International and EU Economics:

3. The Ricardian Model

Lecturer & tutor: Zheng Wang

Office hours: Wed 1.30-3.30pm, Wharfe 222
Email: Z.Wang@hull.ac.uk

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 A man that lays the foundation

David Ricardo (1817)

Developed the concept of
comparative advantage
(CA). CA is the perennial
insight that trade can be
beneficial even if one
country is better at
producing all goods.
Provided arguably the first
rigorous model of
economics framed in his
labour theory of value.

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 Model Set-Up
Model assumptions:
2 countries: home and foreign
1 factor of production: labour
2 goods: wheat and cloth
Constant marginal product of labour
General concepts:
Autarky equilibrium
International trade equilibrium
Terms of trade

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 Technology
Home technology
Labour is the only factor used to produce both goods.
One worker can produce either 4 bushels of wheat or 2
yards of cloth.
The Marginal Product of Labour is the extra output
obtained by using one more unit of labour.
Notation: MPLW = 4 and MPLC = 2.
Alternatively, the production of 1 unit of wheat requires
worker and the production of 1 unit of cloth requires
worker.
Notation: aW = 1/4 and aC = 1/2.
(ai are called unit input coefficients)
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 Production possibilities
Home Production Possibilities Frontier (PPF)
We use the marginal products of labour to construct
Homes PPF.
Assume Home is endowed with 25 workers.
If all the workers were employed in wheat, the economy
could produce 100 bushels.
If they were all employed in cloth, it could produce a
maximum of 50 yards.
The PPF connects these two points.
Key insight: A countrys PPF is determined by its labour
productivity and its labour endowment.
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 Production possibilities
Homes production data is given by:
L = 25, MPLW = 4, MPLC = 2
Maximum wheat output: QW = MPLW(L) = 4x25 = 100
Maximum cloth output: QC = MPLC(L) = 2x25 = 50
This gives us a straight line PPF which is a unique feature of
the Ricardian model.
It assumes the marginal products of labour are constant.
We will consider the case where the marginal product of
labour is diminishing in the specific-factors model.

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Home PPF

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 Slope of PPF
The slope of the PPF can be calculated as the
ratio of marginal products of the two goods.
The slope also equals the opportunity cost of
wheatthe amount of cloth that must be given
up to obtain one more unit of wheat.
50 MPLC L
SlopePPF
100 MPLW L
MPLC 1

MPLW 2

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 Demand
Home Indifference Curve
Given Homes PPF, how much wheat and cloth will
home actually produce? The answer depends on
demand.
Demand can be represented with indifference
curves.
An indifference curve shows the combinations of
two goods that the country can consume and be
equally satisfied.

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 Home preferences
All points on an indifference curve have the
same level of utility.
Points on higher indifference curves have
higher utility.
Indifference curves are often used to show the
preferences of an individual.
But we use indifference curves to show the
preferences of an entire economy.

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Autarky (no-trade) equilibrium

The country is indifferent between A

and B.
The country would be better off on U2,
but C is not feasible to produce.
U0<U1<U2

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 Autarky equilibrium
Autarky equilibrium (at home)
Without trade, the consumption opportunities are
constrained by the production opportunities.
With perfectly competitive markets, the country will
produce at its highest level of utility within the limits of the
PPF.
The highest level of utility that can be reached within the
PPF is U1 with production taking place at point A.
Key insight: under autarky, the economys production point
must coincide with its consumption point.

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 Autarky equilibrium
Equlibrium prices and wage rate
Zero profit condition in wheat (price=marginal cost):
PW = w aW (price = wage rate * labour units)
Zero profit condition in cloth (price=marginal cost):
PC = w aC (price = wage rate * labour units)
PW /PC = aW /aC = MPLC/MPLW
Key insight: relative autarky prices depend only on relative
productivities and not at all on consumer preferences.
=> w= PWMPLW= PCMPLC
Workers are paid a common wage which equals the value of
their marginal productivity in each sector.
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 Foreign Economy
Foreign Economys production possibilities
Assume one foreign worker can produce either one
bushel of wheat or one yard of cloth.
MPL*W = 1, MPL*C = 1 (a*W = 1, a*C = 1)
Since MPL*W <MPLW and MPL*C < MPLW , Foreign has
an absolute productivity disadvantage in each good.
Assume Foreign is endowed with 100 workers.
If all foreign workers were employed in the wheat
sector, they could produce 100 bushels.
If all workers were employed in cloth sector, they could
produce a maximum of 100 yards.

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Foreign PPF

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 Foreign autarky equilibrium
Foreigns preferences are also represented by
indifference curves and production occurs at the
point of highest utility within the foreign PPF.
The slope of the foreign PPF is also the foreign
opportunity cost of wheat.
Foreigns relative price of wheat is P*W/P*C = 1 and
exceeds Homes relative price of wheat (PW/PC = )
The difference in relative autarky prices comes
from the comparative advantage that Home has in
wheat.

