ECON7530

Lecture 2
Comparative Advantage and
The Ricardian Model (Part 1)
Nhan Phan
UQ School of Economics
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2
Learning Objectives
• Explain how the Ricardian model, the most basic model of
international trade, works and how it illustrates the principle of
comparative advantage.
• Distinguish between absolute and comparative advantage, and a
related concept, opportunity costs.
• Describe a no-trade equilibrium using each country’s production
possibilities frontier (PPF) and indifference curve (IC).
• This is a building block, leading to the trade equilibrium for next
week, where we learn how countries gain from trade.
UQ Extend – Why Do Countries Trade?
2 basic reasons:
1. Countries are different from each other
Each country can benefit by concentrating on making goods at which it is
relatively better at producing, and trading for everything else.
• Difference in productivity of labour (due to differences in technology)
• Difference in production resources (labour, labour skills, physical capital, land,
or other factors of production)
2. To achieve economies of scale
• Economies of scale: higher production at lower average cost
UQ Extend
Summary of International Trade theories
Country Reasons of Trade

Difference in
Ricardian model different technology(labour
productivity) Comparative
Advantage
Difference in factor
Hecksher-Ohlin model different
endowment

can be
New trade theory Economies of Scale
identical
Before Ricardo: Mercantilism
(from 1500 to 1800)
• The wealth of a country depends on the
assets (such as gold and silver)
• Export (or trade surplus) is one way of
accumulating wealth: Imports (or trade
deficit) will lead to loss of wealth
• Foreign trade is a zero-sum game (one
country benefits at the expense of others.)
• Smith and Ricardo  react to Mercantilism

Source: Adobe Stock

 The Ricardian Model
Labour productivity
and comparative advantage
UQ Extend – Comparative Advantage
• Opportunity Costs: the value of the next-best alternative when a
decision is made; it's what is given up.
A country has a Comparative Advantage in the production of a good if
the opportunity cost of producing that good is lower in that country
than in other countries.
vs absolute advantage: When one country can produce a unit of a
good with less labour than another country, we say that the first
country has an absolute advantage in producing that good.
 Example - Comps and Roses

Source: Behance|Adobe Stock

Example - Comps and Roses
• Suppose a limited number of workers could produce either roses or
computers.
• Suppose that in the U.S., 1 worker can produce either
100 Computers Or 10000 Roses
• Suppose that in Columbia, 1 worker can produce either
60 Computers Or 9000 Roses
• The U.S. has an absolute advantage in producing BOTH computers
and roses. But what about comparative advantages?
Example - Comps and Roses
• What is the U.S.’s opportunity cost for 1 computer (in terms of roses)?
• How many roses must the US give up producing in order to produce 1 computer?
• What is Colombia’s opportunity cost of production for 1 computer?
• Which country has a lower opportunity cost of production for 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.
Comps and Roses – Opportunity Costs
U.S. Opportunity Cost (OC) of production for Computers
• 1 worker can produce either 100 Computers or 10000 Roses
 If the U.S. wants to produce 100 more Computers, it must take one
worker away from producing Roses, and giving up 10000 Roses
• To produce 1 more Computer, it must give up
10000 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
= 100 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑝𝑝𝑝𝑝𝑝𝑝 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
100 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
• The U.S.’s OC of producing 1 Computer is 100 Roses.
1
• Equivalently, the U.S.’s OC of producing 1 Rose is Computers.
100
Comps and Roses – Opportunity Costs
Columbia’s Opportunity Cost (OC) of production for Computers
• If Columbia wants to produce 60 more Computers, it must take one worker
away from producing Roses – giving up 9000 Roses
• To produce 1 more Computer, it must give up (on average)
9000 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
= 150 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑝𝑝𝑝𝑝𝑝𝑝 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶
60 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶

• Columbia’s OC of producing 1 Computer is 150 Roses.

