Learning Unit 2 ECON452

Ricardian Model and Comparative Advantage International Economics

Objectives
1. Describe the Ricardian model, the most basic model of international
trade with its assumptions
2. Illustrate and interpret a diagram representation and a table
representation of Ricardian model
3. Explain the concept of absolute advantage and the concept of
comparative advantage
Introduction
Two basic reasons 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)
This course develops and presents tools and models to help us
understand how differences between countries give rise to trade
between them and why this trade is mutually beneficial.
International Economic Models
For simplicity, most tools and models are presented in a simplest form
of two countries, two goods, and two (or one) factors and looks at one
specific difference between two countries at time.
– Productivity
– Factor endowment
– Factor mobility
We start with the simplest model called “Ricardian model” and later
extends the model to examine effects of these differences among
countries to lead trade among them.
Purposes of International Economic Models
With tools and models, we examine and measure the five aspects of
trade in economy:
– Pattern of trade (Who trades what)
– Volume of trade (How much to trade)
– Gains from trade (Reasons for trade)
– Income distribution effect of trade (Why some oppose to trade)
– Short-run and long-run effects of trade
Although models are extended, we will examine the same five aspects
of trade in the same way as the Ricardian model.
Mercantilists’ View on Trade

Mercantilism: Belief in the 16th to 18th century Europe that wealth of

country is measure by the stock of precious metals it possesses.
• More gold and silver enable a ruler to maintain stronger army and navy.
• A trade surplus leads to inflow of gold and silver.
• The government restricts imports and stimulate exports.
Neo-mercantilism: the government restricts imports to protect
domestic firms and employment.
Classical Economists’ View on Trade

• David Hume: Argued against British trade policy based on

Mercantilism in the 18th century
• Adam Smith: Advocate free trade which increases wealth (GDP) of
nations in 1776
• David Ricardo: Extend Adam Smith’s argument for free trade by
introducing the concept of comparative advantage and illustrating
gains from trade in the early 19th century
– Ricardian Model
A One-Factor Ricardian Model

Assumptions on the Ricardian model:

1. Two countries: home and foreign
2. Two goods: wine and cheese
3. One factor of production: Labor is the only factor of production.
4. Labor productivity varies across countries due to differences in technology, but
labor productivity across industries is constant in each country.
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.
Unit Labor Requirement
• Unit labor requirement: the number of hours of labor required to produce one
unit of a good or service.
• Labor productivity: the amount of a good or service produced by one hour of
labor.
• A high unit labor requirement means low labor productivity.
Labor productivity = 1 / Unit labor requirement

• Example: It takes 2 hours of labor to produce one unit of wine.

– Unit labor requirement = 2 hours of labor
– Labor productivity = ½ unit of wine per hour of labor
Absolute Advantage
• Absolute advantage: One country is more productive (efficient) than the other
country in production of a good or service.
• When one country can produce one unit of good with less resource (less unit
labor requirement ) than another country, the first country has an absolute
advantage in producing that good.
• Example: Unit labor requirement to produce one pound of cheese is 1 hour of
labor in Home and 6 hours of labor in Foreign.
– Home has an absolute advantage in production of cheese over Foreign.
– Home has a higher labor productivity to produce cheese (1 unit per labor
hour) than Foreign (1/6 unit per labor hour).
 Model Setup and Variable Definitions
Two countries: Home and Foreign (*)
Two goods: Cheese (C) and Wine (W)
One factor of production: Labor (L)
Unit labor requirement Production goods
– to produce one unit of cheese in Home = aLC – Quantity of cheese production in Home = Qc
– to produce one unit of wine in Home = aLW – Quantity of wine production in Home = Qw
– to produce one unit of cheese in Foreign = aLC* – Quantity of cheese production in Foreign = Qc*
– to produce one unit of wine in Foreign = aLW* – Quantity of wine production in Foreign = Qw*
Total labor supply
– Home = L
– Foreign = L*
Absolute Advantage in One Factor Model

• If aLC < aLC* , then Home has an absolute advantage in production of cheese.
• If aLW > aLW* , then Foreign has an absolute advantage in production of wine.
• Each country should produce what they are good at (efficient), then the output
of both goods in the world will rise.
• Home specializes to produce cheese and Foreign specializes to produce wine,
then they exchange (trade) products.
Limitation of Absolute Advantage

• If ac < ac* and aw < aw* , then Home has an absolute advantage in production of
both goods.
• Should Home produce both goods and export both to Foreign? Will it increase
world output of both goods?
• Productivity by itself (absolute advantage) cannot determine a pattern of trade
or gains from trade.
Production Possibility Frontier

