ECON7530
Lecture 3
Comparative Advantage and
The Ricardian Model (Part 2)
Nhan Phan
UQ School of Economics

Learning Objectives
• (Last week) Explain how the Ricardian model, the most basic model of
international trade, works and how it illustrates the principle of
comparative advantage.
• Demonstrate gains from trade and refute common fallacies about
international trade.
• Describe the empirical evidence that wages reflect productivity and
that trade patterns reflect relative productivity.
What Have We Learned Last Week?
• Ricardian model: A one-factor economy
• Production possibilities
• Linear – Why?
• Relative prices and supply
Last Week – One-Factor Economy
• Home has a comparative advantage in production of Cheese
= < ∗∗ = ∗
• Comparative advantage, not absolute advantage, determines the pattern of
trade.
• If both countries trade, relative price of Cheese must be the same in each
country


=

= ∗

∗
• Now, we need to determine what will be the equilibrium world relative
price of Cheese.
It’s all Relative
• In a normal market, how do you determine the price?
• Equilibrium where demand and supply intersects
• But here, there are 2 goods!
• We introduce the concepts of relative demand & relative supply.
Relative Supply
• Definition: the quantity of cheese supplied by all countries relative to
the quantity of wine supplied by all countries.
= + ∗
+ ∗
• The relative supply curve of cheese shows the relationship between
the relative quantity of Cheese supplied and the relative price of
cheese

.
• Unique shape of relative supply curve: step function.
Relative Supply
Relative Quantity of
Cheese
+ ∗
+ ∗
Relative Price of Cheese


Relative Supply of Cheese

∗

∗




∗

∗
Relative Supply
• To understand the shape, we need to examine what happens to world
supply at each relative price level
• Keep in mind: Home has a comparative advantage in Cheese:

< ∗

∗
• If the relative price of cheese is below the opportunity cost of cheese
in both countries


<

< ∗

∗
• No cheese would be produced <
• This explains the first vertical bit of the RS curve
Relative Supply
Relative Quantity of
Cheese
+ ∗
+ ∗
Relative Price of Cheese


Relative Supply of Cheese

∗

∗




∗

∗
Relative Supply
• If the relative price of cheese equals the opportunity cost of cheese in
Home country


=

< ∗

∗
• = : Home country is indifferent about producing wine or cheese.
• ∗ < ∗ : Foreign workers produce only wine.
• What will the relative quantity supplied be?
• Anywhere between 0 and
+
∗
∗ = 0  The lower horizontal line
• But then, what range can
+
∗ be?
Relative Supply
Relative Quantity of
Cheese
+ ∗
+ ∗
Relative Price of Cheese


Relative Supply of Cheese

∗

∗




∗

∗
Relative Supply
• If the relative price of cheese is between the opportunity cost of
cheese in the two countries


<

< ∗

∗
• > : Home country produces only cheese.
• ∗ < ∗ : Foreign country produces only wine.
• Relative supply is Home’s maximum cheese production divided by
Foreign’s maximum wine production


∗ = ∗

∗
• The second vertical bit of the RS curve.
Relative Supply
Relative Quantity of
Cheese
+ ∗
+ ∗
Relative Price of Cheese


Relative Supply of Cheese

∗

∗




∗

∗
Relative Supply
• If the relative price of cheese equals the opportunity cost of cheese in
Foreign country


<

= ∗

∗
• > : Home country produces only cheese.
• ∗ = ∗ : Foreign workers are indifferent about producing wine or cheese
• What will the relative quantity supplied be?
• +
∗

∗ > ∗

∗
• The second horizontal bit of the RS curve.
Relative Supply
Relative Quantity of
Cheese
+ ∗
+ ∗
Relative Price of Cheese


Relative Supply of Cheese

∗

∗




∗

∗
Relative Supply
• If the relative price of cheese is higher than the opportunity cost of
cheese in both countries


< ∗

∗ <
• No wine is produced
• Then, quantity of world relative supply of cheese is undefined (divide by 0)
Relative Demand
• Definition: quantity of cheese demanded in all countries relative to
the quantity of wine demanded in all countries.
• Downward sloping:
• Suppose the price of cheese relative to the price of wine rises.
• Consumers in all countries purchase less cheese and more wine.
• The relative quantity demanded of cheese falls.
Equilibrium with Trade
• As with all competitive markets for products, the equilibrium
(relative) price is found where (relative) Supply meets (relative)
Demand.
• The Equilibrium Relative Price is found at the intersection of the
Relative Supply (RS) curve and the Relative Demand (RD) curve.
Equilibrium with Trade
Equilibrium with Trade
• The Ricardian Model of Trade predicts that each country should produce
the good for which it has a comparative advantage, and that at most only
one country will produce more than one good.
• From the graph before, most likely at trade equilibrium


<

< ∗

∗
• Home specializes in the production of Cheese (in which it has a
comparative advantage) and Export Cheese to Foreign in return for Wine.
• Foreign specializes in the production of Wine (in which it has a comparative
advantage) and Export Wine to Home in return for Cheese.
The Gains from Trade