1
• Equivalently, Columbia’s OC of producing 1 Rose is Computers.
150
Comps and Roses – Opportunity Costs
Opportunity Cost of In the United States In Columbia

1 Computer 100 Roses 150 Roses

1 𝟏𝟏
1 Rose Computers Computers
100 𝟏𝟏𝟏𝟏𝟎𝟎

• A country has a Comparative Advantage in producing a good if the

opportunity cost of producing that good is lower than in other countries.
• U.S. has a comparative advantage in Computer production
• Lowest OC of production for Computers
• Colombia has a comparative advantage in Rose production
• Lowest OC of production for Roses
Comps and Roses – Gains from Trade
• Suppose that the U.S. and Columbia have 10 workers each.
• Consumers want to have both Computers and Roses.
• Suppose in autarky (without trade):
• In the U.S., 6 workers produce Computers, and 4 workers produces Roses
• In Columbia, 5 workers produce Computers, and 5 workers produces Roses
Autarky Computers Roses
U.S. 600 40000
Columbia 300 45000

• Can we do better? Most definitely.

Comps and Roses – Gains from Trade
• Now, suppose all 10 workers in the U.S. produce Computers, and all
10 workers in Columbia produce Roses.
• What will be total world production?
• 1000 computers (U.S.) and 90,000 roses (Columbia)
• Equalizing: now let the U.S. exchange 350 Computers for 42500 Roses
• Both countries now have more Computers and Roses than in autarky!
Autarky Computers Roses Trade Computers Roses
U.S. 600 40000 U.S. 650 42500
Columbia 300 45000 Columbia 350 47500
Comps and Roses – Gains from Trade
• But how do we know they can gain from U.S. specialising in
Computers and Columbia in Roses?
• The U.S. has a comparative advantage in Computers
• Columbia has a comparative advantage in Roses

• Theory of Comparative Advantage: Trade can benefit both countries if

each country exports the goods in which it has a comparative
advantage in.
 UQ Extend – One-Factor Economy
Assumptions
1. Labour is the only factor of production (One-Factor).
2. Labour productivity varies across countries due to differences in
technology, but labour productivity in each country is constant.
3. The supply of labour in each country is constant.
4. Two goods: Wine and Cheese.
5. The Labour market is competitive, and workers can move freely
between industries.
6. Two countries: Home and Foreign.
UQ Extend – One-Factor Economy
• 𝐿𝐿: Total labour force in Home
• 𝑎𝑎𝐿𝐿𝐶𝐶 : Unit labour requirement (ULR) for Cheese
• 𝑎𝑎𝐿𝐿𝑊𝑊 : Unit labour requirement for Wine
• Unit Labour Requirement is the inverse of Labour Productivity
1
• 𝑎𝑎𝐿𝐿𝐿𝐿 = 2: a worker can produce = 0.5 units of cheese in one hour.
𝑎𝑎𝐿𝐿𝐿𝐿
1
• 𝑎𝑎𝐿𝐿𝐿𝐿 = 10: a worker can produce = 0.1 units of cheese in one hour.
𝑎𝑎𝐿𝐿𝐿𝐿
UQ Extend – One-Factor Economy
• 𝑄𝑄𝐶𝐶 : Quantity of Cheese (in pounds) Produced at Home
• 𝑄𝑄𝑊𝑊 : Quantity of Wine (in gallons) Produced at Home
•  𝑎𝑎𝐿𝐿𝐿𝐿 𝑄𝑄𝐶𝐶 : Labour hours employed in Cheese production
•  𝑎𝑎𝐿𝐿𝑊𝑊 𝑄𝑄𝑊𝑊 : Labour hours employed in Wine production
• Home economy has limited resources for production.
• 𝐿𝐿 labour hours to produce Cheese and Wine.
• Total labour hours employed in Cheese and Wine production
combined must be less than or equal to total labour hours available in
the Home economy
𝑎𝑎𝐿𝐿𝐿𝐿 𝑄𝑄𝐶𝐶 + 𝑎𝑎𝐿𝐿𝐿𝐿 𝑄𝑄𝑊𝑊 ≤ 𝐿𝐿
UQ Extend – Production Possibilities
• If the Home economy is efficiently employing all available labour
resources in the economy, we have the Production Possibilities
Frontier (PPF):
𝑎𝑎𝐿𝐿𝐿𝐿 𝑄𝑄𝐶𝐶 + 𝑎𝑎𝐿𝐿𝐿𝐿 𝑄𝑄𝑊𝑊 = 𝐿𝐿
• This shows the maximum amount of a goods that can be produced for a fixed
amount of resources.

