Unit 2:

TRADE AND TECHNOLOGY:

THE RICARDIAN MODEL

Casiano Manrique de Lara Peñate

Federico Inchausti Sintes

 Chapter Outline
• Reasons for Trade
 Proximity
 Resources
 Absolute Advantage
 Comparative Advantage
• Ricardian Model - Assumptions
 The Home Country - Equilibrium
 The Foreign Country - Equilibrium
• Determining the Pattern of International Trade - Equilibrium
 International Trade Equilibrium
 Solving for Wages Across Countries
• Solving for International Prices
 Home Export Supply Curve
 Foreign Import Demand Curve
 International Trade Equilibrium
• Key Points
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Table 2.1 U.S. Imports of Snowboards, 2005
 Reasons for Trade
1.Proximity
 The closer countries are the lower the costs
of transportation.
For example, the largest trading partner of most
European countries is another European country

 The bigger countries are the bigger their

trade volume
 Gravity equation: ImHF = mH x mF x (dHF)-1

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 Reasons for Trade
2.Resources
 A country can have resources that give it an edge
in the production of certain goods.
A country with a lot of snow may be very good at producing
snowboards.

 Resources include land, minerals, labor and

capital.
 Resources are also called factors of production—
the land, labor, and capital used to produce goods
and services.

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 Reasons for Trade

3. Absolute Advantage
 When a country has the best technology for
producing a good, it has an absolute advantage in
the production of that good.
• Germany has an absolute advantage in the production of
snowboards.

 Why is it that so many are imported from China

then?
 Or why doesn’t the U.S. just make all its own
snowboards?
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 Reasons for Trade
4. Comparative Advantage
 Absolute advantage is actually not a good
explanation for trade patterns.
 Comparative advantage is the primary explanation
for trade among countries.
 A country has a comparative advantage in producing
those goods that it produces best compared with
how well it produces other goods.
China does not have an absolute advantage compared to U.S. but is better
at producing snowboards than some other goods. China has lower
opportunity costs of producing snowboards.

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 Reasons for Trade

4. Comparative Advantage

"That it is logically true need not be argued before a

mathematician; that it is not trivial is attested by the
thousands of important and intelligent men who have
never been able to grasp the doctrine for themselves or
to believe it after it was explained to them.“
(Paul Samuelson)

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 Ricardian Model
• The Ricardian model was devised to respond to the mercantilist idea that
exports are good and imports are bad.
• To develop a Ricardian model of trade, we will use an example with two
goods, wheat and cloth, …
 Wheat and other grains are major exports of the U.S. and Europe.
 Many types of cloth are imported into these countries, especially from China.
• … and two countries, Home and Foreign.
• Labor is the only resource used to produce both goods.
• The Home Country
 One worker can produce 4 bushels of wheat or 2 yards of cloth.
 The Marginal Product of Labor is the extra output obtained by using one more
unit of labor.
 MPLW = 4 and MPLC = 2.

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 Ricardian Model
• Home Production Possibilities Frontier
 We can use the marginal products of labor to construct Home’s PPF.
 Assume there are 25 workers in Home.
 If all the workers were employed in wheat, the country could produce 100
bushels:
QW = MPLW x L = 4 x 25 = 100
 If they were all employed in cloth they could produce 50 yards:
QC = MPLC x L = 2 x 25 = 50
 The PPF connects these two points.

• Marginal products of labor are constant. This gives us a straight line

PPF which is a unique feature of the Ricardian model.

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 Ricardian Model
• The slope of the PPF can be calculated as the ratio of marginal
products of the two goods.

• The slope also equals the opportunity cost of wheat - the

amount of cloth that must be given up to obtain one more
unit of wheat.

50 MPLC ( L )
SlopePPF   
100 MPLW ( L )
MPLC 1
 
MPLW 2

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Derivation of the PPF’s functional form

LW + LC = L

QW/MPLW + QC/MPLC = L

QC = L*MPLC – (PMLC / MPLW)*QW

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 Ricardian Model
Figure 2.1

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 Ricardian Model
• Home Indifference Curve
 Given Home’s PPF, how much wheat and cloth will home actually
produce? The answer depends on consumers’ preferences.
 Preferences can be represented by indifference curves.

• An indifference curve shows the combinations of two

goods that the country can consume and be equally
satisfied.
• All points on an indifference curve have the same level
of utility.
• Higher indifference curves show higher utility.

