LECTURE 2
Comparative Advantage and
the Ricardian Model
Van Pham
ECON3116
International Trade
Theory & Policy
Van Pham | ECON3116 International Trade Theory and Policy
2-1
1. Introduction to international trade models
2. The concept of Comparative Advantage
3. The Ricardian model: Autarky – one country
4. The Ricardian model: Trade – two countries
5. Gains from trade in the Ricardian model
6. Misconceptions about comparative advantage
7. Comparative advantage with many goods
8. Adding transport costs and nontraded goods
9. Empirical evidence on the Ricardian model
Lecture Plan
Van Pham | ECON3116 International Trade Theory and Policy
Models of International Trade
• Each model examines one particular issue in greater detail and depth. No
one model captures the whole picture and should not be judged as such.
• A grand all-encompassing model can be built (& solved on computer for
applying), but it would be too complex to understand and learn from.
2-2
Van Pham | ECON3116 International Trade Theory and Policy
2-3
Traditional models of international trade
• Primary factors produce final goods directly; no intermediate goods.
• Factors are not internationally mobile; no migration or capital flows.
• Goods internationally tradeable, with restrictive trade policies, but no
transport costs.
• Perfectly competition in both world market for goods and domestic market
for factors.
• Country may be large player in trade, but individual producers are small.
• This assumption is relaxed in latter half of course.
Van Pham | ECON3116 International Trade Theory and Policy
2-4
Comparative Advantage and the Ricardian model
Sources of Comparative Advantage and Trade
• Cross-country differences in technologies
• Cross-country differences in factor endowments (land, capital and labor)
• Cross-country differences in demand (different preferences)
• Exploiting economies of scale in production
• The Ricardian model: Countries engage in trade because of
their technological differences as reflected in differences in their
relative labour productivity.
Van Pham | ECON3116 International Trade Theory and Policy
The Concept of Labour Productivity
2-5
• A country has a high labour productivity if its unit labor requirement is low.
• aLW is the number of hours of labor required to produce one unit of wine.
For example, if

= 3 and
= 2
then French workers are more productive in producing wine than Australian
workers.
• Marginal product of labour (MPL) – is the amount of output produced by an
additional worker.

=
1

=
1
3

=
1

=
1
2
Van Pham | ECON3116 International Trade Theory and Policy
2-6
• A country has an absolute advantage in a sector if it can produce a greater
output of that sector using the same amount of resources.
• Labour productivity determines the absolute advantage of a country.
The Concept of Absolute Advantage
• Example: If each country, Australia and France, has =1200 (labour hours) in
wine production, the total wine output in each country is

=

=
1200
3
= 400,

=

=
1200
2
= 600.
→ France has an absolute advantage in producing wine.
Van Pham | ECON3116 International Trade Theory and Policy
Opportunity Cost
• The opportunity cost of an unit of cheese is the amount of wine that could be
produced using the same resources.
• E.g. suppose that either 10 pounds of cheese or 5 gallons of wine can be
produced using 10 hours of labour.
▪ OC of 1 pound of cheese is 0.5 gallon of wine
▪ OC of 1 gallon of wine is 2 pounds of cheese.
Comparative Advantage
• A country has a comparative advantage in producing a good if it has a lower
opportunity cost of producing that good than other countries.
• The Ricardian model expands on this concept.
The Concept of Comparative Advantage
Van Pham | ECON3116 International Trade Theory and Policy
Assumptions
1) Two countries: Home and Foreign
2) Two goods: Cheese and Wine
3) One factor: Labour
4) The labour productivity in each good is fixed.
5) Labour mobile across industries, but not across borders.
6) Perfect competition in both goods and factor markets
7) Labour productivities will differ across countries – this will be the
basis for trade between the two countries
2-8
The Ricardian Model - Assumptions
Van Pham | ECON3116 International Trade Theory and Policy
Technology:
The production functions for cheese and wine are:
=


