© Pearson Education Limited 2015.: 1-1 All Rights Reserved

Chapter 3
Labor Productivity
and Comparative
Advantage: The
Ricardian Model
© Pearson Education Limited 2015. All rights reserved. 1-1

Introduction
• Theories of why trade occurs:

– Differences across countries in labor, labor skills,
physical capital, natural resources, and
technology
– Economies of scale (larger scale of production is
more efficient)

Introduction

Introduction (cont.)
• Sources of differences across countries that

lead to gains from trade:
– A. Smith’s Model based on Absolute Advantages.
– The Ricardian model (Econ/Trade Chapter 3)
examines differences in the productivity of labor
(due to differences in technology) between
countries.
– The Heckscher-Ohlin model (Econ/Trade
Chapter 4) examines differences in labor, labor
skills, physical capital, land, or other factors of
production between countries.

INTERDEPENDENCE AND THE GAINS FROM
TRADE
• Basic idea is this: Trade allows people to

specialize in the production of goods for which they
have a comparative advantage. Because of
specialization, total output rises, and through trade,
we are all able to share in the bounty. Everyone can
gain from trade. Restrictions on trade tend to
reduce welfare.
• Independence is self-sufficiency, means that a
country produces everything needed by people of
this country.
• Interdependence means countries specialize in
products that they are better at producing, and
exchange these products with each other.

THE THEORY OF ABSULUTE ADVANTAGES
Quantity of products per day produced by a worker

Food Beverage
USA 50 kg. 30 lt.
Germany 20 kg. 80 lt.
An average American worker produces maximum 50 kg of food a day when he produces only
food. But if he works in beverage sector he can produce maximum 30 lt. of beverage. And, an
average German worker produces maximum 20 kg of food or 80 lt. of beverage in one day.
This table shows the productivity of countries. Productivity means producing in low cost. If the
same worker produces 50 kg in food sector but 30 lt in beverage sector that’s to say he is more
productive in food sector. Or producing in food sector is less costly than in beverage sector. In
this country food is cheap but beverage is expensive.
The USA is better at producing food when Germany is better at producing beverage. The USA
has absolute advantage in food sector while Germany has absolute advantage in beverage
sector.
If we shift workers working in relatively less productive beverage sector to more productive food
sector the countries’ production will increase. In this case, the USA has an excess of food but no
beverage. Germany has an excess of beverage but no food. And they trade their excessive
products each other.
THE THEORY OF ABSULUTE ADVANTAGE

Food Beverage
USA 50 kg. 30 lt.
Germany 20 kg. 80 lt.
Absoulute Adavantage: The comparison among producers of a product according
to their productivity (producing a product smaller quantity of input). A country should
specialize in the products which it produce less costly than the other countries. It
should export these products and imports the products that it doesn’t produce.
Specialization: Shifting factors of production to the sectors of products for which the
country is better at producing (more productively and less costly). The country
abandons the unproductive sectors (stop to produce) and fully allocates its resources
(factors of production) to the most productive sectors.
The USA has an absolute advantage in food sector and Germany is absolutely
advantageous in beverage sector. The USA exports its excessive food production to
Germany and imports beverage from Germany. And Germany exports its excessive
beverage to the USA and imports food from the USA.

THEORY OF COMPARATIVE ADVANTAGES

THEORY OF COMPARATIVE ADVANTAGES

Cloth Wine
The UK 80 unit 40 unit
Portugal 10 unit 20 unit
According to the TAA, in such a case trade is not possible. Because the UK seems to
be self-sufficient. And Portugal has no less costly product to export to the UK.
According to TCA it is still possible: The UK is absolutely advantageous in two

sectors. The UK is eight times more advantageous in cloth industry but only
two times more advantageous in wine industry. Why does the UK still produce
wine?
The UK should close the wine industry and shifts its workers from wine industry to more
productive cloth industry so that the UK may produce more cloths. The UK puts aside
some of these clots for its own use and exports the excessive cloths to Portugal. And the
UK imports wine from Portugal in exchange for cloths.

Introduction
• In this section you will

– Learn how the Ricardian Model explains the gain
from trade
– Understand why countries prefer
interdependence over independence through
comparative advantages.
– Describe the empirical evidence that wages
reflect productivity and that trade patterns
reflect relative productivity.

Comparative Advantage and
Opportunity Cost
• The Ricardian model uses the concepts of
opportunity cost and comparative advantage.
• The opportunity cost of producing something
measures the cost of not being able to produce
something else with the resources used.
• For example, a limited number of workers could
produce either roses or computers.
– The opportunity cost of producing computers is the amount
of roses not produced.
– The opportunity cost of producing roses is the amount of
computers not produced.