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 Ricardian Model
Figure 2.2
The country is indifferent between A
and B
The country is better off on U2 but
cannot produce that much
U0<U1<U2

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 Ricardian Model
• Home Equilibrium
 Without trade, the PPF acts as a budget constraint for the
country.
 In the graph, the highest level of utility that can be reached
while still staying within the PPF is U1 with production at
point A.
 Point A is the no-trade equilibrium. The country can reach
point A with its own production.

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 Ricardian Model
Figure 2.2
The country could produce at point D
but would be at a higher level of utility
at point A.
At point A, on U1, is the best the
country can do

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 Ricardian Model
• Opportunity Cost and Prices
 The slope of the PPF reflects the opportunity
of producing one more bushel of wheat.

 Under perfect competition and with

intersectoral labor mobility the opportunity
cost of wheat equals the relative price of
wheat.

 Price reflects the opportunity cost of a good.

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 Ricardian Model
• Wages
 Determination of wages
 In competitive markets firms hire workers up to the point at which
the hourly wage equals the value of one more hour of production.
 The value of one more hour of labor equals the amount of goods
produced in that hour (MPL) times the price of the good:
 W = MPL x P
 In competitive markets, labor can move freely between
industries.
 Labor will move to the higher paid industry.
 This will continue until there is equalization of wages
between industries.

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 Ricardian Model
• The equalization of wages will give us the following:
PW  MPLW  PC  MPLC
PW MPLC

PC MPLW
 The right hand side is the opportunity cost of obtaining one more
bushel of wheat.

 The left hand side is the relative price of wheat (measured in terms of
how much cloth must be given up) which is the slope of the PPF.

 In equilibrium the slope of the indifference curve is equal to the slope

of the PPF.

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 Ricardian Model
• The Foreign Country
 Assume Foreign’s technology is inferior to Home’s.
 Foreign has an absolute disadvantage in producing
both wheat and cloth as compared to Home.
 Foreign Production Possibilities Frontier
 Assume a foreign worker can produce one bushel of wheat or one yard
of cloth.
 MPL*W = 1, MPL*C = 1
 Assume there are 100 workers available in Foreign.
 If all workers were employed in wheat they could produce 100 bushels.
 If all workers were employed in cloth they could produce 100 yards.
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 Ricardian Model

Figure 2.3

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 Ricardian Model
• Equilibrium in Foreign
 Foreign’s preferences can also be represented by an
indifference curve.
 Foreign produces at the point of highest utility within the PPF
constraint.
 The slope of the PPF is the opportunity cost of wheat.
 The no-trade relative price of wheat is P*W/P*C = 1.
 The relative price exceeds Home’s no-trade relative price of
wheat, which was PW/PC = ½ .

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 Ricardian Model—Foreign

Figure 2.4

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 Ricardian Model

• Comparative Advantage
 Given the information we have gathered, we
can begin to compare the opportunity cost of
production of each good in each country.

 Opportunity cost differences determine

comparative advantages in each country for
each good.

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 Ricardian Model
Opportunity Costs for Goods in
Home and Foreign
Cloth Wheat
(1 Yard) (1 Bushel)

Home 2 Bushels ½ Yard

of Wheat of Cloth

Foreign 1 Bushel 1 Yard

of Wheat of Cloth

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 Ricardian Model
• Comparative Advantage
 A country has a comparative advantage in a good
when it has a lower opportunity cost of producing
than another country.
 By looking at the table we can see that Foreign has a
comparative advantage in producing cloth.
 Foreign’s Opportunity cost of cloth is lower.

 Home has a comparative advantage in producing

wheat.
 Home’s opportunity cost of wheat is lower.

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 Real Comparative Advantage and Trade Patterns
in Apparel, Textiles, and Wheat
• In the US, in 2006 output per employee (labor productivity) in
textiles and apparel industry was around $55,000* ($27.5 per
hour).
• In China labor productivity in 2006 was around $10.000** ($5
per hour).
• The U.S. is 5.5 times more productive in textiles and apparel
than China.
• So the U.S. has an absolute advantage in textiles and apparel.
• Nevertheless, U.S. is a net importer of textiles and apparel
from China (around $80 billion in 2019*).
*https://shenglufashion.com
**https://www.ceicdata.com
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 Real Comparative Advantage and Trade Patterns
in Apparel, Textiles, and Wheat
• For wheat, the U.S. produces 27.5 bushels per hour of labor. China produces only 0.1
bushel per hour of labor.

• The U.S. is thus 275 times as productive in wheat. It thus has the absolute
advantage in wheat.