=


where and are the fixed input-output coefficients, indicating the amount
of labour needed to produce one unit of output.
Here and are outputs and and are inputs of labour in the two
sectors.
• Exercise: Sketch each function in labour-output space.
1-9
The Ricardian Model - Technology
Van Pham | ECON3116 International Trade Theory and Policy
Labour Endowment
• L is the total labour endowment, so
+ = ,
2-10
The Ricardian Model - Technology
where ≥ 0, ≥ 0.
• The production possibility set (PPS) of an economy shows all combinations of
goods that can be produced with a fixed amount of resources. It is given by
+ ≤ , where ≥ 0, ≥ 0.
Production Possibility Set
Van Pham | ECON3116 International Trade Theory and Policy
The Production Possibility Frontier
LCaL /
LWLC aa /
WQ
CQ
The slope of the PPF
slope = ቤ


= −
/a
/a
= −
a
a
OC = − =
a
a
LWaL /
Output of Cheese
The Production Possibility Frontier
The production possibility frontier (PPF) shows the
maximum outputs of goods producible:
+ =
O
u
tp
u
t
o
f
W
in
e

Van Pham | ECON3116 International Trade Theory and Policy
Home country
• Labour endowment: + = = 120
• Technology: labour per unit of output: a = 2 and a = 1
• PPF:
2 + = 120
• Home can produce either 60 gallons of wine or 120 pounds of cheese
• Opportunity Cost:
• OC = 2 pounds of cheese =
a
a
• OC = 0.5 gallons of wine =
a
a
2-12
The Ricardian Model - Example
Van Pham | ECON3116 International Trade Theory and Policy
Home country
WQ
CQ
The PPF equation
2 + = 120
The slope of the PPF
OC = − =
a
a
=


Output of Cheese
The Ricardian Model - Example
O
u
tp
u
t
o
f
W
in
e
a
a
=
1
2
60
120
Van Pham | ECON3116 International Trade Theory and Policy
Under perfect competition, firms maximize profit at P = MC
→ =
1
a
∗
→ =
1
a
∗
If a country produces both goods, with labour mobile across sectors, in equilibrium
= = ,
1
a
∗ =
1
a
∗ , and so
P
P
=
a
a
=
Relative price of cheese = Opportunity cost of cheese
2-14
Profit maximization and industry equilibrium
=
=
Van Pham | ECON3116 International Trade Theory and Policy
Production Choice
• If
P
P
>
a
a
, then
Q =

a
and Q = 0.
• If
P
P
<
a
a
, then
Q = 0 and Q =

a
.
• If
P
P
=
a
a
(so wage = wage), then
Q > 0 and Q > 0.
2-15
LCaL /
WQ
CQ
LWaL /
P
P
>
a
a
P
P
<
a
a
The output levels are not determined, but lie on the PPF.
Van Pham | ECON3116 International Trade Theory and Policy
Production Choice
• If
P
P
> OC, producers will be specialized in cheese production, wine
production is unprofitable.
• If
P
P
< OC, producers will be specialized in wine production, cheese
production is unprofitable
• Therefore, both wine and cheese will be produced only if
P
P
= OC =
a
a
2-16
Van Pham | ECON3116 International Trade Theory and Policy
Home’s Relative Supply Function
2-17
RS
Home’s Relative Supply function for CheeseRelative price
of cheese,
P
P
Relative quantity
of cheese,
Q
Q
a
a
If
P
P
<
a
a
then Q = 0 and
Q
Q
= 0.
If
P
P
=
a
a
then 0 < Q <

a
and
Q
Q
> 0.
If
P
P
>
a
a
then Q =

a
and
Q
Q
= ∞.
Van Pham | ECON3116 International Trade Theory and Policy
Consumption Choice
The consumer takes prices and income as given
and chooses consumptions, and , to maximize
a utility function U( , ) expressing preferences.
2-18
• Income
= ∗ + ∗
• Demand: We assume that relative demand is
a decreasing function of relative prices. E.g.:


