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Ricardo's model: productivity differences as a determinant of trade

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David Ricardo developed the classical theory of comparative advantage in 1817 to explain why countries engage in international trade even when one country's workers are more efficient at producing every single good than workers in other countries. He demonstrated that if two countries capable of producing two commodities engage in the free market, then each country will increase its overall consumption by exporting the good for which it has a comparative advantage while importing the other good, provided that there exist differences in labor productivity between both countries.[10][11] Widely regarded as one of the most powerful[12] yet counter-intuitive[13] insights in economics, Ricardo's theory implies that comparative advantage rather than absolute advantage is responsible for much of international trade.[14]

Countries trade internationally for two reasons:

  • Exploiting differences between countries:
    • Factor endowment (capital, labour, natural resources)
    • productivity
  • In order to exploit economies of scale in production...

Definitions and notations:

  • Labor productivity =
Number of units produced per unit of work
  • Unit quantities of work =
Unit coefficient
Number of work units required per product unit
  • Ricardo's production function

The law of comparative advantage[edit | edit source]

The law of comparative advantage describes how, under free trade, an agent will produce more of and consume less of a good for which they have a comparative advantage.[15]

In an economic model, agents have a comparative advantage over others in producing a particular good if they can produce that good at a lower relative opportunity cost or autarky price, i.e. at a lower relative marginal cost prior to trade.[16] Comparative advantage describes the economic reality of the work gains from trade for individuals, firms, or nations, which arise from differences in their factor endowments or technological progress.[17] (One should not compare the monetary costs of production or even the resource costs (labor needed per unit of output) of production. Instead, one must compare the opportunity costs of producing goods across countries[18]).[19]

An example[edit | edit source]

On Valentine's Day the demand for flowers in the United States is 10 million.

Producing flowers in February in the United States is expensive.

The resources used to produce flowers can be used to produce something else: computers.

Flower production has an opportunity cost in terms of computers (or some other good).

Suppose that in the United States 10 million flowers can be produced with the same resources as 100,000 computers.

Suppose that in South America 10 million flowers can be produced with 30,000 computers.

The 10 million flowers have a lower opportunity cost in South America => specialization in flower production.

Trade gains and comparative advantage: If instead of producing the 10 million flowers they need in the USA, they specialise in computer production and South America specialises in flower production, and they trade, then the "world" will have 70,000 more computers at its disposal.

Économie internationale avantage comparatif exemple 1.png

In Ricardo's model, comparative advantage is determined by relative labour productivity.

Absolute vs. comparative advantage[edit | edit source]

Not all individuals (countries) have an absolute advantage...

The good news is that all countries (individuals) have a comparative advantage: an activity in which one is relatively better than anyone else (as long as there are more activities than countries). Specialization in the activity in which one is relatively better is a source of gain to trade, even when one has no absolute advantage (notion of opportunity cost).

Example: Tony Parker plays basketball better than his gardener. He also cuts the grass faster. Parker therefore has two absolute advantages over his gardener and his gardener has none. However, it is reasonable for Parker to have a gardener. Why does he need a gardener? Because Parker's opportunity cost for the gardening business is much greater than that of his gardener who doesn't play in the NBA.

Ricardo's closed economy[edit | edit source]

Assumptions[edit | edit source]

Labour is the only factor of production

His offer is fixed (perfectly inelastic).

Labour productivity is fixed

Two substitutable goods are produced, namely cheese and wine.

Perfect competition on all markets (goods and labour)

Production possibilities[edit | edit source]

The Production Possibilities Frontier (PPF) gives us the maximum amount of wine that can be produced given the amount of cheese produced.

  • We start from the condition of equilibrium on the labour market :
  • And we solve for (ou ) :
The frontier of production possibilities: Corresponds to figure 3.1 on page 34 of KOM (2012).

Balance of production in the closed economy[edit | edit source]

= price of wine, = cheese price.

= wine salary, = cheese wage

If perfect competition => no profit:

  • =>
  • =>

Perfect mobility of work between the two sectors therefore:

  • If (that is, if
then no wine production
  • If (that is, if
then no cheese production
Production balance.

In a closed economy both goods are produced (because quantities produced = quantities consumed) and as perfect mobility of labour between the two sectors, in balance:

So

Relative price of autarky = opportunity cost</math>

The quantities consumed/produced of each good are determined by the relative demand for the two goods at the relative price set by the unit labour coefficients.

The autarky balance: The autarky quantities consumed are determined by the relative demand conditions.

Trade in the Ricardo model[edit | edit source]

Assumptions[edit | edit source]

Two countries: Home and Foreign*

Two properties: Cheese and Wine

Labour is the only factor of production

His offer is fixed (perfectly inelastic).

Labour productivity is fixed

Perfect competition in all markets: goods and labour

We export the good in which we have a comparative advantage and import the other good.

If => Home has a comparative advantage in cheese production (lower opportunity cost than Foreign)

In free trade balance, we have (complete?) specialization of Home in Cheese and Foreign in Wine.

The equilibrium price is determined by the intersection of relative demand and supply.

