Labour Productivity and Comparative Advantage (Ricardian Model) PDF

Labour Productivity and Comparative Advantage: The Ricardian Model Luisa Giallonardo (University of L’Aquila) 2024-2025 First Semester 2 Contents Introduction The concept of comparative advantage A one-factor economy Trade in a one-factor world...

Labour Productivity and Comparative Advantage: The Ricardian Model Luisa Giallonardo (University of L’Aquila) 2024-2025 First Semester 2 Contents Introduction The concept of comparative advantage A one-factor economy Trade in a one-factor world Misconceptions about comparative advantage Comparative advantage with many goods Empirical evidence on the Ricardian model Summary  Why countries trade? 2 reasons: They are different each other and they look for reaching something they can’t do. They trade in order to achieve economies of scale in production.  Comparative advantage A country has a comparative advantage in producing a good if the opportunity cost of producing that good in terms of other goods is lower than in that country than it is in other countries. Absolute advantage A country has an absolute advantage in production when produces a particular good or service more efficiently than other countries. 5 Introduction Market size and distance between markets determine how much countries buy and sell among each other (the gravity model). But theories differ about how to explain what is traded (countries’ specialization patterns). Whatever its sources, trade is beneficial for every country (the gains from trade) 6 Theories of trade specialization Differences between countries in labour, physical capital, natural resources and technology create comparative advantages, leading to gains from trade (under perfect competition). – The Ricardian model says that differences in productivity of labour between countries, usually explained by differences in technology, cause comparative advantages. – The Heckscher-Ohlin model says that differences in factor endowments (labour, labour skills, physical capital and land) between countries cause comparative advantages. Even if countries are similar, historical accidents may create comparative advantages, and economies of scale (larger is more efficient) reinforce them (under imperfect competition). 7 The Ricardian Model Assumptions of the model 1. Only two countries are modeled: Home and Foreign. 2. Only two goods are produced and consumed: wine and cheese. 3. Labour is the only resource used for production. 4. The supply of labour in each country is constant over time. 5. Technology (as described by labour productivity) is different across countries. 6. Labour productivity in each country is constant over time … 7. … and does not depend on the volume of production. 8. Workers can freely move across sectors, … 9. … but cannot move across countries. 10. Consumer preferences for the two goods are equal across countries. 11. All markets are perfectly competitive. 12. Transport costs and other barriers to trade are ignored. 8 The Ricardian Model Conclusions of the model 1. The pattern of trade (who imports or exports what) is determined by comparative advantages, due to differences in technology across countries 2. Wage rates are determined by labour productivity 3. Trade is beneficial for every country 9 The Ricardian Model Consider a closed economy (country H), as described by the assumptions of the Ricardian model. Because labour productivity is constant, define a unit labour requirement as the constant number of hours of labour required to produce one unit of output. – aLC is the unit labour requirement for cheese in the Home country (labour productivity inverted). – aLW is the unit labour requirement for wine in the Home country. Labour productivity can be denoted as 1/aLC for cheese, and 1/aLW for wine. 10 The Ricardian Model (cont.) The opportunity cost of cheese in terms of wine (OCC) – is defined as the quantity of wine that could have been produced with the labour used to produce one unit of cheese – is computed as the ratio between the unit labour requirements of cheese and wine – OCC = aLC / aLW – OCW = aLW / aLC The total labour endowment of the Home country is denoted as a constant number L 11 Production Possibilities The production possibility frontier (PPF) of an economy shows the maximum amount of a set of goods that can be produced for a fixed amount of resources, with the available technology. The production possibility frontier of the domestic economy has the equation: Total amount of aLCQC + aLWQW ≤ L labour resources labour required for Total units