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The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

International Economics B (Econ 203) Weeks 2: The Ricardian Model

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management University

Term 2, 2016-2017

Economics, Singapore Management University Term 2, 2016-2017 Dr. Ruanjai Suwantaradon School of Economics, Singapore

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Plan for this Class

1. The Ricardian Model: Productivity Differences as a Source of Comparative Advantage

1.1 Assumptions and Set-up of the Model

1.2 Predictions

2. Empirical Evidence for the Ricardian Model

3. General Equilibrium Set-up

for the Ricardian Model 3. General Equilibrium Set-up Dr. Ruanjai Suwantaradon School of Economics, Singapore

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Preamble

We have seen earlier a very general formulation of the principle of comparative advantage.

All that mattered in providing a motivation for trade were differences in autarky relative prices.

The Ricardian model provides the oldest explanation for such differences in autarky relative prices: productivity differences across countries as a source of comparative advantage

The original theory due to David Ricardo dates back to the early 19th century.

due to David Ricardo dates back to the early 19th century. Dr. Ruanjai Suwantaradon School of

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Assumptions

2 countries (Home and Foreign) Variables that refer to the Foreign country indicated by an asterisk:

2 sectors (Clothing and Food)

1 factor of production (Labor): Quantity L, assumed to be fixed Labor is homogenous and fully mobile across the two sectors

In both industries, a simple constant returns-to-scale technology:

The number of units of labor required to produce a unit of output remains constant even as output expands: constant unit labor requirements

Markets are perfectly competitive

Labor markets clear: no unemployment

No trade costs (can be relaxed)

clear: no unemployment No trade costs (can be relaxed) Dr. Ruanjai Suwantaradon School of Economics, Singapore

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Set-up of the Model: Technology Coefficients

(Constant) unit labor requirements fully describe the production technology:

a LF = amount of labor required to produce one unit of food in Home a LC = amount of labor required to produce one unit of clothing in Home

Note that:

1/a LF = Home labor’s productivity in producing food 1/a LC = Home labors productivity in producing clothing (Unit of measurement of 1/a LF and 1/a LC is output per hour)

Larger a L corresponds to lower productivity

Reasons for why unit labor requirements differ across countries could be:

differences in technological knowhow, worker skill sets, strength of labor unions etc.

knowhow, worker skill sets, strength of labor unions etc. Dr. Ruanjai Suwantaradon School of Economics, Singapore

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Deriving the PPF and Autarky Equilibrium

Equilibrium Set-up Deriving the PPF and Autarky Equilibrium Let x F = Home’s output of F

Let x F = Home’s output of F x C = Home’s output of C

Full employment implies:

a LF x F + a LC x C = L

This is Home’s PPF / Transformation Curve

x C = L This is Home’s PPF / Transformation Curve Dr. Ruanjai Suwantaradon School of

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Deriving the PPF and Autarky Equilibrium

Equilibrium Set-up Deriving the PPF and Autarky Equilibrium Let: x F = Home’s output of F

Let:

x F = Home’s output of F

x C = Home’s output of C

Full employment implies:

a LF x F + a LC x C = L

This is Home’s PPF / Transformation Curve

= Opportunity Cost for another

unit of C in terms of F production foregone

Here, production exhibits constant marginal returns

MRT = a LC

a LF

constant marginal returns MRT = a L C a LF Dr. Ruanjai Suwantaradon School of Economics,

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Deriving the PPF and Autarky Equilibrium

Equilibrium Set-up Deriving the PPF and Autarky Equilibrium Equilibrium in autarky: Production: A Consumption: A

Equilibrium in autarky:

Production: A

Consumption: A

Relative price = p C

Welfare = y 0

p

F

=

a

a

LC

LF

Autarky relative price is completely pinned down by the ratio of technology coefficients.

Hence, comparative advantage is determined entirely by technological conditions.

is determined entirely by technological conditions . Dr. Ruanjai Suwantaradon School of Economics, Singapore

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Plan for this Class

1. The Ricardian Model: Productivity Differences as a Source of Comparative Advantage

1.1 Assumptions and Set-up of the Model

1.2 Predictions

2. Empirical Evidence for the Ricardian Model

3. The General Equilibrium Set-up

for the Ricardian Model 3. The General Equilibrium Set-up Dr. Ruanjai Suwantaradon School of Economics, Singapore

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Trade Equilibrium

Suppose that Home is relatively more productive in the clothing industry than

Foreign: a LC

< a

a

LC

LF

a

LF

This automatically means that Foreign is relatively more productive in the food

industry than Home: a

LF

a

LC

<

a

a

LF

LC

food industry than Home: a ∗ LF a ∗ LC < a a LF LC Dr.
food industry than Home: a ∗ LF a ∗ LC < a a LF LC Dr.

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Trade Equilibrium (cont.)

a

a

LC

LF

< a

a

LC

LF

p C < p

p

F

p

C

F

Home has a comparative advantage in Clothing; Foreign in Food

The world relative price or terms of trade p C W must satisfy

p

F

p

p

C

F

p C W p

p

F

p

C

F

and settles at a level that ensures balanced trade:

Value of Home exports of Clothing = Value of Home imports of Food

of Home exports of Clothing = Value of Home imports of Food Dr. Ruanjai Suwantaradon School

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Trade Equilibrium

Suppose p C W = Slope of EB and E B

p

F

p C W = Slope of EB and E ∗ B ∗ p F Specialization patterns:

Specialization patterns:

E is the point on Home’s PPF through which a budget line with slope (p C /p F ) W will allow Home to reach the highest indifference curve possible:

Home specializes completely in Clothing (moves from A to E )

specializes completely in Clothing (moves from A to E ) Dr. Ruanjai Suwantaradon School of Economics,

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Trade Equilibrium

Suppose p C W = Slope of EB and E B

p

F

p C W = Slope of EB and E ∗ B ∗ p F Specialization patterns:

Specialization patterns:

Likewise, E is the point on Foreign’s PPF through which a budget line with slope (p C /p F ) W will allow Foreign to reach the highest indifference curve possible: Foreign specializes completely in Food (moves from A to

E ) and consumes at B

from A ∗ to E ∗ ) and consumes at B ∗ Dr. Ruanjai Suwantaradon School

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Trade Equilibrium

Suppose p C W = Slope of EB and E B

p

F

p C W = Slope of EB and E ∗ B ∗ p F Consumption patterns:

Consumption patterns:

With the new budget line, Home consumes at B and Foreign at B Trade patterns:

Home exports Clothing to Foreign; Foreign exports Food to Home Both countries gain from trade: B and B lie on higher indifference curves than A and A respectively

indifference curves than A and A ∗ respectively Dr. Ruanjai Suwantaradon School of Economics, Singapore

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Absolute Advantage vs Comparative Advantage

Very important to clearly understand the difference between these two concepts:

Home has an absolute advantage in the production of clothing if

a LC < a LC , ie if it is more productive in the cloth industry than Foreign.

Home has a comparative advantage in the production of clothing if

a

a

LC

LF

< a

a

LC

LF

, ie if it is relatively more productive in the cloth industry (lower

opportunity cost of production)

in the cloth industry (lower opportunity cost of production) Dr. Ruanjai Suwantaradon School of Economics, Singapore

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Absolute Advantage vs Comparative Advantage (cont.)

Consider the following table of unit labor requirements (the a’s):

 

Food

Clothing

Home

30

10

Foreign

40

20

Who has the absolute advantage in food? Who has the absolute advantage in clothing?

Who has the comparative advantage in each industry?

What is the range of possible relative world prices at which complete specialization and trade would occur? Who trades which good?

specialization and trade would occur? Who trades which good? Dr. Ruanjai Suwantaradon School of Economics, Singapore

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Absolute Advantage vs Comparative Advantage (cont.)

Consider the following table of unit labor requirements (the a’s):

 

Food

Clothing

Home

30

10

Foreign

40

20

Who has the absolute advantage in food? Who has the absolute advantage in clothing?

Who has the comparative advantage in each industry?

What is the range of possible relative world prices at which complete specialization and trade would occur? Who trades which good?

One country can have an absolute advantage in both food and clothing, but it cannot have a comparative advantage in both.

but it cannot have a comparative advantage in both. Dr. Ruanjai Suwantaradon School of Economics, Singapore

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Trade Equilibrium: The World PPF

General Equilibrium Set-up Trade Equilibrium: The World PPF Combining the Home and Foreign PPF’s, we obtain

Combining the Home and Foreign PPF’s, we obtain the world PPF: ABC

This describes the possible production out- put of the world. To actually consume at some of these points, Home and Foreign may need to trade.

Let’s assume that preferences in both countries are identical and homothetic, and so can be represented by a set of world indifference curves

can be represented by a set of world indifference curves Dr. Ruanjai Suwantaradon School of Economics,

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Trade Equilibrium: The World PPF

General Equilibrium Set-up Trade Equilibrium: The World PPF Some free trade equilibrium possibilities: Point B :

Some free trade equilibrium possibilities:

Point B: World indifference curve passes through the “kink”

Both countries specialize completely (Home in Clothing, Foreign in Food)

Terms of trade lies between the two relative autarky prices (the slopes of the two linear segments)

autarky prices (the slopes of the two linear segments) Dr. Ruanjai Suwantaradon School of Economics, Singapore

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Trade Equilibrium: The World PPF

General Equilibrium Set-up Trade Equilibrium: The World PPF Some free trade equilibrium possibilities: Point J :

Some free trade equilibrium possibilities:

Point J: World indifference curve tangent to Foreign linear segment of the PPF

Home completely specializes in Clothing, but Foreign produces both goods

Terms of trade equal to the Foreign autarky relative price (slope of the foreign linear segment)

Can you describe situations in which the equilibrium is likely to be at J?

situations in which the equilibrium is likely to be at J ? Dr. Ruanjai Suwantaradon School

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Trade Equilibrium: The World Supply and Demand

Set-up Trade Equilibrium: The World Supply and Demand Let’s look at the world market for food

Let’s look at the world market for food:

Recall that a

a

World supply curve for food: A step function

LF

LC

<

a

a

LF

LC

If

to produce any food of food (x F ) W = 0

If

produces food, Home produces only clothing (x F ) W = L

p

F

p

C

<

a

LC , even Foreign will not want

World output

a

LF

a

LF

a

LC

<

p

p

F

C

<

a

a

LF

LC , Foreign only

a

LF

If

between food and clothing; Home specializes completely in clothing.

p

F

p

C

=

a

a

LC , Foreign indifferent

LF

∗ L ⇒ (x F ) W ∈ [0, ∗ a LF ]
L
⇒ (x F ) W ∈ [0,
a
LF ]

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Trade Equilibrium: The World Supply and Demand

Set-up Trade Equilibrium: The World Supply and Demand Let’s look at the world market for food:

Let’s look at the world market for food:

World supply curve for food: A step function

If

completely in food; Home is indifferent

between food and clothing.

p

F

p

C

=

a LF

LC , Foreign specializes

a

Total output of food,

(x F ) W [

a

If

food

LF

LC

a

<

p

p

L

a

LF ,

L

a

LF

+

L

a LF ]

F

C , both countries produce

(x F ) W =

L

a

LF

+

a

L

LF

Exact food output depends on demand

L ∗ a ∗ LF + a L LF Exact food output depends on demand Dr.

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Trade Equilibrium: The World Supply and Demand

Set-up Trade Equilibrium: The World Supply and Demand Let’s look at the world market for food:

Let’s look at the world market for food:

World demand curve for food: Total demand for food in the two countries, downward slop- ing

Some free trade equilibrium possibilities:

Point J :

Foreign produces both goods

Home specializes completely in clothing

Point B :

Foreign specializes completely in food

Home specializes completely in clothing

completely in food Home specializes completely in clothing Dr. Ruanjai Suwantaradon School of Economics, Singapore

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Trade Equilibrium: Wage Determination

With perfect competition:

The marginal cost of production(MC) must be the price of the good, otherwise profits would be positive, and entrants would come in, bidding up the wage rate (w ).

Thus, the competitive profit conditions (from the Kuhn-Tucker Theorem) are

wa LC p C and wa LC = p C if x C > 0 (zero-profit condition: ZPC)

if x C = 0

wa LF p F analogously

wa LC > p C

Equivalently, the wage rate must be the value of the marginal product(VMP)

of that unit of labor:

w p C a LC ,

1

w p F

a LF

1

w ≥ p C a L C , 1 w ≥ p F a LF 1

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Trade Equilibrium: Wage Determination

Equilibrium Set-up Trade Equilibrium: Wage Determination Technology coefficients determine the equi- librium nominal

Technology coefficients determine the equi- librium nominal wage.

p

If

food

C

p

F

<

a

a

LC

LF

: Both countries produce

wa LF = p F and w a

LF

= p F

= 1/a LF ⇒ w ∗ ∗ w 1/a LF ∗ If p C >
= 1/a LF
⇒ w
w
1/a
LF
If
p C
> a
LC
: Both countries produce
a
p F
LF
clothing
⇒ wa LC = p C and w ∗ a
= p C
LC
= 1/a LC
⇒ w
w
1/a
LC

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Trade Equilibrium: Wage Determination

Equilibrium Set-up Trade Equilibrium: Wage Determination If a L C < p C < a a

If a LC < p C < a

a

LF

p

F

a

LC

LF

: Home produces

clothing, Foreign produces food

wa LC = p C and w a

w

w

= 1/a LC

1/a

LF

p

p

C

F

LF

= p F

increases,

Equilibrium relative wage must lie between the two relative productivity ratios

As

p

F

p

C

w

increases.

w

productivity ratios ⇒ As p F p C w ∗ increases. w Dr. Ruanjai Suwantaradon School

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Trade Equilibrium: Wage Determination

Equilibrium Set-up Trade Equilibrium: Wage Determination If a L C < p C < a a

If a LC < p C < a

a

LF

p

F

a

LC

LF

: Home produces

clothing, Foreign produces food

wa LC = p C and w a

w

w

= 1/a LC

1/a

LF

p

p

C

F

LF

= p F

increases,

Equilibrium relative wage must lie between the two relative productivity ratios

Note: Home workers’ real wages improve as

As

p

p

C

F

w

increases.

w

p C

p F

increases:

w

p C = =

w

p

F

1

a LC stays constant, but

a

1

LC

p

p

C

F

increases

So Home workers are better off (in terms of Food they can buy).

workers are better off (in terms of Food they can buy). Dr. Ruanjai Suwantaradon School of

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Trade Equilibrium: Wage Determination

Equilibrium Set-up Trade Equilibrium: Wage Determination If a L C a LF < p C <

If a LC

a

LF

< p C < a

p

F

a

LC

LF

: Home produces

clothing, Foreign produces food

wa LC = p C

w

w

= 1/a LC

1/a

LF

and w a

p

p

C

F

LF

= p F

As p C increases,

p

F

w

increases.

w

Equilibrium relative wage must lie between the two relative productivity ratios

Intuition: The change in relative prices favors the sector in which Home is specializing.

(Conversely, you should verify that Foreign

workers are indeed worse off; w ∗ is constant) ↓ while w ∗ p C
workers are indeed worse off; w ∗
is constant)
while w ∗
p
C
p F

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Summary of Predictions of Ricardian Model

In a 2-country, 2-good Ricardian model:

The patterns of specialization and trade are determined entirely by technological conditions, namely by the relative labor productivities of each country.

If Home has a higher relative labor productivity in the clothing industry (compared to the food industry), it has a lower autarky price of clothing relative to food.

Suppose demand conditions are such that with an opening to trade, the world terms of trade lie strictly between the two autarky relative prices of Home and Foreign.

Home then specializes in clothing and exports it to Foreign. Conversely, Foreign will specialize in food, and export it to Home.

Both countries gain from this mutually beneficial exchange.

Both countries gain from this mutually beneficial exchange. Dr. Ruanjai Suwantaradon School of Economics, Singapore

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Summary of Predictions of Ricardian Model (cont.)

In a multi-country, multi-good world:

We cannot make as sharp a prediction about the patterns of specialization and trade.

Nevertheless, we can still measure a country’s relative productivity in various industries in terms of a reference industry and then rank them.

What we can say is: on average, a country will tend to export those goods in which it has a relative productivity advantage, and import those goods in which it has a relative productivity disadvantage.

Where the exact cut-off between exporting and importing lies will depend on other factors such as demand conditions, size of the labor force in each country etc.

conditions, size of the labor force in each country etc. Dr. Ruanjai Suwantaradon School of Economics,

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Some Drawbacks of the Ricardian Model

Its predictions are much too stark in the 2 × 2 case:

Complete specialization in an industry following an opening to trade.

This is at odds with the data: We do know that countries export a wide range of industries and are not so narrowly specialized.

The model features only one factor of production, labor. Thus, it does not allow us to talk about distributional consequences.

does not allow us to talk about distributional consequences. Dr. Ruanjai Suwantaradon School of Economics, Singapore

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Plan for this Class

1. The Ricardian Model: Productivity Differences as a Source of Comparative Advantage

1.1 Assumptions and Set-up of the Model

1.2 Predictions

2. Empirical Evidence for the Ricardian Model

3. The General Equilibrium Set-up

for the Ricardian Model 3. The General Equilibrium Set-up Dr. Ruanjai Suwantaradon School of Economics, Singapore

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Empirical Evidence for the Ricardian Model

The Ricardian model suggests that countries should tend on average to export more from those industries in which they are relatively more productive.

