TRADE AND TECHNOLOGY: THE RICARDIAN MODEL

TRADE AND TECHNOLOGY: THE RICARDIAN MODEL
2 TRADE AND TECHNOLOGY: THE RICARDIAN MODEL 1 Reasons for Trade 2 Ricardian Model 3 Determining the Pattern of International Trade 4 Solving for International Prices 5 Conclusions

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Introduction Why does the U.S. import goods that it could easily produce itself with its great manufacturing capability? The first part of this book looks at the various reasons for trade: Technological differences Differences in amounts of resources Differences in costs of outsourcing The proximity of countries to each other © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Introduction This chapter focuses on how technology differences across countries affect trade. Ricardian model proposed by the 19th century economist David Ricardo. It explains how the level of a country’s technology affects wages paid to labor in a way that countries with better technology have higher wages. We use this to explain a country’s trade pattern—the products it exports and imports. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Reasons for Trade Proximity The closer countries are the lower the costs of transportation. Resources A country can have resources that give it an edge in the production of certain goods. A country with a lot of snow may be very good at producing snowboards. Resources are also called factors of production—the land, labor, and capital used to produce goods and services. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Reasons for Trade Absolute Advantage When a country has the best technology for producing a good, it has an absolute advantage in the production of that good. Comparative Advantage Absolute advantage is actually not a good explanation for trade patterns. A country has a comparative advantage in producing those goods that it produces best compared with how well it produces other goods. China does not have an absolute advantage compared to U.S. but is better at producing snowboards than some other goods. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

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. Home will be the country exporting wheat and importing cloth. Assume that labor is the only factor of production. Note that the model has two goods and one factor of production. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Ricardian Model The Home Country 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. We can use the marginal products of labor to construct Home’s Production Possibilities Frontier. The PPF shows all feasible combinations of wheat and cloth. Assume there are 25 workers in Home. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Ricardian Model Using the setup, we can show: 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. 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. It is the ratio of the marginal products. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Ricardian Model Figure 2.1 Figure 2.1 Home Production Possibilities Frontier The Home PPF is a straight line between 50 yards of cloth and 100 bushels of wheat. The slope of the PPF equals the negative of the opportunity cost of wheat, that is, the amount of cloth that must be given up (yard) to obtain 1 more bushel of wheat. Equivalently, the magnitude of the slope can be expressed as the ratio of the marginal products of labor for the two goods. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Ricardian Model Home Indifference Curve Given Home’s 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. All points on an indifference curve have the same level of utility. Points on higher indifference curves have higher utility. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

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 Figure 2.2 Home Equilibrium with No Trade Points A and B lie on the same indifference curve and give the Home consumers the level of utility U1. The highest level of Home utility on the PPF is obtained at point A, which is the no-trade equilibrium. Point D is also on the PPF but would give lower utility. Point C represents a higher utility level but is off of the PPF, so it is not attainable in the absence of international trade. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

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. Refer to this as the no-trade equilibrium. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

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. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

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. wage = P*MPL for each industry. In competitive markets, labor can move freely between industries. Wages must be equal across industries. Equalization of wages implies that: This is the relative price of wheat. Cost of wheat in terms of cloth. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Ricardian Model The Foreign Country Assume Foreign’s technology is inferior to Home’s. Foreign has an absolute disadvantage in producing both wheat and cloth as compared to Home. 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. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Ricardian Model Figure 2.3 Figure 2.3 Foreign Production Possibilities Frontier The Foreign PPF is a straight line between 100 yards of cloth and 100 bushels of wheat. The slope of the PPF equals the negative of the opportunity cost of wheat, that is, the amount of cloth that must be given up (1 yard) to obtain 1 more bushel of wheat. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Ricardian Model Comparative Advantage Given the opportunity cost information, we can determine comparative advantages in each country for each good. The table below shows the opportunity cost of each good for both countries: Cloth (1 Yard) Wheat (1 Bushel) Home 2 Bushels of Wheat ½ Yard of Cloth Foreign 1 Bushel 1 Yard © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