Opportunity Cost (cont.)
• Suppose that in the United States 10 million

roses could be produced with the same
resources as 100,000 computers.
• Suppose that in Colombia 10 million roses
could be produced with the same resources
as 30,000 computers.
• Colombia has a lower opportunity cost of
producing roses: has to stop producing
fewer computers.

• The OC of Roses in the US:
– 10.000.000 R = 100.000 C (or 1R = 0,01C)
• The OC of Computers in the US:

– 100.000 C = 10.000.000 R (or 1C = 100R)
• The OC of Roses in Colombia:

– 10.000.000 R = 30.000 C (or 1R = 0,003C)
• The OC of Computers in Colombia:

– 30.000 C = 10.000.000 R (or 1C = 333R)

• A country has a comparative advantage

in producing a good if the opportunity cost
of producing that good is lower in the
country than in other countries.
– The United States has a comparative advantage
in computer production.
– Colombia has a comparative advantage in rose
production.

• Suppose initially that Colombia produces

computers and the United States produces
roses, and that both countries want to
consume computers and roses.
– If it is, the World Economy produce 10 million
roses and 30.000 computers.
– But if it is invers,the WE produces 10 million
reses (by Colombia) and 100.000 computers (bu
the US). So Consumer in the World have 70.000
more computers.

Table 3-1: Hypothetical Changes
in Production
No change in world production of rose.

But 70.000 more computers.
• When countries specialize in production in which

they have a comparative advantage, more goods
and services can be produced and consumed.
– Have the United States stop growing roses and use those
resources to make 100,000 computers instead. Have Colombia
stop making 30,000 computers and grow roses instead.
– If produce goods in which have a comparative advantage (the
United States produces computers and Colombia roses), they
could still consume the same 10 million roses, but could consume
100,000 – 30,000 = 70,000 more computers.

A One-Factor Ricardian Model
• Does trade makes both countries better off?

• The simple example with roses and
computers explains the intuition behind the
Ricardian model.
• We formalize these ideas by constructing a
one-factor Ricardian model using the
following assumptions:

(cont.) (2 x 2 x 1)
1. Two countries: home and foreign.

2. Two goods: wine and cheese.
3. One factor: Labor is the only factor of
production.
4. Labor productivity varies across countries due
to differences in technology, but labor
productivity in each country is constant.
5. The supply of labor in each country is constant.
6. Competition allows workers to be paid a wage
equal to the value of what they produce, and
allows them to work in the industry that pays
the highest wage.

(cont.)
• A unit labor requirement indicates the constant
number of hours of labor required to produce one
unit of output.
• A high unit labor requirement means low labor
productivity.
• Labor supply L indicates the total number of hours
worked in the home country (a constant number).
• Cheese production QC indicates how many pounds
of cheese are produced.
• Wine production QW indicates how many gallons of
wine are produced.

Production Possibilities
• The production possibility frontier (PPF) of an economy shows

the maximum amount of a goods that can be produced for a fixed
amount of resources.
• The PPF equation of the home economy is:
aLCQC + aLWQW ≤ L Total amount of

labor resources
Labor required for each Total Labor required for

each gallon of wine Total gallons
pound of cheese pounds of
produced. produced. of wine
cheese produced
aLC = 1 means that 1 produced For example, aLW
hour of labor = 2 means that 2
produces one pound
hours of labor
of cheese in the home
country.
produces one
gallon of wine in
the home country.

Production Possibilities (cont.)
aLCQC + aLWQW ≤ L
•Suppose
– L= 1,000 hours.
– aLC =1 hour and aLW =2 hours
•PPF becomes QC + 2QW ≤ 1,000.

– Maximum home cheese production is 1,000 pounds.
QC = L/aLC when QW = 0.
– Maximum home wine production is 5,000 gallons.

QW = L/aLW when QC = 0.

Fig. 3-1: Home’s Production
Possibility Frontier

• The o.c. of cheese in terms of wine is aLC /aLW
• The o.c. of wine in terms of cheese is aLW /aLC
• This cost is constant because the unit labor

requirements are both constant.
• Producing an additional pound of cheese requires aLC

hours of labor.
• Each hour devoted to cheese production could have

been used instead to produce an amount of wine.

• For example, if 1 hour of labor is moved to

cheese production, that additional hour
could have produced
aLC /aLW =1 hour/2 hours= ½ gallon of wine.
• Opportunity cost of producing one pound of

cheese is ½ gallon of wine not produced.

Relative Prices, Wages, and
Supply
• Suppose
– the price of cheese :PC =4$
– the price of wine : PW =7$
– The hourly wages is equal to the market price of
goods. wC =PC /aLC and wW=PW/aLW
• Then, a worker earns 4$/h. in cheese sector or
3,5$/h. (7$/2 hours) in wine sector.
– Workers will choose to work in the industry that pays
the higher wage. The the economy as a whole
specialize in cheese sector.
– What happen if Pc drops to 3$?