labour required for Total units each unit of of cheese each unit of wine of wine cheese production production production production 12 Production Possibilities (cont.) Assuming full employment, the production possibilities frontier is represented by the following equation: aLCQC + aLWQW = L QW = L/aLW – (aLC /aLW )QC 13 Production Possibilities (cont.) Figure 3-1: Home’s Production Possibilities Frontier Home wine production, QW, in gallons P Absolute value of slope equals L/aLW opportunity cost of cheese in terms of wine F L/aLC Home cheese production, QC, in pounds 15 Production, Prices and Wages Let PC be the price of cheese and PW be the price of wine. Let wC be the hourly wage of cheese makers and wW be the hourly wage of wine makers. Because of perfect competition, and recalling that labour is the only production factor: – The price of cheese is equal to its average cost, given by its unit labour cost: PC = wC aLC – Hourly wages of cheese makers are equal to the market value of the cheese produced in an hour: wC = PC /aLC – In the wine sector: PW = wW aLW wW = PW /aLW 16 Production, Prices and Wages (cont.) Workers will work in the industry that pays a higher hourly wage. If PC /aLC > PW/aLW workers will only make cheese. In other words, if PC /PW > aLC /aLW the economy will specialize in cheese production If PC /aLC < PW /aLW ↔ PW /PC > aLW /aLC the economy will specialize in wine production 17 Production, Prices and Wages (cont.) If a country wants to consume both wine and cheese (in the absence of international trade), relative prices must adjust so that wages are equal in the wine and cheese industries. – If PC /aLC = PW /aLW PC /PW = aLC /aLW – Production (and consumption) of both goods occurs when the relative price of a good equals the opportunity cost of producing that good (the labour theory of value). 18 Trade in the Ricardian Model Suppose that Home is more efficient than Foreign in both wine and cheese production. Home has an absolute advantage in all productions: its unit labour requirements for wine and cheese production are lower than those at Foreign: aLC < a*LC and aLW < a*LW where “*” notates Foreign country variables 19 Trade in the Ricardian model (cont.) Figure 3-2: Foreign’s Production Possibilities Frontier Foreign wine production, Q*W, in gallons L*/a*LW F* P* L*/a*LC Foreign cheese production, Q*C , in pounds 20 Trade in the Ricardian Model (cont.) A country can be more efficient in producing both goods, but it will have a comparative advantage in only one good — the good in which it has a lower opportunity cost than at Foreign. We assume that Home has a comparative advantage in cheese production: aLC /aLW < a*LC /a*LW Equivalently: aLC / a*LC < aLW /a*LW (1/aLC )/ (1/a*LC ) > (1/aLW )/(1/a*LW ) The ratio between Home and Foreign labour productivity is higher in cheese than in wine production (with respect to Foreign, Home is relatively more productive in cheese than in wine) Home will export enough cheese and Foreign enough wine to equalize the relative price.  Relative prices with trade (cont.) Figure 3-3: World Relative Supply and Demand Relative price of cheese, PC/PW a*LC/a*LW RS 1 RD 2 aLC/aLW RD' Q' L/aLC Relative quantity L*/a*LW of cheese, QC + Q*C QW + Q*W 21 22 Relative prices with trade Without trade, the relative price of a good equals the opportunity cost of producing that good. To calculate relative prices with trade, we first calculate relative supply of cheese: the quantity of cheese supplied by all countries relative to the quantity of wine supplied by all countries at each relative price of cheese, Pc /PW : (QC + Q*C )/(QW + Q*W) Next we consider relative demand of cheese. Equilibrium relative prices in world markets do necessarily fall in the interval between pre-trade relative prices (opportunity costs) in each country. 23 Relative prices with trade (cont.) There is no supply of cheese if the relative price of cheese falls below aLC /aLW. – Why? because Home will specialize in wine production whenever PC /PW < aLC /aLW – And we assumed that aLC /aLW < a*LC /a*LW so Foreign workers won’t find it desirable to produce cheese either. When PC /PW = aLC /aLW , Home workers will be indifferent between producing wine or cheese, but Foreign workers will still produce only wine. 24 Relative prices with trade (cont.) When a*LC /a*LW > Pc /PW > aLC /aLW , Home workers specialize in cheese production because they can earn higher wages, and Foreign workers will still produce only wine. When a*LC /a*LW = PC / PW, Foreign workers will be indifferent between producing wine or cheese, but Home workers will still produce only cheese. 