Smith and Ricardo model

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Smith and Ricardo model

Jan J. Michalek

Absoulte advantage: Smith

Figure 2.1 Adam Smith (1723-1790)

Scottish philosopher, considered by many to be the founder of modern economic science as we know it. Famous for the 'invisible hand', that is how people pursuing their own self- interest actually benefit society as a whole, and the advantages of increasing

"specialization" (the pin factory example). Major publications are The theory of moral sentiments (1759) and An inquiry into the nature and causes of the wealth of nations (1776).

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Smith & Ricardo models:

assumptions



Perfect competition



One homogenous factor of production: L (labor):

mobile at home and immobile internationally



Technology: constant a

_lj

: unit labor requirements  Constant returns to scale (CRS)



No transport costs



No trade barriers between countries;



Two countries (home and foreign) and 2 homogenous goods (C & F: cloth & food)

A One Factor Ricardian Model (cont.) Role of labor

1. Labor is the only resource important for production.

2. Labor productivity varies across countries, usually due to differences in technology, but labor productivity in each country is constant across time.

3. The supply of labor in each country is constant.

4. Only two goods are important for production and consumption: cheese and food.

5. Competition allows laborers to be paid a “competitive”

wage, a function of their productivity and the price of the good that they can sell, and allows laborers to work in the industry that pays the highest wage.

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Smith: absolute advantage

Absolute advantage: Smith

Country has an absolute advantage in production of „c” when: alc<alc*

Smith exchange is possible when: home country has an absolute advantage in one good and foreign in another:

alc<alc* oraz a_lF>a_lF*

Country Cheese (c) Food (F)

Home alc = 2 alF = 5

Foreign alc*= 3 alF*=4

Home reducing production by one unit of food releases 5 hours

Foreign country undertaking production of 1 unit of food employs 4 hours

===> savings of 1 hour

===> trade  game with positive outcome

David Ricardo

Figure 3.1 David Ricardo (1772-1823)

Born in London as the third son of a Jewish family emigrated from Holland he married the daughter of a Quaker and was disinherited by his parents. Ricardo nonetheless accumulated a fortune as a stock-jobber and loan contractor. As Blaug (1986, p. 201) puts it: "Ricardo may or may not be the greatest economist that ever lived, but he was certainly the richest." His fame today rests mainly, of course, on his contributions to the theory of comparative advantage.

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Ricardo model

L Q a Q

a_lc _c _lF _F 

full employment condition (home country)

*

* Q a Q L

a_lc _c _lF _F 

full employment condition (foreign country) L+L*= L

^w

a

_lc

w = P

_c

(zero profit condition) a

lF

w = P

F

(zero profit condition) and the same in foreign country:

a

lc*

w

^*

= P

c

* & a

lF*

w

^*

= P

F*

Production Possibilities

 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 Q_C represents the quantity of cheese produced and Q_F represents the quantity of food produced, then the production possibility frontier of the domestic economy has the equation:

a_LCQ_C + a_LFQ_F = L

Total units of food production Labor required for

each unit of chesse production

Total units of cheese production

Labor required for each unit of food production

Total amount of labor resources

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Equilibrium in autarky

D^*

D U0 U^*0

A^*

A L^*/a^*lc

L^*/a^*lF

L/alF

L/alc 0

0 QC Q^*C

Q^*F

QF

Changes in relative prices

 Assumption: a_LC/a_LF< a_LC*/a_LF*

 i.e. country has a comparative advantage in the production of good „C” (cloth) and foreign in „F” (food)

 In the autarky: Pc/P_F = a_LC/a_LF

 & P^*c/P^*_F = a^*_LC/a^*_LF

 before trade liberalization (P_C/P_F)<(P_C/P_F)^tot <P_C^*/P_F^*)

 after trade liberalization (P_C/P_F)=(P_C/P_F)^tot =(P_C^*/P_F^*)

  model with seven variables : a_lc, a_lF, a_lc*, a_lF*, L, L^*

 and looking for:

 Qc, Q_F, Qc*, Q_F*,  w^*, w & (P_C/P_F)

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Terms of trade: world equilibrium:

a _lC /a _lF <P _C /P _F ^TOT < a _lc /a _lF

2

1 a^*LC/a^*LF

aLC/aLF

RD' RD Pc/PF

RS

(QC+Q^*C)/(QF+Q^*F) (L/aLC)/(L^*/a^*LF)

Equilibrium under free trade

Home

U1

U0

Terms of trade

AC2

AC1

AP

A L/aLC

L/aLF

O QF

Qc

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Equilibrium under free trade