• Rearranging the PPF:

𝐿𝐿 𝑎𝑎𝐿𝐿𝐿𝐿
𝑄𝑄𝑊𝑊 = − 𝑄𝑄𝐶𝐶
𝑎𝑎𝐿𝐿𝐿𝐿 𝑎𝑎𝐿𝐿𝐿𝐿
UQ Extend – Production Possibilities
• PPF for Home economy
𝐿𝐿 𝑎𝑎𝐿𝐿𝐿𝐿
𝑄𝑄𝑊𝑊 = − 𝑄𝑄
𝑎𝑎𝐿𝐿𝐿𝐿 𝑎𝑎𝐿𝐿𝐿𝐿 𝐶𝐶
• Suppose 𝐿𝐿 = 1000, 𝑎𝑎𝐿𝐿𝐿𝐿 = 1 and
𝑎𝑎𝐿𝐿𝐿𝐿 = 2.
• Then the PPF can be written as
1
𝑄𝑄𝑊𝑊 = 500 − 𝑄𝑄𝐶𝐶
2
UQ Extend – Production Possibilities
1
• 𝑄𝑄𝑊𝑊 = 500 − 𝑄𝑄𝐶𝐶 : PPF can also be written as
2
𝑄𝑄𝐶𝐶 = 1000 − 2𝑄𝑄𝑊𝑊
• If Home want to produce 𝑄𝑄𝑊𝑊 = 200 units of Wine, the maximum amount
of Cheese that can be produced is 𝑄𝑄𝐶𝐶 = 1000 − 2 ⋅ 200 = 600.

• The PPF tells us all the possible combinations of Wine and Cheese that
can be produced, given the Labour force available in the Home economy.
UQ Extend – Opportunity Cost
𝐿𝐿 𝑎𝑎𝐿𝐿𝐿𝐿
𝑄𝑄𝑊𝑊 = − 𝑄𝑄𝐶𝐶
𝑎𝑎𝐿𝐿𝐿𝐿 𝑎𝑎𝐿𝐿𝐿𝐿
• If Home economy produces 1 more unit of Cheese, then the production of
Wine must fall by 𝑎𝑎𝐿𝐿𝐿𝐿⁄𝑎𝑎𝐿𝐿𝐿𝐿 units.
𝑎𝑎𝐿𝐿𝐿𝐿
• Hence the opportunity cost of Cheese in the Home economy is 𝑂𝑂𝐶𝐶𝐶𝐶 =
𝑎𝑎𝐿𝐿𝐿𝐿
• The absolute value of the slope of the PPF
• The opportunity cost is constant: the unit labour requirements are both constant.
𝑎𝑎𝐿𝐿𝑊𝑊
• Similarly, the opportunity cost of Wine is 𝑂𝑂𝐶𝐶𝑊𝑊 =
𝑎𝑎𝐿𝐿𝐶𝐶
UQ Extend – Relative Prices and Supply
• The PPF tells us what
combinations of goods can
possibly be produced, given
technology and resources
available to the economy.
• To determine what
combination of Wine and
Cheese is actually produced,
we need to know the relative
price of Cheese and Wine.
UQ Extend – Relative Prices and Supply
• Notation:
• 𝑃𝑃𝐶𝐶 : Price of Cheese in Home country
• 𝑃𝑃𝑊𝑊 : Price of Wine in Home country
𝑃𝑃𝐶𝐶
• : Relative Price of Cheese (with respect to Wine) in the Home Country.
𝑃𝑃𝑊𝑊
• 𝑤𝑤𝐶𝐶 : Hourly wage rate in the Cheese Industry in the Home Country
• 𝑤𝑤𝑊𝑊 : Hourly wage rate in the Wine Industry in the Home Country

