The Classical World of David Ricardo and

Comparative Advantage

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Chapter 3Chapter 3

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Learning Objectives

Explain comparative advantage as the basis of trade.

Identify the difference between absolute and comparative advantage.

Calculate gains from trade in a 2x2 model.

Illustrate comparative advantage using production possibility frontiers.

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Assumptions of the Ricardian Model

A 2-country, 2-commodity world Perfect competition No transportation costs Factors mobile internally, immobile

internationally Constant costs of production Fixed technology for each country All resources are fully employed The “labor theory of value” holds

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Notation

Let: ax = labor time to produce 1 X in

country A ay = labor time to produce 1 Y in

country A bx = labor time to produce 1 X in

country B by = labor time to produce 1 Y in

country B

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Comparative Advantage Defined

Country A has a comparative advantage in good X if:

(Px/Py)A < (Px/Py)B OR if

ax/ay < bx/by OR if

ax/bx < ay/by

If country A has a comparative advantage in good X, country B must have a comparative advantage in good Y.

Comparative Advantage: An Example

Corn (X) Blankets (Y)

U.S. (A) 1 hour/bu 5 hrs/bl

Mexico (B) 3 hrs/bu 6 hrs/bl

Autarky Price Ratios (APRs)

1B = 5C, 1C = 1/5B

1B = 2C, 1C = 1/2B

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3-7

Comparative Advantage

Since the U.S.’s APR for corn is lower than Mexico’s (1/5 < 1/2), the U.S. must have a comparative advantage in corn.

Since Mexico’s APR for blankets is lower than the U.S.’s (2 < 5), Mexico must have a comparative advantage in blankets.

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Comparative Advantage and the Total Gains from Trade

Ricardo’s argument is that trade will be mutually advantageous as long as the two countries’ autarky price ratios are different.

How do we know that this is true?

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Comparative Advantage and the Total Gains from Trade

The Production Possibilities Frontier (PPF) is the set of all combinations Table 3 Cloth Wine Price Ratio in

Autarky

Country A 1 hr / yd 3 hr / bottle 1W: 3C

Country B 2 hr / yd 4 hr / bottle 1W: 2C

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Comparative Advantage and the Total Gains from Trade

Lets assume that Country A has 9,000 labor hours available and Country B has 16,000 labor hours available.

Then, using Table 3,Country A can produce a maximum of 9,000 yards of cloth (9,000 / 1 hr per yard) with no wine production and it can produce a maximum of 3,000 bottles of wine (9,000 / 3 hr per bottle) with no cloth production.

Similarly, Country B can produce a maximum of 8,000 yards of cloth (16,000 / 2 hr per yard) with no wine and a maximum of 4,000 bottles (16,000 / 4 hr per bottle) with no cloth production.

If we assume that these two countries exchange at the terms of trade 1 W:2.5 C.

We also assume that country A exchanges 2,500 yards of cloth for 1,000 bottles of wine.

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Comparative Advantage and the Total Gains from Trade

What are the gains from trade for these two countries if any?

Country A Before Trade After Trade

Cloth Production 6,000 C 6,000 C

Cloth Consumption 6,000 C 6,000 – 2,500(exported cloth) = 3,500 C

Wine Production 1,000 W 1,000 W

Wine Consumption 1,000 W (1,000 before trade+ 1,000 imported wine) = 2,000 W

REQUIRED LABOR HOURS OF PRODUCTION

[ (6,000 *1 ) + (1,000 * 3) ] = 9,000

[ (3,500 * 1) + (2,000*3) ] = 9,500

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Comparative Advantage and the Total Gains from Trade

What are the gains from trade for these two countries if any?

Country B Before Trade After Trade

Cloth Production 3,000 C 3,000 C

Cloth Consumption 3,000 C 3,000 + 2,500(imported cloth) = 5,500 C

Wine Production 2,500 W 2,500 W

Wine Consumption 2,500 W (2,500 before trade - 1,000 exported wine) = 1,500 W

REQUIRED LABOR HOURS OF PRODUCTION

[ (3,000 *2 ) + (2,500 * 4) ] = 16,000

[ (5,500 * 2) + (1,500* 4) ] = 17,000

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Comparative Advantage and the Total Gains from Trade

What are the gains from trade for these two countries if any?