Foreign

U

^*1

U

^*0

Terms of trade

A

^*C2

A

^*C1

A

^*P

A

^*

L

^*

/a

^*LC

L

^*

/a

^*LF

O

^*

Q

^*F

Q

^*

c

Ricardo: numerical example

Home country has a comparative advantage in production of cheese when:

alc/alF<alc^*/alF*

Country Cloth (c) Food (F)

Home alc =1 alF = 2

Foreign alc*=6 alf*=3

Relative prices in autarky:

a/ home : Pc/PF = alc/alF = 1/2 b/ foreign: Pc*/PF*= alc*/alF*=6/3=2

It must be that : Pc/PF<TOT<Pc*/PF*  let’s assume that TOT =1

- home exporting one c employs 1 hour & receives in exchange 1 unit of “F”

(equivalent to 2 hours) ===> saving one hour.

- Foreign exporting 1 unit of food employs 3 hours receiving in exchange one unit of

„c” (equivalent to 6 hours) ====> saving 3 hours

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Ricardo:

numerical example: continued

-->if: w=1$ per one hour & and in foreign country w^* = 1/3$ per one hour (or 1/3 of domestic wage, because home is 3 times more efficient on average) (in fact wages depend on TOT and on equilibrium between RS & RD)

 we would observe the following prices of goods:

TOT=1; w= 1, w*=1/3

Country Cloth (C) Food (F)

Home ^P^C^â^lC^^w^¹ ^P^F ^â^lF^^w^² Foreign ^P^C^*^â^*^lC^^w^*^² ^P^F^*^â^lF^*^^w^*^¹

 Trade is possible: country exports cheaper cloth and imports more expensive food (Foreign imports C and exports F).

 Trade is beneficial for both countries

Ricardo:

numerical example: continued

-->if: w=1$ per one hour & and in foreign country w^* = 1/3$ per one hour (or 1/3 of domestic wage, because home is 3 times more efficient on average) (in fact wages depend on TOT and on equilibrium between RS & RD)

 we would observe the following prices of goods:

TOT=1; w= 1, w*=1/3

Country Cheese (C) Food (F)

Home ^P^C^â^lC^^w^¹ ^P^C^*^â^*^lC^^w^*^² Foreign ^P^F ^â^lF^^w^² ^P^F^*^â^lF^*^^w^*^¹

 Trade is possible: country exports cheaper cheese and imports more expensive food (Foreign imports C and exports F).

 Trade is beneficial for both countries

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Productivity & wages

Limitations of the model:

Transportation Costs and Non-traded Goods



The Ricardian model predicts that countries should completely specialize in production.



But this rarely happens for primarily 3 reasons:

1.

More than one factor of production reduces the tendency of specialization (H-O)

2.

Protectionism

3.

Transportation costs reduce or prevent trade,

which may cause each country to produce the

same good or service

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Common misconceptions

about comparative advantage:

 1. Free trade is beneficial if you country is strong enough to stand up to foreign competition;

 2. Foreign competition is unfair and hurts other countries when it is based on low wages

 3. Free trade exploits less productive countries.

 While labor standards in some countries are less than exemplary compared to Western standards, they are so with or without trade.

 Are high wages and safe labor practices alternatives to trade? Deeper poverty and exploitation (e.g., involuntary prostitution) may result without export production.

 Consumers benefit from free trade by having access to cheaply (efficiently) produced goods.

 Producers/workers benefit from having higher profits/wages—higher compared to the alternative.

Relative productivity and exports

Kenya/EU Kenya Kenya

category name rel. prod. export% - import%

311/2 Food products 117 77,61

313 Beverages 118 -0,50

321 Textiles 109 -4,95

322/3 Wearing apparel and leather products 78 1,19

324 Footwear 306 -0,20

331 Wood products 66 0,16

332 Furniture 72 -0,30

341/2 Paper and printing products 165 -2,86

351/2 Chemicals 66 -15,67

355 Rubber products 352 -0,78

356 Plastic products 170 -2,84

361/2/9 Non-metallic mineral products 99 -0,11

381 Fabricated metal products 282 -1,99

382/3 Machinery 191 -29,31

384 Transport equipment 51 -8,74

385 Professional and scientific equipment 3647 -4,01

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Empirical verification of Ricardo model

Relative productivity and exports

-50 0 50 100

0 50 100 150 200

Relative productivity ratio (Kenya/EU); %

Kenya export (%) - import (%)

food

chemicals

machinery

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Model with many goods

Comparative Advantage With Many Goods (cont.)



Smith and Ricardo model