• The US is world’s second largest wheat exporter, with China being their second
biggest customer.

• Since the absolute advantage in wheat for the U.S. is even

greater than in apparel and textiles, it has the comparative
advantage in wheat.
• China has the comparative advantage in apparel and textiles
because its productive disadvantage relative to the U.S. is less
than in wheat.
• The pattern of trade is determined by comparative advantage.
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 Problem Sets

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 Problem Sets

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 Determining the Pattern of International Trade
• International Trade Equilibrium
 Two countries are in a trade equilibrium when:
 the relative price of each good is the same in the two countries
 the amount of each good that the countries want to trade is
equal
 What is the relative price of wheat or cloth in the trade
equilibrium?
 How does the shift from the no-trade equilibrium to the
trade equilibrium affect production and consumption in
both Home and Foreign?
 How much do both countries import/export of each
good?
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 Determining the Pattern of International Trade
• International Trade Equilibrium
 Relative price of cloth in Foreign is P*C/P*W = 1.
 Relative price of cloth in Home is PC/PW = 2.
 Therefore Foreign would want to export their cloth to Home
- they can produce it for $1 and sell it abroad for $2.
 The opposite is true for Home. Home would want to export
wheat – they can produce it for $½ and sell it abroad for $1.
 Home will export wheat and Foreign will export cloth.
 Both countries export the good for which they have the
comparative advantage.
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 Determining the Pattern of International Trade
• Change in Production and Consumption

 The relative price of wheat in the trade equilibrium

will be between the no-trade price in the two
countries.
 For now we will assume the free-trade price of
PW/PC is 2/3. This is between the price of ½ in Home
and 1 in Foreign.
 We can now take this price and see how trade
changes production and consumption in each
country.
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 Determining the Pattern of International Trade
• How trade makes prices equalize across countries
 As Home exports wheat, quantity of wheat sold at Home
falls.
 The price of wheat at Home is bid up.
 More wheat goes into Foreign’s market.
 The price of wheat in Foreign falls.
 As Foreign exports cloth, the quantity sold in Foreign falls
and rises in Home.
 The price of cloth in Foreign goes up and falls at Home.

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 Determining the Pattern of International Trade
• International Trade
 Home can export wheat at the international relative price of
2/3.
 For each bushel of wheat it exports, it gets 2/3 yards of cloth
in return.
 In the following figure we trace this out to get a new price
line showing the world price.
 The world price line shows the range of consumption possibilities
that a country can achieve by specializing in one good and trading.

 Remember: this is only a consumption possibility because production

is still constrained by the PPF.

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Determining the Pattern of International Trade

• The new world price, PW/PC = 2/3, shows

Cloth, QC (yards) us the new range of consumption
possibilities

• The country can now achieve a higher

utility with the new consumption
50 possibilities

A World price line,

25
Slope = –2/3
U1

50 100 Wheat, QW (bushels)

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 Determining the Pattern of International Trade

• Change in Production and Consumption

 Home producers of wheat can earn more than the

opportunity cost of wheat by selling it to Foreign.

 Home will therefore shift labor resources toward the

production of wheat and increase its production.

 Remember that wages are calculated by the price of the

good times its marginal product.

 Given the information from before, we can calculate the

ratio of wages in the two industries.

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 Determining the Pattern of International Trade
PW MPLW  2   4  8
      1
PC MPLC  3   2  6

Therefore:

PW MPLW  PC MPLC

Wages in wheat  Wages in cloth

• All workers at Home will want to work in wheat and
no cloth will be produced.
• With trade, Home will be fully specialized in wheat
production.
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 Determining the Pattern of International Trade

Home produces 100 bushels but

consumes only 40, so exports equal 60
Cloth, QC (yards)

Home produces 0 yards of cloth but

consumes 40, so imports equal 40.

Home consumption
50

40 C World price line,

U2 Slope = –2/3

25 A
Home imports 40
yards of cloth U1 Home production in
trade equilibrium
B

40 50
50 100
100 Wheat, QW (bushels)

Home exports 60 bushels of wheat

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 Determining the Pattern of International Trade
• International Trade
 Trade allows a country to engage in consumption possibilities it did not
have before trade.

 We can see this as Home reaches a higher indifference curve with trade
than without it.

 This is the first demonstration of gains from trade.

• Pattern of Trade and Gains from Trade

 From the previous figure, we can also see that Home’s exports and imports
are equal when valued in the same units.