Relative Prices, Wages, and Supply
(cont.)
• If the price of cheese relative to the price of

wine exceeds the opportunity cost of cheese
– The relative wage in cheese becomes higher.
– Workers shift to chees sector.
– The economy specializes in cheese.
• PC /PW > aLC /aLW
– wC =PC /aLC > PW/aLW =wW Let’s expresse it by
equations.
– aLC =L/ QC when aLW = 0

– QC = L/aLC when QW = 0

Relative Prices, Wages, and Supply
(cont.)
• PC /PW > aLC /aLW

– wC =PC /aLC > PW/aLW =wW
– aLC =L/ QC when aLW = 0
– QC = L/aLC when QW = 0
In our example:
• 4/7 > ½, the home specialize in cheese.
– 4=4$/1hour>7/2 hours=3,5
– 1=1000 hours/1000 cheese when aLW = 0
– 1000 cheese=1000hours/1hour when QW = 0

Production, Prices, and Wages
(cont.)
• In the open economy, the economy will specialize
in cheese if the relative price of cheese exceeds its
opportunity cost; it will specialize in wine if the
relative price of wine exceeds its opportunity costs.
• In the absence of international trade, Home
would have to produce both goods for its own
consumption. But it will procuce both goods only if
the relative price of cheese is just equal to its
opportunity cost.

(cont.)
• In the absence of international trade,
– Relative prices of goods are equal to their unit labor
requiremets. Wages are equal in the wine and cheese
industries.
– If PC /aLC = PW /aLW workers will not care whether they work
in the cheese industry or the wine industry, so that
production of both goods can occur.
– Production (and consumption) of both goods occurs when
the relative price of a good equals the opportunity cost of
producing that good:
PC /PW = aLC /aLW

(cont.)
• In our example:
– PC =4$ and PW =8$
– then, PC /aLC = PW /aLW ⇒ 4$/1h. = 8$/2h. (4$/1h.)
– Workers will not care whether they work in the cheese

industry or the wine industry, so that production of both
goods can occur.
– Production (and consumption) of both goods occurs when
the relative price of a good equals the opportunity cost of
producing that good:
PC /PW = aLC /aLW ⇒ 4$/8$ = 1h./2h.

Summary for Home Counrty
• Home’s PPF ⇒ aLCQC + aLWQW ≤ L

aLC =1h. aLW =2h L=1.000h.
Pc=4$ Pw=7$
Wc=4$ Ww=3,5$,
• If PC /PW > aLC /aLW
1) The reative wage in cheese (wC /wW) becomes higher
2) Workers shift to cheese sector
3) The Home economy as a whole specialize in cheese.
• In the absence of int trade, Home would produce both goods for its own use.
But producing both goods requires the relative prices of goods to be equal.
Why? Because on this condition, the relative wages in both sector become
equal and workers don’t want to change sector since they earn the same
wage in both sectors.

Trade in the Ricardian Model
• If the home country is more efficient in

wine and cheese production, then it has
an absolute advantage in all production:
– its unit labor requirements for wine and
cheese production are lower than those in the
foreign country
aLC < a*LC and aLW < a*LW
where “*” notates foreign country variables

(cont.)
• A country can be more efficient in

producing both goods, but it will have a
comparative advantage in only one good.
• Even if a country is the most (or least)
efficient producer of all goods, it still can
benefit from trade.

Summary for Foreign Country
• Suppose:
• Foreign’s PPF ⇒ a*LCQ*C + a*LWQ*W ≤ L*
• a*LC=6h., a*LW=3h., L*=3000 h. ⇒ 6Q*C + 3Q*W ≤ 3000
• the home has a comparative advantage in cheese

production:
aLC /aLW < a*LC /a*LW
the OC of cheese in Home the OC of cheese in Foreign
• When the home country increases cheese production, it

reduces wine production less than the foreign country
would.

Fig. 3-2: Foreign’s Production
Possibility Frontier
Since the slope of the PPF
indicates the opportunity cost of
cheese in terms of wine, Foreign’s
PPF is steeper than Home’s.
To produce one pound of cheese,

must stop producing more gallons
of wine in Foreign than in Home.

(cont.)
• Before trade,
– the relative price of cheese to wine reflects the
opportunity cost of cheese in each country.
– the relative price of cheese to wine will be higher in
Foreign than in Home if Foreign has the higher
opportunity cost of cheese.
• After trade, it will be profitable to export cheese
from Home to Foreign (and wine from Foreign
to Home).
• But where does the relative (world) price of
cheese to wine settle?

