Ricardian Model of Trade

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Ricardian Model of Trade
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• The Ricardian Model provides some structure to
  the concept of comparative advantage.
• In the exchange model, the pattern of trade was
  determined by entirely by preferences.
• Ricardo is the other extreme, everything is
  determined by technology.

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The set-up

• A country has L units of labor.
• To produce a unit of good 1 requires a1 units of
  labor.
• To produce a unit of good 2 requires a2 units of
  labor.

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Production
Whats the most of good 1 you could produce?
Corn (good 2)
Tractors (good 1)
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Production
Whats the most of good 1 you could produce?
Corn (good 2)
Tractors (good 1)
L/a1
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Production
Whats the most of good 2 you could produce?
Corn (good 2)
Tractors (good 1)
L/a1
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Production
Suppose you stopped producing 1 unit of good 1.
Corn (good 2)
L/a2
Tractors (good 1)
L/a1
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Production
Suppose you stopped producing 1 unit of good
1. You would have a1 units of labor to produce
good 2. With a1 units of labor, you produce
a1/a2 units of good 2. The slope of the
production curve is a1/a2.
Corn (good 2)
L/a2
Tractors (good 1)
L/a1
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Production
Suppose you stopped producing 1 unit of good
1. You would have a1 units of labor to produce
good 2. With a1 units of labor, you produce
a1/a2 units of good 2. The slope of the
production curve is a1/a2.
Corn (good 2)
L/a2
slope a1/a2
Tractors (good 1)
L/a1
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Two Countries

• Suppose the ratio of unit factor requirements for
  France is
• a1,France/a2,France
• And the ratio of unit factor requirements for
  Germany is
• a1, Germany/a2, Germany
• Then France has the comparative advantage in good
  1 if
• a1,France/a2,Francelt a1, Germany/a2, Germany

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Comparative Advantage
Corn (good 2)
Germany
France
Tractors (good 1)
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Autarky
Given these consumption possibilities, an
individual would choose to consume where the
indifference curve is tangent to the production
set.
Corn (good 2)
L/a2
? (c, t)
slope a1/a2
Tractors (good 1)
L/a1
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Autarky
Given these consumption possibilities, an
individual would choose to consume where the
indifference curve is tangent to the production
set. Since the indifference curve must also be
tangent to the budget constraint, the budget
constraint and the production set must have the
same slope.
Corn (good 2)
L/a2
? (c, t)
slope a1/a2
Tractors (good 1)
L/a1
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Autarky
The slope of the budget constraint is
p1/p2. The slope of the production set
is a1/a2. Therefore p1/p2 a1/a2
Corn (good 2)
L/a2
? (c, t)
slope a1/a2
Tractors (good 1)
L/a1
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Trade
Suppose the world ratio of prices is p1w/p2w.
Corn (good 2)
L/a2
? (c, t)
Tractors (good 1)
L/a1
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Trade
Suppose the world ratio of prices is
p1w/p2w. We know the country could produce the
autarky combination of corn and tractors and then
trade it at world prices.
Corn (good 2)
L/a2
? (c, t)
Tractors (good 1)
L/a1
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Trade
Suppose the world ratio of prices is
p1w/p2w. We know the country could produce the
autarky combination of corn and tractors and then
trade it at world prices. This would be the
endowment model and we know the country would be
better.
Corn (good 2)
L/a2
? (c, t)
Tractors (good 1)
L/a1
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Trade
Suppose the world ratio of prices is
p1w/p2w. Unlike the endowment model, the
country can choose its output. It can produce
anywhere on the production set and then sell at
world prices.
Corn (good 2)
L/a2
? (c, t)
Tractors (good 1)
L/a1
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Trade
Suppose the world ratio of prices is
p1w/p2w. This country specializes in producing
tractors, sells them and then consumes a
combination of tractors and corn.
Corn (good 2)
L/a2
? (c2, t2)
? (c, t)
Tractors (good 1)
L/a1
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Exchange vs. Ricardo
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Trade
In this example p1w/p2wgt a1/a2
Corn (good 2)
L/a2
? (c2, t2)
? (c, t)
Tractors (good 1)
L/a1
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Trade
In this example p1w/p2wgt a1/a2 Could also have
the opposite, then the country specializes in 2.
Corn (good 2)
L/a2
? (c2, t2)
? (c3, t3)
? (c, t)
Tractors (good 1)
L/a1
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Autarky
Suppose both corn and tractors dont have
constant unit input requirements, but instead
display decreasing marginal productivity of
labor?
Corn (good 2)
Tractors (good 1)
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Autarky
Consume on the highest indifference curve that is
feasible, i.e. the one tangent to the production
frontier.
Corn (good 2)
? (c, t)
Tractors (good 1)
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Autarky
In equilibrium, prices have to be tangent to the
indifference curve.
Corn (good 2)
? (c, t)
Tractors (good 1)
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Trade
Suppose the world price ratio is smaller.
Corn (good 2)
? (c, t)
Tractors (good 1)
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Trade
Suppose the world price ratio is smaller.
Corn (good 2)
? (c, t)
? (c2, t2)
Tractors (good 1)
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Trade Triangle
Suppose the world price ratio is smaller? You
produce at c1, t1, but consume at c2, t2.
Corn (good 2)
? (c1, t1)
Exports of corn
? (c2, t2)
Imports of Tractors
Tractors (good 1)