International Economics

The Ricardian Model

Harald Fadinger
University of Mannheim


Outline
Why do countries trade?

Comparative advantage and the gains from trade: an example

Digression: general equilibrium

The Ricardian model: comparative advantage and the gains from trade in a
(general-equilibrium) model with international technological differences

2
Why do countries trade?
Countries engage in international trade for two basic reasons:

Because they are different from each other.

To achieve economies of scale in production.

In the real world, patterns of trade reflect the interaction of both these
motives.

It is useful to look at simplified models in which only one of these motives
is present.

We are going to focus first on how differences between countries give rise
to trade between them and why this trade is mutually beneficial.

3
Comparative advantage and the gains from trade
Paul Samuelson: Comparative advantage is the best example of an
economic principle that is undeniably true yet not obvious to intelligent
people (including Adam Smith).

Example:

Wine and cloth are the only two goods produced in the world (England and
Portugal).

One only production factor: labour. Freely mobile between industries
within each country.

Technologies are different (and fixed) across England and Portugal.

International trade in commodities is costless. (No tariffs, no transport
costs.)

4
Comparative advantage and the gains from trade
5
Wine Cloth Autarky Price Ratios
Portugal a
P
(v) a
P
(c) a
P
(v)/a
P
(c)
England a
E
(v) a
E
(c) a
E
(v)/a
E
(c)
Define a
i
(j) as country is unit labour requirement for producing good j.






Opportunity cost of wine: number of units of cloth the economy would
have to forgo in order to produce an additional unit of wine.

Portugal: a
P
(v)/a
P
(c)

England: a
E
(v)/a
E
(c)

Comparative advantage and the gains from trade
Assume:

Portugal has an absolute advantage in the production of both
commodities:

a
P
(v),a
P
(c) < a
E
(v),a
E
(c)

Portugal has a comparative advantage in the production of wine
(equivalent to England having a comparative advantage in the production
of cloth):

a
P
(v)/a
P
(c) < a
E
(v)/a
E
(c)

6
Comparative advantage and the gains from trade
Because of these relative cost differences, both countries have an incentive
to trade.

Portugal would gain if it produced more wine (and less cloth) and imported
cloth from England at a ratio a
E
(v)/a
E
(c):

Producing one unit less of cloth releases a
P
(c) units of labour.

These a
P
(c) units of labour yield a
P
(c)/a
P
(v) units of wine in Portugal.

Selling the additional wine at English prices for cloth yields
[a
P
(c)/a
P
(v)]*[a
E
(v)/a
E
(c)] > 1 units of cloth.

7
Comparative advantage and the gains from trade
England would gain if it produced more cloth (and less wine) and imported
wine from Portugal at a ratio a
P
(v)/a
P
(c):

Producing one unit less of wine releases a
E
(v) units of labour.

These a
E
(v) units of labour yield a
E
(v)/a
E
(c) units of cloth in England.

Selling the additional cloth at Portuguese prices for wine yields
[a
E
(v)/a
E
(c)]*[a
P
(c)/a
P
(v)] > 1 units of wine.

Very important: The argument above does not depend on a country
having an absolute advantage.
8
Comparative advantage and the gains from trade
At what prices are England and Portugal going to trade with each other?

Wine is coming into England from Portugal (new supply) and Portugal
is demanding English cloth (new demand) downward pressure on
the relative price of wine in England.

Cloth is coming into Portugal from England (new supply) and England
is demanding Portuguese wine (new demand) upward pressure on
the relative price of wine in Portugal.

Under free trade, there will be a single relative price for wine p(v)/p(c):

a
P
(v)/a
P
(c) p(v)/p(c) a
E
(v)/a
E
(c)

Problem: what is the exact value of p(v)/p(c)? We need a more complete
model: when countries trade, the relative prices of commodities are not
only determined by their labour contents, but also by their preferences.


9
The Ricardian model
Assumptions:

There are two countries: England and Portugal.

There are two homogeneous consumption goods: wine and cloth.