There are many empirical evidence in support of this.

Earlier Work: G.D.A. MacDougall (1951), Balassa (1963) and Stern

(1962)

Golub and Hseih (2000)

Nunn (2007), an influential paper in the ‘Trade and Institutions’ literature

paper in the ‘Trade and Institutions’ literature Dr. Ruanjai Suwantaradon School of Economics, Singapore

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Empirical Evidence for the Ricardian Model

Set-up Empirical Evidence for the Ricardian Model Source: Balassa(ReStat, 1963) Comparing UK and US, tested

Source: Balassa(ReStat, 1963)

Comparing UK and US, tested the prediction that nations export goods in which their labor productivity is rel- atively high.

in which their labor productivity is rel- atively high. Dr. Ruanjai Suwantaradon School of Economics, Singapore

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Empirical Evidence for the Ricardian Model

Set-up Empirical Evidence for the Ricardian Model Looking at US-Japan exports. The US tends to export

Looking at US-Japan exports.

The US tends to export more rela- tive to Japan, in those industries in which the US enjoys relatively lower unit costs than Japan.

Source: Golub (1995)

relatively lower unit costs than Japan. Source: Golub (1995) Dr. Ruanjai Suwantaradon School of Economics, Singapore

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Discussions

Based on the Ricardian model which we have seen so far, what responses would you give to each of these statements? Do you think this model is adequate for shedding light on these statements?

1. International trade will only benefit a country if it is better at making something than its trading partner.

2. Low wages in China and India will allow these two countries to take over production of nearly everything.

3. The CEO of The General Motors Company made US$28 million in 2015. The workers in her Central American assembly line made US$5 per hour. This is exploitation, pure and simple.

made US$5 per hour. This is exploitation, pure and simple. Dr. Ruanjai Suwantaradon School of Economics,

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Plan for this Class

1. The Ricardian Model: Productivity Differences as a Source of Comparative Advantage

1.1 Assumptions and Set-up of the Model

1.2 Predictions

2. Empirical Evidence for the Ricardian Model

3. The General Equilibrium Set-up

for the Ricardian Model 3. The General Equilibrium Set-up Dr. Ruanjai Suwantaradon School of Economics, Singapore

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

The General Equilibrium Set-up

Two countries (i): Country 1 and Country 2

Two goods (j): Good 1 and Good 2

Identical utilities of representative consumer/worker in countries example:

u c

i

1

,

c 2 = b 1 ln c 1 + b 2 ln c

i

i

i

2

Endowments of labor in countries

i = 1, 2:

L i units of labor

i = 1, 2, for

Different production technologies across countries:

i

1

y

=

i

1

i

1

l

a

and

i

2

y

=

i

2

i

2

l

a

i = 1, 2

i 1 y = i 1 i 1 l a and i 2 y = i

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Definition of an Autarky Equilibrium

An autarky equilibrium

comsumption plans c 1 i , c 2 i ; and production plans y i , y i , , 2 such that:

1. Taking the prices p 1 i , p 2 i and w i as given, the representative consumer

solves:

in country i is a set of: prices p 1 i , p 2 i ; a wage rate w i ;

1

2

i

l

1

l i

max u c 1 i , c i

1 i , c i

c

2

2

s.t. p i

i

1 c

1 +

i

p i

2 c

2 = w

i L i

2. Given p i and w i , firms in sector j = 1, 2 solve

j

i

j i w l

max i

i , l

y

i

j

j

p

j y

i

j

s.t.