(cont.)
• To see how all countries can benefit from

trade, need to find relative prices when
trade exists.
• First calculate the world relative supply of
cheese: the quantity of cheese supplied by
all countries relative to the quantity of wine
supplied by all countries
RS = (QC + Q*C )/(QW + Q*W)

Relative Supply and Relative Demand
(cont.)
• World relative supply is a step function:

– First step at relative price of cheese equal to Home’s
opportunity cost aLC /aLW, which equals 1/2 in the example.
– Jumps when world relative supply of cheese equals Home’s

maximum cheese production divided by Foreign’s
maximum wine production (L / aLC ) / (L*/ a*LW)
=[(1000/1)/(3000/3], which equals 1 in the example.
– Second step at relative price of cheese equal to Foreign’s

opportunity cost a*LC /a*LW, which equals 2 in the example.

Fig. 3-3: World Relative Supply
and Demand
OC of cheese in
Foreign
OC of cheese in
Home
Relative supply of cheese
Home’s max. cheese prod.

Foreign’s max. Cheese prod.

Relative Supply and Relative
Demand
Possibility#1:
•If the relative price of cheese
falls below the opportunity cost of
cheese in both countries PC /PW <
aLC /aLW < a*LC /a*LW,
– no cheese would be
produced.
– domestic and foreign

workers would be willing
to produce only wine
(where wage is higher).
PC /PW

Demand
Possibility#2:
•When the relative price of
cheese equals the opportunity
cost in the home country PC /PW =
aLC /aLW < a*LC /a*LW ,
– domestic workers are
indifferent about
producing wine or cheese
(wage when producing
wine same as wage when
producing cheese).
PC /PW = – foreign workers produce

only wine.

Demand
Possibility#3:
•When the relative price of cheese
settles strictly in between the
opportunity costs of cheese aLC /aLW <
Pc /PW < a*LC /a*LW ,
– domestic workers produce

only cheese (where their
wages are higher).
– foreign workers still produce
only wine (where their wages
PC /PW are higher).
– world relative supply of
cheese equals Home’s
maximum cheese production
divided by Foreign’s maximum
wine production (L / aLC ) /
(L*/ a*LW).

Demand
Possibility#4:
•When the relative price of
cheese equals the opportunity
cost in the foreign country
aLC /aLW < PC /PW = a*LC /a*LW ,
PC /PW = – foreign workers are
indifferent about
producing wine or cheese
(wage when producing
wine same as wage when
producing cheese).
– domestic workers produce
only cheese.

Demand
Possibility#5:
•If the relative price of cheese
rises above the opportunity cost
of cheese in both countries
PC /PW aLC /aLW < a*LC /a*LW < PC /PW,
– no wine is produced.
– home and foreign workers

are willing to produce only
cheese (where wage is
higher).

Fig. 3-3: World Relative Supply
and Demand
(PC /PW ) ↗ ⇒ RD ↘
PC /PW =

Summary
• Through opportunity cost, we determine

– which good an economy specialize in,
– which country export/import which good,
– whic countries will engage in trade,
– what the world price of good will be
– And now, what countries gain from trade

Gains from Trade
• Gains from trade come from specializing in

the type of production (C or W) which uses
resources (L) most efficiently, and using the
income generated from that production to
buy the goods and services that countries
desire.
– where “using resources most efficiently” means
producing a good in which a country has a
comparative advantage.

Gains from Trade
The OC of cheese in Home is lower than the

OC of cheese in Foreign. So, Home has a
comparative advantage in cheese

Gains from Trade (cont.)
aLC /aLW < PC /PW < a*LC /a*LW
1)The relative price of cheese is higher than its OC in Home

2)The relative price of cheese is lower than its OC in Foreign
3)The wage in cheese becomes higher in Home. Workers shift to
cheese. Economy as a whole specialize in cheese.
4)The wage in cheese is lower in Foreign. Workers shift to wine.
Economy as a whole specialize in wine.
5)Home has a comparative advantage in cheese while Foreign
has a comparative advantage in wine.

6)The World price of chees becomes equal to the Home relative

price of cheese due to its cost/price advantage in international
market.
7)The World price of wine becomes equal to the Foreign relative
price of wine.
8)Home makes profit by exporting cheese while Foreign makes
«profit» by importing it (instead of producing).
9)Foreign makes profit by exporting wine while Home makes
«profit» importing it (instead of producing).

10)Home sells some cheese over its domestic cost. Foreign buys
some cheese below its domestic cost.
11)Home exports some cheese to Foreign in exchange for wine
from Foreign.
12)For profitable trade world price should be between the
countries OCs.
13)Thanks to trade based on specialization by comparative
advantages, both countries consume both goods without
produccing one of them.

Fig. 3-4: Trade Expands
Consumption Possibilities
• Consumption
possibilities expand
beyond the
production possibility
frontier when trade is
allowed.
• With trade,
consumption in each
country is expanded
because world
production is
expanded when each
country specializes in
producing the good in
which it has a
comparative
advantage.

