Chapter 3

Comparative advantage and 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
• Optional topic (many goods)
 Introduction (cont.)
• Sources of differences across countries
that lead to gains from trade:
– The Ricardian model (this 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.
• 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.
 Comparative Advantage and
Opportunity Cost (cont.)
• Suppose that in the United States 10
million roses could be produced with
the same resources as 100,000
computers.
• Suppose that in Colombia 10 million
roses could be produced with the same
resources as 30,000 computers.
• Colombia has a lower opportunity cost
of producing roses: has to stop
producing fewer computers.
 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 United States has a comparative
advantage in computer production.
– Colombia has a comparative advantage
in rose production.
 Table 3-1: Hypothetical
Changes in Production
• Status quo: they produce both goods
• Americans can produce 10 more computers with 10M/100K *
10 = 1,000 roses not produced.
• Colombians can produce 1,000 more roses with 30K/10M *
1,000 = 3 computers not produced.
• The total output of roses remain unchanged
• The total output of computers increases by 7 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 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.
 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
aLCQC + aLWQW ≤ L
labor resources

Total Labor required for

Labor required for Total gallons
pounds of each gallon of
each pound of of wine
cheese wine produced
cheese produced produced
produced
Fig. 3-1: Home’s Production
Possibility Frontier
L=1,000, aLC=1,
aLW=2
 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
not produced.
 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

• Workers will choose to work in the

industry that pays the higher wage.
 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 not care whether they
work 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
• If the home country is more efficient
in wine and cheese production, then
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
where “*” notates foreign country
variables
 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
• When the home country increases
cheese production, it reduces wine
production less than the foreign
country would.
Fig. 3-2: Foreign’s Production
Possibility Frontier

Steeper slope
 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.)

• 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.
• The algebric expression of the RD can be found
out if the utility function is given
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
(L=1K)
Foreign a*LC = 6 hours/lb a*LW = 3 hours/gallon
(L*=3K)
• Suppose that the intersection of RS and RD
occurs at PC /PW = 1 so one pound of cheese
trades for one gallon of wine. (for the CD
utility function, α=0.5)
 A Numerical Example (cont.)
No trade With trade

Qc Qw Dc Dw w/Pc w/Pw w/Pc w/Pw

(note)

home 1000 0 500 500 1 1/2 1 1

foreign 0 1000 500 500 1/6 1/3 1/3 1/3

 A Numerical Example (cont.)
• w/Pc: real wage in terms of cloth
• w/Pw: real wage in terms of wine
• Since, for each country, one real wage rate is
strictly increased in one case and another
remains unchanged, it must be better off.
 Exercises 3.X
1. Using the same information, except
that the free trade relative price is 1/3
instead. Repeat the exercise. What is
alpha equal to in the CD utility
function used?
2. To continue from 1, imagine that L* is
increased slightly. What will happen to
the relative price of cloth under free
trade. Does such an increase in L*
benefit or harm the home country?
Explain your answer.
 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.
Productivity and Wages
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.
 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
whose workers make low wages.
– 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 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.
 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
(Econ/Trade Chapters 4-5).
2. Protectionism (Econ/Trade Chapters 9–
12).
3. Transportation costs reduce or prevent
trade, which may cause each country to
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 (cont.)
• A very poor country like Bangladesh can have
comparative advantage in clothing despite being less
productive in clothing than other countries such as
China because it is even less productive compared to
China in other sectors.
– Productivity (output per worker) in
Bangladesh is only 28 percent of China’s
on average.
– In apparel, productivity in Bangladesh was
about 77 percent of China’s, creating
strong comparative advantage in apparel
for Bangladesh.
Table 3-3: Bangladesh versus
China, 2011
 Empirical Evidence (cont.)
• 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 (cont.)
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.