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. Foreign’s Opportunity cost of cloth is lower. Home has a comparative advantage in producing wheat. Home’s opportunity cost of wheat is lower. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Ricardian Model Equilibrium in Foreign Foreign’s preferences can also be represented by an indifference curve. The no-trade relative price of wheat is P*W/P*C = 1. The relative price exceeds Home’s no-trade relative price of wheat: P*W/P*C = ½ . The difference in relative prices comes from the comparative advantage that Home has in wheat. Shortly, we will show how these differences can form the basis for trade. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Ricardian Model—Foreign
Figure 2.4 Figure 2.4 Foreign Equilibrium with No Trade The highest level of Foreign utility on the PPF is obtained at point A*, which is the no-trade equilibrium. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Comparative Advantage in Apparel, Textiles, and Wheat
U.S. 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 U.S. with sales of $1.6 billion in 1999. Sales per employee were therefore $92,000. This is the average for all U.S. apparel producers. Textiles are even more productive with annual sales per employee of $140,000 in the U.S. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

In China, however, sales per employee are only $13,500 in apparel and $9,000 in textiles. The U.S. is 7 times more productive in apparel and 16 times more productive in textiles. So the U.S. has the absolute advantage in these products. For wheat, the U.S. produces 27.5 bushels per hour of labor. China produces only 0.1 bushel per hour of labor. The U.S. is thus 275 times as productive in wheat. It thus has the absolute advantage in wheat. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Since the absolute advantage in wheat for the U.S. is even greater than in apparel and textiles, it has the comparative advantage in wheat. China has the comparative advantage in apparel and textiles because its productive disadvantage relative to the U.S. is less than in wheat. This explains why the U.S. imports apparel and textiles from China despite higher productivity in the U.S. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Can Comparative Advantage be Created? The Case of “Icewine”
In general we think of a country having a comparative advantage in a good. Certain countries have a comparative advantage in the production of wine. Can a country create a comparative advantage? Areas that get very cold are not good wine producers because the vines get too cold. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Can Comparative Advantage be Created? The Case of “Icewine”
The Niagara Falls region of Canada began producing a product called “icewine” in 1983; it’s now made in British Columbia, too. The grapes are allowed to freeze on the vine before they are picked. The unique flavor of the wine has led to a relatively high demand. This has created a comparative advantage in a certain type of wine, even though Canada does not have the advantage in traditional wine production. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Determining the Pattern of International Trade
What happens now when goods are traded between Home and Foreign? We will see the country’s no-trade relative price determines which product it will export and which it will import. The no-trade relative price equals its opportunity cost of production. Therefore, the pattern of exports and imports will be determined by the opportunity costs of production in each country—their comparative advantage. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

International Trade Equilibrium Relative price of cloth in Foreign is PC/PW = 1. Relative price of cloth in Home is PC/PW = 2. Therefore Foreign would want to export their cloth to Home—they can make it for $1 and export it for more than $1. How Trade Occurs As Home exports wheat, quantity of wheat sold at Home falls. The price of wheat at Home is bid up. More wheat goes into Foreign’s market. The price of wheat in Foreign falls. Similar logic applies to cloth. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

International Trade Equilibrium Two countries are in a trade equilibrium when: the relative price of each good is the same in the two countries the amount of each good that the countries want to trade is equal In understanding the trade equilibrium we need to do two things: Determine the relative price of wheat or cloth in the trade equilibrium. See how the shift from the no-trade equilibrium to the trade equilibrium affects production and consumption in both Home and Foreign. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

International Trade Equilibrium The relative price of wheat in the trade equilibrium will be between the no-trade price in the two countries. Assume the free-trade price of PW/PC is 2/3. We can now take this price and see how trade changes production and consumption in each country. Home producers of wheat can earn more than the opportunity cost of wheat by selling it to Foreign. We can show this with our wage equations. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

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. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Home can export wheat at the international relative price of 2/3. For each bushel of wheat it exports, it gets 2/3 yards of cloth in return. In figure 2.5 we trace this out to get a new price line showing the world price. The world price line shows the range of consumption possibilities that a country can achieve by specializing in one good and trading. Remember: this is only a consumption possibility because production is still constrained by the PPF. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