•  Total costs (TC) in Cheese Industry: 𝑇𝑇𝐶𝐶𝐶𝐶 = 𝑤𝑤𝐶𝐶 ⋅ 𝑎𝑎𝐿𝐿𝐶𝐶 ⋅ 𝑄𝑄𝐶𝐶

•  Total costs (TC) in Wine Industry: 𝑇𝑇𝐶𝐶𝑊𝑊 = 𝑤𝑤𝑊𝑊 ⋅ 𝑎𝑎𝐿𝐿𝐿𝐿 ⋅ 𝑄𝑄𝑊𝑊
UQ Extend – Relative Prices and Supply
• Assumption: markets for Wine and Cheese are perfectly competitive.
• Zero Industry Profit condition at (Long Run) market equilibria:
Π𝐶𝐶 = 𝑇𝑇𝑅𝑅𝐶𝐶 − 𝑇𝑇𝐶𝐶𝐶𝐶 = 𝑃𝑃𝐶𝐶 𝑄𝑄𝐶𝐶 − 𝑤𝑤𝐶𝐶 𝑎𝑎𝐿𝐿𝐿𝐿 𝑄𝑄𝐶𝐶 = 0
Π𝑊𝑊 = 𝑇𝑇𝑅𝑅𝑊𝑊 − 𝑇𝑇𝐶𝐶𝑊𝑊 = 𝑃𝑃𝑊𝑊 𝑄𝑄𝑊𝑊 − 𝑤𝑤𝑊𝑊 𝑎𝑎𝐿𝐿𝑊𝑊 𝑄𝑄𝑊𝑊 = 0

 Wage rates must equal marginal revenue of labour in each industry

in the LR Equilibrium:
𝑷𝑷𝑪𝑪 𝑷𝑷𝑾𝑾
𝒘𝒘𝑪𝑪 = 𝐚𝐚𝐚𝐚𝐚𝐚 𝒘𝒘𝑾𝑾 =
𝒂𝒂𝑳𝑳𝑳𝑳 𝒂𝒂𝑳𝑳𝑾𝑾
UQ Extend – Relative Prices and Supply
• Assumption 5: The Labour market is competitive, and workers can
move freely between industries.
• If the Wine industry pays better (𝑤𝑤𝑊𝑊 > 𝑤𝑤𝐶𝐶 ), every worker will work in the
Wine industry: Home economy will specialise in the production of Wine.
• If the Cheese industry pays better (𝑤𝑤𝑊𝑊 < 𝑤𝑤𝐶𝐶 ), only Cheese will be produced.

• But if Home doesn’t trade with any other country, then both Wine
and Cheese must be produced in the economy.
•  𝒘𝒘𝑾𝑾 = 𝒘𝒘𝑪𝑪 if Home doesn’t trade with another country.
UQ Extend – Relative Prices and Supply
𝑃𝑃𝐶𝐶 𝑃𝑃𝑊𝑊
Industry wage rates: 𝑤𝑤𝐶𝐶 = and 𝑤𝑤𝑊𝑊 =
𝑎𝑎𝐿𝐿𝐿𝐿 𝑎𝑎𝐿𝐿𝐿𝐿

• Home will only produce Cheese if 𝑤𝑤𝐶𝐶 > 𝑤𝑤𝑊𝑊

• Or If the relative price of cheese is greater than the OC of cheese in terms of
𝑃𝑃𝐶𝐶 𝑎𝑎𝐿𝐿𝐿𝐿
wine: >
𝑃𝑃𝑊𝑊 𝑎𝑎𝐿𝐿𝐿𝐿

