Labor Productivity and Comparative Advantage: The Ricardian Model Notes

Chapter 3: Labor Productivity and Comparative Advantage: The Ricardian Model

Introduction to Theories of Trade

• Key Theories of Why Trade Occurs:
  • Differences in resources across countries:
  • Labor
  • Labor skills
  • Physical capital
  • Natural resources
  • Technology
  • Economies of scale lead to greater efficiency at a larger scale of production.

Trade Models Overview

• Ricardian Model:
  • Focuses on differences in labor productivity due to varying technologies in different countries.
• Heckscher-Ohlin Model:
  • Analyzes how countries differ in factors like labor, capital, and land.

Ricardian Model of Trade

• Developed by British economist David Ricardo
• Introduced the concept of comparative advantage in his book "Principles of Political Economy and Taxation" (1817).

Comparative Advantage and Opportunity Cost

• Opportunity Cost:
  • Defined as what must be given up to obtain something.
  • For instance, the opportunity cost of attending a movie is the studying time lost for an exam.
• Examples in Production:
  • If the U.S. can produce 10 million roses or 100,000 computers, the opportunity cost for roses goes up to 100,000 computers.
  • In Colombia, the opportunity cost is 10 million roses for 30,000 computers.

Determining Opportunity Costs

• To find opportunity costs between the U.S. and Colombia for roses and computers:
  • U.S.: 7.5 roses for 1 computer.
  • Colombia: 3.33 roses for 1 computer.
  • Comparative Advantage Outcome:
  • Colombia has a comparative advantage in roses.
  • The U.S. has a comparative advantage in computers.

Trade and Specialization

• When countries focus on their comparative advantages, production increases, leading to more goods available for consumption.
• An example from the U.S. and Colombia moving resources to make 100,000 computers and more roses becomes evident through specialization.

One-Factor Ricardian Model

• Assumptions of the Model:
  1. Two goods: wine and cheese.
  2. Two countries: home and foreign.
  3. Labor is the only factor of production.
  4. Labor productivity varies across countries due to technology differences.
  5. Labor supply in each country is constant.
  6. Markets are perfectly competitive.
  7. Consumers have identical preferences.

Understanding Unit Labor Requirements and Productivity

• Unit Labor Requirement: Indicates the labor hours needed to produce one unit of output.
  • Example: If aLC = 2, 1 hour can produce 0.5 pounds of cheese.
• Higher unit labor requirements indicate lower productivity.

Production Possibilities Frontier (PPF)

• Depicts the maximum output combinations possible for fixed resources.
• For the home economy: a{LC}QC + a{LW}QW \leq L
• Opportunity cost is shown as the slope of the PPF.

Relative Prices, Wages, and Supply

• Relative Prices: Ratio of prices for goods (e.g., cheese vs. wine).
  • The opportunity cost drives the relative prices and shapes decision-making in terms of production and wages.
• Workers are drawn to industries with higher wages:
  • wC = rac{PC}{a_{LC}}
  • wW = rac{PW}{a_{LW}}

The Dynamics of Supply Under Trade

• Trade Introduces: Foreign variables impacting the domestic economy leading to different specializations based on comparative advantages.
  • Even a country that is efficient in all respects can only have a comparative advantage in one area.

Gains from Trade and Income Effects

• Shifts resources to more productive sectors allowing for greater production outputs.
• After trade, countries can consume at points outside their individual PPFs, allowing access to a greater variety of goods.
  • E.g., when Home specializes in cheese, it can trade for wine, yielding better outcomes than producing everything in-house.

Relative Wages and Labor Dynamics

• Wages adjust based on supply changes; higher productivity leads to higher wages, affecting relative wages globally.
• Disparities in wages reflect productivity differences and can lead to fear over trade's effect on lower-wage countries.

Misconceptions about Free Trade

1. Productivity Misunderstandings:
   • Free trade benefits all levels of productivity by allowing countries to avoid inefficient production.
2. Wage Impact Miscommunication:
   • Trade does not universally hurt high-wage countries as it can provide benefits elsewhere.
3. Exploitation Views:
   • Labor conditions are often a space for broader discussion about trade's impacts versus necessary reforms.

Conclusion & Empirical Evidence of the Ricardian Model

• Trade benefits arise through specialization based on comparative advantage.
• Empirical evidence supports that differences in productivity drive trade patterns and specialization benefits—both enhancing consumption and production.
  • Countries engage in trade that reflects their comparative advantage, leading to global economic interconnectedness and efficiency.