Gains from Trade (in terms of labor hours) Country A:

After trade, residents of country A could consume 3,500 C and 2,000 W which would require 9,500 hours of labor so gains from trade is 500 hours (9,500-9,000)

Country B:

After trade, consumption of residents by country B would require 17,000 hours of labor so gains from trade is 1,000 hours (17,000-16,000)

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Comparative Advantage and the Total Gains from Trade

The Production Possibilities Frontier (PPF) is the set of all combinations of goods that a country is capable of producing, given available technology and resources.

Suppose in our example the U.S. has 1000 hours of labor available and Mexico has 1800.

Comparative Advantage: An Example

Corn (X) Blankets (Y)

U.S. (A) 1 hour/bu 5 hrs/bl

Mexico (B) 3 hrs/bu 6 hrs/bl

Autarky Price Ratios (APRs)

1B = 5C, 1C = 1/5B

1B = 2C, 1C = 1/2B

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U.S. Production Possibilities

1000

Corn

Blankets200

500

100

A

Slope: rise/run = -1000/200 = -5

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Slope of the PPF

for this example, -5 Notice: the slope (in absolute value) is

the APR of the good on the horizontal axis.

Therefore, the slope is the opportunity cost of the good on the horizontal axis.

The slope is also the marginal rate of transformation.

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Mexico’s Production Possibilities

600

Corn

Blankets300

Slope = -2, or the opportunity cost of blankets

150

300 B

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Classical Model: The Gains from Trade

Suppose that in autarky, the U.S. is at point A, producing and consuming 500 corn and 100 blankets.

Suppose that in autarky, Mexico is at point B, producing and consuming 300 corn and 150 blankets.

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U.S. Production Possibilities

1000

Corn

Blankets200

500

100

A

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Mexico’s Production Possibilities

600

Corn

Blankets300

300

150

B

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Classical Model: The Gains from Trade

Suppose now that the U.S. and Mexico agree to trade at an “exchange rate” of 1B = 3.33C (or, 1C = .3B).

If the U.S. specializes in corn, how many units of corn could it produce? 1000.

If Mexico specializes in blanket manufacture, how many blankets could be made? 300.

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The Gains from Trade: U.S.

If the U.S. wants to continue to consume 500C, they will now have 500C to trade for blankets.

If the “exchange rate” is 1B = 3.33C (or, 1C = .3B), how many blankets can the U.S. get in exchange for 500C?

150 Therefore, the U.S. can consume outside

its PPF (to point C) by trading!

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U.S. Production Possibilities

1000

Corn

Blankets200

500

100

CA

150

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The Gains from Trade: Mexico

If Mexico wants to continue to consume 150B, they will now have 150B to trade for corn.

If the “exchange rate” is 1B = 3.33C (or, 1C = .3B), how much corn can Mexico get in exchange for 150B?

500 Therefore, Mexico can also move

outside its PPF (to point D) by trading!

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Mexico’s Production Possibilities

600

Corn

Blankets300150

B300

500D

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The Gains from Trade Note: In general, the Ricardian model

results in complete specialization. However, in trade between a small and

a large country the small country may not be able to produce enough to satisfy the large country; the large country might then partially specialize.

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The Consumption Possibilities Frontier (CPF)

The CPF is a collection of points that represent combinations of corn and blankets that a country can consume if it trades.

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U.S. Consumption Possibilities

1000

Corn

Blankets200

500

100

CA

150 300

CPF

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The Consumption Possibilities Frontier (CPF)

The CPF’s slope is the same as the terms of trade.

The CPF pivots around the production point.

If trade is to the benefit of a country, the CPF lies outside the PPF.

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Mexico’s Consumption Possibilities

600

Corn

Blankets300150

B300

500D

1000

CPF

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The Limits to Mutually Advantageous Trade

“Exchange rate” must be at least as great as Mexico’s APR.

“Exchange rate” must be no greater than the U.S.’s APR.

Bottom line: we still don’t know how the terms of trade will be determined, but they must be between the countries’ APRs if trade is to be mutually beneficial.

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The CPF and “Small” Countries

The nearer are the terms of trade to a country’s APR, the less that country will gain from trade.

The farther away the terms of trade are from a country’s APR, the more that country will gain from trade.

Moral: to Ricardo, small countries stand to gain a lot from trade, large countries gain less.