• Home will only produce Wine if wC < 𝑤𝑤𝑊𝑊

• Or if the relative price of cheese is less than the opportunity cost of cheese in
𝑃𝑃𝐶𝐶 𝑎𝑎𝐿𝐿𝐿𝐿
terms of wine: <
𝑃𝑃𝑊𝑊 𝑎𝑎𝐿𝐿𝐿𝐿
UQ Extend – Relative Prices and Supply
• Home will produce both Cheese and Wine if 𝑤𝑤𝐶𝐶 = 𝑤𝑤𝑊𝑊 or, equivalently,
if the relative price of cheese is equal to the opportunity cost of cheese in
terms of wine.
𝑃𝑃𝐶𝐶 𝑎𝑎𝐿𝐿𝐿𝐿
=
𝑃𝑃𝑊𝑊 𝑎𝑎𝐿𝐿𝐿𝐿
• If there is no trade, the relative price of Cheese at Home must equal its
opportunity cost of production in terms of Wine.
• Labour Theory of Value in absence of Trade: Relative prices of goods are
equal to their relative unit labour requirements
A Whole New Country
Consider now the Foreign country (noted by a ∗ in notations). Let:
• 𝐿𝐿∗ : Available Labour Force in Foreign
∗ ∗
• 𝑎𝑎𝐿𝐿𝐿𝐿 , 𝑎𝑎𝐿𝐿𝐿𝐿 : Unit Labour Requirements for Cheese and Wine in Foreign,
respectively
• Suppose that Home has a comparative advantage in the production of Cheese
• Home has lower opportunity cost of Cheese production than Foreign
• Equivalently, Foreign has the comparative advantage in producing Wine
∗ ∗
𝑎𝑎𝐿𝐿𝐿𝐿 𝑎𝑎𝐿𝐿𝐿𝐿 𝑎𝑎𝐿𝐿𝑊𝑊 𝑎𝑎𝐿𝐿𝑊𝑊
𝑂𝑂𝐶𝐶𝐶𝐶 = < ∗ = 𝑂𝑂𝐶𝐶𝐶𝐶∗ 𝑂𝑂𝐶𝐶𝑊𝑊 = ∗
> ∗ = 𝑂𝑂𝐶𝐶𝑊𝑊
𝑎𝑎𝐿𝐿𝐿𝐿 𝑎𝑎𝐿𝐿𝐿𝐿 𝑎𝑎𝐿𝐿𝐶𝐶 𝑎𝑎𝐿𝐿𝐶𝐶
Foreign’s PPF
∗
𝐿𝐿∗ 𝑎𝑎𝐿𝐿𝐿𝐿
∗
𝑄𝑄𝑊𝑊 = ∗ − ∗ 𝑄𝑄𝐶𝐶∗
𝑎𝑎𝐿𝐿𝐿𝐿 𝑎𝑎𝐿𝐿𝑊𝑊
• Foreign’s opportunity cost of producing Cheese
is higher than Home’s
∗
𝑎𝑎𝐿𝐿𝐿𝐿 𝑎𝑎𝐿𝐿𝐿𝐿
∗ >
𝑎𝑎𝐿𝐿𝐿𝐿 𝑎𝑎𝐿𝐿𝐿𝐿

When 𝑄𝑄𝐶𝐶∗ is on the Horizontal axis:

• The (absolute) slope of Foreign’s PPF is greater
than that for Home.
• Foreign’s PPF is steeper.
Relative Prices in Autarky
• In autarky, in each country: Relative Price of Cheese is determined by
Relative Unit Labour Requirements of Cheese
• Reflects the opportunity cost of cheese in terms of wine