A Numerical Example
Unit labor requirements for home and foreign countries
Cheese Wine
Home aLC = 1 hour/lb aLW = 2 hours/gallon
Foreign a*LC = 6 hours/lb a*LW = 3 hours/gallon
• What is opportunity cost of cheese and wine?
– OC of cheese= aLC /aLW = ½

– OC of wine =aLW /aLC = 2
Home
– OC of cheese=aLC /aLW = 2
– OC of wine=aLW /aLC = ½
Foreign

A Numerical Example
Cheese Wine
• Which country has comparative advantage?
– The home country is more efficient in both industries, but has a comparative advantage only in cheese
production.
1/2 = aLC /aLW < a*LC /a*LW = 2
– The foreign country is less efficient in both industries, but has a comparative advantage in wine production.

A Numerical Example
Cheese Wine
• Where should the world equlibrium price setlle?
– With trade, the equilibrium relative price (World price) of cheese to wine settles
between the two opportunity costs of cheese.
1/2 = aLC /aLW < PC /PW <a*LC /a*LW = 2

A Numerical Example (cont.)

• Home’s PPF ⇒ aLCQC + aLWQW ≤ L*

• Suppose aLC=1h., aLW=2h., L=1000 h.
⇒ QC + 2QW ≤ 1000
• Home country can trade its 1,000

maximum production of cheese for 1,000
wine, instead of the 500 gallons of wine it
could produce itself in the absence of trade.

• Foreign’s PPF ⇒ a*LCQ*C + a*LWQ*W ≤ L*

• Suppose a*LC=3h., a*LW=6h., L*=3000 h.
⇒ 3Q*C + 6Q*W ≤ 3000
• Foreign country can trade its 1,000

maximum production of wine for 1,000
cheese, instead of the 500 cheese it could
produce itself in the absence of trade.

Relative Wages
• Relative wages are the wages of the home

country relative to the wages in the foreign country.
• Productivity (technological) differences determine
relative wage differences across countries.
• Relative wages cause Home to have a cost
advantage in only cheese and Foreign to have a
cost advantage in only wine.

A Numerical Example
Cheese Wine
Home is 6 times as
productive in cheese
production, but 1.5
times as productive
in wine production.
Foreign

Relative Wages (cont.)
• The relative wage lies between the ratio of the

productivities in each industry.
– The home country is 12/2 = 6 times as productive in

cheese production, but only 6/4 = 1.5 times as productive
in wine production.
– The home country has a wage 3 times higher than the
foreign country.
– Since Home specializes in cheese, the relative wage in

cheese prevails in Home (12$/h.).
– Since Foreign specializes in wine, the relative wage in wine
prevails in Foreign (4$/h.)

• These relationships imply that both countries have

a cost advantage in production.
– High wages can be offset by high productivity.
– Low productivity can be offset by low wages.
• In the home economy, producing one unit of cheese

costs $12 (1h X $12/hr) but would have cost $24
(6h. X $4/hr) in Foreign.
• In the foreign economy, producing one unit of wine

costs $12 (3 h X $4/hr) but would have cost $24
(2h. X $12/hr) in Home.

• Because foreign workers have a wage that is only

1/3 the wage of domestic workers, they are able to
attain a cost advantage in wine production, despite
low productivity.
• Because domestic workers have a productivity that
is 6 times that of foreign workers in cheese
production, they are able to attain a cost advantage
in cheese production, despite high wages.

Do Wages Reflect Productivity?
• Do relative wages reflect

relative productivities of the
two countries?
• Evidence shows that low
wages are associated with
low productivity.
– Wage of most countries
relative to the U.S. is
similar to their
productivity relative to
the U.S.

Do Wages Reflect Productivity?
(cont.)
• Other evidence shows that wages rise as

productivity rises.
– As recently as 1975, wages in South Korea were
only 5% of those of the United States.
– As South Korea’s labor productivity rose (to
about half of the U.S. level by 2007), so did its
wages.

Misconceptions about
Comparative Advantage
1. Free trade is beneficial only if a country is more

productive than foreign countries.
– But even an unproductive country benefits from free trade
by avoiding the high costs for goods that it would
otherwise have to produce domestically.
– High costs derive from inefficient use of resources.
– The benefits of free trade do not depend on absolute
advantage, rather they depend on comparative
advantage: specializing in industries that use resources
most efficiently.

Comparative Advantage (cont.)
2. Free trade with countries that pay low wages hurts
high wage countries.
– While trade may reduce wages for some workers, thereby
affecting the distribution of income within a country,
trade benefits consumers and other workers.
– Consumers benefit because they can purchase goods
more cheaply.
– Producers/workers benefit by earning a higher income in
the industries that use resources more efficiently,
allowing them to earn higher prices and wages.

Comparative Advantage (cont.)
3. Free trade exploits less productive countries
whose workers make low wages.
– While labor standards in some countries are less than
exemplary compared to Western standards, they are so
with or without trade.
– Are high wages and safe labor practices alternatives to
trade? Deeper poverty and exploitation may result
without export production.
– Consumers benefit from free trade by having access to
cheaply (efficiently) produced goods.
– Producers/workers benefit from having higher
profits/wages—higher compared to the alternative.

