1Copyright © 2012 Pearson Addison-Wesley. All rights reserved.Chapter 3Labor Productivity and Comparative Advantage: The Ricardian ModelCopyright © 2012 Pearson Addison-Wesley. All rights reserved.3-2Preview• Opportunity costs and comparative advantage• Production possibilities• Relative supply, relative demand & relative prices• Trade possibilities and gains from trade• Wages and trade• Misconceptions about comparative advantage• Transportation costs and non-traded goods• Empirical evidence2Copyright © 2012 Pearson Addison-Wesley. All rights reserved.3-3Introduction• Sources of differences across countries that lead to gains from trade:– The Ricardian model (Chapter 3) examines differences in the productivity of labor (due to differences in technology) between countries.– The Heckscher-Ohlin model (Chapter 5) examines differences in labor, labor skills, physical capital, land, or other factors of production between countries.Copyright © 2012 Pearson Addison-Wesley. All rights reserved.3-4Ricardian Model Assumptions1. Two countries: domestic and foreign. 2. Two goods: wine and cheese.3. Labor is the only resource needed for production.4. Labor productivity is constant.5. Labor productivity varies across countries due to differences in technology.6. The supply of labor in each country is constant.7. Labor markets are competitive.8. Workers are mobile across sectors.3Copyright © 2012 Pearson Addison-Wesley. All rights reserved.3-5Comparative Advantage• Suppose that the domestic country has a comparative advantage in cheese production: its opportunity cost of producing cheese is lower than in the foreign country.aLC/aLW< a*LC/a*LW When the domestic country increases cheese production, it reduces wine production less than the foreign country does because the domestic unit labor requirement of cheese production is low compared to that of wine production. Copyright © 2012 Pearson Addison-Wesley. All rights reserved.3-6Comparative Advantage• Domestic country has an absolute advantagein producing cheese if aLC< a*LC– needs less labor to produce a pound of cheese than foreign country:– unit labor requirement for cheese production is lower than in the foreign country.– more efficient in producing cheese.• Domestic country has an absolute advantage in producing wine if aLW< a*LW.4Copyright © 2012 Pearson Addison-Wesley. All rights reserved.3-7Comparative Advantage• Even a country that is the most (or least) efficient producer of all goods still can benefit from trade.– Even a (rich, developed) country with an absolute advantage in both goods will have a comparative advantage in only one good — the good where its absolute advantage is larger.– Even a (poor, developing) country with an absolute disadvantage in both goods will have a comparative advantage in producing something — the good where its absolute disadvantage is smaller.Copyright © 2012 Pearson Addison-Wesley. All rights reserved.3-8Numerical Examplea*LW = 4a*LC = 8ForeignaLW= 2aLC= 1DomesticWine (gallons)Cheese (pounds)Unit labor requirements (hours)24821**==<=LWLCLWLCaaaa5Copyright © 2012 Pearson Addison-Wesley. All rights reserved.3-9Opportunity Cost Example• To produce an additional pound of cheese requires aLChours of work. • Each hour devoted to cheese production could have been used to produce a certain amount of wine instead, equal to1 hour/(aLWhours/gallon of wine) = (1/aLW) gallons of wine• If 1 hour of labor is moved to cheese production, that additional hour of labor could have produced 1 hour/(2 hours/gallon of wine) = 1/2 gallons of wine.Copyright © 2012 Pearson Addison-Wesley. All rights reserved.3-10Production Possibilities Frontier•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.•If QC represents the quantity of cheese produced and QWrepresents the quantity of wine produced, then the production possibility frontier of the domestic economy has the equation:aLCQC+ aLWQW= LTotal units of wine productionLabor required for each unit of cheese productionTotal units of cheese productionLabor required for each unit of wine productionTotal amount of labor resources6Copyright © 2012 Pearson Addison-Wesley. All rights reserved.3-11Fig. 3-1: Home’s Production Possibility FrontierCopyright © 2012 Pearson Addison-Wesley. All rights reserved.3-12Production Possibilities Frontier• PPF in labor constraint form: aLCQC + aLWQW = L• Cheese endpoint of PPF: if produce only cheese, pounds when QW = 0.• Wine endpoint of PPF: if produce only wine, gallons when QC= 0.LCCaLQ =LWWaLQ =7Copyright © 2012 Pearson Addison-Wesley. All rights reserved.3-13Production Possibilities Frontier• PPF in slope-intercept form:QW= L/aLW– (aLC/aLW)QC• Slope of PPF equals – (aLC/aLW)– Constant, so PPF is a straight line.• The opportunity cost of cheese production is:– The quantity of wine production given up aLC/aLW– Equal to the absolute value of the slope of the PPFCopyright © 2012 Pearson Addison-Wesley. All rights reserved.3-14Example 3.1 Home PPF• In the home country, producing one pound of cheese requires one unit of labor, and producing one gallon of wine requires two units of labor. Home has a labor supply of 1000.• Find and graph the Home PPF.CWWCWLWCLCQQQQLQaQa2150010002−==+=+8Copyright © 2012 Pearson Addison-Wesley. All rights reserved.3-15Example 3.1 Home PPF• What is the most cheese Home can produce?• What is the most wine Home can produce?pounds 100011000===LCCaLQgallons 50021000===LWWaLQCopyright © 2012 Pearson Addison-Wesley. All rights reserved.3-16Example 3.1 Home PPF• What is the opportunity cost of cheese production for Home?• Where does it appear in the PPF equation?– Absolute value of the slope wineof gallon 21=LWLCaa9Copyright © 2012 Pearson Addison-Wesley. All rights reserved.3-17Example 3.1 Home PPF015000 1000Cheese (pounds)Wine (gallons)PPFslope -1/2500Copyright © 2012 Pearson Addison-Wesley. All rights reserved.3-18Exercise 3.1 US PPF• In the United States, producing one unit of cheese requires 1 unit of labor, while producing one unit of wine requires 4 units of labor. US labor supply is 600.• Find and graph the US PPF.• Determine the US maximum cheese production.• Determine the US maximum wine production.• Find the US opportunity cost of cheese in terms of wine. • Where does it appear in the equation describing