• Production Possibility Frontier: The boundary between the combinations of

goods and services that can be produced and the combinations that cannot be
produced, given the available factors of production and the state of technology.
• The country’s labor supply limits the production of two goods:
PPF of Home: aLCQc + aLWQw ≤ L
Maximum quantity of cheese produced = L/aLC
Maximum quantity of wine produced = L/aLW
Slope of PPF = aLC/aLW
Production Possibility Frontier - Example
• Unit labor requirement to produce one unit of cheese in Home = 1 hour of labor
• Unit labor requirement to produce one unit of wine in Home = 2 hours of labor
• Total labor supply in Home = 1,000 hours
– PPF of Home: Qc + 2 x Qw ≤ 1,000
– How many units of cheese can Home produce at most?
1,000 units = 1,000 hour / 1 labor hour
– How many units of wince can Home produce at most?
500 units = 1,000 hours / 2 labor hours
– Slope of Home’s PPF
1/2 = 1 labor hour / 2 labor hours
Opportunity Cost

• Opportunity cost: the value of the best alternative forgone. The benefits you
could have received by taking an alternative action.
• In case of two goods economy, an opportunity cost of producing one good is the
number of the other good that it sacrifices. It measures a tradeoff between two
goods.
• Example: Labor productivity in Home is 1 unit of cheese per hour and 1/2 unit of
wine per hour of labor.
– One hour of labor can produce either 1 unit of cheese or ½ unit of wine.
– An opportunity cost of producing 1 unit of cheese is ½ unit of wine
forgone.
Production Possibility Frontier - Diagram
• Slope of Home PPF = 500/1000 = ½
• Slope of PPF measures an opportunity
cost of producing one unit of a good
measured along the horizontal axis
(cheese) where it is measured in terms of
units of the other good measured along
the vertical axis foregone (wine).
– An opportunity cost of producing one unit
of cheese is ½ unit of wine.
• PPF is a straight line because an
opportunity cost is constant (1/2) that is,
its slope is constant.
Opportunity Cost - Formula

• Unit labor requirement to produce one pound of cheese in Home = aLC

• Unit labor requirement to produce one gallon of wine in Home = aLW
• Opportunity cost of one unit of cheese = aLC/aLW units of wine.
• Opportunity cost of one unit of wine = aLW/aLC units of cheese.
– Example: An opportunity cost of producing one unit of cheese is ½ unit of
wine, and an opportunity cost of producing one unit of wine is 2 units of
cheese.
• These costs are constant because the unit labor requirements are both constant.
Comparative Advantage

• 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.
• Law of comparative advantage: A country should specialize to
produce the goods on which the country has a comparative
advantage and export them.
Comparative Advantage - Formula
• Even if one country is at an absolute disadvantage relative to another country in
the production of every good, it has a comparative advantage in making at least
one good.
– Home country has a comparative advantage in production of cheese
if aLC/aLW < aLC*/aLW*
– Foreign country has a comparative advantage in production of wine
if aLW/aLC > aLW*/aLC*
• In a two-country, two-good model, if one country has a comparative advantage
in one good, then the other country must have a comparative advantage in the
other commodity.
– When aLC/aLW < aLC*/aLW*, it must be aLW/aLC > aLW*/aLC*.
Comparative Advantage - Example
If Unit labor requirement
• to produce one pound of cheese in Home = 1 hour of labor
• to produce one gallon of wine in Home = 2 hours of labor
• to produce one pound of cheese in Foreign = 6 hours of labor
• to produce one gallon of wine in Foreign = 3 hours of labor
Then, an opportunity cost
• to produce one pound of cheese is 1/2 in Home and 6/3 in Foreign.
• to produce one gallon of wine is 2 in Home and 3/6 in Foreign.
So,
• Home country has a comparative advantage in production of cheese (1/2 < 2).
• Foreign country has a comparative advantage in production of wine (2 > 1/2).
Relative Price
• Relative price: the price of one good divided by the price of another good
(Pc/Pw), where Pc is a price of cheese and Pw is a price of wine.
• Example: If a price of cheese (Pc) is $12 and a price of wine (Pw) is $24, then
Pc/Pw = $12/$24 = 1/2.
• Relative price is equal to the opportunity cost of the commodity in numerator
(cheese).
– On PPF diagram, relative price (Pc/Pw) is equal to a slope of PPF (aLC/aLW).
Pc/Pw = aLC/aLW
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Dr. Ryoichi Sakano
Dr. Ryoichi Sakano
North Carolina A&T State University
North Carolina A&T State University