The new world price, PW/PC = 2/3, shows us the new range of consumption possibilities U1 A Wheat, QW (bushels) Cloth, QC (yards) B Home production 50 25 The country can now achieve a higher utility with the new consumption possibilities U2 World price line, Slope = –2/3 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Home produces 100 bushels but consumes only 40, so exports equal 60 World price line, Slope = –2/3 U2 U1 Wheat, QW (bushels) Cloth, QC (yards) 50 100 Home produces 0 yards of cloth but consumes 40, so imports equal 40. Home consumption 40 C Home imports 40 yards of cloth 25 A Home production B 40 50 Home exports 60 bushels of wheat © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Trade allows a country to engage in consumption possibilities it did not have before trade. We can see this as Home can now be on a higher indifference curve with trade than they were without it. This is the first demonstration of gains from trade. Pattern of Trade and Gains from Trade From figure 2.5, we can also see that Home’s exports and imports are equal when valued in the same units. Trade is balanced. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Figure 2.6 Figure 2.6 Foreign Equilibrium with Trade With a world relative price of wheat of 2/3, Foreign production will occur at point B*. Through international trade, Foreign is able to export 2/3 yard of cloth in exchange for 1 bushel of wheat, moving down the world price line B*C*. Foreign consumption occurs at point C*, and total exports are 40 yards of cloth in exchange for imports of 60 bushels of wheat. Relative to its pretrade wheat and cloth consumption (point A*), Foreign consumes 10 more bushels of wheat and 10 more yards of cloth. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Pattern of Trade and Gains from Trade Each country is exporting the good for which it has the comparative advantage. This confirms that the pattern of trade is determined by comparative advantage. This is the first lesson of the Ricardian model. There are gains from trade for both countries. This is the second lesson of the Ricardian model. It refutes the notion that free trade benefits one country while harming the other. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Pattern of Trade and Gains from Trade However, we have not yet determined the level of wages across countries. Relative prices converge. Do wages? Wages do rise in each country, but they do not converge. (Important political implications) They are determined by absolute advantage, not comparative advantage. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Solving for Wages Across Countries As stated before, in competitive labor markets, firms will pay workers the value of their marginal product. Since Home produces and exports wheat, they will be paid in terms of that good—the real wage is MPLW = 4 bushels of wheat. The workers sell the wheat on the world market at a relative price of PW/PC = 2/3. We can use this to calculate the real wage in terms of cloth: (PW/PC)MPLW = (2/3)4 = 8/3 yards. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Solving for Wages Across Countries We can do this for Foreign as well and summarize: 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 Foreign workers earn less than Home workers as measured by their ability to purchase either good. This fact reflects Home’s absolute advantage in the production of both goods. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Wages are determined by absolute advantage and trade is determined by comparative advantage. This should make sense. The only way a country with poor technology can export at a price others are willing to pay is by having low wages. As a country develops better technology, its wages will rise. (Compare to autarky wages) Workers become better off through receiving higher wages. As countries engage in trade, the Ricardian model predicts that their real wages will rise. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

We can see this in the real world Per capita income in China in 1978 was estimated at $925. In 2000, per capita income in China had risen to $3750. Per capita income in India more than doubled from $1180 in 1978 to $2480 in 2000. It is strongly believed that the opportunity for these countries to engage in international trade has been crucial in raising their standard of living. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Labor Productivity and Wages
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. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Figure 2.7: Labor Productivity and Wages, 2001 Figure 2.7 Labor Productivity and Wages, 2001 Labor productivity is measured by value-added per hour of work and can be compared with the wages paid in manufacturing in various countries. The general ranking of countries—from highest to lowest—in terms of labor productivity is the same as the ranking in terms of wages: countries with higher labor productivity pay higher wages, just as the Ricardian model predicts. Source: U.S. Department of Labor, Bureau of Labor Statistics © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

