4 Ricardian Model Ricardian Model 1 Intellectual History a Mercantilism b Smith c Ricardo 2 Graphical Ricardian Model a PPFs b Supply and Demand Curves c Autarky Equilibrium d Free Trade Equilibrium e Trade Triangles 3 Conclusions Mercantilism Accumulate wealth Country s goal should be to accumulate as much wealth as possible Assumes trade is a zero sum game one country s gain is another country s loss Imports are acceptable only if they are raw materials but only to add value to it and make new more expensive goods to export Exports good because they make us create jobs Smith Wealth is measured by how happy the citizens are More we are able to consume goods and services the better off we are Maximize economic well being while alive Ricardo Simplifying Assumptions 1 Only 2 countries US and ROW 2 Only 2 goods Wheat and cellphones 3 Only 1 resource Labour 4 Zero transportation cost 5 Perfectly competitive market Production level Firm will produce up to P MC Marginal Labor Cost only in this case 6 Resources are a given and fully employed There is opportunity cost to production Critical that this is roughly true 7 Constant marginal product of labor Critical for one result only Complete specialization 8 Each country has a comparative advantage in one good To Smith Critical that it is an absolute advantage Absolute advantage Comparative advantage Can produce it using fewer resources than another country Can produce it at a lower opportunity cost than another country how much wheat have to be forgone to produce 1 unit of cellphones Causes countries to trade and allows them to gain from trade 4 Ricardian Model Principle of Comparative Advantage Countries will produce and export the good s in which they have a comparative advantage and both countries can and will gain from trade Gains in world production can be distributed in ways that both countries can both benefit Absolute advantage isn t necessary US 4 Hours 1 Hour US Hours Required for 1 Cell Phone 1 Wheat Amount of other good that has to be forgone to produce 1 Cell Phone 1 Wheat ROW 5 Hours 2 Hours ROW 4 Wheat Cell Phones 5 2 Wheat 2 5 Cell Phones Production Possibility Frontier Maximum quantity of one good we can produce given the quantity of the other good being produced Hours Required for 1 Cell Phone 1 Wheat Total Labor Hours Demand curve equations 22 5 and 19 are given US 4 Hours 1 Hour 100 mil labor hours year QC D 22 5 2 5 PC PW ROW 5 Hours 2 Hours 200 mil labor hours year QC D 19 2 PC PW US PPF Slope ROW PPF Slope 2 5 same equation as above Opportunity cost of 1 more cell phone QW QC PC P W 4 Supply and Demand Curves Relative prices matter not absolute prices Staircase shaped supply curve After trade US will produce and export when trade occurs PC PW will decrease If relative price of cell phones decrease o Substitution Effect Something becomes cheaper people o Income Effect substitute away from other goods to this good Purchasing power goes up and 1 if cell phones are a normal good quantity of cell phones demanded increases 2 if cell phones 4 Ricardian Model Relative price and quantity for cell phones move in opposite directions Downward sloping demand curve US are an inferior good quantity of cell phones demanded decreases After trade PC P W increases and ROW will export cellphones If relative price of cell phones decrease o Substitution Effect Q increases o Income Effect Stuff you export is more exp than the stuff you import purchasing power increases If cell phones is an inferior good income effect causes Q to decrease o In international trade we expect income effect substitution effect since we assume specialization and all their income comes from exporting that good o Assume that income effect dominates Demand curve slope is positive Suppose trade opens Lets show each country will export the good that it has comparative advantage in Suppose Wage 100 hr in US o PC 400 you can make 1 cell phones in 4 hours and 100 hr o PW 100 PC P W 4 Suppose Wage 50 Euros hr in ROW o PC 250 Euros you can make 5 cell phones an hour and 50 Euros hr o PW 100 Euros 2 5 PC P W Suppose someone buys 2 5 wheat in the US for 250 price of wheat 100 unit because 1 hour is req o Sells 2 5 wheat to ROW for 250 Euros o Buys 1 cell phone in the ROW for 250 Euros o Sells 1 cell phone in the US for 400 o Makes 150 net o Exchange rate doesn t matter redundant info currency doesn t matter in this example because the importer and exporter is the same Trade Equilibrium Requires ROW PC PW 1 Relative price of cell phones in US Relative price of cell phones in PC P W 4 Ricardian Model 2 US cell phone imports ROW cell phone exports Consumption Possibility Frontier CPF PPF at every point Everyone gains from trade Terms of Trade TT P Exports P Imports TTUS P W 1 3 PC PC TTROW P W 3 When the terms of trade change the CPF slopes of both countries change o Both slopes become steeper o Slope of the CPF of the US is the price ratio TTROW NOT the terms of Terms of trade is a zero sum game If one countries TT increases the trade for US other country s TT falls Conclusions of Ricardian Model 1 Differences in Technology Produce according to your comparative advantages and trade 2 Countries will export their comparative advantage goods 3 Both countries will gain from trade 4 Complete specialization in the comparative advantage good Some Problems 1 Complete specialization is the exception not rule 2 Doesn t explain where the comparative advantage really comes from 3 We ve lost the losers a Solution Model using more than one resource not just Labor