<

< ∗

∗
Compared to autarky:
• Domestic workers earn a higher income from cheese production
• The relative price of cheese increases with trade.
• Foreign workers earn a higher income from wine production
• The relative price of cheese decreases with trade (making cheese cheaper),
and the relative price of wine increases with trade.
The Gains from Trade
• 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 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.
The Gains from Trade
International trade allows
Home and Foreign to
consume anywhere within
the outer lines, which lie
outside the countries’
production frontiers.
A Numerical Example
• What is the OC of producing cheese
in each country?
• = = 12; ∗ = ∗∗ = 63 = 2
• To produce 1 kg of cheese, it needs to
stop producing 0.5l of wine
Unit labor
requirements Cheese Wine
Home = 1 hour/kg = 2 hours/litre
Foreign ∗ = 6 hours/kg ∗ = 3 hours/litre12 = < ∗∗ = 2
• Home country has absolute advantage in both.
• However, it only has comparative advantage in cheese production
• Foreign country has comparative advantage in wine production
• Suppose the intersection of RS and RD occurs at � = 1
A Numerical Example
• Suppose Home country wants to consume 1 more litre of wine
• In autarky, it must reduce

= 2 kgs of cheese production.
• With trade, it can simply buy one litre of wine for one kg of cheese.
• Suppose Foreign country wants to consume 1 more kg of cheese
• In autarky, it must reduce
∗

∗ = 2 litres of wine production.
• With trade, it can simply buy one kg of cheese for one litre of wine.
• Both countries have benefited from trade.
Relative Wages
If Labor Productivity at Home is higher for both Cheese and Wine, why
is Foreign sufficiently competitive in the Wine market to be able to
export Wine to Home?
• Lower labor productivity in Foreign implies that wages will be lower
in Foreign – which reduces the cost of wine production in Foreign.
• Relative wages: the wages of the home country relative to the wages
in the foreign country.
• Productivity (technological) differences determine relative wage differences
across countries.
Relative Wages
• Suppose that = $12/kg, and = $12/litre
• Since domestic workers specialize in cheese production after trade,
their hourly wages will be
= = $121 = $12
• Since foreign workers specialize in wine production after trade, their
hourly wages will be

∗ =

∗ = $123 = $4
• The relative wage of domestic workers is therefore

∗
= $12$4 = 3
Relative Wages
• The relative wage lies between the ratio of the productivities in each
industry.
• In our example:
∗

= 3
2
<
∗
= 3 < ∗

= 6
• These relationships imply that both countries have a cost advantage
in production.
• High wages can be offset by high productivity.
• Low productivity can be offset by low wages.
ULR Cheese Wine
Home = 1 hour/kg = 2hours/litre
Foreign ∗ = 6 hours/kg ∗ = 3hours/litre
Relative Wages (Math)
•
∗
=

⋅

∗

• Since

<

< ∗

∗ , this implies that
⇒


⋅

∗

<

⋅

∗

< ∗

∗ ⋅

∗

⇒

∗

<
∗
< ∗

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.
• Other evidence shows that wages rise as productivity rises.
• As recently as 1975, wages in South Korea were only 5% 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.
Productivity and Wages
A country’s wage rate (relative to the US) is roughly proportional to the
country’s productivity (relative to the US).
Source: International Monetary Fund and The Conference Board.
Misconceptions about Comparative Advantage
1. Free trade is beneficial only if a country is more productive than
foreign countries.
• 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
• Aka the Pauper Labour Argument
• Trade benefits consumers and many workers.
• However, trade may reduce wages for some workers,
thereby affecting the distribution of income within a
country
• Consumers benefit because they can purchase
goods more cheaply.
• Producers/workers benefit by earning a higher
income in the industries that use resources more
efficiently
• Earn higher prices and wages.
Source: Picryl
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.
• Are high wages and safe labor practices alternatives to trade? Deeper
poverty and exploitation may result without export production.
• Consumers benefit from free trade by having access to cheaply
(efficiently) produced goods.
• Producers/workers benefit from having higher profits/wages—higher
compared to the alternative.
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.
2. Protectionism.
3. Transportation costs reduce or prevent trade, which may cause each
country to produce the same good or service.
• Nontraded goods and services (e.g., haircuts) exist due to high transport costs.
• Countries tend to spend a large fraction of national income on nontraded
goods and services.
• Lecture 1: about 60% of jobs in the U.S. are non-tradable (2005)
Transportation Costs
• Originally, Home produces Cheese and imports Wine
• At a relative wage of 3, 3 hours of Foreign labour costs as much as 1
hour of Home labour
• Compared to current Home ULR of 2 hours, Home imports Wine
Suppose the transportation cost is 150%
• This means Wine import to Home now costs 7.5 hours of Foreign
labour, or 2.5 hours of Home labour
• Home is now better off just producing Wine domestically
ULR Cheese Wine
Home = 1 hour/kg = 2 hours/litre
Foreign ∗ = 6 hours/kg ∗ = 3 hours/litre
Empirical Evidence
• The Ricardian Model predicts that each country exports goods for
which it has a comparative advantage – for which it has a lower
opportunity cost.
• Do countries export those goods in which their productivity is
relatively high?
• 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.
• 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.
Empirical Evidence
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.
Source: Flickr
Source: Wikimedia Commons
Empirical Evidence
• A very 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.
Bangladeshi Output per
Worker as % of China
Bangladeshi exports
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
Overall, 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.
Source: Adobe Stock
Summary
• Countries export goods in which they have a comparative advantage –
high productivity or low wages give countries a cost advantage.
• With trade, the relative price settles in between what the relative
prices were in each country before trade.
• Trade benefits all countries due to the relative price of the exported
good rising: income for workers who produce exports rises, and
imported goods become less expensive.
• Empirical evidence supports trade based on comparative advantage,
although transportation costs and other factors prevent complete
specialization in production.