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Economics for Management Studies
Victor Barac

Problem 1: Ricardian vs. Specific-Factors Model a. The Ricardian model is constructed such that the only difference between countries is in their production technologies, focusing only on comparative advantage. All other features are assumed identical across countries. The Ricardian model shows that everyone could benefit from trade. This can be shown using an aggregate representation of welfare or by calculating the change in real wages to workers. However, one of the reasons for this outcome is the simplifying assumption that there is only one factor of production. The Ricardian model shows the possibility that an industry in a developed country could compete against an industry in a less developed country even though the LDC industry pays its workers much lower wages. Therefore, countries trade in Ricardian model because the model shows that free trade can never make country worse off, and in most cases free trade would make it better off. The specific factor model suggests that if there is an increase in the price of good, the owners of the factor of production specific to that good will profit in real terms. In this model only one factor of production is assumed to be specific to a particular industry. Therefore, in the specific factor model, factors of production that cannot move between industries will gain or lose the most from opening a country to trade; the factor of production that is specific to the import industry will lose in real terms, as the relative price of the import good falls. The factor of production that is specific to the export industry will gain in real terms, as the relative price of the export good rises. b. The Ricardian model is a general equilibrium model. This means that it describes a complete circular flow of money in exchange for goods and services. Thus, the sale of goods and services generates revenue to the firms which in turn is used to pay for the factor services (wages to workers in this case) used in production. The factor income (wages) is used, in turn, to buy the goods and services produced by the firms. This generates revenue to the firms and the cycle repeats again. A "general equilibrium" arises when prices of goods, services and factors are such as to equalize supply and demand in all markets simultaneously. The specific factor model is used to demonstrate the effects of economic changes on labour allocation, output levels and factor returns. Many types of economic changes can be considered including a movement to free trade, the implementation of a tariff or quota, growth of the labour or capital endowment, or technological changes. c. The Ricardian model assumes that there is only one factor of production (labour), constant returns to scale, perfect competition and that technology varies across countries. The model is a general equilibrium model in which all markets (i.e., goods and factors) are perfectly competitive. The goods produced are assumed to be homogeneous across countries and firms within an industry. Goods can be costlessly shipped between countries (i.e., there are no transportation costs). Labour is homogeneous within a country but may have different productivities across countries. This implies that the production technology is assumed to differ across countries. Labour is costlessly mobile across industries within a country but is immobile across countries. Full employment of labour is also assumed. Consumers (the labourers) are assumed to maximize utility subject to an income constraint. In the specific factor model there are 2 goods (manufactures and food), 3 factors of production (labour, capital and land), manufactures are produced using capital and labour and food is produced using land and labour. Labour is a mobile factor and land and capital are specific factors. It also assumes that identical technology across countries, diminishing marginal returns to labor in both industries (decreasing MPLMand MPL ) aAd perfect competition in all markets. When a country open to trade in SF model, it has a comparative advantage in (and exports) the good that uses the specific factor in which it is relatively well-endowed (and for which its relative autarky price if lower than the relative world price). The real returns to the mobile factor are ambiguous, the real returns to the factor specific to the exporting sector increase, and the real returns to the factor specific to the importing sector decrease. d. The specific factor model is more general because in the Ricardian model there are gain from trade but does not say anything about income distribution. Trade has a big affect on income distribution because resources cannot move immediately or costlessly from one industry to another. Industries differ in the factor of production they demand. Therefore, the specifi
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