Week 2: The Ricardian Model Flashcards
Two reasons why countries engage in international trade
- Countries are different from each other in terms of climate land capital-labor and technology. Comparative advantage
- Countries try to achieve scale economies in production
What is the Ricardian model based on
- The Ricardian model is based on technological differences across countries which are reflected in labour productivity
What is comparative advantage?
- One country has a comparative advantage over another country if it is able to produce the same amount of a good at a cheaper oppournity cost than the other country
- If each country exports the goods in which it has a comparative advantage in (lower oppournity cost) than all countries can in principle gain from trade.
What is Ricardo’s theory?
- If each country specializes in the production of the good with Lower opportunity costs then trade can be mutually beneficial.
What is an absolute advantage
- Absolute advantage is when a country can produce the good at a cheaper cost per unit then its competitors
7 Assumptions of the Ricardian Model
- There are two countries in the world (Home and foreign)
- Only two goods
- Labour is the only factor in production
- Labor is not mobile across
- The supply of labor is fixed in each country
- The productivity of labor in each good is fixed
- Perfect competition prevails in the market
What is the unit labor requirement
- The unit labour requirement is the number of hours of labor required to produce one unit of output.
What is a PPF?
- The PPF of an economy shows the maximum amount of a good that can be produced for any given amount of another and vice versa
- E.g the maximum amount of Good X that can be produced given ur producing X amount of Good Y
Example of PPF
Explain what relative price is
Explain why the price of wages across two different industries will be the same under perfect competition
We assume workers are mobile and can work in both industries
Therefore the wages across industries would be the same otherwise the worker will move industry.
In perfect competition Price = Marginal cost
What is marginal cost equal to?
- Producing one unit of W means I have to use aLW units of labor for wine and pay the worker w.
When will an economy specialize in the production of one good?
- If the relative price of cloth Pc/Pw exceeds its opportunity cost then the economy will specialize in the production of cloth.
Foreign and home PPF showing the opportunity cost in each economy
What determines the relative price (Pc/Pw) after trade
- The relative supply of cloth. The relative supply of cloth = total quantity of cloth supplied in both country x and y divided by the total quantity of wine supplied.
- The relative demand of cloth
World relative supply and demand
We can have different relative demand curves.
Relative supply has a step function form
The relative quantity of cloth x-axis and the relative price of the cloth y-axis.
If we assume the Relative demand curve cuts the relative supply curve at point 1, it will mean the relative price in equilibrium will be between 3 and 5
Opportunity cost = 3 in the home economy and 5 in the world economy
If after free trade the equilibrium price is between 3 and 5 it will mean the home economy doesn’t produce any more wine.
This is because if the price Is larger than 3 it is better for the economy to just specialize in producing more cloth and no longer produce wine instead just get it from trading this is shown by L/alc. The global production of wine is totally fur filed by the foreign economy.
The step function is vertical because as long g as the relative price is between 3 and 5 it will lead to complete specialisation (both countries specialising)
Myth 1: Free trade is only beneficial only if a country is strong enough to withstand foreign competition
Myth 2: Foreign competition is unfair and hurts rich countries when it is based on low wages in foreign countries
Myth 3: Trade exploits a poor country and makes Its workers worse off if they receive much lower wages than elsewhere.
Step function of relative supply
If relative prices is such that prices equal marginal cost then the country will produce both goods as there is no need to trade