𝑃𝑃𝐶𝐶 𝑎𝑎𝐿𝐿𝐿𝐿 𝑃𝑃𝐶𝐶∗ ∗

𝑎𝑎𝐿𝐿𝐿𝐿
= ∗ = ∗
𝑃𝑃𝑊𝑊 𝑎𝑎𝐿𝐿𝐿𝐿 𝑃𝑃𝑊𝑊 𝑎𝑎𝐿𝐿𝐿𝐿
• But what if the 2 countries can trade with one another?
• Will they want to trade with one another?
• Will prices change in each country? How?
• Will each country benefit from trade?
Trade in the Ricardian Model
• In autarky, since Home has a comparative advantage in Cheese
∗
𝑎𝑎𝐿𝐿𝐿𝐿 𝑎𝑎𝐿𝐿𝐿𝐿
< ∗ , relative price of Cheese must be lower at Home than in
𝑎𝑎𝐿𝐿𝐿𝐿 𝑎𝑎𝐿𝐿𝐿𝐿
Foreign:
𝑎𝑎𝐿𝐿𝐿𝐿 𝑃𝑃𝐶𝐶 𝑃𝑃𝐶𝐶∗ ∗
𝑎𝑎𝐿𝐿𝐿𝐿
= < ∗ = ∗
𝑎𝑎𝐿𝐿𝐿𝐿 𝑃𝑃𝑊𝑊 𝑃𝑃𝑊𝑊 𝑎𝑎𝐿𝐿𝐿𝐿

• If trade is allowed, will relative prices in each country stay at pre-trade

levels?
Trade in the Ricardian Model
• Suppose trade is possible, and that the relative price of cheese is still lower in Home,
𝑃𝑃𝐶𝐶 𝑃𝑃𝐶𝐶∗
such that < ∗
𝑃𝑃𝑊𝑊 𝑃𝑃𝑊𝑊
• An arbitrage possibility arises: A trader can perform the following transaction to earn
profit:
Transaction Price Change
Buy 1 unit of Cheese in Home 𝑃𝑃𝐶𝐶 𝑃𝑃𝐶𝐶 : monetary cost
Sell 1 unit of Cheese in Foreign 𝑃𝑃𝐶𝐶∗ +𝑃𝑃𝐶𝐶∗ − 𝑃𝑃𝐶𝐶 : monetary gain
∗ 𝑃𝑃𝐶𝐶∗
Buy Wine in Foreign with money from sale of Cheese 𝑃𝑃𝑊𝑊 ∗ units of wine bought
𝑃𝑃𝑊𝑊
𝑃𝑃𝐶𝐶∗
Sell Wine in Home 𝑃𝑃𝑊𝑊 ∗ ⋅ 𝑃𝑃𝑊𝑊 : monetary gain
𝑃𝑃𝑊𝑊
𝑃𝑃𝐶𝐶∗
Net Change ∗ ⋅ 𝑃𝑃𝑊𝑊 − 𝑃𝑃𝐶𝐶 > 0
𝑃𝑃𝑊𝑊
Trade in the Ricardian Model
• If relative price of Cheese is lower in Home, everyone has an incentive to
• Buy Cheese from Home to Sell in Foreign
• Buy Wine from Foreign to Sell in Home.
• Home:
• Demand for Cheese will increase, pushing up the Home Price of Cheese ↑ 𝑃𝑃𝐶𝐶
• Supply of Wine will increase, pushing down the Home Price of Wine (↓ 𝑃𝑃𝑊𝑊 )
𝑃𝑃𝐶𝐶
•  Relative Home Price of Cheese will Increase ↑
𝑃𝑃𝑊𝑊
• Foreign:
• Supply of Cheese will increase, pushing down the Foreign Price of Cheese ↓ 𝑃𝑃𝐶𝐶∗
∗
• Demand for Wine will increase, pushing up the Foreign Price of Wine (↑ 𝑃𝑃𝑊𝑊 )
𝑃𝑃𝐶𝐶∗
•  Relative Foreign Price of Cheese will Fall ∗ ↓
𝑃𝑃𝑊𝑊
Equilibrium Relative Price after Trade
• Therefore, relative prices must be the same in both countries after
trade.
• Otherwise, arbitrage opportunities exist, moving relative prices until they are
equal.
𝑃𝑃𝐶𝐶 𝑃𝑃𝐶𝐶∗
= ∗
𝑃𝑃𝑊𝑊 𝑃𝑃𝑊𝑊
• But how is the equilibrium relative price determined?
• To be continued in the next lecture!
Summary
1. Differences in the productivity of labour 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 other
countries.
3. Countries export goods in which they have a comparative advantage
– high productivity or low wages give countries a cost advantage.