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Econ 231-01 Chapter 3


Labor Productivity and Comparative Advantage: The Ricardian Model

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Objectives:
?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

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Theories of why trade occurs:
? Differences across countries in labor, labor skills, physical capital, natural resources, and technology ? Economies of scale (larger scale of production is more efficient)

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. Ex: 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.
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? Suppose that in the U.S. 10 million roses could be produced with the same resources that could produce 100,000 computers. ? Suppose that in Colombia 10 million roses could be produced with the same resources that could produce 30,000 computers. ? Workers in Columbia would be less productive than those in the U.S. in manufacturing computers. ? Colombia has a lower opportunity cost of producing roses. ? The U.S. has a lower opportunity cost of producing computers. ? 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 U.S. has a comparative advantage in computer production. ? Colombia has a comparative advantage in rose production.

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? Suppose initially that Colombia produces roses and the U.S. produces computers, and that both countries want to consume computers and roses. ? Can both countries be made better off?

? When countries specialize in production in which they have a comparative advantage, more goods and services can be produced and consumed.
? Have U.S. stop growing roses and use those resources to make 100,000 computers instead. Have Colombia stop making 30,000 computers and grow roses instead.
? If produce goods in which have a comparative advantage (U.S. produces computers and Colombia roses), they could still consume the same 10 million roses, but could consume 100,000 – 30,000 = 70,000 computers.
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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: 1. 2. 3. 4. 5. Labor is the only factor of production. Labor productivity varies across countries due to differences in technology, but labor productivity in each country is constant. The supply of labor in each country is constant. Two goods: wine and cheese. Competition allows workers to be paid a “competitive” 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.
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?

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.

?

Labor supply L indicates the total number of hours worked in the home country (a constant number).

?
?

Cheese production QC indicates how many pounds of cheese are produced.
Wine production QW indicates how many gallons of wine are produced.
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?

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:

?

aLCQC + aLWQW ≤ L
Labor required for each pound of cheese produced Total pounds of cheese produced Labor required for each gallon of wine produced

Total amount of labor resources Total gallons of wine produced

? Maximum home cheese production is QC = L/aLC when QW = 0. ? Maximum home wine production is QW = L/aLW when QC = 0.

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? For example, suppose that the economy’s labor supply is 1,000 hours. ? The PPF equation aLCQC + aLWQW ≤ L becomes QC + 2QW ≤ 1,000. ? Maximum cheese production is 1,000 pounds. ? Maximum wine production is 500 gallons.

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? 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

? 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

? 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) = ? gallon of wine. ? Opportunity cost of producing one pound 10 of cheese is ? gallon of wine.

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

? Because workers like high wages, they will work in the industry that pays the higher wage.

? If the price of cheese relative to the price of wine exceeds the opportunity cost of producing cheese PC /PW > aLC /aLW ,
? Then the wage in cheese will exceed the wage in wine PC /aLC > PW/aLW

? So workers will make only cheese (the economy specializes in cheese production).

? If the price of cheese relative to the price of wine is less than the opportunity cost of producing cheese PC /PW < aLC /aLW ,
? then the wage in cheese will be less than the wage in wine PC /aLC < PW/aLW
? so workers will make only wine (the economy specializes in wine production).
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? If the price of cheese relative to the price of wine equals the opportunity cost of producing cheese PC /PW = aLC /aLW ,
? then the wage in cheese equals the wage in wine PC /aLC = PW/aLW

? so workers will be willing to make both wine and cheese.

? 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 have no incentive to work solely 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

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