Free trade raises aggregate world production efficiency because more of both goods are likely to be produced with the same number of workers. The surprising result of this example is that a country that is technologically inferior to another in the production of all goods can nevertheless benefit from trade with that country. The straight downward-sloping line is the production possibility frontier. It is one of the simplest models, and still, by introducing the principle of comparative advantage, it offers some of the most compelling reasons supporting international trade. Perhaps the most fundamental assumption behind Ricardo’s theory is that a country’s terms of trade adjust to ensure balanced trade. It is also one of the most commonly misunderstood principles. Learn why free and costless labor mobility and homogeneous labor force wages to be equal in both industries. Plugging in the relationships derived in the previous section yields. represents the purchasing power of wages—that is, the quantity of goods the wages will purchase. This means that it describes a complete circular flow of money in exchange for goods and services. Perhaps some consumers would have more and others less. Labor is costlessly mobile across industries within a country but is immobile across countries. On the other hand, the son is “least worse” at raking and planting but “most worse” at rototilling. What are the levels of production and the pattern of trade when free trade occurs? Because of the increase in output, it is possible to construct a terms of trade between the countries such that each country consumes more of each good with specialization and trade than was possible under autarky. QW = quantity of wine produced in the United States, LW = amount of labor applied to wine production in the United States, aLW = unit labor requirement in wine production in the United States (hours of labor necessary to produce one unit of wine). When countries specialize in their comparative advantage good, world output of both wine and cheese rises. ), and the sophistication of its capital stock (machinery, infrastructure, communications systems). Plugging this in and simplifying yields the results in Table 2.13 "Autarky Real Wages". Individuals in different countries may have different preferences or demands for various products. In corn? Explain why. First, note that the higher price of cheese in France means that cheese workers in the United States could get more wine for their cheese in France than in the United States. Starting with the zero-profit condition in the wine industry, show why the winemaker’s wage depends on the price of wine and wine productivity. Thus PC∗/PW∗ falls once trade is opened. How many bananas and machines would the United States produce if it applied half of its workforce to each good? Real wages are typically measured by dividing nominal wages by a price index. We assume that some workers are more internationally adroit and thus move first. Ricardian theory of international trade Between 1500 and 1750 most economists advocated Mercantilism which promoted the idea of international trade for the purpose of earning bullion by running a trade surplus with other countries. Hence it is the opportunity cost of cheese production (in terms of wine). An increase in world output given the same level of inputs is called an increase in world productive efficiency. Labor is homogeneous within a country but may have different productivities across countries. This means the United States is two and one-half times as productive as France in wine production. Explain why everyone benefits from trade. This has been thought to be a significant deficiency for Ricardian trade theory since intermediate goods comprise a major part of world international trade. Essentially, we assume that consumer demands are such as to generate the chosen production point. Two goods are produced by both countries. Suppose Taiwan’s unit labor requirement for timber is six, its unit labor requirement for VCRs is two, and it has forty-eight million workers. A comparative advantage is also defined as the good in which a country’s relative productivity advantage (disadvantage) is greatest (smallest). There are several models that are used to analyze the dynamics of international trade. Let us start with the Ricardian model with a continuum of tradeable goods, adopted from Dornbusch, Fischer, and Samuelson (DFS) (1977). B) trade between two countries may benefit both regardless of which good each exports. Suppose each country specialized in the wrong good. Cheese output rises from nineteen to twenty-four pounds. (i.e., identical) across firms and countries. This means that the United States must give up less wine to produce another pound of cheese than France must give up to produce another pound. Since the price of wine is higher in the United States, French wine workers will one by one over time begin to sell their wine in the U.S. market. Suppose, as before, that Portugal is more productive than England in the production of both cloth and wine. In the presentation of the Ricardian model it seems as if one must apply a mathematical formula (comparing opportunity costs) to identify which country has a comparative advantage and then instruct firms (perhaps by government decree) as to which goods they ought to produce. The amount of one good traded per unit of another in a mutually voluntary exchange. It is calculated by dividing the cheese worker’s wage by the price of wine and is written as wCPW. This misconception often leads to erroneous implications, such as a fear that technology advances in other countries will cause our country to lose its comparative advantage in everything. Specialization in the example means that the United States produces only cheese and no wine, while France produces only wine and no cheese. Next, each of these is defined formally using the notation of the Ricardian model. Next, consider French wine workers immediately after trade opens. Learn how the plot of the labor constraint yields the production possibility frontier. The garden is prepared in less time with the son’s help than it could have been done independently by the father. If an appropriate terms of tradeThe amount of one good traded per unit of another in a mutually voluntary exchange. The motivation here is profit. In the Ricardian model, the allocation of workers to production, the quantities of the goods produced, and the terms of trade are endogenous. After the father finishes rototilling, he begins planting seeds in the section the son has already raked. However, since it would cost additional resources to transport the corn from Poland to England (expense of carriage), it makes intuitive sense that corn should be produced in England, rather than imported, since Polish corn would wind up with a higher price than English corn in the English market. This result occurs for any free trade price ratio that lies between the autarky price ratios. The equation is easily plotted by following three steps. This theory of comparative advantage, also called comparative cost theory, is regarded as the classical theory of international trade. To maximize profit, they must lower their wage. The father completes the task in less time and thus winds up with some additional leisure time that the father and son can enjoy together. (If workers were paid different wages, the lower-wage workers would move to the higher-wage industry.). ∗All starred variables are defined in the same way but refer to the process in France. In the example, the United States is consuming five gallons of wine and producing none, so it must import the five gallons from France. Second, since we merely made up a terms of trade that generated the interesting conclusion, we could ask whether a favorable terms of trade is likely to arise. Since aLC represents hours of labor needed to produce one pound of cheese, its reciprocal, 1/aLC, represents the labor productivity of cheese production in the United States. It also means that the slope of the U.S. PPF is flatter than the slope of France’s PPF. Pop Quiz The Ricardian model demonstrates that A) trade between two countries will benefit both countries. Consequently, price of car will begin to rise in country 1 (where it was initially low) and fall in country 2 (where it was initially high). In so doing, they would be led to maximize the output of goods and satisfy consumer demands to the extent possible given the limited resources in the economy. Suppose we split the wine surplus equally and give three extra pounds of cheese to France and two extra pounds to the United States. Thus, the element of transport cost is ignored. Note that trade based on comparative advantage does not contradict Adam Smith’s notion of advantageous trade based on absolute advantage. The classical approach, in terms of comparative cost advantage, as presented by Ricardo, basically seeks to … However, because the model assumes full employment and costless mobility of labor, all these workers are immediately gainfully employed in the other industry. No capital or land or other resources are needed for production. Labor productivity is defined as the quantity of output produced with one unit of labor; in the model, it is derived as the reciprocal of the unit labor requirement. Clearly each task would take the father less time to complete than it would take the son. To see this more clearly, consider points A and B in Figure 2.2 "Defining Opportunity Cost". The terms of trade is TOT = 5 gals./6 lbs., or 5/6 gals./lb. The free trade prices will be those prices that equalize total supply of each good in the world with total demand for each good. The focus on real wages allows us to see the effect of free trade on individual consumers in the economy. Depict an equilibrium using the free trade prices in each country to show why national welfare would fall in free trade relative to autarky. The PPF formula is aLCQC + aLWQW = L. If we plug the exogenous variables for the United States into the formula, we get QC + 2QW = 24. In David Ricardo’s original numerical example, he demonstrated that when both countries specialize in their comparative advantage goods and engage in free trade, both countries can experience gains from trade. 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