Full employment of labor is also assumed. Also, because all workers receive the same wage in each country, the real wage calculations tell us that everyone benefits equally in each country. However, because the model assumes full employment and costless mobility of labor, all these workers are immediately gainfully employed in the other industry. It is the reciprocal of the unit labor requirement. Wine output rises from six to eight gallons. This theory is developed by a classical economist David Ricardo. Since the unit labor requirement for cheese does not change in moving to free trade, there is also no change in the real wage in terms of cheese. Learn how the autarky terms of trade is determined in a Ricardian model. Also, if aLW < aLW∗, then the United States has the absolute advantage in wine production relative to France. The son also benefits because he has contributed his skills to a productive activity and will enjoy a sense of accomplishment. The United States specializes in production of its comparative advantage good but trades to achieve its consumption point at the red C. In free trade, the United States realizes a level of aggregate utility that corresponds to the indifference curve IFT. Jeopardy Questions. Ricardo showed that the specialization good in each country should be that good in which the country had a comparative advantage in production. Workers want to get more for the goods they are selling. With specialization, the same forty-eight worker hours produce twenty-four pounds of cheese and eight gallons of wine. Positive profit sends a signal to the rest of the economy and new firms enter the industry. Nevertheless, as Jagdish N. Bhagwati pointed out in his article “The Pure Theory of International Trade: A Survey”, 1964, this model ought to be analysed form a normative point of view, since it does help prove the welfare proposition that trade is beneficial. Thus the countries will want some of each good after specialization, and the only way to accomplish this is through trade. The goods are assumed to be identical, or homogeneous, within and across countries. With so many unrealistic assumptions, it is difficult for some people to accept the conclusions of the model with any confidence, especially when so many of the results are counterintuitive. In other words, low wages in another country in a particular industry is not sufficient information to determine which country’s industry would perish under free trade. Suppose the United States implements a costless technology improvement program that lowers the U.S. unit labor requirement for timber to two. For instance, point E cannot be reached by any of these countries, since it is outside their production-possibility frontier. It is called Ricardian Theory because Ricardo, an economist founded this theory in 1817 and named it the Theory of Comparative Advantage. Ricardian theory of comparative advantage has the merit of demonstrating that international trade is possible even when a country is able to produce all goods at cheaper cost, provided the cost advantage is comparatively more in some goods than in the others. Consider a Ricardian model. The five main reasons international trade takes place are differences in technology, differences in resource endowments, differences in demand, the presence of economies of scale, and the presence of government policies. This means that real wages in free trade for wine workers in the United States need not be calculated since the United States will no longer have any wine workers. If these two countries specialize in their comparative advantage good, then world production rises for both goods. The workers are assumed to be identical in the productive capacities within, but not across, countries. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”. The increased supply will reduce the price of cheese in the French market, meaning that over time, the quantity of wine obtained for a pound of cheese will fall. France realizes a level of aggregate utility that corresponds to the indifference curve IAut∗. Labor productivity gives the quantity of wine a wine worker makes in an hour of work. If the United States is a much larger country, in that it has a larger workforce, it will have a larger demand for both wine and cheese. Since zero profit results in each producing industry, we can simply rewrite the relationship derived above to construct the following formula for the real wage: This means that the real wage of a worker in terms of how much cheese can be purchased is equal to labor productivity in cheese production. In this description, we do not predict that a result will carry over to the complex real world. Since the differences in prices arise directly out of differences in technology between countries, it is the differences in technology that cause trade in the model. According to Ricardian theory of trade, comparative advantage determines the pattern of trade. Table 2.11 Labor Productivity in Italy and Germany. The other major change that occurs is that the United States specializes in cheese production, while France specializes in wine production. To see this more clearly, consider points A and B in Figure 2.2 "Defining Opportunity Cost". In order for consumption of both goods to be higher in both countries, trade must occur. In this case, aLC (10) < aLC∗ (20) and aLW (2) < aLW∗ (5), so the United States has the absolute advantage in the production of both wine and cheese. Once the father and son return, the father must complete the remaining tasks on his own. The model assumes that goods can be transported between countries at no cost. the implicit trade model underlying Ricardo's Principles as well as his other writings. Thus finding the solution to a model means solving for the values of the endogenous variables. If Portugal is twice as productive in cloth production relative to England but three times as productive in wine, then Portugal’s comparative advantage is in wine, the good in which its productivity advantage is greatest. The nominal wage is the amount of dollars the worker receives. Finally, the theory of comparative advantage is all too often presented only in its mathematical form. The term describing the set of all output combinations that can be produced within an economy. Since both countries are assumed to be the same size in the example, this indicates the U.S. absolute advantage in the