25 Relative prices with trade (cont.) Relative demand of cheese is the quantity of cheese demanded in all countries relative to the quantity of wine demanded in all countries at each relative price of cheese. As the relative price of cheese rises, consumers in all countries will tend to purchase less cheese and more wine, so that the relative quantity of cheese demanded falls. Relative demand is assumed to be equal across countries. Whatever the level of relative demand, equilibrium relative prices with trade will fall in the interval between pre-trade relative prices (opportunity-costs) in the two countries. 26 Gains from Trade Gains from trade come from specializing in production that use resources most efficiently, and using the income generated from that production to buy the goods and services that countries desire. – Where “specializing” means using all the available labour in only one good, – and “using resources most efficiently” means producing a good in which a country has a comparative advantage. Home workers earn a higher income from cheese production because the relative price of cheese increases with trade (making wine cheaper). Foreign workers earn a higher income from wine production because the relative price of wine increases with trade (making cheese cheaper). 27 Gains from Trade (cont.) Think of trade as an indirect method of production or a new technology that converts cheese into wine or vice versa. Without the ‘trade technology’, a country has to allocate resources to produce all of the goods that it wants to consume (direct method of production). With the ‘trade technology’, a country can specialize its production and trade (“convert”) the products for the goods that it wants to consume. 28 Gains from Trade (cont.) Another way to see the gains from trade is showing how consumption possibilities expand beyond the production possibility frontier when trade is allowed. The consumption possibilities frontier (CPF) shows a country’s budget constraint: the different baskets of the two goods which can be purchased with the country’s income. – The relative price of the two goods is equal to the absolute value of the slope of the CPF, that is the amount of consumption of one good which must be given up to obtain one more unit of the other good. Without trade, consumption is restricted to what is produced. 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. 29 Gains from Trade (cont.) Figure 3-4: Trade Expands Consumption Possibilities Quantity Quantity of wine, QW of wine, Q*W T F* P F P* T* Quantity Quantity of cheese, QC of cheese, Q*C (a) Home (b) Foreign 30 A Numerical Example Unit labour requirements for Home and Foreign countries Cheese Wine Home aLC = 1 aLW = 2 hour/pound hours/gallon Foreign a*LC = 6 a*LW = 3 hours/pound hours/gallon 31 A Numerical Example (cont.) Home country is more efficient in both industries, but it has a comparative advantage only in cheese production. The Foreign country is less efficient in both industries, but it has a comparative advantage in wine production. aLC /aLW = 1/2 < a*LC /a*LW = 2 With trade, the equilibrium relative price of cheese must be between aLC /aLW = 1/2 and a*LC /a*LW = 2 Suppose that PC /PW = 1 in equilibrium. – In words, one pound of cheese trades for one gallon of wine. 32 A Numerical Example (cont.) If the home country does not trade, it can use one hour of labour to produce 1/aLW = 1/2 gallon of wine. – (2 hours of labour are required to make 1 gallon of wine with the direct method of production) If the home country does trade, it can use one hour of labour to produce 1/aLC = 1 pound of cheese, sell this amount to the Foreign country at current prices to obtain 1 gallon of wine. – (1 hour of labour is required to make 1 gallon of wine with the indirect method of production) If the Foreign country does not trade, it can use one hour of labour to produce 1/a*LC = 1/6 pounds of cheese. – (6 hours of labour are required to make 1 pound of cheese with the direct method of production) If the Foreign country does trade, it can use one hour of labour to produce 1/a*LW = 1/3 gallon of wine, sell this amount to the Home country at current prices to obtain 1/3 pound of cheese. – (3 hours of labour are required to make 1 pound of cheese with the indirect method of production) 33 Misconceptions About Comparative Advantage 1. Free trade is beneficial only if your country is strong enough to stand up to foreign competition. – But even a technologically backward country benefits from free trade by avoiding the high costs for goods that it would otherwise have to produce domestically. – A country’s cost advantage does not depend only on its relative productivity, but also on its relative wage. – There will be at least one good where the disadvantage due to low productivity will be more than offset by lower wages. 34 Misconceptions About Comparative Advantage (cont.) 2. Free competition is unfair and hurts other countries when it is based on low wages. – But even a high-wage country benefits from free trade by avoiding the high costs for goods that it would otherwise have to produce domestically. – A country’s cost advantage does not depend only on its relative wage, but also on its relative productivity. – There will be at least one good where the disadvantage due to high wages will be more than offset by higher productivity. 35 Misconceptions About Comparative Advantage (cont.) 3. Trade exploits a country and makes it worse off if its workers receive much lower wages than workers in other nations (theory of unequal exchange). – While wages and labour standards in some countries are very low compared to Western standards, they are so with or without trade. – Are high wages and safe labour practices alternatives to trade? Deeper poverty and exploitation may result without export production (e.g. as a consequence of an international boycott) – Consumers benefit from free trade by having access to cheaply (efficiently) produced goods. – Workers benefit from having higher wages—higher compared to the alternative. 36 Comparative Advantage with Many Goods (cont.) Let w represent the wage rate in the Home country and w* represent the wage rate in the Foreign country. – If waL1 < w*a*L1 then only the Home country will produce good 1, since its average cost is lower there. – Or equivalently, if a*L1 /aL1 > w/w* (1/aL1)/(1/a*L1) > w/w* If the relative productivity of a country in producing a good is higher than the relative wage, then the good will be produced in that country. 37 Comparative Advantage with Many Goods Suppose now there are N goods produced, indexed by i = 1,2,…N. The Home country’s unit labour requirement for good i is aLi, and that of the Foreign country is a*Li Goods will be produced wherever it is cheaper to produce them. 38 Comparative Advantage with Many Goods (cont.) Suppose there are 5 goods produced in the world: 39 Comparative Advantage with Many Goods (cont.) If w/w* = 3, the Home country will produce apples, bananas, and caviar, while the Foreign country will produce dates and enchiladas. – The relative productivities of the Home country in producing apples, bananas and caviar are higher than the relative wage. – The unit production cost of the Home country for apples, bananas and caviar is lower than in the Foreign country 40 Comparative Advantage with Many Goods (cont.) How is the relative wage determined? By the relative supply and relative (derived) demand for labour services. The relative supply of labour is assumed to be independent of w/w* and is fixed at an amount determined by the populations in the Home and Foreign countries. 41 Comparative Advantage with Many Goods (cont.) The relative (derived) demand for Home labour services falls when w/w* rises. As Home labour becomes more expensive relative to Foreign labour, – goods produced in the Home country become more expensive, and demand for these goods and the labour to produce them falls. – fewer goods will be produced in the Home country, further reducing the demand for Home labour. Suppose w/w* increases from 3 to 3.99: – The Home country would produce apples, bananas, and caviar, but the demand for these goods and the labour to produce them falls as the relative wage rises. Suppose w/w* increases from 3.99 to 4.01: – Caviar is now too expensive to produce in the Home country, so the caviar industry moves to the Foreign country, causing a discrete (abrupt) drop in the demand for Home labour. Comparative Advantage with Many Goods (cont.) Figure 2-5: Determination of Relative Wages Relative wage rate, w/w* RS Apples 10 Bananas 8 Caviar 4 3 Dates 2 Enchiladas 0.75 RD Relative quantity of labour, L/L* 42 43 Empirical evidence: complete specialization The Ricardian model predicts that countries completely specialize in the comparative advantage good. But this rarely happens for primarily three reasons: 1. If there is more than one factor of production, specialization is not complete 2. Protectionism and/or … 3. … transportation costs reduce or prevent trade, which may cause each country to produce the same good or service.  