Relative global demand and supply[edit | edit source]

Corresponds to figure 3.3 on page 38 of KOM (2012).
Corresponds to figure 3.3 on page 38 of KOM (2012).
Corresponds to figure 3.3 on page 38 of KOM (2012).

Gains from trade[edit | edit source]

Note: in an open economy, the frontier of production possibilities (from slope to slope) is not the same as in an open economy. and the consumer's budget constraint (of slope are no longer necessarily confused!

Let's remember that

Corresponds to figure 3.4 on page 39 of KOM (2012).

Salaries[edit | edit source]

In the presence of trade, the prices of goods are identical in both countries (otherwise arbitration).

Thus, absolute productivity differences between countries mean that wages are not necessarily equal.

But as long as the relative price of free trade is between the two prices of autarky, (real) wages rise in both countries when trade is opened up.

Empirical evidence on Ricardo's model[edit | edit source]

Despite higher absolute productivity in the United States than in England at the end of World War II, exports from both countries were in line with the prediction of Ricardo's model (McDougall, EJ 1951).

Économie internationale évidence empirique sur le modèle de Ricardo 1.png

Three misconceptions about comparative advantage[edit | edit source]

« Openness to free trade can only benefit an economy if it is sufficiently efficient or competitive. »

Wrong: What determines gains in trade is not the absolute advantage, but the relative advantage.
et , Mais donc and so Home wins by specializing in cheese production, even though it is 10 times less productive than Foreign.

« Competition from low-wage countries is unfair and penalizes developed countries ("social dumping"). »

Wages reflect differences in absolute productivity between countries. And gains from trade are independent of absolute benefits.
Hourly labour costs in Europe.

« International trade allows companies and consumers in developed countries to exploit workers in the Third World by keeping wages low. »

Wrong: Trade increases workers' wages by allowing them to specialize where they are relatively more productive. When the price of the exportable good increases (Cheese), this leads to an increase in real wages.
The solution is not to stop trade, but to allow them to increase their productivity (education, institutions, respect for the law, etc.).

Summary[edit | edit source]

The Ricardian model is the simplest model to explain how differences between countries can lead to trade gains.

Labour is the only factor of production and gains from trade are explained by differences in relative productivity between countries.

In the Ricardian model, a country will export the good in which it has a comparative advantage, and import the good in which it has a comparative disadvantage, even when it has an absolute advantage in the production of that imported good.

Gains to trade can be seen as :

  • Trade being a more productive indirect method of production...
  • An expansion of the countries' consumption possibilities

The distribution of gains to trade will depend on the difference between relative prices of autarky and relative prices of free trade.

The basic prediction of the Ricardian model that a country exports more of the good in which it has higher relative productivity (regardless of its absolute productivity) has been confirmed by a large number of studies.

Annexes[edit | edit source]

References[edit | edit source]

  1. Page personnelle de Federica Sbergami sur le site de l'Université de Genève
  2. Page personnelle de Federica Sbergami sur le site de l'Université de Neuchâtel
  3. Page personnelle de Federica Sbergami sur Research Gate
  4. Céline Carrère - Faculté d'économie et de management - UNIGE
  5. Céline Carrère - Google Scholar Citations
  6. Director Céline Carrère - Rectorat - UNIGE
  7. Céline Carrère | Sciences Po - Le Laboratoire Interdisciplinaire d'Evaluation des Politiques Publiques (LIEPP)
  8. Céline Carrere - EconPapers
  9. Céline Carrère's research works - ResearchGate
  10. Baumol, William J. and Alan S. Binder, 'Economics: Principles and Policy', p. 50
  11. O'Sullivan, Arthur; Sheffrin, Steven M. (2003) [January 2002]. Economics: Principles in Action. The Wall Street Journal: Classroom Edition (2nd ed.). Upper Saddle River, New Jersey: Pearson Prentice Hall: Addison Wesley Longman. p. 444. ISBN 978-0-13-063085-8. 
  12. Steven M Suranovic (2010). "International Trade Theory and Policy". 
  13. Krugman, Paul (1996). "Ricardo's Difficult Idea". Retrieved 2014-08-09. 
  14. Wikipedia contributors. (2020, February 11). Comparative advantage. In Wikipedia, The Free Encyclopedia. Retrieved 08:40, March 9, 2020, from https://en.wikipedia.org/w/index.php?title=Comparative_advantage
  15. Dixit, Avinash; Norman, Victor (1980). Theory of International Trade: A Dual, General Equilibrium Approach. Cambridge: Cambridge University Press. p. 2. 
  16. "BLS Information". Glossary. U.S. Bureau of Labor Statistics Division of Information Services. February 28, 2008. Retrieved 2009-05-05. 
  17. Maneschi, Andrea (1998). Comparative Advantage in International Trade: A Historical Perspective. Cheltenham: Elgar. p. 1. 
  18. "The Theory of Comparative Advantage: Overview". Flat World Knowledge. Retrieved 23 February 2015. 
  19. Wikipedia contributors. (2020, February 11). Comparative advantage. In Wikipedia, The Free Encyclopedia. Retrieved 08:40, March 9, 2020, from https://en.wikipedia.org/w/index.php?title=Comparative_advantage