production of both goods. Emphasis mine. Labor productivityThe quantity of a good that can be produced per unit of labor input. This means that England may nevertheless benefit from free trade even though it is assumed to be technologically inferior to Portugal in the production of everything. In corn? To maximize profit, they must lower their wage. Plugging in the production point from Table 2.8 "Autarky Production and Consumption" yields 16 + 2(4) = 24, and since 16 + 8 = 24, the production point must lie on the PPF. Next, each of these is defined formally using the notation of the Ricardian model. In David Ricardo’s original numerical example, he demonstrated that when both countries specialize in their comparative advantage goods and engage in free trade, both countries can experience gains from trade. The cost of producing cheese in the United States is one half gallon of wine per pound of cheese. Suppose the unit labor requirements in wine production are aLWEng = 1/3 hour per liter and aLWPort = 1/2 hour per liter, while the unit labor requirements in corn are aLCEng = 1/4 hour per kilogram and aLCPort = 1/2 hour per kilogram. The father estimates that it will take him three hours to prepare the garden if he works alone, as shown in Table 2.1 "Father’s Task Times without Son". Even though we define prices and wages in monetary terms, all relevant solutions in the model are described in terms of ratios in which the money or dollars cancel out. It is not possible that a country does not have a comparative advantage in producing something unless the opportunity costs (relative productivities) are equal. If the United States has the comparative advantage in cheese production, then aLCaLW 2/5, France has a disadvantage in production of both goods. In this way, we might raise the well-being of all individuals despite differences in relative productivities. ∗All starred variables are defined in the same way but refer to the process in France. A country is said to have a comparative advantage in the production of a good (say, cloth) if it can produce it at a lower opportunity cost than another country. The U.S. production and consumption points in free trade are at the red P and C, respectively. The autarky price ratio or terms of trade represents the amount of wine that exchanges per unit of cheese on the domestic barter market. It is quite common to see misapplications of the principle of comparative advantage in newspaper and journal stories about trade. This result occurs for any free trade price ratio that lies between the autarky price ratios. Let one country be the United States and the other France. Table 2.8 Autarky Production and Consumption. Since the United States consumed sixteen pounds of cheese and four gallons of wine in autarky, it would now have eighteen pounds of cheese and five gallons of wine after specialization and trade. There are two ways to evaluate the welfare effects of trade in the Ricardian model. Because of this advantage, both countries would benefit from international trade. Many people who learn about the theory of comparative advantage quickly convince themselves that its ability to describe the real world is extremely limited, if not nonexistent. Note that trade based on comparative advantage does not contradict Adam Smith’s notion of advantageous trade based on absolute advantage. We assume that some workers are more internationally adroit and thus move first. Many firms produce output in each industry such that each firm is too small for its output decisions to affect the market price. We could also say that goods from different firms are perfect substitutes for all consumers. Instead, we carry the logic of comparative advantage to the real world and ask how things would have to look to achieve a certain result (maximum output and benefits). A movement along the curve represents a transfer of labor resources out of one industry and into another such that all labor remains employed. The sources of the misunderstandings are easy to identify. The PPF formula is aLCQC + aLWQW = L. If we plug the exogenous variables for the United States into the formula, we get QC + 2QW = 24. The quantity of a good that can be purchased per unit of work. In the Ricardian model, the unit labor requirements and the labor endowment are exogenous. However, France’s disadvantage is smallest in cheese; therefore, France has a comparative advantage in cheese. The labor productivity in cheese if four hours of labor are needed to produce one pound. Also consider France’s perspective. Ricardo argued that trade gains could arise if countries first specialized in their comparative advantage good and then traded with the other country. It is one of the simplest models, and still, by introducing the principle of comparative advantage, it offers some of the most compelling reasons supporting international trade. Thus the United States is twice as productive as France in cheese production. Assume the United States has 3,200 workers and Ecuador has 400 workers. In this case, the time needed for each task might look as it does in Table 2.3 "Task Times with Incorrect Specialization". Thus the slope of the line between A and B is the opportunity cost, which from above is given by −(aLC/aLW). This implies. The second expression means that labor productivity in cheese in the United States is greater than in France. Consider a Ricardian model with two countries, the United States and Ecuador, producing two goods, bananas and machines. Although the results follow logically from the assumptions, the assumptions are easily assailed as unrealistic. The real world, on the other hand, consists of many countries producing many goods using many factors of production. This means that the cost of producing wine (in terms of cheese) exceeds the price of wine (also in terms of cheese). However, one does not compare the monetary costs of production or even the resource costs (labor needed per unit of output) of production. The significance of this assumption is demonstrated in the immobile factor model in Chapter 4 "Factor Mobility and Income Redistribution". New Trade Theory of International Trade takes a different approach from the Ricardian and the Heckscher-Ohlin models on why countries engage in international trade. This represents exports of wine from France to the United States. In autarky, this means that the production and consumption point for a country are the same. Profit is defined as total revenue minus total cost. Suppose two countries, the United States and France, are initially in autarky. Once the prices are equalized, there will be no incentive to trade any additional amount. First of all, a change in the terms of trade can have conflicting effects. The term used to describe the amount of peaches that must be given up to produce one more bushel of tomatoes. The initial differences in relative prices of the goods between countries in autarky will stimulate trade between the countries. 