Comparative Advantage with
Many Goods
• Suppose now there are N goods produced, indexed
by i = 1,2,…N.
• The home country’s unit labor requirement for good
i is aLi, and the corresponding foreign unit labor
requirement is a*Li .
• Goods will be produced wherever cheapest to
produce them.

Many Goods (cont.)
• w: the wage rate in the home country.

• w*: the wage rate in the foreign country.
– If w < w* in a good then only the home country

will produce that good, since total wage
payments are less there.
– Or equivalently, if a*L1 /aL1 > w/w*, if the relative
productivity of a country in producing a good is
higher than the relative wage, then the good will
be produced in that country.

Table 3-2: Home and Foreign
Unit Labor Requirements
a*L1 /aL1 > w/w*=3
Pay attention
where (*) is!
If w/w* = 3, the home country will produce apples, bananas, and

caviar, while the foreign country will produce dates and enchiladas.
The relative productivities of the home country in producing apples,

bananas, and caviar are higher than the relative wage.
Suppose Home’s wage increases (w↗)and w/w* = 5, Home will lose its
comarative advantage for Caviar and will produce appels and bananas.

Many Goods (cont.)
• If each country specializes in goods that use
resources productively and trades the products for
those that it wants to consume, then each benefits.
– If a country tries to produce all goods for itself, resources
are “wasted”.
• The home country has high productivity in apples,
bananas, and caviar that give it a cost advantage,
despite its high wage.
• The foreign country has low wages that give it a
cost advantage, despite its low productivity in date
production.

Many Goods (cont.)
a*L1 /aL1 > w/w*
• Suppose w/w* increases from 3 to 3.99:

– The home country would produce apples, bananas, and caviar, but the demand
for these goods and the labor to produce them would fall as the relative wage
rises.
• Suppose w/w* increases from 3.99 to 4.01:
– Caviar is now too expensive to produce in the home country, so the caviar
industry moves to the foreign country, causing a discrete (abrupt) drop in the
demand for domestic labor services.
• Consider similar effects as w/w* rises from 0.75 to 10.

Many Goods (cont.)
• How is the relative wage
determined?
• By the relative supply of and
relative (derived) demand for
labor services.
• The relative (derived) demand for
home labor services falls when
w/w* rises. As domestic labor
services become more expensive
relative to foreign labor services,
– goods produced in the home
country become more
expensive, and demand for
these goods and the labor
services to produce them falls.
– fewer goods will be produced
in the home country, further
reducing the demand for
domestic labor services.

Many Goods (cont.)
• Finally, suppose that relative supply of labor is
independent of w/w* and is fixed at an amount
determined by the populations in the home and
foreign countries.

Transportation Costs and Non-
traded Goods
• The Ricardian model predicts that countries

completely specialize in production.
• But this rarely happens for three main
reasons:
1. More than one factor of production reduces the
tendency of specialization (Econ/Trade Chapters
4-5).
2. Protectionism (Econ/Trade Chapters 9–12).
3. Transportation costs reduce or prevent trade,
which may cause each country to produce the
same good or service.

Transportation Costs and Non-
traded Goods (cont.)
• Nontraded goods and services (ex., haircuts

and auto repairs) exist due to high transport
costs.
– Countries tend to spend a large fraction of
national income on nontraded goods and
services.
– This fact has implications for the gravity model
and for models that consider how income
transfers across countries affect trade.

a*L1 /aL1 > w/w*=3
Home exports first three

and imports last two.
Suppose now a transportation cost (T) of %100: we add it to imported dates. One
unit of imported date that costed 12h. without T now costs 24h. (12+%100T).
24h. of Foreign unit labor requirement is equivalent to 8h. (a*L1 /(w/w*)=24/3) in
Home. With T, Foreign lost its cost advantage. For Home producing dates at 6h. is
cheaper than importing from Foreign.
a*L1 /aL1 > w/w*=12h / 6h ≱ 12$ / 4$ = 3, then Home imports dates.
With T=%100, a*L1 /aL1 > w/w*=24h / 6h > 12$ / 4$ = 3, then Home produces it.

a*L1 /aL1 > w/w*=3

With T, the unit cost of enchilades is 18h. (9+%100T). 18h. of Foreign unint labor
cost is equivalent to 6h. (a*L1 /(w/w*)=18/3) in Home. For Home ti is still cheaper
to import dates from Foreign. Because production cost is higher (12h>6h.)
a*L1 /aL1 > w/w*=9/ 12h ≱ 12$ / 4$ = 3, then Home imports enchilidas.
With T=%100, a*L1 /aL1 > w/w*=18h / 12h > 12$ / 4$ = 3, then Home still imports
enchilidas

a*L1 /aL1 > w/w*=3

a*L1 /aL1 > w/w*=12h / 3h > 12$ / 4$ = 3
with %100 of T, the cost of Home’s caviar doubles (6h.) to Foreign.
a*L1 /aL1 > w/w*=12h / 6h ≱ 12$ / 4$ = 3
Home lost its comparative advantage. Foreign produces caviar.

