Theories of Trade and Ricardian Model

Theories of Trade

• Difference-based models: Focus on countries' varying labor skills, natural resources, and technology—yielding different productivity advantages.

• Economies of scale models: Emphasize efficiency gains from specialization, where countries specialize in certain products to benefit from larger-scale production.

Ricardian Model

• Trade driver: Differences in relative labor productivity across countries.

• Opportunity cost: The cost of foregoing producing one good because resources are dedicated to another good.

• Comparative advantage: Advantage in producing a good with a lower opportunity cost compared to other countries.

• Gains from trade: Increased production and consumption of goods compared to self-sufficiency.

• Assumptions:

  • Labor is the only factor of production.
  • Labor productivity differs across countries and is constant.
  • Labor supply and quantity of goods are fixed.
  • Only two goods are produced and consumed.
  • Perfect competition, free entry/exit, and labor mobility.
  • Two countries (Home and Foreign).
  • No transportation costs.

• Production possibilities frontier (PPF): Represents the maximum output combinations using available resources.

  • Defined by the amount of labor and unit labor requirements (lower unit labor requirement means higher productivity).
  • Formula: aLC * QC + aLW * QW = L (where L is total labor hours, aLC and aLW are unit labor requirements for cheese and wine, Q represents the quantities of each).

• Relative Prices and Opportunity Cost:

  • Opportunity cost of cheese in terms of wine = aLC / aLW.
  • Equilibrium occurs when wages for producing wine and cheese are equal, represented by PC / aLC = PW / aLW, leading to PC / PW = aLC / aLW.

• Comparative Advantage Example:

• If Home has a lower opportunity cost for cheese production ( aLW/aLC < a*LW/a*LC ), then Home will have a comparative advantage in producing cheese. This comparative advantage leads to beneficial trade.

• Relative Price and Trade:

  • If Home’s relative price of cheese is lower its opportunity cost, thus exporting to foreign country is profitable.

• World Relative Supply (RS): The relationship between the relative quantities of cheese and wine supplied by all countries:

  • RS Values: The world supply is affected by the price of cheese relative to the opportunity costs for both countries.
    • If PC / PW is lower than both home and foreign countries' opportunity cost of cheese production (comparative advantage), world supply is zero.
    • If PC / PW is higher than both countries' opportunities cost, then the world supply is infinite.
    • If PC / PW is equal to the opportunity cost of cheese in the home country, then the world relative supply (RS) is between 0 and infinity (in practice).