Chapter 3

Labor Productivity
and Comparative
Advantage: The Ricardian
Model
Preview
• Opportunity costs and comparative advantage
• A one-factor Ricardian model
• Production possibilities
• Gains from trade
• Wages and trade
• Misconceptions about comparative advantage
• Transportation costs and non-traded goods
• Empirical evidence
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 (cont.)
• Sources of differences across countries that lead to
gains from trade:
- The Ricardian model (Chapter 3) examines
differences in the productivity of labor (due to
differences in technology) between countries.

- The Heckscher-Ohlin model (Chapter 4) examines

differences in labor, labor skills, physical capital, land,
or other factors of production between countries.
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.
Comparative Advantage and
Opportunity Cost (cont.)
• 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.
Comparative Advantage and
Opportunity Cost (cont.)
• Suppose that in the U.S. 10 million roses could be produced
with the same resources that could produce 100,000
computers.

• Suppose that in Colombia 10 million roses could be produced

with the same resources that could produce 30,000 computers.

• Workers in Columbia would be less productive than those in the

U.S. in manufacturing computers.
Comparative Advantage and
Opportunity Cost (cont.)
• Colombia has a lower opportunity cost of producing
roses.

- Colombia can produce 10 million roses, compared

to 30,000 computers that it could otherwise
produce.

- The U.S. can produce 10 million roses, compared to

100,000 computers that it could otherwise produce.
Comparative Advantage and
Opportunity Cost (cont.)
• The U.S. has a lower opportunity cost of producing
computers.
- Colombia can produce 30,000 computers, compared
to 10 million roses that it could otherwise produce.
- The U.S. can produce 100,000 computers, compared to
10 million roses that it could otherwise produce.
- The U.S. can produce 30,000 computers, compared to
3.3 million roses that it could otherwise produce.
Comparative Advantage and
Opportunity Cost (cont.)
• 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 U.S. has a comparative advantage in computer

production.

- Colombia has a comparative advantage in rose

production.
Comparative Advantage and
Opportunity Cost (cont.)

• Suppose initially that Colombia produces

computers and the U.S. produces roses, and that
both countries want to consume computers and
roses.

• Can both countries be made better off?

Table 3-1: Hypothetical Changes
in Production
Comparative Advantage and
Trade
• When countries specialize in production in which they have a
comparative advantage, more goods and services can be
produced and consumed.

- Have U.S. 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

(U.S. 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

• 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:
A One-Factor Ricardian Model
(cont.)

• 1. Labor is the only factor of production.

• 2. Labor productivity varies across countries due

to differences in technology, but labor
productivity in each country is constant.
• 3. The supply of labor in each country is constant.
A One-Factor Ricardian Model
(cont.)
• 4. Two goods: wine and cheese.

• 5. Competition allows workers to be paid a

“competitive” wage equal to the value of what
they produce, and allows them to work in the
industry that pays the highest wage.
• 6. Two countries: home and foreign.
A One-Factor Ricardian Model
(cont.)
• A unit labor requirement indicates the constant number of
hours of labor required to produce one unit of output.

- aLC is the unit labor requirement for cheese in the home

country. For example, aLC = 1 means that 1 hour of labor
produces one pound of cheese in the home country.

- aLW is the unit labor requirement for wine in the home country.
For example, aLW = 2 means that 2 hours of labor produces one
gallon of wine in the home country.

• A high unit labor requirement means low labor productivity.

A One-Factor Ricardian Model
(cont.)
• 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 production possibility frontier of the home

economy is:
Total amount of labor
resources

aLCQC + aLWQW ≤ L
Labor required for each Total gallons of
Total pounds Labor required for each
pound of cheese wine produced
of cheese gallon of wine produced
produced
produced
 Production Possibilities (cont.)

• Maximum home cheese production is

QC = L/aLC when QW = 0.

• Maximum home wine production is

QW = L/aLW when QC = 0.
Production Possibilities (cont.)

• For example, suppose that the economy’s

labor supply is 1,000 hours.

• The PPF equation aLCQC + aLWQW ≤ L

becomes QC + 2QW ≤ 1,000.

• Maximum cheese production is 1,000

pounds.

• Maximum wine production is 500 gallons.

Fig. 3-1: Home’s Production Possibility
Frontier
 Production Possibilities (cont.)
• The opportunity cost of cheese is how many
gallons of wine Home must stop producing in
order to make one more pound of cheese:
aLC /aLW
• This cost is constant because the unit labor
requirements are both constant.
• The opportunity cost of cheese appears as the
absolute value of the slope of the PPF.
QW = L/aLW – (aLC /aLW )QC
Production Possibilities (cont.)
• 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
equal to

1 hour/(aLW hours/gallon of wine)

= (1/aLW) gallons of wine

Production Possibilities (cont.)
• For example, if 1 hour of labor is moved to
cheese production, that additional hour could
have produced

1 hour/(2 hours/gallon of wine)

= ½ gallon of wine.