Preferences over the two goods are identical (and homothetic) for all
individuals and the two countries.

Preferences are subject to diminishing marginal utility in the consumption
of each good.

There is just one production factor: labour. Each country has a fixed
number of workers: L
E
, L
P
.

10
The Ricardian model
England and Portugal have different technologies to produce the two
goods. (Portugal has a comparative advantage in the production of wine.)

Technologies are subject to constant returns to scale (CRS):

q
i
(j) = L
i
(j)/a
i
(j).

All markets are perfectly competitive.

No means of storage: at each point in time consumer expenditure equals
income.

Labour is perfectly mobile between industries and perfectly immobile
between countries.

Free trade.

11
Digression: general equilibrium
Country is (i = E,P) autarkic general equilibrium consists of an allocation
{x
i
(v), x
i
(c), q
i
(v), q
i
(c), L
i
(v), L
i
(c)} and a set of prices {p
i
(v), p
i
(c), w
i
}, such
that:

Consumers maximise utility taking prices as given:

max U[x
i
(v),x
i
(c)]
s.t. : p
i
(v)x
i
(v) + p
i
(c)x
i
(c) w
i
L
i

x
i
(v), x
i
(c) 0

Firms maximise profits in each sector j (j = c,v) taking prices as given:

max p
i
(j)q
i
(j) - w
i
L
i
(j)
s.t.: q
i
(j) = L
i
(j)/a
i
(j)
q
i
(j) 0

12
Digression: general equilibrium
Equilibrium profits are zero if commodity j is produced:

p
i
(j)q
i
(j) - w
i
L
i
(j) = 0 if q
i
(j) > 0

Markets clear:

x
i
(j) = q
i
(j)

L
i
(c) + L
i
(v) = L
i


13
Digression: general equilibrium
A free-trade general equilibrium consists of an allocation {x
i
(v), x
i
(c), q
i
(v),
q
i
(c), L
i
(v), L
i
(c)} for i = E, P, and a set of prices {p
i
(v), p
i
(c), w
i
}, such that

The law of one price holds: p
E
(j) = p
P
(j) = p(j)

Consumers maximise utility taking prices as given:

max U[x
i
(v),x
i
(c)]
s.t.: p
i
(v)x
i
(v) + p
i
(c)x
i
(c) w
i
L
i

x
i
(v), x
i
(c) 0

Firms maximise profits in each sector j (j = c,v) taking prices as given:

max p
i
(j)q
i
(j) - w
i
L
i
(j)
s.t.: q
i
(j) = L
i
(j)/a
i
(j)
q
i
(j) 0

14
Digression: general equilibrium
Equilibrium profits are zero if commodity j is produced:

p
i
(j)q
i
(j) - w
i
L
i
(j) = 0 if q
i
(j) > 0

Markets clear:

x
E
(j) + x
P
(j) = q
E
(j) + q
P
(j)

L
i
(c) + L
i
(v) = L
i



15
The Ricardian model: production possibilities
Each countrys limits on production are defined by the following
inequality:
a
i
(v)q
i
(v) + a
i
(c)q
i
(c) L
i


The production possibility frontier (PPF) is defined as the combinations
of wine and cloth that an economy can produce efficiently, given its
resources and technology.

In our model, the PPF is given by the following equation (from the labour
market clearing condition):

a
i
(v)q
i
(v) + a
i
(c)q
i
(c) = L
i


Slope of the PPF: - [a
i
(v)/a
i
(c)]. When the PPF is a straight line, the
opportunity cost of wine in terms of cloth is constant.

