP L = Marginal Physical Product of L VMP L = Value Marginal Product of L

33. 33 Prices & Wages P X = MC = w/MPP L MPP L is measured as units of X per hour, O LX Productivity may be stated as hours per unit of X, a LX, or units of X per hour worked, O LX. a LX = 1/O LX P X = w /O LX

34. 34 Trade & Wages Substitute P X = W /O LX  W/O LS < E x W* /O* LS  W/O LT > E x W*/O* LT To solve divide both sides by (E x W*) multiply both sides by O LS or O LT

35. 35 Trade & Wages (Cont.)

36. 36 Trade & Wages (Cont.) A’s relative wage must not exceed its relative productivity in its comparative advantage good.

37. 37 Trade & Wages (Cont.) A’s relative wage must exceed its relative productivity in its comparative disadvantage good (T).

38. 38 Competitive Advantage The ability to sell a good at the lowest price. Usually results from comparative advantage Alternatively, it may be the result of... –Government subsidies for inefficient industries –An undervalued exchange rate

39. 39 Losing Competitive Advantage If Home’s relative wage ratio (W/W*) exceeds its relative productivity (O LS /O LS *), its S will cost _______ than Foreign’s. If a country’s currency is overvalued (say $1/£ instead of $2/£), comparative advantage may be lost -- both goods may be cheaper in ___________.

40. 40 Losing Competitive Advantage If Home’s relative wage ratio (W/W*) exceeds its relative productivity (O LS /O LS *), its S will cost more than Foreign’s. If a country’s currency is overvalued (say $1/£ instead of $2/£), comparative advantage may be lost -- both goods may be cheaper in Britain.

41. 41 Country A’s price-consumption curve.

42. 42 Derivation of country A’s offer curve.

43. 43 International trade equilibrium.

44. 44 Cambodian Textiles Update US offered to expand Cambodia’s export quota by 14% if “working conditions is the Cambodia textile and apparel sector substantially comply with” local and internationally recognized core standards. Dec ’99 – US officials decide that Cambodia has fallen short, but offered 5% –Cambodia to establish independent monitoring with the International Labor Organization, ILO

45. 45 Cambodian Textiles Update ILO leery, fearing weakening of local monitoring capability ILO agrees after US pledges $500,000 in technical assistance to Cambodian labor ministry US also paying $1 million (of $1.4 mil.) for a 3-year monitoring effort –USTR press release 18 May 2000

46. 46 Cambodian Textiles Update Sep ’00 – US officials grant Cambodia another 4% increase –9% increase continued for ’01 Other news: –Nov ’00 -- ILO rules Burma’s progress on forced labor inadequate. Section 33 action authorized. As of March ’01, no member country has taken action. US & EU considering sanctions –Bush proposed reducing US contributions to the ILO budget.

47. 47 0 2 4 6 8 10 2 4 6 8 10 SOYBEANS, S (millions of bushels per year) L Quantity of Soybeans Demanded H CIC 1 CIC 2 CIC 0 G Autarky General Equilibrium |slope PPF| = P S /P T = 2 yd.T/bu.S TEXTILES, T (millions of yards per year) PPF P S /P T = 1 yd.T/bu.S P S /P T = 2.5 yd.T/bu.S 4.7 1.8

48. 48 0 2 4 6 8 10 2 4 6 8 10 SOYBEANS, S (millions of bushels per year) C Degree of Specialization X CIC 1 CIC 2 CIC 0 G Autarky Equilibrium TEXTILES, T (millions of yards per year) PPF C = COMPLETE SPECIALIZATION, ALLOWS GREATER CONSUMPTION X = COMPLETE SPECIALIZATION, P = PARTIAL SPECIALIZATION P D

49. 49 Tony Auth, NY Times editorial cartoon, December 2, 1999