 Home exports 60 bushels of wheat; multiplying this by the price of wheat in

terms of cloth, 2/3, gives 40. This equals the amount of cloth that is
imported.

 Gains from trade with balanced trade (contradicts mercantilists’ view).

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Determining the Pattern of International Trade

Figure 2.6

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 Determining the Pattern of International Trade
• Pattern of Trade and Gains from Trade
 Each country is exporting the good for which it has the comparative
advantage.
 This confirms that the pattern of trade is determined by comparative
advantage.
 This is the first lesson of the Ricardian model.
 There are gains from trade for both countries.
 This is the second lesson of the Ricardian model.
 However, we have not yet determined the level of wages across countries.
 Relative prices converge. Do wages converge, too?
 Wages do rise in each country, but they do not converge.
 Wage differences are determined by absolute advantage, not by
comparative advantage.
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 Determining the Pattern of International Trade
• Solving for Wages Across Countries
 As stated before, in competitive labor markets, firms will
pay workers the value of their marginal product.

 Since Home produces and exports wheat, they will be paid

in terms of that good—the real wage is MPLW = 4 bushels of
wheat.

 The workers sell the wheat on the world market at a relative

price of PW/PC = 2/3.

 We can use this to calculate the real wage in terms of cloth:

(PW/PC) x MPLW = (2/3) x 4 = 8/3 yards.

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 Determining the Pattern of International Trade
• Solving for Wages Across Countries
 Home real wage is
 4 bushels of wheat
 8/3 yards of cloth
 Foreign real wage is
 3/2 bushels of wheat
 1 yard of cloth
 Foreign workers earn less than Home workers as measured
by their ability to purchase either good.
 This fact reflects Home’s absolute advantage in the production of
both goods.

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 Determining the Pattern of International Trade
• Wages are determined by absolute advantage and
trade is determined by comparative advantage.
• This makes sense.
 The only way a country with poor technology can export
at a price others are willing to pay is by having low
wages.
• The more productive a country’s labor force, the
higher their wages.
 Workers become better off through receiving higher
wages.
 As countries engage in trade, the Ricardian model
predicts that their real wages will rise in both countries.
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 Determining the Pattern of International Trade
Per capita income in China in 1981 was estimated at $220, in 2000 it was $940.
In 2001 China joined the WTO. Since then China’s income per capital has
increased more than tenfold: $10.640 in 2020.

https://www.macrotrends.net/countries/CHN/china/gni-per-capita China being member of the WTO

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 Labor Productivity and Wages
• Labor productivity can be measured by the value-added per
hour in manufacturing.
 Value-added is the difference between sales revenue in an industry and
the costs of intermediate inputs.

 Equals the payments to labor and capital in an industry.

 The Ricardian model ignores capital so we can measure labor

productivity as value-added divided by the number of hours worked, or
value-added per hour.

• Figure 2.7 shows value-added per hour in manufacturing for

several countries.
 Countries with higher labor productivity pay higher wages, just as the
Ricardian model predicts.

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 Labor Productivity and Wages
Figure 2.7: Labor Productivity and Wages, 2001

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 Labor Productivity and Wages
• We can also see the connection between productivity
and wages over time.

• Figure 2.8 shows that the general upward movement

in labor productivity is matched by upward movement
in wages.

• This is also an implication of the Ricardian Model. An

increase in productivity (increasing MPL) raises
wages.

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 Labor Productivity and Wages

Figure 2.8

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 Solving for International Prices
• In the previous analysis we assumed the world price of
wheat was 2/3.
• In reality world price is determined by export supply
and import demand.
• We will derive a Home export supply curve.
 Shows the amount Home wants to export at various relative
prices.
• Similarly, we will derive a Foreign import demand
curve.
 Shows the amount of wheat that Foreign will import at
various relative prices.
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 Solving for International Prices
• Home Export Supply Curve
 The export supply curve will have the relative price of
wheat on the Y-axis and the amount of wheat on the X-
axis.
 We saw before a relative price of 2/3 related to exports
of 60 bushels.
 The first point on the export supply curve (point C’ in figure 2-
9(b)) represents the horizontal distance from point B to C in
figure 2-9(a).

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 Solving for International Prices
 When the relative price of wheat is ½, Home exports of wheat
are zero (no-trade equilibrium).
 Second point on the export supply curve (point A’ in figure 2.9(b)).

 For the 3rd point, we assume the relative price of wheat is ½ in

trade equilibrium.
 At this price, Home could produce any amount of wheat on the PPF and
exchange the respective amount for cloth to reach consumption point A.
• Workers are willing to shift between industries as the wages are the same.

