ECON 121: International Trade Theory

Lecture 3: Ricardian Model (Intro)

Pablo Fajgelbaum

UCLA

October 2, 2024
This Lecture

Basic elements of the Ricardian Model

Based on Krugman et al., Chapter 3

Where do Gains From Trade Come From?
Where do Gains From Trade Come From?

1 More efficient allocation of resources

▶ i.e. resources moving where they are more productive
▶ within countries that differ in technologies, factors of production,

institutions,...

2 More efficient allocation of consumption

▶ i.e. goods move where they are valued more
▶ across consumers with different incomes, tastes,...

3 Market size
▶ higher efficiency through returns to scale
▶ product diversity
▶ more competition
But will everyone be better off?

Think of trade the same way you do as some big innovation

▶ Creates winners and losers
▶ Expansion and contraction of sectors
▶ Changes what jobs are available

In an international trade context, who finds trade beneficial?

▶ Buyers of imports (consumers and firms)
▶ Sellers of exports (workers, business owners)

Gains From Trade Theorem: when all gains and losses within a country are added
up, countries are better off trading
David Ricardo (1772-1823)

British of Portuguese descent

Member of Parliament
Inspired to think about economics after reading Wealth of Nations
Wrote Principles of Political Economy and Taxation (1817)
Ricardo’s Idea: Comparative Advantage

Intellectual context: Mercantilist thinking, i.e.,

▶ a positive trade balance is the source of a nation’s wealth, and
▶ tariffs are a policy instrument to achieve it

Ricardo: an argument against mercantilism

▶ Trade is advantageous even when people didn’t think it would be
▶ Trade benefits both partners, even if one is a clearly superior producer
of all goods

Two key concepts:

▶ Absolute advantage: one country is better at everything
▶ Comparative advantage: one country is relatively better than you in
some things versus others
Comparative Advantages in Ricardo’s Words

From Chapter 7 of David Ricardo’s Principles (1817)

“Under a system of perfectly free commerce, each country naturally devotes its
capital and labour to such employments as are most beneficial to each. This
pursuit of individual advantage is admirably connected with the universal good of
the whole. By stimulating industry (...) and by using most efficaciously the
peculiar powers bestowed by nature, it distributes labour most effectively and most
economically.(...) It is this principle which determines that wine shall be made in
France and Portugal, that corn shall be grown in America and Poland, and that
hardware and other goods shall be manufactured in England.”

"England exported cloth [to Portugal] in exchange for wine because, by so doing,
her industry was rendered more productive to her; she had more cloth and wine
than if she had manufactured both for herself; and. . . the industry of Portugal
could be more beneficially employed for both countries in producing wine."
A Non-Intuitive Idea

Paul Samuelson: “Comparative advantage is the best example of an

economic principle that is undeniably true yet not obvious to
intelligent people.”

Deirdre McCloskey: “If you can instantly grasp that logic (and go on
believing it for practical purposes such as opposing Donald Trump’s
view of foreign trade) you are either already an economist or have an
astonishing natural ability for the subject.”
Ricardian Model

Questions that the model answer:

▶ How does growth of foreign countries impact the domestic country?
▶ Does it matter how foreign countries grow?
⋆ accumulation of factors (population growth)
⋆ sector-neutral vs sector biased technological growth
▶ Which country gains more from international trade?

Model is NOT designed to answer distributional questions

Empirical foundations. Consistent with:

▶ Productivity drives trade
▶ Large countries trade less relative to GDP
Ricardian Model Assumptions
2 countries (Home and Foreign) and 2 goods (Wine and Cheese)

One factor of production: Labor

▶ L and L∗ : endowments of labor in Home and Foreign
▶ We use * to denote variables in Foreign country

Production function has constant returns to scale

Lj
▶ Quantity produced of good j = C , W at Home: Qj =
aLj
L∗
⋆ At Foreign: Qj∗ = j
∗
aLj
▶ Lj and L∗j are quantities of labor used in good j at Home and Foreign
∗
▶ aLj and aLj are the unit labor requirements

Workers are freely mobile across sectors (but immobile between countries)

Perfect competition
Ricardian Model Assumptions
2 countries (Home and Foreign) and 2 goods (Wine and Cheese)

One factor of production: Labor

▶ L and L∗ : endowments of labor in Home and Foreign
▶ We use * to denote variables in Foreign country

Production function has constant returns to scale

Lj
▶ Quantity produced of good j = C , W at Home: Qj =
aLj
L∗
⋆ At Foreign: Qj∗ = j
∗
aLj
▶ Lj and L∗j are quantities of labor used in good j at Home and Foreign
∗
▶ aLj and aLj are the unit labor requirements

Workers are freely mobile across sectors (but immobile between countries)

Perfect competition
Ricardian Model Assumptions
2 countries (Home and Foreign) and 2 goods (Wine and Cheese)

One factor of production: Labor

▶ L and L∗ : endowments of labor in Home and Foreign
▶ We use * to denote variables in Foreign country

Production function has constant returns to scale

Lj
▶ Quantity produced of good j = C , W at Home: Qj =
aLj
L∗
⋆ At Foreign: Qj∗ = j
∗
aLj
▶ Lj and L∗j are quantities of labor used in good j at Home and Foreign
∗
▶ aLj and aLj are the unit labor requirements