16
The Ricardian model: consumer behaviour
Consumer preferences are described by indifference curves.

In equilibrium, the slope of the indifference curve equals the slope of the
budget constraint:

MRS = [U/x
i
(v)]/[U/x
i
(c)] = p(v)/p(c)

17
The Ricardian model: producer behaviour
Producers of good j maximise profits taking prices as given:

max p
i
(j)[L
i
(j)/a
i
(j)] - w
i
L
i
(j)
s.t.: L
i
(j) 0

First-order condition:

p
i
(j)/a
i
(j) w
i
and L
i
(j) 0
[p
i
(j)/a
i
(j) - w
i
]L
i
(j) = 0


18
The Ricardian model: producer behaviour
Both goods will be produced in positive amounts if and only if

p
i
(v)/a
i
(v)

= p
i
(c)/a
i
(c) p
i
(v)/p
i
(c)

= a
i
(v)/a
i
(c)

If p
i
(v)/a
i
(v) = w
i
> p
i
(c)/a
i
(c), the relative price of wine is greater than its
opportunity cost, and the economy specializes completely in the production
of wine:

L
i
(v) = L
i
and q
i
(v) = L
i
/a
i
(v)

If p
i
(c)/a
i
(c) = w
i
> p
i
(v)/a
i
(v), the relative price of cloth is greater than its
opportunity cost, and the economy specializes completely in the production
of cloth:

L
i
(c) = L
i
and q
i
(c) = L
i
/a
i
(c)

19
The Ricardian model: autarky equilibrium
20
q(c), x(c)
q(v), x(v)
Portugal
q(c), x(c)
q(v), x(v)
England
The Ricardian model: autarky equilibrium
With no trade, consumption of each good j must equal production.

The autarkic equilibrium occurs at the point of tangency between an
indifference curve and the PPF.

Diminishing MU implies consumers demand positive amounts of both
goods in equilibrium.

Positive production of both goods implies p
i
(v)/a
i
(v)

= p
i
(c)/a
i
(c).

21
The Ricardian model: free-trade equilibrium
22
q(v)/q(c),
x(v)/x(c)
p(v)/p(c)
a
E
(v)/a
E
(c)

a
P
(v)/a
P
(c)
RS
W


RD
W


The Ricardian model: free-trade equilibrium
23
q(v)/q(c),
x(v)/x(c)
p(v)/p(c)
a
E
(v)/a
E
(c)

a
P
(v)/a
P
(c)
RS
W


RD
W


The Ricardian model: free-trade equilibrium
24
q(v)/q(c),
x(v)/x(c)
p(v)/p(c)
a
E
(v)/a
E
(c)

a
P
(v)/a
P
(c)
RS
W


RD
W


The Ricardian model: free-trade equilibrium
From F.O.C. of firms profit maximization problem, firms specialise in the
production of wine if the relative price of wine exceeds its opportunity cost,
and viceversa.

At least one country specializes in the production of a single good:

p
E
(j) = p
P
(j) = p(j).

For one country to produce both goods, p(v)/p(c)

= a
i
(v)/a
i
(c).

But a
P
(v)/a
P
(c) < a
E
(v)/a
E
(c).

25
The Ricardian model: free-trade equilibrium
The free-trade equilibrium has three possible cases:

a
P
(v)/a
P
(c) = p(v)/p(c) < a
E
(v)/a
E
(c)

a
P
(v)/a
P
(c) < p(v)/p(c) < a
E
(v)/a
E
(c)

a
P
(v)/a
P
(c) < p(v)/p(c) = a
E
(v)/a
E
(c)

World relative prices are determined by supply and demand at the level of
the world economy.

26
The Ricardian model: free-trade equilibrium
The world PPF:
27
q(v), x(v)

q(c), x(c)

The Ricardian model: free-trade equilibrium
The world PPF:
28
q(v), x(v)

q(c), x(c)

The Ricardian model: free-trade equilibrium
The world PPF:
29
q(v), x(v)

q(c), x(c)

The Ricardian model: gains from trade
30
q(c), x(c)

q(v), x(v)

Portugal
q(v), x(v)

q(c), x(c)

England
The Ricardian model: gains from trade
Gains from trade:

Trade expands each countrys consumption possibilities.

Consumers can attain a higher indifference curve than prior to trade.

Consumption possibilities frontier lies outside the PPF.

More formally: country i gains from trade if and only if p(v)/p(c)
a
i
(v)/a
i
(c). (Why?)

31