The Ricardian Model of Comparative Advantage

Lecture 1

International Trade Theory

1/2008

The Ricardian Model of Comparative Advantage

Kornkarun Kungpanidchakul, Ph.D

Ref: http://pioneer.netserv.chula.ac.th/~kkornkar/inter%20trade%20undergrad/Lecture%201.doc

Opportunity cost

-          Comes from the next best foregone alternative

-          To find the opportunity cost, you must have more than one alternative, goods or activities

Adam Smith (wealth of Nations, 1776)

-          introduces principles of division of labor and specialization among countries

-          each country produces goods that it can produce more for the same level of resources/time.

-          “ law of absolute advantage”

Absolute Advantage: Country A has absolute advantage in good X comparing with country B if country A can produce more units of good X than country B, given that both countries have the same level of resources, technology and time.

Assumption:

1. Constant opportunity cost (linear PPF)
2. Two countries with one factor “labor”
3. Two commodities (suppose Fish and Chips)

Country	Amount produced / unit of labor
	Fish	Chips
Canada	100	50
Japan	50	150

So Canada has absolute advantage in producing fish and Japan has absolute advantage in producing chips.

What is Adam Smith’s suggestion?

à Canada produces only fish and Japan produces only chips. Then trade pattern is Canada exports fish, Japan exports chips.

The Ricardian Model of Comparative Advantage

            Consider the following table,

country	Amount produced / unit of labor		Opportunity Cost
	Fish	Chips	Fish	Chips
Canada	100	160	1 F= 1.6 C	1 C= 5/8 F
Japan	50	150	1 F=3 C	1F =1/3 C

           

            Canada has absolute advantage in both Fish and Chips. Therefore, according to absolute advantage, no trade occurs.

            David Ricardo introduced principle of “Comparative Advantage” or “Comparative Cost”

Assumptions:

1. Labor is only production factor. The technology is constant returns to scale.
2. Identical tastes in both countries. Therefore, relative prices are solely determined by supply side or technology.

Example 1: Suppose that there are two countries, namely Canada and Japan. They have the total level of resource of L and L* respectively.

Country	Amount produced / unit of labor		Opportunity Cost
	Fish	Chips	Fish	Chips
Canada	1	1/2	1F = ½ C	1C = 2 Fish
Japan	1	1	1F = 1 C	1C = 1F

Comparative Advantage

            Country A has comparative advantage in good X comparing with country B if country A can produce good X with the lower opportunity cost.

            Define the formal notation of comparative advantage. Given that a_LF is the unit cost required to produce fish, a_LC is the unit cost required to produce chips. Then  means that the opportunity cost of fish in Canada is lower than the opportunity cost in Japan. Therefore, Canada has a comparative advantage in fish while Japan has comparative advantage in chips. If , Canada has an absolute advantage in fish.

Autarky Equilibrium

Production Possiblity Frontier: A curve showing all combinations of two goods that can be produced for given resources and technology. The slope is opportunity cost or marginal rate of transformation (MRT)

Fish

           

            In autarky economy, the country will product at the point that the indifference curve is tangent to PPF.

Equilibrium Condition:

1.

2.

3.

            Therefore, if we have interior solution, 1. and 2. implies:

           

Trading Equilibrium

            There are three possible types of equilibrium. Let is the world relative price, then we have:

1. If , then Japan diversifies between fish and chips while Canada specializes in Fish.
2. If , then both countries specialize with Canada specializes in fish and Japan specializes in chips.
3. If , then Japan will specialize in chips while Canada diversifies.

            In all equilibriums, Canada exports fish while Japan export chips. Therefore, even diversified economy, patterns of international trade is specialized in the Ricardian model.

The Gains from Trade

1. When , Canada gains from trade since it can consume outside its own PPF.

F

   Canada’s PPF

F

    Japan’s PPF

2. When , both countries can consume outside its own PPF.

F

   Canada’s PPF

F

   Japan’s PPF

3.When , only Japan’s PPF shifts up.

F

    Canada’s PPF

F

   Japan’s PPF

We can draw the world joint PPF as follows:

            The kinked point is when both countries specialize.