 Home could produce in A (no exports) or in B (exports of 50) or in any

point in between.

 Third point on the export supply curve (point B’ in figure 2.9(b))

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 Solving for International Prices

Figure 2.9
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 Solving for International Prices
• The flat portion of the export supply curve is a
special feature of the Ricardian model.
 The PPF is a straight line.

 Production can occur anywhere along the PPF as

workers shift between industries.

 This leads to all the export levels between A’ and B’.

 At prices above ½, production (complete

specialization) doesn’t change with price changes,
but consumption does.
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 Solving for International Prices
• Foreign Import Demand Curve
 At the world relative price of 2/3, Foreign imports 60 bushels of
wheat. This is represented by point C*’, the first point on the
import demand curve in figure 2.10(b).
 The no-trade equilibrium in Foreign, with a relative price of 1,
entails zero imports. A*’ is the second point.
 With trade at an assumed price of 1 production may be in all
points between A* and B*. At B* Foreign imports 50 bushels of
wheat. B*’ is the third point.
 At prices below 1, production (complete specialization) doesn’t
change with price changes, but consumption does.

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 Solving for International Prices

Figure 2.10
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 Solving for International Prices
• International Trade Equilibrium
 We need to put the Home export supply together with the
Foreign import demand.
 The exports from Home come from the excess domestic
supply.
 The imports to Foreign come from the excess domestic
demand.
 This is the World market for wheat (figure 2.11):
 Equilibrium price of 2/3 and trade of 60 bushels of wheat.

 This is the amount that clears the world market.

 Excess supply of Home equals the excess demand by Foreign.

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Solving for International Prices
Figure 2.11

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 Solving for International Prices
• The Terms of Trade
 The price of a country’s exports divided by the price of its
imports.
 For Home, PW/PC is their terms of trade.
 An increase in PW or a fall in PC will raise Home’s terms of
trade.
 An increase in the terms of trade makes the country better
off.
 It will earn more from its exports and pay less for its imports.
 For Foreign, PC/PW is the terms of trade and a higher relative
price for cloth makes it better off.

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The Terms of Trade for Primary Commodities
• Latin American economist Raúl Prebisch and British
economist Hans Singer each put forward the hypothesis
that the price of primary commodities would decline
over time relative to the price of manufactured goods.

• Primary commodities are often exported by developing

countries, so their terms of trade would decline over
time.

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 The Terms of Trade for Primary Commodities
• This theory might be true for a couple of reasons:
• First,

 As countries become richer, they spend a smaller share of their income on

food.

 As world income grows, demand for food falls relative to the demand for
manufactured goods. Therefore, the price of agricultural products can also
be expected to fall relative to manufactured goods.

• Second,

 For mineral products, industrialized countries continually find substitutes

in the production of manufactured products.

 The substitution away from mineral products is a form of technological

progress, and as it proceeds, can lead to a fall in demand and in the price
of raw materials.

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The Terms of Trade for Primary Commodities
• There are also reasons why the theory might not be true:
• First,
 Technological progress in manufactured goods can certainly lead to a fall
in the price of these goods as they become easier to produce.
 This is a fall in terms of trade for industrialized countries rather than
developing countries.
• Second,
 At least for oil, the cartel restricting prices has caused an increase in the
terms of trade for oil-exporting countries.

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The Terms of Trade for Primary Commodities
• Figure 2.12 shows 24 primary commodities from 1900–1998,
with their world price relative to the overall price of
manufactured goods.

• From these results for different commodities, we can conclude

that there are some that follow the pattern predicted by
Prebisch and Singer, with falling prices relative to
manufacturing.

• However, this is not the general rule. Other primary

commodities have had increasing or non-consistent change in
their prices.

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Figure 2.12 Relative Price of Primary Commodities
 Key Points
1. A country has comparative advantage in producing a good when the
opportunity cost of producing the goods is lower than the opportunity cost
of producing the good in another country.

2. The pattern of trade between countries is determined by comparative

advantage.

3. All countries experience gains from trade.

4. The level of wages in each country is determined by its absolute
advantage, that is, by the productivity of labor (PML).
5. The equilibrium price of a good on the world market is determined where
the export supply of one country equals the import demand of the other
country.
6. A country’s terms of trade, the price of its export good divided by the price
of its import good, affect how well off a country is from trade.

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

 Problem Sets

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

 Problem Sets

© 2007 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor