Chapter 3

Labor Productivity and Comparative Advantage:

The Ricardian Trade Model
Introduction
• Differences across countries are a key reason why trade occurs:

 The Ricardian model (Chapter 3) examines differences in the productivity of

labor (due to differences in technology) between countries.

 The Specific Factors model (Chapter 4) and the Heckscher-Ohlin model

(Chapter 5) examine differences in labor, labor skills, physical capital, land,
or other factors of production between countries.

 Trade may also arise due to economies of scale (larger scale of production is
more efficient).  (Chapter 8)
The Concept of Comparative Advantage

• Comparative advantage in international trade will be determined by

comparing opportunity costs across countries.

• The opportunity cost of producing something measures the cost of not

being able to produce something else with the resources used.
 we learn this concept from Principles of Economics
The Concept of Comparative Advantage
• A simple example with roses and computers explains the intuition behind the
concepts of opportunity cost and comparative advantage in the Ricardian model.

• For example, suppose 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.
The Concept of Comparative Advantage

Some numerical exercise:

• Suppose there are 2 countries: US and Colombia with same resources
• Suppose that in the US, 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:

 So, it has to stop producing fewer computers in order to free up resources
to make a rose.
The Concept of Comparative Advantage

• 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.

 Colombia has a comparative advantage in rose production.

 The United States has a comparative advantage in computer
production.
The Concept of Comparative Advantage
• Suppose initially that Colombia produces 30,000 computers and the
United States produces 10 million roses, and that both countries want
to consume computers and roses.

 This is NOT a good situation for both countries.

 There is a way for both to be better off.

• How can both countries be made better off?

The Concept of Comparative Advantage (6 of 6)

(Answer) ‘Specialization’ !!!!!

When countries specialize in production in which they have a
comparative advantage, more goods and services can be produced
and consumed.

 Have the United States stop growing roses and use those
resources to make 100,000 computers instead. Have Colombia
stop making 30,000 computers and grow 10 million instead.

 Both countries altogether could still consume the same 10

million roses, but could consume 100,000 – 30,000 = 70,000
more computers.
 Table 3.1 Hypothetical Changes in Production

Initial production Million Roses Thousand Computers

Blank

United States 10 0

Columbia 0 30
Total 10 30

Million Roses Thousand Computers

Blank

Production United States 0 100

based on
Comparative Columbia 10 0
Advantage Total 10 100

Same 10 70 more computer !!!!

The Ricardian Trade Model
A One-Factor Economy
We formalize these ideas (comparative advantage) by constructing a one-
factor Ricardian model using the following assumptions:

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.
4. Two goods: wine and cheese.
5. Competition allows workers to be paid a wage equal to the value of
what a worker produces, and allows them to work in the industry that
pays the higher wage.
6. Two countries: home and foreign.
A One-Factor Economy
Structure of Model

Supply Side (PPF and RS) Demand Side (U max and RD)

Closed Economy Equilibrium (1 country)

Free Trade Equilibrium (2 countries)

A One-Factor Economy
• 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.
aLC hours of labor produce 1 pound of cheese in the home country.

 aLW is the unit labor requirement for wine in the home country.
aLW hours of labor produce 1 gallon of wine in the home country.

• A high unit labor requirement means low labor productivity.

 Labor productivity is how much output one hour of labor creates.

 1/aLC and 1/aLW

A One-Factor Economy
• Labor supply L indicates the total amount of labor resources—the number of hours
worked (a constant parameter).

How to allocate L to the two goods production? ( L = LC + LW )

(1) Cheese

 aLC indicates the amount of labor hours required for each 1 pound of cheese
produced (and it is a constant !!!!).

 Cheese production Qc indicates how many total pounds of cheese that the home
country produces.

Then, total hours of labor worked for cheese production LC = aLCQC

A One-Factor Economy

(2) Wine

 aLW indicates the amount of labor hours required for each 1 gallon of wine produced
(and it is a constant !!!!).

 Wine production QW indicates how many total gallons of wine that the home country
produces.

Then, total hours of labor worked for wine production LW = aLWQW

Production Possibilities
• The production possibility frontier (PPF) of an economy shows the
maximum amount of goods that can be produced for a fixed
amount of resources (L).
• The PPF of the home economy is

aLCQc  aLW Qw  L
L
• Maximum home cheese production is Qc  when Qw  0.
aLC

• Maximum home wine production is L

QW  when QC  0.
aLW
 Production Possibilities
• For example, suppose that the home economy’s labor supply is L= 1,000 hours.
 aLC = 1 hour/lb, so 1 hour of labor produces 1 pound of cheese in the home country.
 aLW= 2 hours/gallon, so 2 hours of labor produces 1 gallon of wine in the home country.

 Then, PPF equation aLCQC + aLWQW ≤ L becomes QC+2QW ≤ 1,000

Also, we can identify extreme cases:

Maximum cheese production is 1,000 pounds.  Point F (Figure 3.1)
Maximum wine production is 500 gallons.  Point P (Figure 3.1)

 Figure 3.1 PPF line

Figure 3.1 Home’s Production Possibility Frontier

L a 
QW    LC  QC
aLW  aLW 

The line PF shows the maximum amount of cheese Home can produce given any
production of wine, and vice versa.
Production Possibilities
In the Figure 3.1:

aLC
• The opportunity cost of cheese =
aLW

• The opportunity cost of cheese is how many gallons of wine Home must
stop producing in order to make one more pound of cheese.
 The opportunity 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.

L  aLC 
QW    QC
aLW  aLW 
Production Possibilities
More intuition about the “slope”

• Producing an additional pound of cheese requires aLC hours of labor.

• Each 1 hour of aLC 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 
  gallons of wine
 aLW 

aLC
 The opportunity cost of producing 1 pound of cheese is gallon
aLW
of wine not produced.
Production Possibilities
• For example, suppose that aLC= 1 and aLW= 2.

If 1 hour of labor is moved to cheese production, that additional hour

could have produced (but actually did not produce) is:
 1
1 hour/(2 hours/gallon of wine)    gallon of wine.
2

1
So, the opportunity cost of producing 1 pound of cheese is gallon
2
of wine not produced.
Relative Prices and Relative Supply
• PC is the price of cheese; PW is the price of wine.
• wC is the wage paid to workers who make cheese, and wW is the wage
paid to workers who make wine.

• Due to competition in the labor and goods markets:

 Hourly wages of cheese makers will equal the value of the cheese
produced in an hour: PC
WC 
aLC

 Hourly wages of wine makers will equal the value of the wine
produced in an hour: W  PW
W
aLW
Relative Prices and Relative Supply
• Workers will choose to work in the industry that pays the higher wage.
(Perfect mobility of workers between industry)

(case 1) If the price of cheese relative to the price of wine exceeds the opportunity
cost of producing cheese:
PC aLC
 ,
PW aLW

Then the wage paid when making cheese will exceed the wage in wine:
PC P
WC   W  WW .
aLC aLW

So, workers will make only cheese (the economy specializes in cheese production).
 Maximum amount of Cheese = QC = L/aLC
No Wine = QW = 0
Relative Prices and Relative Supply
(case 2)
If the price of cheese relative to the price of wine less than the opportunity cost of
producing cheese:
PC a
 LC ,
PW aLW
Then the wage in cheese will be less than the wage in wine:

PC P
WC   W  WW .
aLC aLW
So, workers will make only wine (the economy specializes in wine production).
 Maximum amount of Wine = QW = L/aLW
No Cheese = QC = 0
Relative Prices and Relative Supply
(case 3)
• If the price of cheese relative to the price of wine equals the opportunity cost of
producing cheese:
PC a
 LC ,
PW aLW

Then the wage in cheese will equal the wage in wine:

PC P
WC   W  WW .
aLC aLW

So workers will be willing to make both wine and cheese.

A pair of (QC , QW) that aLCQC + aLWQW = L
Relative Prices and Relative Supply

• Home’s supply curve is a 1-step function

The step at relative price of cheese equal to Home’s opportunity cost

Pc/Pw
(Case 1): Qc/Qw = ∞

PC a
 LC (Case 3): A pair of (QC , QW)
PW aLW that aLCQC + aLWQW = L

(Case 2): Qc/Qw = 0

Qc/Qw
Relative Prices and Relative Supply
Numerical example:
• suppose cheese sells for PC  $4  pound, and wine sells for PW  $7  gallon.

𝑃𝐶
• Wage paid producing cheese is = ($4/ pound) *(1 pound/hour) = $4/hour
𝑎𝐿𝐶

𝑃𝑊
• Wage paid producing wine is = ($7/ gallon) * (1/2 gallon/hour) = $3.5/hour
𝑎𝐿𝑊

𝑄𝐶
• Workers would be willing to make only cheese  𝑄𝑊
=∞

(the relative price of cheese 4/7 exceeds the opportunity cost of cheese 1/2)
Relative Prices and Relative Supply
Numerical example:
• If the price of cheese drops to PC  $3  pound :

𝑃𝐶
 Wage paid producing cheese drops to = ($3/ pound) *(1 pound/hour) = $3/hour
𝑎𝐿𝐶

𝑃𝑊
 Wage paid producing wine is still = ($7/ gallon) * (1/2 gallon/hour) = $3.5/hour
𝑎𝐿𝑊

𝑄𝐶
• Now workers would be willing to make only wine  =0
𝑄𝑊
(the relative price of cheese 3/7 is now less than the opportunity cost of cheese 1/2)
Relative Prices and Relative Supply

• Home’s supply curve in this numerical example

𝑄𝐶 𝑃𝐶
= ∞ if = 4/7
𝑄𝑊 𝑃𝑊
Pc/Pw
 This cannot be drawn in the blue line of RS.
𝑃𝐶
= 4/7
𝑃𝑊
aLC 𝑄𝐶 𝑃𝐶
=1/2 = 0 if = 3/7
𝑄𝑊 𝑃𝑊
aLW
𝑃𝐶 𝑄𝐶
= 3/7 =0  This is the point on the blue vertical section.
𝑃𝑊 𝑄𝑊

Qc/Qw
Relative Prices and Relative Supply
• If the home country wants to consume both wine and cheese (in the absence of
international trade, i.e. closed economy), relative prices must adjust so that
wages are equal in the wine and cheese industries.
PC P PC P
 If  W , then WC   W  WW .
aLC aLW aLC 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 a
 LC
PW aLW
Relative Prices and Relative Demand
• There is a representative consumer whose choices are the national choice.
• So, here we treat the consumer’s optimal consumption as the national demand for goods.

(1) The representative consumer faces a budget constraint (BC) line as follows.

𝐼 = 𝑃𝐶 𝑄𝐶 + 𝑃𝑊 Q 𝑊

• 𝐼 is the national income level. The representative consumer spends all the income to consume
Cheese and Wine so that it can maximize its subjective satisfaction level from consumption.

• The BC line can be rewritten as follows.

𝐼 𝑃𝐶
𝑄𝑊 = − 𝑄
𝑃𝑊 𝑃𝑊 𝐶
Relative Prices and Relative Demand
𝐼 𝑃𝐶
𝑄𝑊 = − 𝑄
𝑃𝑊 𝑃𝑊 𝐶

𝐼
Y-intercept:  the possible maximum amount of Wine consumption
𝑃𝑊
𝐼
X-intercept: 𝑃𝐶
 the possible maximum amount of Cheese consumption
𝑃
Slope: − 𝑃 𝐶  the market (objective) valuation on 1 unit of Cheese measured in terms of Wine.
𝑊

For example, you pay 𝑃𝐶 dollars to buy 1 Cheese. Now instead of buying 1 Cheese with 𝑷𝑪 ,
how many unit of Wine can you buy with 𝑷𝑪 ?

𝑃𝐶
The answer: 𝑃𝑊
unit of Wine.
Relative Prices and Relative Demand
(2) The subjective satisfaction level from consumption is measured by a function of utility from
consumption as follows.

Max 𝑼 = 𝑼 𝑸𝑾 , 𝑸𝑪 , given 𝐼 = 𝑃𝐶 𝑄𝐶 + 𝑃𝑊 Q 𝑊

1/3 2/3 β 1−β

Example: Cobb-Douglas Utility function  𝑈 = 𝑄𝐶 𝑄𝑊 (or generally, 𝑈 = 𝑄𝐶 𝑄𝑊 )

(3) Optimal Consumption Choice:

• When the consumer reaches an optimal consumption bundle, the following two conditions hold at the
same time.
𝑷𝑪 𝑰 𝑷
𝑷𝑾
= 𝑴𝑹𝑺 and 𝑸𝑾 = 𝑷 − 𝑷 𝑪 𝑸𝑪
𝑾 𝑾

• Here, the MRS (marginal rate of substitution) can be obtained from the utility function as follow.

𝑑𝑄𝑊 𝑀𝑈𝐶 1 𝑄𝑊
𝑀𝑅𝑆 ≡ − = =
𝑑𝑄𝐶 𝑀𝑈𝑊 2 𝑄𝐶
 [Relative Demand ]
[Utility Maximization]
Relative Prices and Relative Demand
Relative Demand
• The relative demand for goods from this example as follows. (See the Figure)

𝑃𝐶 1 𝑄𝑊
=
𝑃𝑊 2 𝑄𝐶

• Note
(1) The right hand side is nothing but just the MRS. So, the relative demand function can be
obtained from the MRS directly, by equating it with the relative price.

(2) The right hand side (i.e. MRS) is only a function of relative quantity of goods, without
Income level (I).
Closed Economy’s Equilibrium:
 What if the Closed Economy is not in Equilibrium:
An Example: Pc/Pw

Qw Absolute value At point B

of the slope of = Qc/Qw
Budge Constraint =∞
= Pc/Pw
at point A
Qw A RS
The absolute
value of
slope of PPF
RD
= aLC/aLW
B

Qc At point A = Qc/Qw
Qc
Qc/Qw > 0
Pc/Pw will be decreased.
Cheese market: Excess supply  Pc is too high, so Pc becomes lower.  BC curve will overlap with PPF
Wine market: Excess demand  Pw is too low, so Pw become higher.  GO BACK to equilibrium
 as inPage 36.
Trade in the Ricardian Model
• Use “ * “ to indicate foreign country variables.

• When one country can produce a unit of a good with less labor
than another country, we say that the first country has an absolute
advantage in producing that good.

• If aLC  aLC , Home labor is more efficient than Foreign in producing

cheese. So, Home has an “absolute advantage” in producing Cheese.

• Does that guarantee that Home should export cheese?

Trade in the Ricardian Model
• Comparative advantage, not absolute advantage, determines the
pattern of trade (more about this distinction later).

• Suppose that the home country has a comparative advantage in

cheese production: its opportunity cost of producing cheese is lower
than the foreign country. 
aLC aLC
 
aLW aLW

• When the home country increases cheese production, home reduces

wine production less than the foreign country would.

 This can be seen with the slope of PPF line.

Trade in the Ricardian Model
• Since the slope of the PPF indicates the opportunity cost of
cheese in terms of wine, Foreign’s PPF is steeper than
Home’s.
Figure 3.1 Home’s Production Possibility Frontier (left)
Figure 3.2 Foreign’s Production Possibility Frontier (right)

aLC aLC
 
aLW aLW

Because Foreign’s relative unit labor requirement in cheese is higher than Home’s (it needs to give up
many more units of wine to produce one more unit of cheese), its production possibility frontier is
steeper.
Trade in the Ricardian Model
• Before any trade occurs, the relative price of cheese to wine reflects the
opportunity cost of cheese in terms of wine in each country.
𝑃𝐶 𝑎𝐿𝐶 𝑃𝐶∗ 𝑎𝐿𝐶
∗

𝑃𝑊
=
𝑎𝐿𝑊
, ∗ =𝑎∗
𝑃𝑊 𝐿𝑊

• 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.
∗
𝑎𝐿𝐶 𝑎𝐿𝐶 𝑃𝐶 𝑃𝐶∗
< ∗ → < ∗
𝑎𝐿𝑊 𝑎𝐿𝑊 𝑃𝑊 𝑃𝑊

• It will be profitable to ship cheese from Home to Foreign (and wine from
Foreign to Home)

• Question: If trade occurs, where does the relative price of cheese to wine
settle in the world market?
Determining the Relative Price after Trade
• 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 as a function of relative
price of cheese in world market:

QC  QC
RS 
QW  QW
Determining the Relative Price after Trade
(case 1)
• If the relative price of cheese falls below the opportunity cost of
cheese in both countries
PC aLC aLC 𝑄𝐶 + 𝑄𝐶∗
   , → ∗ =0
PW aLW aLW 𝑄𝑊 + 𝑄𝑊

 No cheese would be produced in Home nor in Foreign.

𝐿 𝐿∗
𝑄𝐶 = 0, 𝑄𝐶∗ = 0, 𝑄𝑊 = ∗
, 𝑄𝑊 = ∗
𝑎𝐿𝑊 𝑎𝐿𝑊

 Domestic and foreign workers would be willing to produce only

wine (where wage is higher).
𝑃𝐶 𝑃𝑊 𝑃𝐶 𝑃𝑊
𝑤𝐶 = < = 𝑤𝑊 𝑤𝐶∗ ∗
= ∗ < ∗ = 𝑤𝑊
𝑎𝐿𝐶 𝑎𝐿𝑊 𝑎𝐿𝐶 𝑎𝐿𝑊
Determining the Relative Price after Trade
(Case 2)
• When the relative price of cheese equals the opportunity cost in the home
country, but still less than in the foreign country

PC aLC aLC 𝑄𝐶 + 𝑄𝐶∗ 𝐿Τ𝑎𝐿𝐶
   , ∗ ∈ ( 0, ∗ )
PW aLW aLW 𝑄𝑊 + 𝑄𝑊 𝐿∗ Τ𝑎𝐿𝑊

 Domestic workers are indifferent about producing wine or cheese

(wage when producing wine same as wage when producing cheese).
𝑃𝐶 𝑃𝑊
A pair of (QC , QW) that aLCQC + aLWQW = L, and 𝑤𝐶 = = = 𝑤𝑊
𝑎𝐿𝐶 𝑎𝐿𝑊
 Foreign workers produce only wine.
𝐿∗ 𝑃𝐶 𝑃𝑊
𝑄𝐶∗ = ∗
0, 𝑄𝑊 = ∗ , and 𝑤𝐶∗ = ∗ < ∗
∗ = 𝑤𝑊
𝑎𝐿𝑊 𝑎𝐿𝐶 𝑎𝐿𝑊
Determining the Relative Price after Trade
(case 3)
• When the relative price of cheese settles strictly in between the opportunity costs of
cheese of the two countries

aLC PC aLC 𝑄𝐶 + 𝑄𝐶∗ 𝐿Τ𝑎𝐿𝐶
   , ∗ = ∗
aLW PW aLW 𝑄𝑊 + 𝑄𝑊 𝐿∗ Τ𝑎𝐿𝑊

 Domestic workers produce only cheese (where their wages are higher).
𝑃𝐶 𝑃𝑊 𝐿
𝑤𝐶 = > = 𝑤𝑊 → 𝑄𝐶 = ,𝑄 = 0
𝑎𝐿𝐶 𝑎𝐿𝑊 𝑎𝐿𝐶 𝑊
 Foreign workers still produce only wine (where their wages are higher).
∗
𝑃𝐶 𝑃𝑊 ∗ ∗ ∗
𝐿∗
𝑤𝐶 = ∗ < ∗ = 𝑤𝑊 → 𝑄𝐶 = 0, 𝑄𝑊 = ∗
𝑎𝐿𝐶 𝑎𝐿𝑊 𝑎𝐿𝑊
 World relative supply of cheese equals Home’s maximum cheese production
divided by Foreign maximum wine production
Determining the Relative Price after Trade
(Case 4)
• When the relative price of cheese equals the opportunity cost in the foreign
country, but exceeds the home’s opportunity cost:

 𝑄𝐶 + 𝑄𝐶∗ 𝐿Τ𝑎𝐿𝐶
aLC PC aLC
   , 𝑄𝑊 + 𝑄𝑊∗ ∈ ( ∗Τ ∗
𝐿 𝑎𝐿𝑊
, ∞ )
aLW PW aLW

 Foreign workers are indifferent about producing wine or cheese (wage when
producing wine same as wage when producing cheese).
𝑃𝐶 𝑃𝑊
A pair of (Q*C , Q*W) that a*LCQ*C + a*LWQ*W = L*, and 𝑤𝐶∗ ∗
= ∗ = ∗ = 𝑤𝑊
𝑎𝐿𝐶 𝑎𝐿𝑊
 Domestic workers produce only cheese.
𝑃𝐶 𝑃𝑊 𝐿
𝑤𝐶 = > = 𝑤𝑊 → 𝑄𝐶 = ,𝑄 = 0
𝑎𝐿𝐶 𝑎𝐿𝑊 𝑎𝐿𝐶 𝑊
Determining the Relative Price after Trade
(case 5)
• If the relative price of cheese rises above the opportunity cost of
cheese in both countries

aLC aLC P 𝑄𝐶 + 𝑄𝐶∗
   C , 𝑄𝑊 + 𝑄𝑊∗ = ∞
aLW aLW PW

 No wine is produced in Home or in Foreign.

𝐿 ∗
𝐿∗ ∗
𝑄𝐶 = , 𝑄𝐶 = ∗ , 𝑄𝑊 = 0, 𝑄𝑊 =0
𝑎𝐿𝐶 𝑎𝐿𝐶

 Both domestic and foreign workers are willing to produce only

cheese (where wage is higher).
𝑃𝐶 𝑃𝑊 𝑃𝐶 𝑃𝑊
𝑤𝐶 = > = 𝑤𝑊 𝑤𝐶∗ ∗
= ∗ > ∗ = 𝑤𝑊
𝑎𝐿𝐶 𝑎𝐿𝑊 𝑎𝐿𝐶 𝑎𝐿𝑊
Determining the Relative Price after Trade
• World relative supply is a 2-step function:
Determining the Relative Price after Trade
• Relative demand of cheese is the quantity of cheese demanded in all
countries relative to the quantity of wine demanded in all countries.

• We assumed “identical preference” of all consumers in the world.

 Example: Same utility function in Home and in Foreign

𝑷𝑪
= 𝑴𝑹𝑺 is the same in both country.
𝑷𝑾
Determining the Relative Price after Trade
• 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 demand for cheese relative to wine is a “decreasing” function of

the relative price of cheese to wine.

• See Figure 3.3 for the Relative demand of cheese

Figure 3.3 World Relative Supply and Demand

RS

𝑃𝐶 𝐹𝑇
( )
𝑃𝐹

RD under trade
is the same as
RD RD under no-trade.

The RD curves show that the demand for cheese relative to wine is a decreasing function of the price of
cheese relative to that of wine, while the RS curve shows that the supply of cheese relative to wine is an
increasing function of the same relative price.
Figure 3.3 World Relative Supply and Demand
If RD’ is the relative demand,
Then, at point 2, the world relative price of cheese
after trade is home’s relative aLC/aLW =1/2.

Home needs not specialize in producing either

cheese or wine. In fact home produce both.

But,
Foreign specializes completely in producing Wine.

In this case, only foreign gets benefit from trade,

But, Home does not.

We leave this case aside, to understand

the mutual gains from trade.
The Gains from Trade

aLC PC aLC
Point 1 at the Figure 3.3  a  P  a ,
LW W LW

• Gains from trade come from specializing in the type of production

that uses resources most efficiently, and using the income
generated from that production to buy the goods and services that
countries desire.

• “Using resources most efficiently” means producing a good in

which a country has a comparative advantage.
The Gains from Trade
After Trade, compared to “before trade”,

aLC PC aLC
   ,
aLW PW aLW
• Domestic (Home) workers earn a higher income from cheese production because the
relative price of cheese increases with trade.
𝑃𝐶 𝑃𝑊
𝑤𝐶 = > = 𝑤𝑊
𝑎𝐿𝐶 𝑎𝐿𝑊

• 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.
𝑃𝐶 𝑃𝑊
𝑤𝐶∗ ∗
= ∗ < ∗ = 𝑤𝑊
𝑎𝐿𝐶 𝑎𝐿𝑊
The Gains from Trade
Production Side:

• 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.
The Gains from Trade
Consumption Side:

• 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.
Figure 3.4 Trade Expands Consumption Possibilities

International trade allows Home and Foreign to consume anywhere within the
outer lines, which lie outside the countries’ production frontiers.
Home before and after trade
Foreign before and after trade

FT
Mathematical Example: Problem Set
• I will give a problem set for the mathematical example.

• You should be able to solve them, mathematically.

• Here, I give a simple numerical example for the important intuitions of

Ricardian Trade model.

• In particular, we will discuss the relationship between relative wages and

relative productivity between countries, which is the most insightful logics
about gains from trade based on the Ricardian Trade model.
A Simple numerical Example
Unit labor
requirements Cheese Wine

Home aLC  1hour lb a sub start expression L C end expression = 1 hour per pound

aLW  2hours gallon

a sub start expression L W end expression = 2 hours per gallon

Foreign
*
aLC  6hours lb
a to the asterisk power sub start expression L C end expression = 6 hours per pound
*
aLW  3hours gallon
a to the asterisk power sub start expression L W end expression = 3 hours per gallon

• What is the home country’s opportunity cost of producing cheese?

aLC 1 It means that, to produce 1 pound of cheese, need to stop

 ,
aLW 2 producing 1
gallon of wine.
2
• What is the foreign country’s opportunity cost of producing cheese?

2 gallons of wine
A Simple numerical Example
• The home country is more efficient in both industries, but has
a comparative advantage only in cheese production.

• The foreign country is less efficient in both industries, but has

a comparative advantage only in wine production.
*
1 aLC aLC
  * 2
2 aLW aLW

Before Trade,
the relative price of cheese to wine in Home = ½ gallon of wine.
the relative price of cheese to wine in Foreign = 2 gallon of wine.
A Simple numerical Example
• With trade, the equilibrium relative price of cheese to wine
settles between the two opportunity costs of cheese.
• Suppose the intersection of RS and RD occurs at
PC
 1, So, 1 pound of cheese trades for 1 gallon of wine.
Pw

 Trade causes the relative price of cheese to rise in the home

country and fall in foreign.
A Simple numerical Example
• With trade, the foreign country can buy (import) 1 pound of cheese by
PC
producing and paying (exporting)  one gallon of wine,
PW

aLC
 Instead of stopping production of   2 gallons of wine
aLW
to free up enough labor to produce 1 pound of cheese
in the absence of trade.
• Suppose L  3,000.

The foreign country can produce its 1,000 gallons maximum production of
wine and possibly exchange for 1,000 pounds of cheese under trade,
instead of the 500 pounds of cheese it could produce itself under non-trade.
A Simple numerical Example
• With trade, the home country can buy (import) 1 gallon of wine for
PW
 one pound of cheese,
PC
aLW
• instead of stopping production of  2 pounds
aLC
of cheese to free up enough labor to produce one gallon of wine
in the absence of trade.

• Suppose L = 1,000

The home country can produce 1,000 pounds maximum production of

cheese and possibly exchange for 1,000 gallons of wine under trade,
instead of the 500 gallons of wine it could produce itself under no-trade.
Relative Wages and Relative productivity
• Suppose that PC=$12/pound, and PW=$12/gallon.

• Since home workers specialize in cheese production after trade,

their hourly wages will be

PC $12
  $12.
aLC 1
• Since foreign workers specialize in wine production after trade,
their hourly wages will be
PW $12

  $4.
aLW 3
$12
• The relative wage of Home workers is therefore  3.
$4
Relative Wages and Relative productivity
Unit labor
requirements Cheese Wine

Home aLC  1hour lb a sub start expression L C end expression = 1 hour per pound

aLW  2hours gallon

a sub start expression L W end expression = 2 hours per gallon

Foreign
*
aLC  6hours lb
a to the asterisk power sub start expression L C end expression = 6 hours per pound
*
aLW  3hours gallon
a to the asterisk power sub start expression L W end expression = 3 hours per gallon

 From this example, consider the relative productivity between the two countries
for each industries.
Relative Wages and Relative productivity
• The relative wage (3) lies between the ratio of the productivities
in each industry.
6
• The home country is 6 times as productive in
1
cheese production, but only 3
 1.5 times as
2
productive in wine production, compared to the foreign country.

• The home country has a wage 3 times higher than the foreign
country. $12
 3.
$4
Relative Wages and Relative productivity
• These relationships imply that both countries have a cost advantage in
production.
 Home: High wages can be offset by high productivity.
 Foreign: Low productivity can be offset by low wages.

• In the Home economy, producing 1 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 1 gallon of wine costs

$12 (three workers paid $4  hr), but would have cost

$24  two paid $12  hr  in Home.
Relative Wages and Relative productivity
• Because foreign workers have a wage that is only 1/3
the wage of home workers, they are able to attain a cost
advantage in wine production, despite low productivity.

• Because home 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 United States is similar
to their productivity relative to the United States.
Productivity and Wages

A country’s wage rate is roughly proportional to the country’s productivity

Source: International Monetary Fund and The Conference Board.
Do Wages Reflect Productivity?
• Other evidence shows that wages rise as productivity rises.
• As recently as 1975, wages in South Korea were only 5
percent 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
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.

(1) Consumers benefit because they can purchase goods

more cheaply.

(2) 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
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.

• Deeper poverty and exploitation may result without export

production.

(1) Consumers benefit from free trade by having access to

cheaply (efficiently) produced goods.

(2) Producers/workers benefit from having higher

profits/wages—higher compared to the alternative.
Applications:
(1) 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 the corresponding foreign unit labor requirement is aLi .

• Goods will be produced wherever cheapest to produce them.

 See next page.

Applications:
(1) Comparative Advantage with Many Goods
• 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 wage payments are less there.

1
• Or equivalently, a *L1 w 𝑎𝐿1 𝑤
 , 1
> ∗
𝑤
aL1 w ∗
𝑎𝐿1

If the relative productivity of Home to Foreign in producing good

1 is higher than the relative wage of Home to Foreign, then the
good will be produced in Home.
 Table 3.2 Home and Foreign Unit Labor Requirements

• Suppose there Home Unit Labor Foreign Unit Labor Relative Home Productivity
are five goods Good
Requirement Requirement Advantage
produced in
aLi aLi * a Li  / aLi
the world:
Apples 1 10 10
• apples,
bananas, Bananas 5 40 8
caviar,
dates, and Caviar 3 12 4
enchiladas.
Dates 6 12 2

Enchiladas 12 9 0.75
Applications:
(1) Comparative Advantage with Many Goods

w
• Suppose that  3, (meaning that Home workers are paid 3 times
w* higher than Foreign workers!!)

 Then, how each country specializes their productions?

Home country will produce apples, bananas, and caviar,

Foreign country will produce dates and enchiladas.

Why?
 The relative productivities of the home country in
producing apples, bananas, and caviar are higher than the
relative wage.
Applications:
(1) Comparative Advantage with Many Goods

Home Unit Labor Foreign Unit Labor Relative Home Productivity

Good
Requirement Requirement Advantage

Apples 1 10 10

Bananas 5 40 8

Caviar 3 12 4 w
 3,
Dates 6 12 2 w*
Enchiladas 12 9 0.75

(1) The home country has high productivity in apples, bananas, and caviar that give it a cost
advantage, despite its high wage.
(2) The foreign country has low wages that give it a cost advantage, despite its low
productivity, in date production.
Applications:
(1) Comparative Advantage with Many Goods
Then, the question is:
w
How is the relative wage determined, when there are many goods?
w*

Answer: By the relative supply of and relative (derived) demand for labor services.

(A) Labor Supply

w
• Relative supply (RS) of labor is independent of .
w*

L and L* are fixed at an amount determined by the populations in the

home and foreign countries.
Applications:
(1) Comparative Advantage with Many Goods

(B) Labor Demand

w
 The relative (derived) demand for home labor services falls when rises.
w*

As domestic labor services become more expensive relative to foreign

labor services, the demand for domestic labor services changes as follows.

(1) goods produced in the Home country become more

expensive, and demand for these goods and the labor services
to produce them falls.

(2) fewer goods will be produced in the Home country, further

reducing the demand for domestic labor services.
Table 3.2 Home and Foreign Unit Labor Requirements

Home Unit Labor Foreign Unit Labor Relative Home Productivity

Good
Requirement aLi
a sub start expression L i end expression Requirement aLi *
a sub start expression L i end expression to the asterisk power Advantage a Li  / aLi
Start fraction a sub start expression L i end expression to the asterisk power over a sub start expression L i end expression end fraction

Apples 1 10 10 𝑤
= 4.01
Bananas 5 40 8 𝑤∗
𝑤
Caviar 3 12 4 = 3.99
𝑤∗
Dates 6 12 2 𝑤
=3
Enchiladas 12 9 0.75 𝑤∗
Applications:
(1) Comparative Advantage with Many Goods
w
• Suppose increases from 3 to 3.99:
w*
 The home country would still produce apples, bananas, and caviar,
but the demand for these goods and the labor to produce them
would fall as the relative wage rises. (because those goods
become more expensive.)