We can also see the connection between productivity and wages over time. Figure 2.8 shows that the general upward movement in labor productivity is matched by upward movement in wages. This is also predicted by the Ricardian Model. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Figure 2.8 Figure 2.8 Labor Productivity and Wages over Time The trends in labor productivity and wages can also be graphed over time. The general upward movement in labor productivity is matched by upward movements in wages, as predicted by the Ricardian model. Source: U.S. Department of Labor, Bureau of Labor Statistics. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Solving for International Prices
In the previous analysis we assumed the world price of wheat was 2/3. In reality world price is determined by a market for exports and imports. We will derive a Home export supply curve. Shows the amount it wants to export at various relative prices. Similarly we will derive a Foreign import demand curve. Shows the amount of wheat that it will import at various relative prices. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Home Export Supply Curve The export supply curve will have the relative price of wheat on the Y-axis and the amount of wheat on the X-axis. We use the information in figure 2.9 to derive the curve. Compare production and consumption at each relative price. When Pw/Pc=1/2, Exports=0. When Pw/Pc=2/3, Exports=60. The flat portion of the export supply curve is a special feature of the Ricardian model. The PPF is a straight line. Production can occur anywhere along the PPF as workers shift between industries. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Figure 2.9 Home Export Supply Panel (a) repeats Figure 2-5 showing the trade equilibrium for Home with production at point B and consumption at point C. Panel (b) shows the Home export supply of wheat. When the relative price of wheat is ½, Home will export any amount of wheat between 0 and 50 bushels, along the segment A′B′ of the Home export supply curve. For relative prices above ½ Home exports more than 50 bushels, along the segment B′C′. For example, at the relative price of 2/3, Home exports 60 bushels of wheat. Figure 2.9 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Foreign Import Demand We can use a similar analysis to construct the import demand for wheat in figure 2.10. At the world relative price of 2/3, Foreign imports 60 bushels of wheat, C* and C*’. The no-trade equilibrium in Foreign, with a relative price of 1, is zero imports, A* and A*’. Production can shift from point A, at a price of 1, as workers move between industries: If workers all shift to cloth. Foreign imports 50 bushels of wheat, B* and B*’. This gives us the import demand curve. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Figure 2.10 Foreign Import Demand Panel (a) repeats Figure 2-6, showing the Foreign trade equilibrium with production at point B* and consumption at point C*. Panel (b) shows Foreign import demand for wheat. When the relative price of wheat is 1, Foreign will import any amount of wheat between 0 and 50 bushels, along the segment A*’B*’ of the Foreign import demand curve. For relative prices below 1, Foreign imports more than 50 bushels, along the segment B*’C*’. For example, at the relative price of 2/3, Foreign imports 60 bushels of wheat. Figure 2.10 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

International Trade Equilibrium We need to put the Home export supply together with the Foreign import demand. The exports from Home come from the excess domestic supply. The imports to Foreign come from the excess domestic demand. This is the World market for wheat (figure 2.11): Equilibrium price of 2/3 and trade of 60 bushels of wheat. This is the amount that clears the world market. Desired sales of Home equal the desired purchases by Foreign. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

Figure 2.11 Figure 2.11: World Market for Wheat Putting together the Home export supply curve and the Foreign import demand curve for wheat, the world equilibrium is established at point C ’, where the relative price of wheat is . At this price, Home exports of 60 bushels just equal Foreign imports of wheat. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

The Terms of Trade The price of a country’s exports divided by the price of its imports. For Home, PW/PC is their terms of trade. An increase in PW or a fall in PC will raise Home’s terms of trade. An increase in the terms of trade is good for a country: it makes it better off. A country will earn more for its exports. A country will pay less for its imports. For Foreign, PC/PW is the terms of trade and a higher relative price for cloth makes it better off. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

The Terms of Trade for Primary Commodities
Latin American economist Raúl Prebisch and British economist Hans Singer each put forward the hypothesis that the price of primary commodities would decline over time relative to the price of manufactured goods. Primary commodities are often exported by developing countries, so their terms of trade would decline over time. Empirical evidence for this theory is mixed. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

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TRADE AND TECHNOLOGY: THE RICARDIAN MODEL

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