The Ricardian Model

Topic 2 (continued)
Reference: Krugman, P. and Obsfeld, M. and Melitz, M., International Economics: Theory and
Policy, 9th edition, Addison-Wesley (Chapter 3: Page 24-35)

This model of international trade was originally proposed by the British

economist David Ricardo, who introduced the concept of comparative
advantage in the early 19th century. Here, international trade is solely due to
international differences in the productivity of labor.

Assumptions:

Two countries: Home and Foreign

One-factor economy (Labor is the only factor of production)
Two goods can be produced- Wine and Cheese
Full Employment of Labor
Constant returns to scale
Zero profit in production
Technology can be summarized by unit labor requirement (the number
of hours required to produce a pound of cheese or a gallon of wine).
Note that we are defining unit labor requirement as the inverse of
productivity.

Production Possibilities at Home

aLW= unit labor requirement in wine at Home (e.g. 2)
aLC= unit labor requirement in cheese at Home (e.g. 1)
L= total labor supply at home (e.g. 1000)
QC= total production of cheese
Qw= total production of wine
Under full employment assumption, we must have
a LC Q C +a LW Q W L (1)

QW =

a
L
LC QC (2)
a LW a LW

Because any economy has limited resources, there are limits on what it can
produce and there are always trade-offs. To produce more of one good, the
economy must sacrifice some production of another good. These tradeoffs
are illustrated graphically by the Production Possibility Frontier (line PF in
figure 3-1).

We assume aLW=2, aLC= 1 and L= 1000, then if the economy devoted all its
L
labor to cheese production, it could, as shown in figure 3-1, produce aLC
pounds of cheese (1000 pounds). If it devoted all its labor in wine production
L
instead, it cound produce aLW gallons (1000/2=500 gallons) of wine.
When the PPF is a straight line, the opportunity cost of a pound of cheese in
terms of wine is constant. The absolute value of the slope of the PPF is the
opportunity cost. So from equation (2) the opportunity cost of cheese in
aLC
terms of wine is aLW .

Relative Prices and Supply

The PPF simply shows the different mixes of goods that an economy can
produce. But to determine what the economy will actually produce, we need
to look at prices.
In our simplified model, with labor as the only factor of production, the
supply of cheese and wine will be determined by the movement of labor to
whichever sector pays the higher wage.
Suppose aLW=2, aLC= 1, PC=$4 and PW=$7. If workers produce cheese, they
earn $4 an hour but if they produce wine they earn $3.5 per hour. So workers
will be better off producing cheese and the economy as a whole will produce
cheese.
Alternatively, suppose aLW=2, aLC= 1, but PC=$3 and PW=$7. If workers
produce cheese, they earn $3 an hour but if they produce wine they earn
$3.5 per hour. So workers will be better off producing wine and the economy
as a whole will produce wine.
More generally, the economy will produce cheese if the relative price of
cheese exceeds its opportunity cost in terms of wine; it will specialize in the
production of wine if the relative price of cheese is less than its opportunity
cost in terms of wine.
Here,

PC
PW

= relative price of cheese in terms of wine and

aLC
aLW

Opportunity cost of cheese in terms of wine.

Mathematically, produce cheese if

And produce wine if

P C a LC
4 1
>
(e . g . > )
PW a LW
7 2

P C a LC
3 1
<
(e . g . < )
PW a LW
7 2

In absence of trade, Home would have to produce both the goods itself. So
P C a LC
we must have PW = a LW . Thus in an autarky economy, the relative prices of
goods are equal to their relative unit labor requirement.

Introducing Trade in One-Factor Model

3

Now we consider another country- Foreign. We assume

aLW*= unit labor requirement in wine at Foreign
aLC*= unit labor requirement in cheese at Foreign
L*= total labor supply at Foreign
And Home is less productive than Foreign in wine but more productive in
cheese. So we have
a LW
a LC

aLC
<
aLW
The slope of the PPF is the opportunity cost of cheese in terms of wine. As
the above equation shows, Foreign's frontier is steeper than Home's.

