Thus the sale of goods and services generates revenue to the firms that in turn is used to pay for the factor services (wages to workers in this case) used in production. This means that goods are identical in all their characteristics such that a consumer would find products from different firms indistinguishable. This also represents exports of cheese from the United States to France. Since the U.S. PPF is flatter than France’s, this means that the opportunity cost of cheese production is lower in the United States and thus indicates that the United States has the comparative advantage in cheese production. If Portugal is twice as productive in cloth production relative to England but three times as productive in wine, then Portugal’s comparative advantage is in wine, the good in which its productivity advantage is greatest. Thus labor cannot move from one country to another in search of higher wages. In the Ricardian model, the parameters (L, aLC, aLW) are exogenous. Chapter 2 "The Ricardian Theory of Comparative Advantage", Chapter 3 "The Pure Exchange Model of Trade", Chapter 5 "The Heckscher-Ohlin (Factor Proportions) Model", Chapter 6 "Economies of Scale and International Trade", Chapter 8 "Domestic Policies and International Trade", Section 8.3 "Production Subsidies as a Reason for Trade", Section 8.6 "Consumption Taxes as a Reason for Trade", http://socserv.mcmaster.ca/econ/ugcm/3ll3/smith/wealth/index.html, Section 2.12 "Appendix: Robert Torrens on Comparative Advantage", http://socserv2.socsci.mcmaster.ca/ ~econ/ugcm/3ll3/ricardo/prin/index.html, http://socserv2.socsci.mcmaster.ca/~econ/ugcm/3ll3/mill/index.html, Table 2.1 "Father’s Task Times without Son", Table 2.3 "Task Times with Incorrect Specialization", Chapter 4 "Factor Mobility and Income Redistribution", Figure 2.3 "Production Possibility Frontiers", Table 2.8 "Autarky Production and Consumption", Table 2.9 "Production with Specialization in the Comparative Advantage Good", Table 2.10 "Consumption and Production after Trade", http://socserv2.socsci.mcmaster.ca/~econ/ugcm/3ll3/smith/wealth/wealbk04, Table 2.14 "Changes in Real Wages (Autarky to Free Trade)", Figure 2.5 "Comparing Autarky and Free Trade Equilbriums". Adam Smith stated that countries could benefit from trade if they produce a specific good at a lower cost in comparison to its foreign counterpart and then trade its own product with a … Even in this case, each country will have a comparative advantage in the production of one of the goods. In the Ricardian model, opportunity cost is the amount of a good that must be given up to produce one more unit of another good. The primary issue in the analysis of this model is what happens when each country moves from autarkyThe situation in which a country does not trade with the rest of the world. is perhaps the most important concept in international trade theory. Economies of scale refer to a production process in which production costs fall as the scale of production rises. Assume the United States has a comparative advantage in cheese production relative to France. It is shown that the purchasing power of all workers’ wages in both countries would rise in moving to free trade. The following story is meant to explain some of the insights within the theory of comparative advantage by placing the model into a more familiar setting. For more information, see Rod Hay, “Adam Smith,” McMaster University Archive for the History of Economic Thought. As a matter of fact, Ohlin’s theory begins where the Ricardian theory of international trade ends. Learn how the plot of the labor constraint yields the production possibility frontier. Normally, when we measure the price and cost in dollar terms, when the price per unit exceeds the cost per unit, then positive profit is realized. However, by virtue of the wonders of the market mechanism, everyone is made better off as well. The U.S. PPF is given by the red line, while France’s PPF is given by the green line. Without international trade, each country would only be able to produce (and therefore to consume) any amount of both wine and cloth inside or at the country’s production-possibility frontier (green for England and red for Portugal). The father in the household sets aside one Sunday afternoon to do the job but hopes to complete the job as quickly as possible. (i.e., identical) across firms and countries. John Stuart Mill was concerned with reciprocal demand as he argued that it was not necessarily true that demand and supply across countries would be met. The PPS is represented by all the points within and on the border of the red triangle in Figure 2.1 "Production Possibilities". In corn? Ricardian theory of international trade Between 1500 and 1750 most economists advocated Mercantilism which promoted the idea of international trade for the purpose of earning bullion by running a trade surplus with other countries. In particular, we must describe the relationship between prices and wages. When countries move to free trade, the real wage with respect to the exported good remains constant, but the real wage with respect to the imported good rises in both countries. Suppose the productivities are aLSUS = 2 soap bars per worker, aLSE = 4 soap bars per worker, aLTUS = 8 toothbrushes per worker, and aLTE = 4 toothbrushes per worker. Fortunately, none of this is necessary if the market, or the invisible hand, is allowed to operate. In the example, the United States is consuming five gallons of wine and producing none, so it must import the five gallons from France. The real wageThe quantity of a good that can be purchased per unit of work. The Ricardian model assumes that all workers are identical, or homogeneous, in their productive capacities and that labor is freely mobile across industries. However, every worker who demands both wine and cheese will be able to buy more of both goods. In … It is the reciprocal of the unit labor requirement. To calculate autarky real wages, we simply plug the autarky price ratio into the real wage formulae. The PPF equation is a linear equation—that is, it describes a line. Learn how the autarky terms of trade is determined in a Ricardian model. As a result of trade, the price ratio, or terms of trade, will lie in between the two countries’ autarky price ratios. Real wages are typically measured by dividing nominal wages by a price index. The cheese workers’ wage is a quantity of cheese. Goods, or production factors, that are identical and thus perfectly substitutable in