Workers are freely mobile across sectors (but immobile between countries)

Perfect competition
Ricardian Model Assumptions
2 countries (Home and Foreign) and 2 goods (Wine and Cheese)

One factor of production: Labor

▶ L and L∗ : endowments of labor in Home and Foreign
▶ We use * to denote variables in Foreign country

Production function has constant returns to scale

Lj
▶ Quantity produced of good j = C , W at Home: Qj =
aLj
L∗
⋆ At Foreign: Qj∗ = j
∗
aLj
▶ Lj and L∗j are quantities of labor used in good j at Home and Foreign
∗
▶ aLj and aLj are the unit labor requirements

Workers are freely mobile across sectors (but immobile between countries)

Perfect competition
Ricardian Model Assumptions
2 countries (Home and Foreign) and 2 goods (Wine and Cheese)

One factor of production: Labor

▶ L and L∗ : endowments of labor in Home and Foreign
▶ We use * to denote variables in Foreign country

Production function has constant returns to scale

Lj
▶ Quantity produced of good j = C , W at Home: Qj =
aLj
L∗
⋆ At Foreign: Qj∗ = j
∗
aLj
▶ Lj and L∗j are quantities of labor used in good j at Home and Foreign
∗
▶ aLj and aLj are the unit labor requirements

Workers are freely mobile across sectors (but immobile between countries)

Perfect competition
Production Possibilities of the Economy
Wine 𝑄"

𝐿
𝑎&"

𝑎&#
𝑎&"

𝐿 Cheese 𝑄#
𝑎&#

What is the meaning of the slope (aLC /aLW ) of the PFF?

Production Possibilities of the Economy
Wine 𝑄"

𝐿
𝑎&"

𝑎&#
𝑎&"

𝐿 Cheese 𝑄#
𝑎&#

The slope of the PPF the opportunity cost of Cheese in terms of Wine
Relative Prices and Supply
Definitions:
▶ w = wage
▶ PC = price of C, PW = price of W

Value of the marginal product of labor (i.e., how much revenue does a unit of
labor create?)
▶ In C: PC
aLC
PW
▶ In W: aLW

Given prices, workers choose to work where the value of the marginal product is
higher. Hence:  
PC PW
w = max ,
aLC aLW
PC aLC
▶ If PW
= aLW
, workers are indifferent (and both goods could be produced)
PC aLC
▶ If PW
> aLW
, all workers produce cheese
PC aLC
▶ If PW
< aLW
, all workers produce wine
Consumers

Each worker is a consumer with wage income w

▶ Budget constraint of each consumer:

PC cC + PW cW ≤ w

⋆ cC and cW is the consumption of C and W of each consumer

▶ Each consumer chooses cC and cW to maximize individual utility U (cC , cW )

From consumer optimization, relative demand for good C is defined as follows:

cC
RD =
cW
PC
▶ RD decreases with the relative price of C : PW
↑, then RD ↓
▶ Does not depend on income
Individual Budget Constraint
Wine 𝑐!

𝑃! 𝑐! + 𝑃" 𝑐" = 𝑤

𝑃!
𝑃"

Cheese 𝑐"
Individual Budget Constraint and Utility
Wine 𝑐!

𝑈 𝑐" , 𝑐!

𝑃!
𝑃"

Cheese 𝑐"
Relative Prices under Autarky

Suppose that the Home economy is in autarky (=closed to international trade)

Because each country must produce both goods, then under autarky at Home:
PCa Pa
wa = = W
aLC aLW
▶ Where w a , PCa , PW
a
denote the value of each variable under autarky

Therefore, under autarky, relative prices equal relative unit labor requirements
 a
PC aLC
=
PW aLW

▶ I.e., the autarky price equals the opportunity cost

Individual Consumption under Autarky
Wine 𝑐!

𝑢 # = 𝑈 𝑐"# , 𝑐!
#

𝑃! 𝑎!
=
𝑃" 𝑎"

Cheese 𝑐"

Under autarky, utility is u A

Aggregate Economy’s Budget Constraint
Wine

𝑃𝑃𝐹 = 𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 𝐵𝑢𝑑𝑔𝑒𝑡 𝐶𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑡

𝐿
𝑎$"

#
𝑃! 𝑎$!
=
𝑃" 𝑎$"

𝐿 Cheese
𝑎$!

Under Autarky, the PPF of the economy determines what the economy can consume
Aggregate Economy’s Budget Constraint
Wine

𝐴𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 𝑃𝑜𝑖𝑛𝑡 𝑢𝑛𝑑𝑒𝑟 𝐴𝑢𝑡𝑎𝑟𝑘𝑦

" "
𝐶! = 𝑄!

𝑈 𝐶# , 𝐶! = 𝐿 ∗ 𝑢"
#
𝑃! 𝑎$!
=
𝑃" 𝑎$"

𝐶#" = 𝑄#" Cheese

a = Q a and C a = Q a
Aggregate consumption equals aggregate production: CW W C C
Recap of Key Concepts

Unit Labor Requirement

Production Possibility Frontier

Resource Constraint

Budget Constraint

Autarky
Next Lecture

Specialization patterns and the gains from trade in the Ricardian

Model

Please read Chapter 3 of Krugman et al. and Chapter 2 of Irwin