Empirical Evidence
• Do countries export those goods in which their

productivity is relatively high?
• The ratio of U.S. to British exports in 1951

compared to the ratio of U.S. to British labor
productivity in 26 manufacturing industries
suggests yes.
• At this time the U.S. had an absolute advantage in

all 26 industries, yet the ratio of exports was low in
the least productive sectors of the U.S.

Fig. 3-6: Productivity and Exports

Empirical Evidence (cont.)
• A very poor country like Bangladesh can have

comparative advantage in clothing despite being
less productive in clothing than other countries such
as China because it is even less productive
compared to China in other sectors.
– Productivity (output per worker) in Bangladesh is
only 28 percent of China’s on average.
– In apparel, productivity in Bangladesh was about
77 percent of China’s, creating strong
comparative advantage in apparel for
Bangladesh.

Table 3-3: Bangladesh versus
China, 2011

Empirical Evidence (cont.)
• The main implications of the Ricardian

model are well supported by empirical
evidence:
– productivity differences play an important role in
international trade
– comparative advantage (not absolute advantage)
matters for trade

Summary
1. Differences in the productivity of labor

across countries generate comparative
advantage.
2. A country has a comparative advantage in

producing a good when its opportunity cost
of producing that good is lower than in
other countries.

Summary (cont.)
3. Countries export goods in which they have

a comparative advantage - high
productivity or low wages give countries a
cost advantage.
4. With trade, the relative price settles in
between what the relative prices were in
each country before trade.

Summary (cont.)
5. Trade benefits all countries due to the

relative price of the exported good rising:
income for workers who produce exports
rises, and imported goods become less
expensive.
6. Empirical evidence supports trade based
on comparative advantage, although
transportation costs and other factors
prevent complete specialization in
production.

Critisism on the Ricardian Model
Unit Labor Requirement
(hour) Opportunity Cost
Cloth Wine OC of Cloth in Wine OC of Wine in Cloth
the UK 7 8 0,88 1,14
Portugal 13 10 1,30 0,77
Result UK specializes in Cloth Portugal specializes in Wine
Trade allows the UK to exchange 1 unit of cloth (that costs 7

h.) for 1 unit of wine (that costs 8 h. in domestic market)
with Portugal. The UK saves 1 h. of labor.
Trade allows Portugal to export 1 unit of wine (produced in

10h.) and import 1 unit of cloth from the UK. Before trade, 1
unit of cloth was produced in 13h. But now it costs 10h.
Thanks to trade! Portugal saves 3h. of labor.

the UK 9 8 1,13 0,89
Portugal 13 10 1,30 0,77
In this case, the model predicts that the UK exchanges 1 unit of

cloth (that costs 9 h.) for 1 unit of wine (that costs 8 h. in
domestic market) with Portugal. This time the UK doesn’t save
but loses 1 h. of labor.
If the UK produced wine, it had costed 8 h. But instead, the UK

pays more (1 cloth/9 h.) for 1 imported wine that It produced in
8 h. before trade.
In such a case, trade doesn’t give cost advantage to the UK

although the Ricarian model predicts so.

the UK 9 8 1,13 0,89
Portugal 13 10 1,30 0,77
Ricardo didn’t predicted such a case. He didn’t care about which

country gain more from trade.
What is important for him is social welfare: a rise in the quantity

of goods available to consumer at a cheaper price; and a rise in
the world production of goods in which each country has a
comparative advantage.

• In the 2x2x1 models, one of the two

countries specializes in industrial product
(the UK/cloth) other in agricultural product
(Portugal/wine).
• However, agricultural product is subject to
diminishing return of land.
• Let’s look at the theory of rent developped
by Ricardo.

• Let’s look at the theory of rent developped by Ricardo.

• As population increases, more food is needed. And gradually it requires
new arable land.
• But arable lands have different fertility levels. From more fertil to less
fertil, new lands will be used for agricultural production. Finally the use of
arable lands of a country will arrive to an end.
• New lands gradually yield fewer crops (diminishing return).
• As the use of arable land approaches to the end, due to its scarcity, rents
will increase. Thus, cost of agricultural goods will increase.
• This has an outcome for industrial sector: as the cost of foods increases,
the wage paid in industrial sector will gradually become less sufficient.
Industrial workers will ask for higher wage to keep their purchasing power
constant (real wage). So, cost of production in industrial sector will be
forced to increase. Importing agricultural products from abroad at a
cheaper price is a solution for industrial country!