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Foreign autarky equilibrium

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To summarise:
Opportunity costs (or real prices)
Cloth Wheat
(1 Yard) (1 Bushel)
Home 2 Bushels Yard
of Wheat of Cloth

Foreign 1 Bushel 1 Yard

of Wheat of Cloth

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 Comparative advantage
Comparative Advantage
A country has a comparative advantage in a good
when it has a lower opportunity cost of producing
it than another country.
From the Table we can see that Foreign has a
comparative advantage in producing cloth as
Foreigns opportunity cost of cloth is lower (1<2).
Home has a comparative advantage in producing
wheat as its opportunity cost of wheat is lower
(1/2<1).

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Determining the Pattern of International Trade

Autarky price comparisons:

Relative price of cloth in Foreign is P*C/P*W = 1.
Relative price of cloth in Home is PC/PW = 2.
Price difference across countries: Foreign would want to
export its cloth to Homeas it can make it for the cost of 1
and export it for more than 1.
The opposite is true for wheat.
Home will export wheat and Foreign will export cloth.
Both countries export the good in which they have a
comparative advantage.

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 International Trade Equilibrium

International Trade Equilibrium

The relative price of wheat in the trade equilibrium (or the
international terms of trade) will be between the autarky
relative prices in Home and Foreign.
For now we will assume the free-trade price of wheat,
PW/PC , is 2/3. This is between the autarky price of in
Home and the autarky price of 1 in Foreign.
Given this free trade price of wheat, we can now see how
both countries benefit from trade.

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 Gains from trade:
increased consumption opportunities and utility
Home producers of wheat can earn more than the
opportunity cost (or autarky price) of wheat by
selling it to Foreign.
Home will therefore shift labour toward the
production of wheat and increase its production.
Remember wages are calculated by the price of
the good times its marginal product.
Given the information from before, we can
calculate the wage rates in the two sectors.

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 Labour market condition (Home)

PW MPLW 2 4 8
1
PC MPLC 3 2 6
Therefore
PW MPLW PC MPLC
Wages in wheat Wages in cloth

All Home workers have an incentive to move into the

wheat sector and no cloth will be produced.
With trade, Home will be fully specialised in wheat
production.
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Terms of trade and increased consumption
opportunities
Home can export wheat at the international
relative price (or terms of trade) of 2/3.
For each bushel of wheat it exports, it gets 2/3
yards of cloth in return.
The world price line (or terms of trade line) shows
the range of consumption possibilities that the
country can achieve by specialising in wheat and
trading it.
International trade allows to separate production
(point B) from consumption (point C).
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 Free trade equilibrium (Home)
Home produces 100 bushels of wheat but
consumes only 40, so it exports 60
Cloth, QC (yards)
Home produces 0 yards of cloth but
consumes 40, so it imports 40.

Home consumption
50

40 C World price line (terms of trade

U2 line), slope = 2/3

25 A
Home imports 40
yards of cloth U1 Home production

40 50
50 100
100 Wheat, QW (bushels)

Home exports 60 bushels of wheat

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Free trade equilibrium (Foreign)

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Perhaps numbers tell a better story

Consumption opportunities under Autarky:

Home: 100 bushels of wheat or 50 yards of cloth
Foreign: 100 bushels of wheat or 100 yards of cloth
Consumption opportunities under Trade:
Home: 100 bushels of wheat or 67 (100*(2/3)) yards of
cloth
Foreign: 150 (100*(3/2) ) bushels of wheat or 100 yards
of cloth
Gains from trade:
Home: 17 yards of cloth
Foreign: 50 bushels of wheat
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 Gains from trade:
increased real wages
As stated before, in competitive labour markets, firms will
pay workers the value of their marginal product.
Since Home produces and exports wheat, workers can be
thought of being paid in wheat. As 1 unit of labour
produces 4 bushels of wheat, the real wage of home
workers is MPLW (= 4 bushels of wheat).
Workers can sell wheat on the world market at a relative
price of PW/PC = 2/3.
We can use this to calculate their real wage in terms of
cloth: (PW/PC)MPLW = (2/3)4 = 8/3 yards.
Through trade, 1 unit of labour is able to buy 8/3 yards.

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 Gains from trade:
increased real wages
Home real wage is
4 bushels of wheat or
8/3 yards of cloth (> 2, the autarky level)
Foreign real wage is
1 yard of cloth or
3/2 bushels of wheat (>1, the autarky level)
(since(PC/PW) MPL*C = (3/2)1 = 3/2)
Trade leads to an increase in real wages in both countries,
but the real wages do not converge.
Home workers earn a higher real wage than foreign workers
because of their absolute productivity advantage.

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Key insight: real wages in the trade equilibrium

Wages are determined by

absolute advantage (productivity)

Trade is determined by
comparative advantage
The only way a country with poor technology can export at
a price others are willing to pay is by having low wages.

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 Summary
The Ricardian model is about the reallocation of a single factor,
labour, across alternative uses.
It is comparative (productivity) advantage, not absolute (productivity)
advantage, which matters for the direction of specialisation and the
realisation of the gains from trade. Absolute productivity advantage
determines wage rates.
Gains from trade captured in three different ways: increase in utility,
increase in consumption opportunities or increase in real wages.
Distribution of the gains from trade depends on the terms of trade.
Because of the one factor assumption, there cant be any domestic
conflict about the gains from trade in the Ricardian framework.
To analyse potential domestic conflict from trade, we need to relax
the one factor assumption. This leads to the specific-factors model.
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