Transportation costs Transportation costs increase costs of production, so change the probability to trade and improve the probability some goods become non-tradable. In some cases transportation is also virtually impossible (services such as haircuts and auto repair, except where there is a metropolitan area that straddles a border, like Detroit, Michigan–Windsor, Ontario). 45 Empirical Evidence: The Role of Technology in Trade Patterns Do countries export those goods in which they enjoy comparative advantages? Do countries export those goods in which their productivity is relatively high? The ratio of US to British exports in 1951 compared to the ratio of US to British labour productivity in 26 manufacturing industries suggests yes. At that time the US had an absolute advantage in all 26 industries, yet the ratio of US to UK exports was relatively low in the least productive sectors of the US. Empirical Evidence (cont.) 46  Empirical Evidence Compare Chinese output and productivity with that of Germany for various industries using 1995 data. – Chinese productivity (output per worker) was only 5 percent of Germany’s on average. – In apparel, Chinese productivity was about 20 percent of Germany’s, creating a strong comparative advantage in apparel for China. Table 3-3: China versus Germany, 1995 Comparative Advantage in Apparel, Textiles, and Wheat U.S. Textile and apparel industries face intense import competition. Burlington Industries announced in January 1999 it would reduce production capacity by 25% due to increased imports from Asia. After layoffs they employed 17,400 persons in the U.S. with sales of $1.6 billion in 1999. Sales per employee, in general apparel sector, were therefore $92,000 in the U.S. This is the average for all U.S. apparel producers. Textiles are even more productive with annual sales per employee of $140,000 in the U.S. Comparative Advantage in Apparel, Textiles, and Wheat In China, however, sales per employee are only $13,500 in apparel and $9,000 in textiles. The U.S. is 7 times more productive than China in apparel and 16 times more productive than China in textiles. So the U.S. has the absolute advantage in these products. For wheat, the U.S. produces 27.5 bushels per hour of labor. China produces only 0.1 bushel per hour of labor. The U.S. is thus 275 times more productive than China in wheat. It thus has the absolute advantage in wheat. Comparative Advantage in Apparel, Textiles, and Wheat Since the absolute advantage in wheat for the U.S. is even greater than in apparel and textiles, it has the comparative advantage in wheat. China has the comparative advantage in apparel and textiles because its productive disadvantage relative to the U.S. is less than in wheat. This explains why the U.S. imports apparel and textiles from China despite higher productivity in the U.S. 52 Do Wages Reflect Productivity? In the Ricardian model, relative wages reflect relative productivities of the two countries. Is this an accurate prediction? Some argue that low wage countries pay low wages despite growing productivity, putting high wage countries at a cost disadvantage. But evidence shows that low wages are associated with low productivity. It is different when we consider productivity growth rates, that are generally higher in developing countries. Do Wages Reflect Productivity? (cont.) 53 54 Do Wages Reflect Productivity? (cont.) 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 (which were more than half of U.S. levels by 2007). 55 Summary 1. The Ricardian model explains trade patterns through differences in the productivity of labour across countries 2. Gains from trade arise from specialization based on comparative advantages. § A country has a comparative advantage in producing a good if the opportunity cost of producing that good is lower in the country than it is in other countries. § A country with a comparative advantage in producing a good uses its resources most efficiently when it specializes in that good and trades it against the other good. 56 Summary (cont.) 3. When countries specialize and trade according to the Ricardian model, the relative price of the produced good rises, income for workers rises and imported goods are less expensive for consumers. 4. Trade is predicted to benefit both high productivity and low productivity countries. 5. High productivity or low wages give countries a cost advantage that allow them to produce efficiently. 6. Although empirical evidence supports trade based on comparative advantage, transportation costs and other factors prevent complete specialization in production.