• Opportunity cost of producing one pound of

cheese is ½ gallon of wine.
Relative Prices, Wages, and
Supply
• Let PC be the price of cheese and PW be the price of wine.
• Due to competition,
- Hourly wages of cheese makers equal the value of
the cheese produced in an hour: PC /aLC
- Hourly wages of wine makers equal the value of the
wine produced in an hour: PW /aLW
• Because workers like high wages, they will work in the
industry that pays the higher wage.
Relative Prices, Wages, and
Supply (cont.)
• If the price of cheese relative to the price of
wine exceeds the opportunity cost of
producing cheese PC /PW > aLC /aLW ,

- Then the wage in cheese will exceed the

wage in wine PC /aLC > PW/aLW

- So workers will make only cheese (the

economy specializes in cheese production).
 Relative Prices, Wages, and
Supply (cont.)
• If the price of cheese relative to the price of
wine is less than the opportunity cost of
producing cheese PC /PW < aLC /aLW ,

- Then the wage in cheese will be less than

the wage in wine PC /aLC < PW/aLW

- So workers will make only wine (the

economy specializes in wine production).
Production, Prices, and Wages
• If the price of cheese relative to the price of
wine equals the opportunity cost of producing
cheese PC /PW = aLC /aLW ,

- Then the wage in cheese equals the wage

in wine PC /aLC = PW/aLW

- So workers will be willing to make both

wine and cheese.

 Production, Prices, and Wages
(cont.)
• For example, suppose cheese sells for PC = $4/pound and
wine sells for PW = $7/gallon.

- Wage paid producing cheese is

PC /aLC = ($4/pound)(1 pound/hour) = $4/hour.

- Wage paid producing wine is

PW /aLW = ($7/gallon)(1/2 gallon/hour) = $3.50/hour.

- Workers would be willing to make only cheese (the

relative price of cheese 4/7 exceeds the opportunity cost
of cheese of ½).
Production, Prices, and Wages
(cont.)

• If the price of cheese drops to PC = $3/pound:

- Wage paid producing cheese drops to
PC /aLC = ($3/pound)(1 pound/hour) = $3/hour.
- Wage paid producing wine is still $3.50/hour if
price of wine is still $7/gallon.
- Now workers would be willing to make only wine
(the relative price of cheese 3/7 is now less than
the opportunity cost of cheese of ½).
 Production, Prices, and Wages
(cont.)

• If the home country wants to consume both wine and cheese (in the
absence of international trade), relative prices must adjust so that
wages are equal in the wine and cheese industries.

- If PC /aLC = PW /aLW workers will have no incentive to work solely 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

Trade in the Ricardian Model
• Suppose the home country is more efficient
in wine and cheese production.

• 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

Trade in the Ricardian Model
(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.
Trade in the Ricardian Model
(cont.)
• Suppose that the home country has a comparative
advantage in cheese production: its opportunity cost of
producing cheese is lower than in the foreign country.
aLC /aLW < a*LC /a*LW
where “*” notates foreign country variables
• When the home country increases cheese production,
it reduces wine production less than the foreign
country would.
Trade in the Ricardian Model
(cont.)
• 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.
Fig. 3-2: Foreign’s Production Possibility
Frontier
 Trade in the Ricardian Model
(cont.)
• Before any trade occurs, the relative price of cheese to
wine reflects the opportunity cost of cheese in terms of
wine in each country.
• In the absence of any trade, the relative price of
cheese to wine will be higher in Foreign than in Home if
Foreign has the higher opportunity cost of cheese.
• It will be profitable to ship cheese from Home to
Foreign (and wine from Foreign to Home) – where does
the relative price of cheese to wine settle?
Trade in the Ricardian Model
(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
• 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).
Relative Supply and Relative
Demand (cont.)
• 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).
- foreign workers produce only wine.
 Relative Supply and Relative
Demand (cont.)
• 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 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).
Relative Supply and Relative
Demand (cont.)
• When the relative price of cheese equals the
opportunity cost in the foreign country

aLC /aLW < PC /PW = a*LC /a*LW ,

- foreign workers are indifferent about producing

wine or cheese (wage when producing wine
same as wage when producing cheese).

- domestic workers produce only cheese.

Relative Supply and Relative
Demand (cont.)
• If the relative price of cheese rises above the
opportunity cost of cheese in both countries
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).
 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),
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.
Relative Supply and Relative
Demand (cont.)
• Relative demand of cheese is the quantity of
cheese demanded in all countries relative to the
quantity of wine demanded in all countries.

