Chapter 3. Labor Productivity and Comparative Advantage: The Ricardian Model

Chapter 3 Labor Productivity and Comparative Advantage: The Ricardian Model

Introduction There are potential gains from trade whenever there are differences in autarky prices across countries. We now explore the underlying reasons why such differences in price may arise. 1. Preferences: Can generate any trade pattern with arbitrary differences in tastes. 2. Technology: Ricardian model chapter 3 3. Factor Proportions: Specific factors and Heckscher-Ohlin models chapters 4-5 ECON40710 University of Notre Dame 3-2

Introduction As we develop the model, we will provide answers to some fundamental questions: What determines the trade pattern? What is the impact of trade on (aggregate) welfare? Within a country, does everyone gains from trade? ECON40710 University of Notre Dame 3-3

The Ricardian Model Road Map Opportunity costs and comparative advantage Ricardian model Empirical evidence Wages ECON40710 University of Notre Dame 3-4

Illustrative Examples EXAMPLE 1 Adam Smith, 1776 Consider the following 2-country, 2-good example: a worker in country A can produce 4 bottles of Wine or 1 pound of Cheese a worker in country B can produce 1 bottles of Wine or 4 pounds of Cheese Would countries gain from trading with each other? ECON40710 University of Notre Dame 3-5

Illustrative Examples Yes, if they specialize according to their absolute advantage Country A (B) has an absolute advantage in the production of Wine (Cheese) because country A (B) workers can produce more of that good. ECON40710 University of Notre Dame 3-6

Illustrative Examples Suppose there are 100 workers in each country: Under autarky each country allocates half of the work force to each good Country A produces and consumes 200 bottles of Wine and 50 pounds of cheese Country B produces and consumes 50 bottles of Wine and 200 pounds of cheese If each country specializes according to absolute advantage: Country A produces 400 bottles and country B produces 400 pounds World production goes up ECON40710 University of Notre Dame 3-7

Illustrative Examples If we split production equally across countries, consumption in each country is: 200 bottles of Wine and 200 pounds of Cheese Both countries are better off as a result of trade The actual equilibrium distribution depends on consumer preferences (prices) but welfare will go up. ECON40710 University of Notre Dame 3-8

Illustrative Examples EXAMPLE 2 David Ricardo (1817) Consider the following 2-country, 2-good example: a worker in country A can produce 4 bottles of Wine or 2 pounds of Cheese a worker in country B can produce a bottle of Wine or a pound of Cheese ECON40710 University of Notre Dame 3-9

Illustrative Examples Country A has an absolute advantage in the production of both goods because country A workers can produce more of both goods. Would countries gain from trading with each other? ECON40710 University of Notre Dame 3-10

Illustrative Examples Both countries would gain from trade, because the opportunity cost of wine in terms of cheese is lower in country A than country B. The opportunity cost is the cost of an alternative that must be forgone in order to pursue a certain action. We say that a country has a comparative advantage in producing a good if the opportunity cost of producing the good in that country is lower than it is in other countries. Illustrative example notes ECON40710 University of Notre Dame 3-11

The Ricardian Model When countries specialize in the production of the good for which they have a comparative advantage, world output increases. Therefore, there are potential gains from trade. We now formalize this argument using the Ricardian model: One (perfectly mobile) factor of production: Labor (L) Two goods: Wine and Cheese Production exhibit constant returns to scale Perfect competition Ricardian model notes ECON40710 University of Notre Dame 3-12

The Ricardian Model Summary Ricardo assumes there are technological (or labor productivity) differences across countries. Differences in technologies result in across country variation in autarky relative prices (comparative advantage) Differences in autarky relative prices across countries imply potential gains from trade ECON40710 University of Notre Dame 3-13

The Ricardian Model Countries gain from trade because they can exploit their comparative advantages export the good that is relatively expensive import the good that relatively cheap. The pattern of trade is determined by comparative advantages A country with absolute advantages in all goods gains from trade A country without absolute advantages gains from trade ECON40710 University of Notre Dame 3-14

Misconceptions about Comparative Advantage 1. Free trade is beneficial only if a country is more productive than foreign countries. But 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. 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. ECON40710 University of Notre Dame 3-15

Misconceptions about Comparative Advantage 2. Free trade with countries that pay low wages hurts high wage countries. While trade may reduce wages for some workers, thereby affecting the distribution of income within a country, trade benefits consumers and other workers. 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, allowing them to earn higher prices and wages. ECON40710 University of Notre Dame 3-16

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. ECON40710 University of Notre Dame 3-17

Empirical Evidence In the Ricardian model, countries export the good they produce relatively more efficiently than other countries. The model predict that countries will export the goods for which the autarky price is lower than the trade price How strongly do changes in price correlate with exports? ECON40710 University of Notre Dame 3-18

comparative Empirical advantageevidence 63 Fig. 4. Net exports and price changes for 1869. Source: Japan Bureau of Revenue (1893) for trade data and Kinyu Kenkyukai (1937), Miyamoto (1963), Ono (1979), Yamazaki (1983), and Mitsui Bunko (1989) for price data. ECON40710 University of Notre Dame 3-19 rose substantially, so that the graph expresses price changes adjusted

Empirical Evidence 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 U.S. had an absolute advantage in all 26 industries, yet the ratio of exports was low in the least productive sectors of the U.S. ECON40710 University of Notre Dame 3-20

Empirical Evidence ECON40710 University of Notre Dame 3-21

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. ECON40710 University of Notre Dame 3-22

Empirical Evidence China is more productive in All industries and Apparel The difference in productivity is smaller in Apparel which indicate that Bangladesh has a comparative advantage in Apparel As expected Bangladesh exports relatively more Apparel compared to All industries ECON40710 University of Notre Dame 3-23

Empirical Evidence 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 ECON40710 University of Notre Dame 3-24

Wages We have shown that in the Ricardian model, comparative advantage is determined by the relative productivity of labor It is therefore surprising that the wage rates have not entered the discussion. There is much concern expressed in high-income economies about the possible effects of competition from low-wage workers in developing economies. We now look at the impact of trade on wages Wages in Ricardian model ECON40710 University of Notre Dame 3-25

Productivity and Wages An important prediction of the model is that real wages are determined by labor productivity (absolute advantage) We expect that real wages will be higher in countries where labor is more productive. How strongly does labor productivity correlates with exports? ECON40710 University of Notre Dame 3-26

Productivity and Wages Source: U.S. Bureau of Labor, BLS Labor productivity can be measured by the value-added per hour in manufacturing. There is a positive association between labor productivity and wages in this cross-section of countries (2001). ECON40710 University of Notre Dame 3-27

Productivity and Wages ECON40710 University of Notre Dame 3-28

Productivity and Wages Source: U.S. Bureau of Labor, BLS Wages and productivity are increasing over time within each country. ECON40710 University of Notre Dame 3-29

Conclusions From Ricardo we learn that: The pattern of trade is determined by comparative advantages Wages are determined by absolute advantages More productive workers have higher wages independent of trade Trade increases the real wage in terms of the imported good Important questions left unanswered: Where do the differences in technology come from? Why do they persist over time. ECON40710 University of Notre Dame 3-30