In absence of trade, Home's relative price of cheese=

aLC
aLW

And Foreign's relative price of cheese=

aLW
aLC

However, with international trade, if the relative price of cheese is higher in

Foreign than Home, it will be profitable to ship cheese from Home to Foreign
and to ship wine from Foreign to Home. This cannot go on indefinitely.
Eventually relative prices will be equalized in both the countries.

Determining the Relative Price after Trade

We need a general equilibrium analysis which takes account of the linkages
between two markets.

RS=World relative supply curve

RD=World relative demand curve
World relative price is determined by intersection of RS and RD.
The funny 'step' shape (with flat sections linked by vertical sections) of the
RS can be explained by the derivation of the RS curve.
First, as drawn, the RS shows there is no supply of cheese if world
aLC
relative price drops below aLW . Because here,
a LW
a LC

P C a LC
<
<
PW a LW
So both Home and Foreign will specialize in wine production.

 Next when

P C a LC
=
PW a LW

Home will be willing to produce any relative

amount of the two goods, producing the flat section of the RS.
aLW
aLC

However, since
, Foreign will still specialize in wine production.
PC
<
PW
a LW
a LC

aLC PC
<
<
aLW PW

With

Home will specialize in cheese production and

Foreign will continue its wine production.

Here since all Home's labor will produce cheese, the production of
L
cheese at Home will be aLC and all Foreign's labor will produce
a LW
L

units of wine.

So the relative supply of cheese will be

L /aLC
L /aLW

At

aLW
aLC

, we know that Foreign workers are indifferent between

PC
=
PW

producing cheese and wine. Thus we again have another flat section of
RS.

*
LW

Numerically, if we assume: aLW= 2, aLC= 1, a

= 3 and aLC = 6 then

aLC 1
=
aLW 2

6
a LW= =2
3
a LC
and
.

When the RS intersects RD at point 1, the post-trade price will be in between

the pre-trade prices of 1/2 and 2, e.g. 1/2<1<2. In this case each country
specializes in the production of the good in which it has a comparative
advantage: Home produces cheese only and Foreign produces wine only.
If however, the relevant RD is RD' then intersection of RD' and RS will be at
point 2 where
a LW
a LC

aLC PC
=
<
aLW PW

(Or

1 1
= < 2 . So only Foreign specializes in wine production
2 2

but Home produces both cheese and wine.

For the time being, let's just ignore the intersection at point 2.
So the normal result of trade is that the price of a traded good (cheese)
relative to that of another good (wine) ends up somewhere in between its
pre-trade levels in the two countries.
Due to this convergence, each country will specialize in production of that
good in which it has a lower unit labor requirement.
The rise in the relative price of cheese at Home will lead Home to specialize
in cheese production (at point F in figure 3-4).
The fall in the relative price of cheese at Foreign will lead Foreign to
specialize in wine production (at point F* in figure 3-4).

The Gains from Trade

There are two ways in which gains from trade can be shown.

Trade as Indirect method of Production:

Home could produce wine directly, but trade with Foreign allows it to
"produce" wine by producing cheese and then trading the cheese for
wine. This indirect method of production is a more efficient method
than direct production.
E.g. Opportunity cost of cheese in terms of wine at Home is 1/2. But we
know that the relative price of cheese in terms of wine after trade will
be greater than this, say 1. So here, instead of producing 2 hours of
labor to produce a gallon of wine, it can use that labor to produce 2
pounds of cheese, and then trade that cheese for 2 gallons of wine.

Effect of trade on each country's PPF:

In absence of trade, the consumption possibilities are the same as
production possibilities (the solid lines PF and P*F*). Once trade is
allowed, the economy can consume a different mix of cheese and wine
from the mix it produces. The new consumption possibilities of Home
and Foreign are shown by TF and T*F* respectively.
So trade has enlarged the range of choice and so has made each
country better off.
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