3. The goods markets clear:

i

c

i

c

1

2

=

=

y j i =

l

j

i

i

j

a

4. The labor market in country i clears:

l

i

1

+ = L i

i

l

2

labor market in country i clears: l i 1 + = L i i l 2

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Definition of a Free Trade Equilibrium

A

comsumption plans c 1 ,

production plans y 1 , y 1 , , , y 2 , y 2 , ,

1. Taking the prices p 1 , p 2 and w i as given, the representative consumer in

country i, i = 1, 2 solves:

free trade equilibrium is a set of: prices p 1 ,

1

1

2

1 , c 2 , c 2 ; and

c

2

1

2

1

l

1

1

l

2

1

2

2

l

1

2

l

2

p 2 ; wages w 1 ,

w 2 ;

such that:

max u c 1 i , c 2 i

1 i , c i

c

2

s.t. p 1 i +

1

c

p 2 i = w

2

c

i L i

2.

p 1 w i a 1 0,

i

= 0 if y i > 0,

1

i = 1, 2

i

where y 1 =

p 2 w i a 2 0,

i

= 0 if y i > 0,

2

i = 1, 2

3. The goods markets clear:

1 +

c

1 +

c

1

2

c 1 2

c 2 2

=

=

i

where y 2 =

y

1 + y 2

1 + y 2

y

1

2

1

2

l

a

i

1

i

1

i

2

i

2

l

a

4. The labor market in country i, i = 1, 2, clears:

l

i

1

+ = L i

i

l

2

country i , i = 1 , 2, clears: l i 1 + = L i

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Example 1

Suppose that both countries have identical preference: u c 1 , c 2 = ln c 1 + ln c but different labor endowment and production technologies.

In particular, Country 1 has labor endowment

requirements a

Country 2 has labor endowment

and a

L 2 =1800, and unit labor requirements a 2 = 2

i

i

i

i

2

L ¯ 1 =1000 and unit labor

1

1

= 1 and a

1

1

= 2.

¯

1

2

2

= 3.

,

Solve for each country’s autarky equilibrium and for a free-trade equilibrium.

Please refer to the supplementary note ’Example 1 of Ricardian GE Model’.

supplementary note ’Example 1 of Ricardian GE Model’. Dr. Ruanjai Suwantaradon School of Economics, Singapore

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Example 2 for Self Practice

u

i

c 1 ,

c 2 = ln c 1 + ln c

i

i

i

2

1

1

y

1

1

= l

,

y

2

1 =

l

2

1

2 ,

1

y 2 =

1

2

l

2

2

2

y

2

2

= l

,

,

L 1 = 12

L 2 = 12

In this case, we have a free-trade equilibrium in which

 

i

p

1

i

p

2

w

i

 

i

c

1

i

c

2

y i

1

y i

2

 

i

1

l

i

2

l

Country 1

 

1

1 6

1

 

6

12

0

12

0

Country 2

 

1

1 6

1

 

6

0

12

 

0

12

Note that with free trade p 1 = p 2 = p 1 and p 1 = p 2 = p

1

1

2

2

2

.

and p 1 = p 2 = p 1 1 2 2 2 . Dr. Ruanjai

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Summary

In the 2-country, 2-good setting setting, you should know how to:

relate the slope of the PPF for a given country to its unit labor coefficients / technology coefficients

predict the pattern of specialization and trade, given a set of unit labor coefficients

recognize that pinning down the actual terms of trade ultimately depends on demand conditions

understand broadly what forms of empirical evidence have been found in support of the Ricardian model

know how to solve a general equilibrium model for an autarky and free-trade equilibrium for the Ricardian framework

and free-trade equilibrium for the Ricardian framework Dr. Ruanjai Suwantaradon School of Economics, Singapore

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model

The Ricardian Model: Theory The Ricardian Model: Empirical Evidence The General Equilibrium Set-up

Disclaimer

These slides have been made available to students for the sole purpose of self study. They should not be disseminated without my prior permission, nor should they be re-used for commercial purposes. The material draws on:

2007,

Slides from Caves, Frankel, and Jones, World Trade and Payments: An Introduction, 10th edition. c Pearson Addison-Wesley.

Slides from Carbaugh, International Economics, 12th edition. c Thomson Learning.

Slides from Krugman and Obstfeld, International Economics: Theory and Policy, 7th edition. Prepared by

2009, South-Western, a division of

Thomas Bishop. c

2006, Pearson Addison-Wesley.

Slides from Husted and Melvin, International Economics, 7th edition. c

2007, Pearson Addison-Wesley.

I have also greatly benefited from material shared by Davin Chor (in turn drawn from Pol Antr`as, Pao-Li Chang, C. Fritz Foley, and Edwin Lai). All errors are my own.

C. Fritz Foley, and Edwin Lai). All errors are my own. Dr. Ruanjai Suwantaradon School of

Dr. Ruanjai Suwantaradon School of Economics, Singapore Management UniversityInternational Economics B (Econ 203) Weeks 2: The Ricardian Model