ECON 2300 Chapter Notes - Chapter 2: Real Wages, Foreign Worker, Razorbill

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7 Feb 2016
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Chapter 2 -- Ricardian Model
This chapter presents a simple model of trade that highlights the role of comparative
advantage as a motive for trade and a means of gaining from trade.
The insight that you should gain from today’s class is that free trade with a country that is
the US’s technological inferior can benefit both that country and the U.S.
Ricardo's basic idea is that what matters for gaining from trade is your opportunity cost
rather than your actual costs.
The opportunity cost of a good x is how much of some other good, say y, you have to
give up in order to produce/get one unit of good x.
Gains from Trade
If each country produces the good for which it has the lowest opportunity cost, the world
as a whole produces more, making it possible in principle to raise everyone’s standard of
living.
A country has a comparative advantage in producing a good if the opportunity cost of
producing that good in terms of other goods is lower in that country than it is in other
countries.
In this way, Trade between two countries can benefit both countries if each country
exports the goods in which it has a comparative advantage.
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We still need a model to show that countries will indeed export the goods in which they
have comparative advantage.
We’ll develop simplest possible model in which trade is solely due to international
differences in labor productivity.
Ricardian (One-factor) Model
Two countries: “Home” and “Foreign” (*)
Two goods produced: wine (W) and cheese (C)
Fixed labor supplies, L and L*, in each country.
UNIT LABOR REQUIREMENTS:
aLW = hours of labor (L) required to produce one gallon of wine (W) in Home
aLW* = " " " " " Foreign.
aLC = hours of labor (L) required to produce one yard of cloth (C) in Home
aLC* = " " " " " " " " Foreign.
Example: 1 hour of labor in Home can produce 1/aLW gallons of wine.
Denote wages by w and w*
Assume labor is perfectly mobile across industries within a country (implies zero profits
for firms).
Use unit labor requirements to draw Production Possibilities Frontiers (PPF) for each
country.
The opportunity cost of a good only equals the absolute value of the slope of PPF when
the good in question is on the horizontal axis.
If instead you were asked for opportunity cost of wine in terms of cheese, answer would
be 1/[absolute value of slope of PPF]
The PPF determines what the economy can produce. It doesn’t tell you what it will
produce. But it’s useful in determining supplies of different goods as a function of prices.
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Perfect labor mobility implies zero profits:
aLCwC = PC
aLWwW = PW
so wages in each industry
wC=PC/aLC
wW=PW/aLW
wC>wW
QC = L/aLC, QW = 0.
(workers only willing to take jobs in cheese industry)
wC<wW
QC = 0, QW = L/aLW.
(workers only willing to take jobs in wine industry)
Gives supplies as function of relative prices:
QC = 0 QW = L/aLW if PC/PW < aLC/aLW
QC = L/aLC , QW = 0 if PC/PW > aLC/aLW
Can describe specialization as function of opportunity costs:
The economy will specialize in the production of cheese if the relative price of cheese
exceeds its opportunity cost;
will specialize in wine if relative price of cheese is less than its opportunity cost.
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