= 2 ൘

RD
Relative price
of cheese,
P
P
Relative quantity
of cheese,
Q
Q
P
P
Q
Q
Van Pham | ECON3116 International Trade Theory and Policy
Autarky Equilibrium
• Autarky means no international trade for the economy
• Autarky equilibrium requires
✓ Supply equals demand for each good
✓ Producers maximize profits
✓ Labour market clears
• This determines the autarky equilibrium price ratio
• Assuming that consumers always demand both goods, both goods are produced
Accordingly, the autarky equilibrium price ratio is given by
2-19
Equilibrium conditions and solution
P
P
= OC =
a
a
Van Pham | ECON3116 International Trade Theory and Policy
2-20
LCaL /
WQ
CQ
LWaL /
P
P
=
a
a
Example: Autarky in Home country:
Autarky Equilibrium – Example
D = Q
D = Q
RD
RS
Relative price
of cheese,
P
P
Relative quantity
of cheese,
Q
Q
a
a
Q
Q


OCC =
aLC
aLW
=
1
2
, so
PC
PW
= OCC =
1
2
.
Van Pham | ECON3116 International Trade Theory and Policy
Example assumptions
∗ =
∗ +
∗ = 120

∗ = 2 and
∗ = 3
2-21
Foreign’s Production
Possibility Frontier
F
P
The PPF equation

∗
∗ +
∗
∗ = ∗
2
∗ + 3
∗ = 120
The slope of the PPF
− =
∗ =

∗

∗ =



∗

∗

∗

∗
∗

∗
∗/
∗
Foreign country
Van Pham | ECON3116 International Trade Theory and Policy
2-22
RD
RS
Relative price
of cheese,
P
P
Relative quantity
of cheese,
Q
Q
a
a
Q
Q
RD*
RS*
Relative price
of cheese,

∗

∗
Relative quantity
of cheese,

∗

∗

∗

∗

∗

∗
P
P
<

∗

∗
Comparative Advantage and Trade
Van Pham | ECON3116 International Trade Theory and Policy
International Trade Equilibrium
• Now countries can trade with each other
• International trade equilibrium now requires that world demand equals world
supply for each good.
• This establishes a world price ratio, at which countries trade.
• Trade equilibrium
✓ Each country exports the good that it produces at a cheaper relative price
(or lower opportunity cost) in autarky
• This is called the Principle of Comparative Advantage
2-23
Comparative advantage and trade
Van Pham | ECON3116 International Trade Theory and Policy
2-24
In our example, = 1, = 2 and
∗ = 3,
∗ = 2. Thus,

∗

∗ =
3
2
>


=
1
2
and so

∗ =

∗

∗ > =



∗ =

∗

∗ < =
a
a
.
• Home has a comparative advantage in cheese production.
• Foreign has a comparative advantage in wine production.
• Home will export cheese to Foreign in exchange for wine.
Comparative Advantage and Trade
Van Pham | ECON3116 International Trade Theory and Policy
• World relative supply:
+
∗
+
∗
• World relative demand:
+
∗
+
∗
• For simplicity, we will assume the same consumer preferences in both
countries. Thus, the world relative demand function and the two national
relative demand functions coincide, as do the indifference curves.
2-25
World Relative Supply and Demand
Van Pham | ECON3116 International Trade Theory and Policy
2-26
1
RD1
RD2
2
RS
World Relative Supply and Demand
Relative price
of cheese,
P
P
World relative quantity
of cheese,
Q+
∗
Q+∗
a
a

∗

∗
/a
∗/
∗
1) Home produces both C & W,
Foreign specializes in W.
2) Home specializes in C,
Foreign specializes in W.
3) Home specializes in C,
Foreign produces both C & W.
RD3
3
Van Pham | ECON3116 International Trade Theory and Policy
2-27
1
I2
2
World PPF
Cheese
1) Home produces both C & W,
Foreign specializes in W.
2) Home specializes in C,
Foreign specializes in W.
3) Home specializes in C,
Foreign produces both C & W.
3

a
+
∗

∗
Wine

a
+
∗

∗
Equilibrium is determined by comparative advantage,
not absolute advantage.

′

′ =
a
a
a
a
<

′

′ <

∗

∗

′

′ =

∗

∗
Van Pham | ECON3116 International Trade Theory and Policy
International Trade Equilibrium
Ricardian Principle of Comparative Advantage
• Each country will export the good in which it has a comparative advantage and
import the good in which it has a comparative disadvantage.
Related Results from the Ricardian Model
• The world price will be (weakly) between the autarky prices.
• If the world price is strictly between the autarky prices, each country will specialize
in the production of the good in which it has a comparative advantage.
• If the world price is the same as the autarky price for a country, that country will
produce both goods. The other country will specialize in production (as above).
2-28
Van Pham | ECON3116 International Trade Theory and Policy
2-29
Gains From Trade
We show that Specialization and Trade are beneficial to all countries.
Assume that the equilibrium is at point (2), i.e.,
a
a
<

′

′ <

∗

∗ .
→ Home has a comparative advantage in cheese, while Foreign has a
comparative advantage in wine.
→ Home specializes in cheese and Foreign specializes in wine to trade
with each other.
Van Pham | ECON3116 International Trade Theory and Policy
2-30
Trade Expands Consumption Possibilities: Home country
CPC
PPF
(a) Home
Quantity
of wine, QW
Quantity of cheese, QC LCaL /

a

′

′
=

′

′ >
a
a
=
a
a

a
If Home produces wine, in one hour it
can produce
1
a

If Home produce cheese, and then
trade for wine. In one hour it gets
1
a

′

′ ,
1
a

′

′ >
1
a
Gains From Trade
Van Pham | ECON3116 International Trade Theory and Policy
2-31
If Foreign produces wine and then trade
wine for cheese. In one hour it gets more
cheese than if it has to produce cheese
by itself
1

∗

′

′ >
1

∗ .CPC
PPF
(b) Foreign
Quantity
of wine, QW
Quantity
of cheese, QC
∗

∗

′

′
=

′

′ <

∗

∗
=

∗

∗
∗

∗
∗/
∗
Trade Expands Consumption Possibilities: Foreign country
Gains From Trade
Van Pham | ECON3116 International Trade Theory and Policy
2-32
• Labour in both countries is better off in trade than in autarky: labourers
can buy more of the good no longer produced.
Benefit of trade: ability to buy cheaper imports!
• In the absence of trade, the consumption possibility curve is the same
as the production possibility curve. Trade enlarges the consumption
possibility for each of the two countries.
• In equilibria (1) and (3), the country producing both goods has no gain,
but no loss either.
Gains From Trade
Van Pham | ECON3116 International Trade Theory and Policy
2-33
Exception: when Foreign is very large
PC /PW
QC/QW
0
G
RD
RS
Foreign 2
Home ½
• In this unusual case, Foreign is so
large compared to Home that trade
with Home makes no difference to
relative prices in Foreign.
• Foreign continues to produce both
goods, even under free trade, whereas
Home specializes in cheese.
• The smaller country (Home) gains a
lot from trade, but the bigger country
(Foreign) does not.
Gains From Trade -
Van Pham | ECON3116 International Trade Theory and Policy
2-34
PWC
QW/QC
0
G
RD
RS
Foreign
2
Home ½
• In this unusual case, Home is so
large compared to Foreign that trade
with Foreign makes no difference to
relative prices in Home.
• Home continues to produce both
goods, even under free trade,
whereas Foreign specializes in wine.
• The smaller country (Foreign) gains a
lot from trade, but the bigger country
(Home) does not.
Exception: or when Home is very largeGains From Trade -
Van Pham | ECON3116 International Trade Theory and Policy
1-35
• Because there are technological differences between the two countries,
trade in goods does not make wages equal across the two countries.
• A country with absolute advantage in both goods will enjoy a higher wage
after trade.
Wages and Trade
Overview
Van Pham | ECON3116 International Trade Theory and Policy
2-36
Factors terms
of trade
Goods terms
of trade
Labor productivity ratio
in the export industries
Assume that equilibrium is at (2):
• Wages are: =
1
a

′ and ∗ =
1

∗
′ .
• Relative wages are:

∗
=

∗
a
∗

′

′
• A higher labour productivity in Home, i.e., lower a, means a higher real
wage for Home’s workers.
• A higher relative price for cheese (Home’s export good) means a higher
relative wage for Home’s workers.
Wages and Trade: Real and Relative Wages
Van Pham | ECON3116 International Trade Theory and Policy
2-37
If equilibrium is at (1), i.e., Home is large, then
• Wages are: =
1
a

′ =
1
a

′ , and
∗ =
1

∗
′
• Relative wages are:

∗
=

∗
a
∗

′

′ =

∗
a
.
• A higher labour productivity in Home, i.e., lower a, means a higher
real wage for Home’s workers.
• Absolute advantage in wine (produced by both countries) determines
the relative wage between Home and Foreign countries.
Wages and Trade: Real and Relative Wages
Van Pham | ECON3116 International Trade Theory and Policy
2-38
Slide 2-38
Gains from Trade: A Numerical Example
• The world price of wine and cheese are: PW =$15 / gallon and PC = $15 / pound
• In autarky, one labour unit in Home yields:
1
a
= 1 pound of cheese or
1

= 0.5 gallon of wine.
• Under trade, one labour unit can be used to produce
1
a
= 1 pound of cheese in
Home, then trade for
1
a


= 1 gallon of wine at the world price,
which is more than what it gets in autarky.
Unit Labor Requirements
Van Pham | ECON3116 International Trade Theory and Policy
Gains from Trade: A Numerical Example
2-39
• The world price of wine and cheese are: PW =$15 / gallon and PC = $15 / pound
• Home worker’s wage is
=
1
a
=
1
1
$15 = $15
• Foreign worker’s wage is
∗ =
1

∗ =
1
3
$15=$5.
• Therefore, the relative wage of Home will be $15/$5 = 3.
→ The country with the absolute advantage will enjoy a higher wage after trade.
Van Pham | ECON3116 International Trade Theory and Policy
1-40
• This argument fails to recognize that trade is based on comparative not
absolute advantage.
• 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.
Misconceptions About Comparative Advantage
India: “We can't
compete with highly
productive US labor.”
Productivity and Competitiveness
Myth 1: Free trade is beneficial only if
a country is strong enough to
withstand foreign competition.
Van Pham | ECON3116 International Trade Theory and Policy
1-41
• Again in our example Foreign has lower wages but Home still
benefits from trade.
• Consumers benefit because they can purchase goods more cheaply
(more wine in exchange for cheese).
• Producers/workers benefit by earning a higher income (by using
resources more efficiently and through higher prices/wages).
Misconceptions About Comparative Advantage
US: “We can't
compete with low-
wage Indian labor.”
The Pauper Labor Argument
Myth 2: Foreign competition is unfair
and hurts other countries when it is
based on low wages.
Van Pham | ECON3116 International Trade Theory and Policy
1-42
Exploitation
Myth 3: Trade makes the workers worse off in countries with lower wages.
• Absolute advantage does matter: it affects the standard of living. Here
each US worker can buy much more than each Indian worker, whether
we compare the two in autarky, or compare them with trade.
• In the absence of trade these workers would be worse off.
• Denying the opportunity to export is to condemn poor people to
continue to be poor.
Misconceptions About Comparative Advantage
Van Pham | ECON3116 International Trade Theory and Policy
1-43
Setting Up the Model
• Both countries consume and are able to produce a large number, N, of
different goods.
Relative Wages and Specialization
• The pattern of trade will depend on the ratio of Home to Foreign wages.
• Goods will always be produced where it is cheapest to make them.
– For example, it will be cheaper to produce good i in Home if waLi < w
*a*Li ,
or by rearranging if

∗
a
>

∗
.
Comparative Advantage with Many Goods
Van Pham | ECON3116 International Trade Theory and Policy
Comparative Advantage with Many Goods
2-44
• A country has a cost advantage in any good for which its relative productivity
is higher than its relative wage.
– If, for example, w/w* = 3, Home will produce apples, bananas, and caviar,
while Foreign will produce only dates and enchiladas.
– Both countries will gain from this specialization.
Which country produces which goods?
Van Pham | ECON3116 International Trade Theory and Policy
Comparative Advantage with Many Goods
2-45
3
10
Apples
8
Bananas
4
Caviar
2
Dates
0.75
Enchiladas
RD
Determination of Relative Wages
RS
Relative wage
Rate, w/w*
Relative quantity
of labor, L/L*
Determining the Relative Wage
• To determine relative wages in a multi-
good economy we must look at the
relative demand for labour (i.e., the
relative derived demand).
• The relative demand for Home labour
depends negatively on the ratio of
Home to Foreign wages.
Relative supply
of labour
Van Pham | ECON3116 International Trade Theory and Policy
1-46
Adding Transport Costs and Nontraded Goods
There are three main reasons why specialization in the real international
economy is not extreme:
• The existence of more than one factor of production.
• Protectionism.
• It is costly to transport goods and services.
The result of introducing transport costs makes some goods nontraded.
In some cases transportation is virtually impossible.
» Example: Services such as haircuts and auto repair cannot be traded
internationally.
Van Pham | ECON3116 International Trade Theory and Policy
2-47
• The ratio of US to British exports in 1951
compared to the ratio of US to British labor
productivity in 26 manufacturing industries
suggests yes.
• At this time the US had an absolute
advantage in all 26 industries, yet the ratio
of exports was low in the least productive
sectors of the US.
Empirical Evidence on the Ricardian Model
Productivity and ExportsDo countries export those goods in which their
productivity is relatively high?
Van Pham | ECON3116 International Trade Theory and Policy
2-48
Empirical Evidence on the Ricardian Model
Do Wages Reflect Productivity?
(1) Cross-section evidence
• Wage differences across countries do
reflect productivity differences.
• A country’s wage rate is roughly
proportional to the country’s productivity
• Low-wage countries also have lower
productivity.
Hourly wage, as
percentage of U.S.
Source: KOM, International Monetary
Fund and The Conference Board
Van Pham | ECON3116 International Trade Theory and Policy
Empirical Evidence on the Ricardian Model
2-49
Do Wages Reflect Productivity?
(2) Time-series evidence
The general upward movement in
labour productivity is matched by
upward movements in wages, as
predicted by the Ricardian model.
These are average labour productivity
figures for an economy. The
productivities in different sectors will be
dispersed around this average, and the
pattern can vary across countries.
Van Pham | ECON3116 International Trade Theory and Policy
2-50
Source: Productivity Commission, 2023, Productivity Insights: Productivity growth and wages – a forensic look
Australia’s Labour Productivity and Real Wages
• Productivity and real wages have grown
together in Australia.
• In all industries except Mining and
Agriculture, which account for over 95% of
employment, the difference between
productivity growth and wages growth has
been relatively low.
• Real producer wage, i.e., wages relative to
the firms’ output prices, has grown in line
with productivity.
• Real consumer wage, i.e., wages relative to
the prices that consumers pay for goods and
services, has been relatively flatter.
Van Pham | ECON3116 International Trade Theory and Policy
Reading
KOM, Chapter 3.
Feenstra and Taylor, Chapter 2.