consumption, or production. Figure 2.3 Production Possibility Frontiers. What is labor productivity in the wine industry in England and in Portugal? In this case, neither country has a comparative advantage in anything. Because the idea of comparative advantage is not immediately intuitive, the best way of presenting it seems to be with an explicit numerical example as provided by Ricardo. In the Ricardian model, the PPF is linear. To calculate the free trade real wage, plug in the free trade price ratio. The higher price received for each country’s comparative advantage good would lead each country to specialize in that good. Ricardo, improving upon Adam Smith’s exposition, developed the theory of international trade based on what is known as the Principle of Comparative Advantage (Cost). Using the two production functions and the labor constraint, we can describe the production possibility frontier (PPF)The set of all output combinations that could be produced in a country when all the labor inputs are fully employed. In other words, X is the opportunity cost of producing cheese. The first theory section of this course develops models that provide different explanations or reasons why trade takes place between countries. Well, when the price of cheese in terms of wine exceeds the opportunity cost of cheese, it is also true, via cross multiplication, that. If these two countries specialize in their comparative advantage good, then world production rises for both goods. Learn to identify and distinguish absolute advantage and comparative advantage. Which country has the absolute advantage in beer? The real wage of wine workers in terms of wine is the quantity of wine that a wine worker can buy with a unit of work. Portugal would produce only wine, consuming Cw and exporting Xw to England, while England would produce only cloth, consuming Cc and exporting Xc to Portugal. allow the countries to trade freely thereafter. Also, because all workers receive the same wage in each country, the real wage calculations tell us that everyone benefits equally in each country. In this way, we might raise the well-being of all individuals despite differences in relative productivities. The first method, called absolute advantage, is the way most people understand technology differences. In this case, all the wine workers would want to move to the cheese industry for any wage greater than wW. A country with the higher price for a good in terms of the other good and compared to the other country will import that good. However, since the price of cheese in terms of wine rises, U.S. cheese workers can get more wine for each unit of cheese in exchange. To identify a country’s comparative advantage good requires a comparison of production costs across countries. The cost of producing wine in France is one half pound of cheese per gallon of wine, while in the United States, it is two pounds per gallon. Consumption and production after trade for the two countries is shown in Table 2.10 "Consumption and Production after Trade". On second thought, the father decides to let his son help according to the following procedure. Thus if. Note also that the slope of the line between A and B is given by the formula. This means that the cost of producing wine (in terms of cheese) exceeds the price of wine (also in terms of cheese). What three things must be achieved to maximize world output? Indeed, one of the most difficult aspects of economic analysis is how to interpret the conclusions of models. An absolute advantage arises when a country has a good with a lower unit labor requirement and a higher labor productivity than another country. of wine in New Zealand. Below we define two different ways to describe technology differences. How many bananas and machines would the United States produce if it applied half of its workforce to each good? We can write this as, where PC is the price of cheese in dollars per pound, wC is the wage paid to workers in dollars per hour, PCQC is total industry revenue, and wCLC is total industry cost. This means that no money is used to make transactions. French cheesemakers have all become winemakers because of specialization, which means all French workers are no worse off and most likely better off as a result of free trade. Using the relationship between wages and prices when zero profit results in the cheese industry implies that. Positive profit sends a signal to the rest of the economy and new firms enter the industry. This generates revenue to the firms and the cycle repeats again. First, consider the fate of U.S. cheese workers. Table 2.3 Task Times with Incorrect Specialization. If the price rises by a greater percentage than the wage, the ability to purchase that good falls and the worker may be worse off. With so many unrealistic assumptions, it is difficult for some people to accept the conclusions of the model with any confidence, especially when so many of the results are counterintuitive. Label the vertical distance X. In The Wealth of Nations, Adam Smith said, “[An individual is] led by an invisible hand to promote an end which was no part of his intention.”See Book 4, Chapter 2 in Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, McMaster University Archive for the History of Economic Thought, http://socserv2.socsci.mcmaster.ca/~econ/ugcm/3ll3/smith/wealth/wealbk04. It can be argued that world output would increase when the principle of comparative advantage is applied by countries to determine what goods and services they should specialise in producing. Is it possible to make up a different terms of trade such that one country enjoys all the benefits of increased production while the other is made worse off? The free trade prices will be those prices that equalize total supply of each good in the world with total demand for each good. Real wage is a measure of the purchasing power of a wage and is an effective measure of well-being. Firms are assumed to maximize profit, while consumers (workers) are assumed to maximize utility. France realizes a level of aggregate utility that corresponds to the indifference curve IAut∗. There is only one place: wine workers. Figure 2.5 "Comparing Autarky and Free Trade Equilbriums" compares autarky and free trade equilibriums for the United States and France. The rule used by perfectly competitive firms is to choose the output level that equalizes the price (. National welfare can be represented with a set of aggregate indifference curves plotted in a PPF diagram. This means that