Economies of scale refer to a production process in which production costs fall as the scale of production rises. If we calculated comparative advantages, then England would also have the comparative advantage in cloth and Portugal would have the comparative advantage in wine. Therefore, to dismiss the results of economic analysis on the basis of unrealistic assumptions means that one must dismiss all insights contained within the entire economics discipline. Suppose two countries, the United States and France, move from autarky to free trade. Similarly, real wages for cheese workers in France need not be calculated. But that’s only a temporary fix. Ricardo’s surprising result was that a country can gain from trade even if it is technologically inferior in producing every good. The second expression means that labor productivity in cheese in the United States is greater than in France. then the United States has relatively higher real wages with respect to cheese purchases than it does in wine purchases. Since zero profit results in each producing industry, we can simply rewrite the relationship derived above to construct the following formula for the real wage: This means that the real wage of a worker in terms of how much cheese can be purchased is equal to labor productivity in cheese production. Thus the sale of goods and services generates revenue to the firms that in turn is used to pay for the factor services (wages to workers in this case) used in production. The real wage of wine workers in terms of cheese is the quantity of cheese that a wine worker can buy with a unit of work. But he did not explain how after all this comparative costs difference arises. The unit labor requirementsThe quantity of labor needed to produce one unit of a good. Instead, what matters is relative wage comparisons. Production technology differences exist across industries and across countries and are reflected in labor productivity parameters. The five main reasons international trade takes place are differences in technology, differences in resource endowments, differences in demand, the presence of economies of scale, and the presence of government policies. The increased supply of wine to the United States lowers its price on the U.S. market. ∗All starred variables are defined in the same way but refer to the process in France. Suppose two countries, the United States and France, are initially in autarky. Furthermore, although Ricardian theory of comparative costs may show the limits within which the equilibrium must be, it does not show how to determine the terms of trade, and hence the price of the goods. If the price rises by a greater percentage than the wage, the ability to purchase that good falls and the worker may be worse off. Suppose that the son rakes slower than the father plants and that the father completes the sowing process just as the son finishes raking. In this case, neither country has a comparative advantage in anything. The loss in wine production necessary to produce more cheese represents the opportunity cost to the economy. Only one of the goods would work. Labor is always fully employed. Finally, the theory of comparative advantage is all too often presented only in its mathematical form. Labor is the one factor of production used to produce each of the goods. The surprising result of this example is that a country that is technologically inferior to another in the production of all goods can nevertheless benefit from trade with that country. The usual way of stating the Ricardian model results is to say that countries will specialize in their comparative advantage good and trade it to the other country such that everyone in both countries benefits. Then make up a plausible free trade price ratio. Adam Smith wrote in The Wealth of Nations, “If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage” (Book IV, Section ii, 12).For more information, see Rod Hay, “Adam Smith,” McMaster University Archive for the History of Economic Thought, http://socserv.mcmaster.ca/econ/ugcm/3ll3/smith/wealth/index.html. A numerical example can display only one possible outcome for the model. Also, all workers are assumed to be identical. On the other hand, the son is “least worse” at raking and planting but “most worse” at rototilling. Ricardian theory of international trade Between 1500 and 1750 most economists advocated Mercantilism which promoted the idea of international trade for the purpose of earning bullion by running a trade surplus with other countries. Perhaps an individual abstains from alcohol consumption. Workers can move freely and costlessly between industries but cannot move to another country. In fact, all production possibilities regardless of whether full employment is fulfilled are referred to as the production possibility set (PPS). Fortunately, none of this is necessary if the market, or the invisible hand, is allowed to operate. Below we define two different ways to describe technology differences. The PPF equation can be rewritten as. The motivation here is profit. Depict an equilibrium using the free trade prices in each country to show why national welfare would fall in free trade relative to autarky. Profit is defined as total revenue minus total cost. The terms of trade is TOT = 5 gals./6 lbs., or 5/6 gals./lb. What are the levels of production and the pattern of trade when free trade occurs? Note this implies that raking takes the son almost two hours compared to one hour for the father. ), and the sophistication of its capital stock (machinery, infrastructure, communications systems). This theory of comparative advantage, also called comparative cost theory, is regarded as the classical theory of international trade. This highlights the importance of specializing in production of the task in which you have a comparative advantage. The first known statement of the principle of comparative advantage and trade appears in an article by Robert Torrens in 1815 titled Essay on the External Corn Trade. In other words, either each country has the comparative advantage in one of the two goods or neither country has a comparative advantage in anything. Since the free trade indifference curve IFT lies to the northeast of the autarky indifference curve IAut, national welfare rises as the United States moves to free trade. International trade involves the extension of the principle of specialisation or division labour to the sphere of international exchange. This is how Ricardo presented his argument originally. In the Ricardian model, the unit labor requirements and the labor endowment are exogenous. This generates revenue to the firms and the cycle repeats again. Ricardo asserted that even if a nation does not posses absolute advantage, there are chances of gains through trade among the nations on the basis of comparative advantage. Learn how the autarky terms of trade is determined in a Ricardian model. The garden story offers an intuitive explanation for the theory of comparative advantage and also provides a useful way of interpreting the model results. A variable whose value is determined as an outcome of, or solution to, the model. For example, the Chinese are likely to demand more rice than Americans, even if consumers face the same price. Since transportation costs are zero, more profit can be made through export than with sales domestically. Why? The reason is that such a model is too complicated to work with. It is calculated by dividing the worker’s wage by the price of wine, written as wW/PW. This implies that if production occurs in an industry, be it in autarky or free trade, then economic profit must be zero. To calculate the free trade real wage, plug in the free trade price ratio. In the immobile factor model, we address the implications of adjustment costs across industries. France’s autarky production and consumption points are determined by finding the aggregate indifference curve that is tangent to the French PPF. The labor and goods markets are assumed to be perfectly competitive in both countries. Labor is homogeneous within a country but heterogeneous (nonidentical) across countries. The quantity of a good that can be produced per unit of labor input. A comparative advantage is also defined as the good in which a country’s relative productivity advantage (disadvantage) is greatest (smallest). Two such models are Ricardian and Heckscher-Ohlin models. It was formulated by David Ricardo in 1815. Models are, by their nature, simplifications of the real world and thus all economic models contain unrealistic assumptions. Real wages are an appropriate measure of worker well-being because they represent the purchasing power of the wage. When trade opens, the United States will specialize in its comparative advantage good, which, by rearranging the above inequality, can easily be shown to be cheese. Consider a Ricardian model with two countries, the United States and Ecuador, producing two goods, bananas and machines. By assumption, the United States has the absolute advantage in cheese production and wine production because aLC(1) < aLC∗(6) and aLW(2) < aLW∗(3). 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