Smith and Ricardo model - Jan J. Michalek
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Smith and Ricardo
model
Jan J. Michalek
Absoulte advantage: Smith
Figure 2.1 Adam Smith (1723-1790)
Scottish philosopher, considered by many to be the founder of modern economic science
as we know it. Famous for the 'invisible hand', that is how people pursuing their own self-
interest actually benefit society as a whole, and the advantages of increasing
"specialization" (the pin factory example). Major publications are The theory of moral
sentiments (1759) and An inquiry into the nature and causes of the wealth of nations
(1776).
1Smith & Ricardo models:
assumptions
z Perfect competition
z One homogenous factor of production: L (labor):
mobile at home and immobile internationally
z Technology: constant alj: unit labor requirements Î
Constant returns to scale (CRS)
z No transport costs
z No trade barriers between countries;
z Two countries (home and foreign) and 2 homogenous
goods (C & F: cloth & food)
A One Factor Ricardian Model
(cont.) Role of labor
1. Labor is the only resource important for production.
2. Labor productivity varies across countries, usually due to
differences in technology, but labor productivity in each
country is constant across time.
3. The supply of labor in each country is constant.
4. Only two goods are important for production and
consumption: cheese and food.
5. Competition allows laborers to be paid a “competitive”
wage, a function of their productivity and the price of the
good that they can sell, and allows laborers to work in the
industry that pays the highest wage.
2Smith: absolute advantage
Absolute advantage: Smith
Country has an absolute advantage in production of „c” when: alc savings of 1 hour
===> trade Î game with positive outcome
David Ricardo
Figure 3.1 David Ricardo (1772-1823)
Born in London as the third son of a Jewish family emigrated from Holland he married
the daughter of a Quaker and was disinherited by his parents. Ricardo nonetheless
accumulated a fortune as a stock-jobber and loan contractor. As Blaug (1986, p. 201) puts
it: "Ricardo may or may not be the greatest economist that ever lived, but he was certainly the
richest." His fame today rests mainly, of course, on his contributions to the theory of
comparative advantage.
3Ricardo model
alc ⋅ Qc + alF ⋅ QF ≤ L full employment condition (home country)
a ⋅Q + a ⋅Q ≤ L
*
lc
*
c
*
lF
*
F
*
full employment condition (foreign country)
L+L*= Lw
alc w = Pc (zero profit condition)
alF w = PF (zero profit condition)
and the same in foreign country:
alc*w* = Pc* & alF*w*= PF*
Production Possibilities
z The production possibility frontier (PPF) of an economy shows
the maximum amount of a goods that can be produced for a fixed
amount of resources.
z If QC represents the quantity of cheese produced and QF
represents the quantity of food produced, then the production
possibility frontier of the domestic economy has the equation:
aLCQC + aLFQF = L Total amount of
labor resources
Labor required for Total units Labor required for Total units
each unit of of cheese each unit of food of food
chesse production production production production
4Equilibrium in autarky
QF Q*F
L*/a*lF
L/alF
A*
D U0 U*0
0 A L/alc QC 0 D* L*/a*lc Q*C
Changes in relative prices
z Assumption: aLC/aLF< aLC*/aLF*
z i.e. country has a comparative advantage in the production of
good „C” (cloth) and foreign in „F” (food)
z In the autarky: Pc/PF = aLC/aLF
z & P*c/P*F = a*LC/a*LF
z before trade liberalization (PC/PF)Terms of trade: world equilibrium: alC/alF
Equilibrium under free trade
Q*F
Foreign
A*P
Terms of trade
L*/a*LF
A* A*C2
A*C1
U*1
U*0
O* L*/a*LC Q*c
Ricardo: numerical example
Home country has a comparative advantage in production of cheese when:
alc/alFRicardo:
numerical example: continued
-->if: w=1$ per one hour & and in foreign country w* = 1/3$ per one hour
(or 1/3 of domestic wage, because home is 3 times more efficient on average)
(in fact wages depend on TOT and on equilibrium between RS & RD)
Î we would observe the following prices of goods:
TOT=1; w= 1, w*=1/3
Country Cloth (C) Food (F)
Home PC = alC ⋅ w = 1 PF = alF ⋅ w = 2
Foreign PC* = alC
*
⋅ w* = 2 PF* = alF* ⋅ w* = 1
Î Trade is possible: country exports cheaper cloth and imports more expensive food
(Foreign imports C and exports F).
Î Trade is beneficial for both countries
Ricardo:
numerical example: continued
-->if: w=1$ per one hour & and in foreign country w* = 1/3$ per one hour
(or 1/3 of domestic wage, because home is 3 times more efficient on average)
(in fact wages depend on TOT and on equilibrium between RS & RD)
Î we would observe the following prices of goods:
TOT=1; w= 1, w*=1/3
Country Cheese (C) Food (F)
Home PC = alC ⋅ w = 1 PC* = alC
*
⋅ w* = 2
Foreign PF = alF ⋅ w = 2 PF* = alF* ⋅ w* = 1
Î Trade is possible: country exports cheaper cheese and imports more expensive
food (Foreign imports C and exports F).
Î Trade is beneficial for both countries
8Productivity & wages
Limitations of the model:
Transportation Costs and Non-traded
Goods
z The Ricardian model predicts that countries
should completely specialize in production.
z But this rarely happens for primarily
3 reasons:
1. More than one factor of production reduces the
tendency of specialization (H-O)
2. Protectionism
3. Transportation costs reduce or prevent trade,
which may cause each country to produce the
same good or service
9Common misconceptions
about comparative advantage:
z 1. Free trade is beneficial if you country is strong enough to stand up
to foreign competition;
z 2. Foreign competition is unfair and hurts other countries when it is
based on low wages
z 3. Free trade exploits less productive countries.
z While labor standards in some countries are less than exemplary compared
to Western standards, they are so with or without trade.
z Are high wages and safe labor practices alternatives to trade? Deeper
poverty and exploitation (e.g., involuntary prostitution) may result without
export production.
z Consumers benefit from free trade by having access to cheaply (efficiently)
produced goods.
z Producers/workers benefit from having higher profits/wages—higher
compared to the alternative.
Relative productivity and
exports
Kenya/EU Kenya Kenya
category name rel. prod. export% - import%
311/2 Food products 117 77,61
313 Beverages 118 -0,50
321 Textiles 109 -4,95
322/3 Wearing apparel and leather products 78 1,19
324 Footwear 306 -0,20
331 Wood products 66 0,16
332 Furniture 72 -0,30
341/2 Paper and printing products 165 -2,86
351/2 Chemicals 66 -15,67
355 Rubber products 352 -0,78
356 Plastic products 170 -2,84
361/2/9 Non-metallic mineral products 99 -0,11
381 Fabricated metal products 282 -1,99
382/3 Machinery 191 -29,31
384 Transport equipment 51 -8,74
385 Professional and scientific equipment 3647 -4,01
10Empirical verification of
Ricardo model
Relative productivity and
exports
100
Kenya export (%) - import (%)
food
50
0
0 50 100 150 200
chemicals
machinery
-50
Relative productivity ratio (Kenya/EU); %
11Model with many goods
Comparative Advantage
With Many Goods (cont.)
z If w/w* = 3, the domestic country will produce
apples, bananas, and caviar, while the
foreign country will produce dates and
enchiladas.
z The relative productivities of the domestic country
in producing apples, bananas and caviar are
higher than the relative wage.
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