• As the price of cheese relative to the price of wine

rises, consumers in all countries will tend to
purchase less cheese and more wine so that the
relative quantity demanded of cheese falls.
Fig. 3-3: World Relative Supply and
Demand
Gains From Trade
• Gains from trade come from specializing in the
type of production which uses resources 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 (cont.)
• Domestic workers earn a higher income from
cheese production because the relative price of
cheese increases with trade.
• Foreign workers earn a higher income from wine
production because the relative price of cheese
decreases with trade (making cheese cheaper)
and the relative price of wine increases with
trade.
Gains From Trade (cont.)

• Think of trade as an indirect method of production

that converts cheese into wine or vice versa.
• Without trade, a country has to allocate resources to
produce all of the goods that it wants to consume.
• With trade, a country can specialize its production
and exchange for the mix of goods that it wants to
consume.
Gains From Trade (cont.)

• 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.
Fig. 3-4: Trade Expands Consumption
Possibilities
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 the home country’s opportunity cost of

producing cheese? aLC /aLW = ½, to produce one
pound of cheese, stop producing ½ gallon of wine.
 A Numerical Example (cont.)
• 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 (cont.)
• With trade, the equilibrium relative price of
cheese to wine settles between the two
opportunity costs of cheese.
• Suppose that the intersection of RS and RD
occurs at PC /PW = 1 so one pound of cheese
trades for one gallon of wine.
• Trade causes the relative price of cheese to
rise in the home country and fall in foreign.
A Numerical Example (cont.)
• With trade, the foreign country can buy one pound of
cheese for PC /PW = one gallon of wine,
- instead of stopping production of a*LC /a*LW = 2
gallons of wine to free up enough labor to produce
one pound of cheese in the absence of trade.
- Suppose L* = 3,000. The foreign country can trade
its 1,000 gallons maximum production of wine for
1,000 pounds of cheese, instead of the 500 pounds
of cheese it could produce itself.
A Numerical Example (cont.)

• With trade, the home country can buy one gallon of

wine for PW /PC = one pound of cheese,
- instead of stopping production of aLW /aLC = two
pounds of cheese to free up enough labor to produce
one gallon of wine in the absence of trade.
• The home country can trade its 1,000 pounds
maximum production of cheese for 1,000 gallons of
wine, instead of the 500 gallons of wine it could produce
itself.
 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.
• The home wage relative to the foreign wage will settle in
between the ratio of how much better Home is at making
cheese and how much better it is at making wine compared
to Foreign.
• Relative wages cause Home to have a cost advantage in only
cheese and Foreign to have a cost advantage in only wine.
Relative Wages (cont.)

• Suppose that PC = $12/pound and PW = $12/gallon.

• Since domestic workers specialize in cheese production
after trade, their hourly wages will be
PC/aLC = $12 /1= $12
• Since foreign workers specialize in wine production
after trade, their hourly wages will be
PW/a*LW = $12/3 = $4
• The relative wage of domestic workers is therefore
$12/$4 = 3
Relative Wages (cont.)

• The relative wage lies between the ratio of the

productivities in each industry.
- The home country is 6/1 = 6 times as
productive in cheese production, but only 3/2
= 1.5 times as productive in wine production.
- The home country has a wage 3 times
higher than the foreign country.
Relative Wages (cont.)

• 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 pound of cheese costs
$12 (one worker paid $12/hr) but would have cost $24 (six
paid $4/hr) in Foreign.
• In the foreign economy, producing one gallon of wine costs
$12 (three workers paid $4/hr) but would have cost $24 (two
paid $12/hr) in Home.
 Relative Wages (cont.)

• 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.
 Productivit
y and
Wages

Source: International Monetary Fund, Bureau

of Labor Statistics, and The Conference Board
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 (which were more than half of U.S.
levels by 2007).
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.
Misconceptions About 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.
Misconceptions About Comparative
Advantage (cont.)
• 3. Free trade exploits less productive countries.

- 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 (ex., involuntary prostitution) 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 that of the foreign country is a*Li .

• Goods will be produced wherever cheapest to

produce them.
 Comparative Advantage With Many
Goods (cont.)

• Let w represent the wage rate in the home country and w*

represent the wage rate in the foreign country.
- If waL1 < w*a*L1 then only the home country will produce
good 1, 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
Comparative Advantage with
Many Goods (cont.)
• Suppose there are 5 goods produced in the world:
apples, bananas, caviar, dates, and enchiladas.
• 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.
 Comparative Advantage With 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.
Comparative Advantage With 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.
Comparative Advantage With Many
Goods (cont.)
• 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.

Fig. 3-5: Determination of Relative
Wages
Comparative Advantage With
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 (Chapter 4).

• 2. Protectionism (Chapters 8–11).

• 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.
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
• Compare Chinese output and productivity with
that of Germany for various industries using
1995 data.
- Chinese productivity (output per worker) was

only 5 percent of Germany’s on average.

- In apparel, Chinese productivity was about 20

percent of Germany’s, creating a strong

comparative advantage in apparel for China.
Table 3-3: China versus
Germany, 1995
Empirical Evidence
• 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

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.