The Classical World of David Ricardo and Comparative Advantage Chapter 3 The Classical World of David Ricardo and Comparative Advantage McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objectives Explain comparative advantage as the basis of trade. Identify the difference between absolute and comparative advantage. Calculate gains from trade in a 2x2 model. Illustrate comparative advantage using production possibility frontiers.

Assumptions of the Ricardian Model A 2-country, 2-commodity world Perfect competition No transportation costs Factors mobile internally, immobile internationally Constant costs of production Fixed technology for each country All resources are fully employed The “labor theory of value” holds

Notation Let: ax = labor time to produce 1 X in country A ay = labor time to produce 1 Y in country A bx = labor time to produce 1 X in country B by = labor time to produce 1 Y in country B

Comparative Advantage Defined Country A has a comparative advantage in good X if: (Px/Py)A < (Px/Py)B OR if ax/ay < bx/by OR if ax/bx < ay/by If country A has a comparative advantage in good X, country B must have a comparative advantage in good Y.

Comparative Advantage: An Example 3-6

Comparative Advantage Since the U.S.’s APR for corn is lower than Mexico’s (1/5 < 1/2), the U.S. must have a comparative advantage in corn. Since Mexico’s APR for blankets is lower than the U.S.’s (2 < 5), Mexico must have a comparative advantage in blankets.

Comparative Advantage and the Total Gains from Trade Ricardo’s argument is that trade will be mutually advantageous as long as the two countries’ autarky price ratios are different. How do we know that this is true?

Comparative Advantage and the Total Gains from Trade The Production Possibilities Frontier (PPF) is the set of all combinations of goods that a country is capable of producing, given available technology and resources. Suppose in our example the U.S. has 1000 hours of labor available and Mexico has 1800.

U.S. Production Possibilities Corn 1000 Slope: rise/run = -1000/200 = -5 A 500 100 200 Blankets

Slope of the PPF for this example, -5 Notice: the slope (in absolute value) is the APR of the good on the horizontal axis. Therefore, the slope is the opportunity cost of the good on the horizontal axis. The slope is also the marginal rate of transformation.

Mexico’s Production Possibilities Corn 600 Slope = -2, or the opportunity cost of blankets Blankets 300

Classical Model: The Gains from Trade Suppose that in autarky, the U.S. is at point A, producing and consuming 500 corn and 100 blankets. Suppose that in autarky, Mexico is at point B, producing and consuming 300 corn and 150 blankets.

U.S. Production Possibilities Corn 1000 A 500 100 200 Blankets

Mexico’s Production Possibilities Corn 600 B 300 150 Blankets 300

Classical Model: The Gains from Trade Suppose now that the U.S. and Mexico agree to trade at an “exchange rate” of 1B = 3.33C (or, 1C = .3B). If the U.S. specializes in corn, how many units of corn could it produce? 1000. If Mexico specializes in blanket manufacture, how many blankets could be made? 300.

The Gains from Trade: U.S. If the U.S. wants to continue to consume 500C, they will now have 500C to trade for blankets. If the “exchange rate” is 1B = 3.33C (or, 1C = .3B), how many blankets can the U.S. get in exchange for 500C? 150 Therefore, the U.S. can consume outside its PPF (to point C) by trading!

U.S. Production Possibilities Corn 1000 A C 500 100 150 200 Blankets

The Gains from Trade: Mexico If Mexico wants to continue to consume 150B, they will now have 150B to trade for corn. If the “exchange rate” is 1B = 3.33C (or, 1C = .3B), how much corn can Mexico get in exchange for 150B? 500 Therefore, Mexico can also move outside its PPF (to point D) by trading!

Mexico’s Production Possibilities Corn 600 D 500 B 300 150 Blankets 300

The Gains from Trade Note: In general, the Ricardian model results in complete specialization. However, in trade between a small and a large country the small country may not be able to produce enough to satisfy the large country; the large country might then partially specialize.

The Consumption Possibilities Frontier (CPF) The CPF is a collection of points that represent combinations of corn and blankets that a country can consume if it trades.

U.S. Consumption Possibilities Corn 1000 A C 500 CPF 100 150 200 300 Blankets

The Consumption Possibilities Frontier (CPF) The CPF’s slope is the same as the terms of trade. The CPF pivots around the production point. If trade is to the benefit of a country, the CPF lies outside the PPF.

Mexico’s Consumption Possibilities 1000 Corn CPF 600 D 500 300 B 150 Blankets 300

The Limits to Mutually Advantageous Trade “Exchange rate” must be at least as great as Mexico’s APR. “Exchange rate” must be no greater than the U.S.’s APR. Bottom line: we still don’t know how the terms of trade will be determined, but they must be between the countries’ APRs if trade is to be mutually beneficial. Mexico’s APR: 1B = 2C; why trade if U.S. isn’t paying more than that? Also, Mexico can buy corn for ½ a blanket; why import if U.S. sells at a higher price than that?

The CPF and “Small” Countries The nearer are the terms of trade to a country’s APR, the less that country will gain from trade. The farther away the terms of trade are from a country’s APR, the more that country will gain from trade. Moral: to Ricardo, small countries stand to gain a lot from trade, large countries gain less.