• Because of the UK’s increasing demand for

Portuguese wine, Portugal will use less fertil lands
for more wine production.
• Diminishing return in new lands and rising cost of
production, the price of Poruguese wine will increase and
Portugal will lose its comparative advantage in wine!
• In such a case, trade allows the UK to save itself

from the risks of agricultural production
(diminishing returns, rising cost and price level
(inflation:decrease in purchasing power).

• The Ricardian model is a static model not a dynamic

model:
• Comparing relative positions of countries
(costs/prices/wages) in a given time, we decide
which good a country must specialize in.
• But comparative advantage of a country can
change over time depending on the improvement
in its technology level.
• China, S.Korea were poor, agricultural countries 50
years ago, but their comparative advantage is in
industrial products.

• The Ricardian model is a supply-side model; it ignores

demand-side:
• If a country has a comparative advantage in a good
(matchbox!) that is not so much demanded by other
country, what happen?
• In such a case, this country, if specialized in matchbox,
can not import sufficient goods that it needed. It has
almost nothing to export for its import needs.
• The Model is based on a barter economy. Production costs are
not affected by any volatiliy in exchange rates.

• The Ricardian model handles homogenious goods:

• Newertheless, goods have different quality levels that are
subject to price differenciation in international market.
• The Ricardian model assumes homogenious factor of
production (labor):
• Labor used in production of a good is not necessarily be the same both
across countries and sectors. There are high skilled workers and low skilled
workers.
• On the other hand, changing the sector (from wine to cheese) in
consideration to comparative advantage, is not easy for workers. Imagine
the situation of a mechanical engineer if the country has a comparative
advantage in computer. How does he easly change its abilities?
• The Model does’t explain the reason for cross country difference
in factor productivity.

• The Ricardian model is based on «constant return to scale»,

«full specialization», «perfect competition», and «full
employment».
– Many industries are subject to «increasing return to scale». As the
quantitiy of product increases, the average unit cost of that good
decreases, and return increases due to growing scale.
– No country wants to totally specialize in a good. Even a county has a
comparative advantage in one good, it still continues to produce a little bit
of other good.
– Perfect competition is an ideal market structure. Most of sectors works
under imperfect market conditions (monopolistic competition, oligopoly).
– Ricardian model assumes an easly transfert of workers from one sector to
another. Even if it is the case, it is not so easy for workers to gain required
skills in other sector. During training period they are unemployed.
«unemployment» is more realistic since the Great Deperssion in 1929.

• The Ricardian model doesn’t stress on the impact of trade on

the income distribution within a country.
• The Ricardian model doesn’t care about which country gain
more from trade.
• The Ricardian model assume two country with similar size.
What happen if one is big (the US) and other is small (Banana
Republic)?
– Although Banana Republic has a compratative advantage in
bananas, it can not provide sufficient bananas for US market. In
this case US must continue to produce some bananas for its
needs in addition to computers while Banana Republic fully
specialized in bananas.

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Chapter 3

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• Theories of why trade occurs:

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• Sources of differences across countries that

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• Basic idea is this: Trade allows people to

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Quantity of products per day produced by a worker

Quantity of products per day produced by a worker

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Quantity of products per day produced by a worker

According to TCA it is still possible: The UK is absolutely advantageous in two

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• In this section you will

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• Suppose that in the United States 10 million

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• The OC of Computers in the US:

• The OC of Roses in Colombia:

• The OC of Computers in Colombia:

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• A country has a comparative advantage

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• Suppose initially that Colombia produces

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No change in world production of rose.

• When countries specialize in production in which

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• Does trade makes both countries better off?

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1. Two countries: home and foreign.

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• The production possibility frontier (PPF) of an economy shows

aLCQC + aLWQW ≤ L Total amount of

Labor required for each Total Labor required for

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– aLC =1 hour and aLW =2 hours

•PPF becomes QC + 2QW ≤ 1,000.

– Maximum home wine production is 5,000 gallons.

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• The o.c. of cheese in terms of wine is aLC /aLW

• The o.c. of wine in terms of cheese is aLW /aLC

• This cost is constant because the unit labor

• Producing an additional pound of cheese requires aLC

• Each hour devoted to cheese production could have

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• For example, if 1 hour of labor is moved to

• Opportunity cost of producing one pound of

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• If the price of cheese relative to the price of

– aLC =L/ QC when aLW = 0

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• PC /PW > aLC /aLW

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aLC /aLW < aLC /aLW

aLC /aLW < PC /PW < aLC /aLW

aLC /aLW < PC /PW < aLC /aLW

aLC /aLW < PC /PW < aLC /aLW

1/2 = aLC /aLW < PC /PW <aLC /aLW = 2

• Foreign’s PPF ⇒ aLCQC + aLWQW ≤ L*