there is an increase in world productivity—more output per unit of labor. Plugging these values for LC and LW into the labor constraint yields the equation for the PPF: This equation has three exogenous variables (aLC, aLW, and L) that we assume have known values and two endogenous variables (QC and QW) whose values must be solved for. The wine workers earn a quantity of wine. The first known statement of the principle of comparative advantage and trade appears in an article by Robert Torrens in 1815 titled Essay on the External Corn Trade. The further from each production-possibility frontier, the better the terms of trade are, and therefore the gains from trade are also greater. The term describing the set of all output combinations that can be produced within an economy. However, because the model assumes full employment and costless mobility of labor, all these workers are immediately gainfully employed in the other industry. For example, the Chinese are likely to demand more rice than Americans, even if consumers face the same price. Overall efficiency declines in this case compared with the father acting alone. This occurs because labor is assumed to be homogeneous—that is, all labor is the same—and because there is free mobility between industries. Thus both countries can gain from trade. L = the labor endowment in Canada (the total number of hours the workforce is willing to provide), aLC = unit labor requirement in cheese production in Canada (hours of labor necessary to produce one unit of cheese), aLW = unit labor requirement in wine production in Canada (hours of labor necessary to produce one unit of wine). The Ricardian model plays an important pedagogical role in international economics, but has received scant empirical attention since the 1960s. With some algebraic manipulation, we can rewrite the PPF equation into the standard form for an equation of a line, generally written as y = mx + b, where y is the variable on the vertical axis, x is the variable on the horizontal axis, m is the slope of the line, and b is the y-intercept. A variable whose value is determined external to the model and whose value is known to the agents in the model. It would seem, however, that this is an unlikely occurrence. Since the differences in prices arise directly out of differences in technology between countries, it is the differences in technology that cause trade in the model. Points inside the PPF are production possibilities but correspond to underemployment of labor resources. The PPF formula is aLCQC + aLWQW = L. If we plug the exogenous variables for the United States into the formula, we get QC + 2QW = 24. Thus England would have the comparative advantage in cloth production relative to Portugal if it must give up less wine to produce another unit of cloth than the amount of wine that Portugal would have to give up to produce another unit of cloth. He introduced this theory for the first time in his book “On the Principles of Political Economy and Taxation”, 1817, using a simple numerical example concerning the trade between Portugal and the England in the following way: Let’s say the labour costs per unit of cloth (C) and wine (W) produced by England (E) and Portugal (P) are as those seen in the adjacent figure. define the technology of production in two countries. Only later did John Stuart Mill introduce demand into the model. In a two-country, two-good, one-factor Ricardian model, specialization in each country’s comparative advantage good can raise world output of both goods. But he did not explain how after all this comparative costs difference arises. Ricardo, improving upon Adam Smith’s exposition, developed the theory of international trade based on what is known as the Principle of Comparative Advantage (Cost). Since both countries are assumed to be the same size in the example, this indicates the U.S. absolute advantage in the production of both goods. After the father finishes rototilling, he begins planting seeds in the section the son has already raked. Endogenous variablesA variable whose value is determined as an outcome of, or solution to, the model. The modern version of the Ricardian model assumes that there are two countries producing two goods using one factor of production, usually labor. Instead, one must compare the opportunity costs of producing goods across countries. The term used to describe workers who have the same productivity in multiple industries. France, which began with three pounds of cheese and two gallons of wine in autarky, would now have six pounds of cheese and three gallons of wine. This means PW/PC falls, which also means that its reciprocal, PC/PW, rises. He assumed that the productivity of labor (i.e., the quantity of output produced per worker) varied between industries and across countries. Note that anything related exclusively to France in the model will be marked with an asterisk. The reduction in the number of firms reduces industry supply, which raises the product’s market price and raises profit for all remaining firms in the industry. Suppose the unit labor requirements are aLBUS= 8, aLBE = 4, aLMUS = 2, and aLME = 4. Next, suppose the barriers to trade that induced autarky are suddenly lifted and the United States and France are allowed to trade freely. This implies that to benefit from specialization and free trade, Portugal should specialize in and trade the good that it is “most better” at producing, while England should specialize in and trade the good that it is “least worse” at producing. The only case in which neither country has a comparative advantage is when the opportunity costs are equal in both countries. Thus, as long as individuals are profit seeking, the price differences that arise in autarky will be sufficient to induce export and specialization in the comparative advantage good. The term used to describe the quantity of steel that can be produced with an hour of labor. Suppose each country specialized in the wrong good. For instance, point E cannot be reached by any of these countries, since it is outside their production-possibility frontier. Let the two produced goods be wine and cheese. This means cheese workers are at least as well off in free trade as they were in autarky. Thus technological superiority is not enough to guarantee continued production of a good in free trade. The garden is prepared in less time with the son’s help than it could have been done independently by the father. 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