8. First, consider the fate of U.S. cheese workers. Individuals in different countries may have different preferences or demands for various products. These quantities are shown in Table 2.9 "Production with Specialization in the Comparative Advantage Good". For example, the Ricardian model of trade, which incorporates differences in technologies between countries, concludes that everyone benefits from trade, whereas the Heckscher-Ohlin model, which incorporates endowment differences, concludes that there will be winners and losers from trade. In other words, the Ricardian model is both one of the most misunderstood and one of the most compelling models of international trade. It is calculated by dividing the wine worker’s wage by the price of cheese, written as (wW/PC). In this case, gains from trade could be realized if both countries specialized in their comparative and absolute advantage goods. The Ricardian model plays an important pedagogical role in international economics, but has received scant empirical attention since the 1960s. That is, there are no barriers of tariffs or controls to the international I trade between the two countries. The Ricardian model of international trade attempts to explain the difference in comparative advantage on the basis of technological difference across the nations. Goods can be transported costlessly between countries. The free trade price ratio (or terms of trade) will be equal in both countries and will lie between the two countries’ autarky terms of trade. The invisible hand refers to the ability of the market, or the market mechanism, to allocate resources to their best possible uses. In the end, the price of each country’s export good (its comparative advantage good) will rise and the price of its import good (its comparative disadvantage good) will fall. Notice that in autarky, the real wage of cheese workers is exactly the same as the real wage of wine workers with respect to purchases of both goods. Thus PC∗/PW∗ falls once trade is opened. L = the labor endowment in Canada (the total number of hours the workforce is willing to provide), aLC = unit labor requirement in cheese production in Canada (hours of labor necessary to produce one unit of cheese), aLW = unit labor requirement in wine production in Canada (hours of labor necessary to produce one unit of wine). Calculate each country’s autarky price ratio. Which country has the comparative advantage? To accomplish this, labor would have to move from the comparative disadvantage industry into the comparative advantage industry. In this case, neither country has a comparative advantage in anything. then neither country has a comparative advantage. Torrens’s final point is that this trading outcome may be superior for England even if the lands of England should be superior to the lands of Poland—in other words, even if corn can be more efficiently produced in England (i.e., at lower cost) than in Poland. Firms choose output to maximize profit. By rearranging the zero-profit condition, we can write the wage as a function of everything else to get, Recall that the production function for cheese is QC=LCaLC. We can more clearly see why the slope of the PPF represents the opportunity cost by noting the units of this expression: Thus the slope of the PPF expresses the number of gallons of wine that must be given up (hence the minus sign) to produce another pound of cheese. Suppose the U.S. unit labor requirement for timber is three, its unit labor requirement for videocassette recorders (VCRs) is eight, and it has forty-eight million workers. Suppose that there are in England, unreclaimed districts, from which corn might be raised at as small an expense of labor and capital, as from the fertile plains of Poland. In this way, both countries may gain from trade. However, the assumptions of the model will guarantee that production uses all available resources, and so we can use the less general specification with the equal sign. In the immobile factor model, we address the implications of adjustment costs across industries. The goods produced are assumed to be homogeneous across countries and firms within an industry. For simplicity, we assume there are no transportation costs to move the products across borders. Second, since we merely made up a terms of trade that generated the interesting conclusion, we could ask whether a favorable terms of trade is likely to arise. Stated this way, it is easy to imagine how it would not hold true in the complex real world. The factor is homogeneous and can freely move between industries. Specialization and trade will increase the set of consumption possibilities, compared with autarky, and will make possible an increase in consumption of both goods nationally. Suppose, as before, that Portugal is more productive than England in the production of both cloth and wine. In Figure 2.4 "Autarky Equilibriums" we depict the autarky production and consumption points for the United States and France. When trade opens, the addition of France’s supply and demand will have a relatively small effect on the U.S. price. What effect would this have on the world supply of timber? Nominal wages (meaning wages measured in dollars) to workers in each industry will equal the output price divided by the unit labor requirement in that industry. The second method, called comparative advantage, is a much more difficult concept. First, the principle of comparative advantage is clearly counterintuitive. In David Ricardo’s original presentation of the model, he focused exclusively on the supply side. Using the two production functions and the labor constraint, we can describe the production possibility frontier (PPF)The set of all output combinations that could be produced in a country when all the labor inputs are fully employed. 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