• Suppose w increases from 3.99 to 4.01:

w*
 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

rises from 0.75 to 10.
w*
Figure 3.5 Determination of Relative Wages

In a many-good Ricardian model, relative wages are determined by

the intersection of the derived relative demand curve for labor, RD,
with the relative supply, RS.
Applications:
(2) Transportation Costs and Nontraded 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 (Chapters 4–5).

2. Protectionism by trade policies (Chapters 9–12).

3. Transportation costs reduce or prevent trade, which may

cause each country to produce the same good or service.
Applications:
(2) Transportation Costs and Nontraded Goods

• Nontraded goods and services (e.g., haircuts and auto

repairs) exist due to high transport costs.

 In reality, countries tend to spend a large fraction of

national income on nontraded goods and services.
Applications:
(2) Transportation Costs and Nontraded Goods
A simple analysis from our Ricardian Trade Model:
𝑃𝐶
(1) Home exports 1 cheese and imports units of Wine.
𝑃𝑊

 Now, suppose that t (0<t<1) of Wine has “melt down” in the middle of Ocean.

𝑃𝐶
 Then, only (1 − 𝒕) units of Wine will be arrived (imported) in Home.
𝑃𝑊

So, in order to enjoy the gain from free trade, the following condition should be satisfied;
𝑷𝑪 𝒂𝑳𝑪
𝟏−𝒕 > .
𝑷𝑾 𝒂𝑳𝑾
Applications:
(2) Transportation Costs and Nontraded Goods
𝑃𝑊
(2) Foreign exports 1 wine and imports units of cheese.
𝑃𝐶

 Now, suppose that t (0<t<1) of Cheese has “melt down” in the middle of Ocean.

𝑃𝑊
 Then, only (1 − 𝒕) units of Cheese will be arrived (imported) in Foreign.
𝑃𝐶

So, in order to enjoy the gain from free trade, the following condition should be satisfied;
𝑷𝑾 𝒂∗𝑳𝑾
𝟏−𝒕 > .
𝑷𝑪 𝒂∗𝑳𝑪
Applications:
(2) Transportation Costs and Nontraded Goods

The two conditions should hold true, for the mutual gains from Trade:

𝑷𝑪 𝒂𝑳𝑪 𝑷𝑾 𝒂∗𝑳𝑾
𝑷𝑾
𝟏−𝒕 >
𝒂𝑳𝑾
and 𝟏−𝒕 > .
𝑷𝑪 𝒂∗𝑳𝑪

∗
𝑎𝐿𝐶 𝑃𝐶 𝑎𝐿𝐶
< < ∗ (1 − 𝑡)
𝑎𝐿𝑊 1 − 𝑡 𝑃𝑊 𝑎𝐿𝑊

This implies the following figure:

 Applications:
(2) Transportation Costs and Nontraded Goods

• This Figure shows

mutual gain from trade
still exist, even with
the transportation costs.

• However, if the t is too large,

then, the mutual gain from trade
may disappear, and
goods may not be traded.
 Can you show this case in the
figure?
 More applications:
(3) Country Size
• When country size increases
Or alternatively,
when the difference of country size
gets larger between Home and
Foreign,

Figure: L is larger

 The specialization point moves to

the right hand side
 The relative price of cheese to
wine becomes smaller.

Welfare gain of Home from trade

gest smaller, while Foreign can enjoy
larger welfare.

Note: Extreme case – If L is really large, then what happens?  Trade may not be possible!!!
 More applications:
(4) Technology change
• When the technology of a country
changes

Figure: aLC is smaller (tech. improvement)

 The opportunity costs of producing

cheese at Home becomes even smaller.
 The specialization point moves to the
right hand side.

 The relative price of cheese to wine falls.

Foreign can enjoy a larger welfare,

But,
Home’s welfare is ambiguous.

Note: There are still mutual gains from trade.

Empirical Evidence for Ricardian Trade Model
• A testable idea for Ricardian prediction
 Do countries export those goods in which their productivity
is relatively high?

Supportive findings:

(1) 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.
 Figure 3.6 Productivity and Exports

At this time, the United States had

an absolute advantage in all 26
industries, yet the ratio of exports
was low in the least productive
sectors of the United States.

A comparative study showed that U.S. exports were high relative to British exports
in industries in which the United States had high relative labor productivity.
(Each dot represents a different industry.)
Empirical Evidence
(2) A 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

Bangladeshi Output per Bangladeshi exports

Blank

Worker as % of China as % of China

All industries 28.5 1.0
Apparel 77 15.5

Source: McKinsey and Company, “Bangladesh’s ready-made garments industry: The

challenge of growth,” 2012; UN Monthly Bulletin of Statistics.
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