Ricardian Trade Model
Ricardian Trade Model
One factor economy * 2 countries (home, foreign) * 2 goods (cheese, wine)
We will focus on HOME 1st.
One factor – LABOUR (homogeneous)
Lc: Labor used in Cheese production
Lw: Labor used in Wine production
Exogenous total endowment of labor : L
Resource Constraint: Lc + Lw = L (1)
Production Functions: Qc = Lc / aLc Qw= Lw / aLw (2)
aLc = amount of labor needed to produce one unit of cheese aLw = amount of labor needed to produce one unit of wine
(aLc + aLw – exogenous)
These production fuctions are characterized by constant returns to scale (CRS) * If you double Lc it would also double Qc
Are there production possibilities for this economy? Substitute production function into the resource constraint (2) into (1)
aLc x Qc + aLw x Qw = L
How do we find the PPF?
Let Qw = 0 Qc = Lc / aLc
Let Qc =0 Qw= Lw / aLw
Slope of the PPF = opportunity cost of producing an extra unit of cheese in terms of wine (rise/ run)
Ie:- to produce one extra unit of cheese, we have to give up aLc/ aLw units of wine.
Why? note: In the absence of international trade, a country’s consumption possibility set = production possibilities set.
Terminology a country that does not engage in international trade is referred to as a closed economy or in a state of autarky. Free trade: allow for possibility of trade between Home and Foreign.
Where will the economy end up producing on its PPF?
Well, it depends on DD and how the economy is organized.
FOREIGN COUNTRY
It has the same structure as the Home country, however just different in values.
[aLc* aLw* L*]
Now, how does Home’s and Foreign’s PPF’s compare?
Terminology * If aLc < aLc* (home<foreign) than Home has an ABSOLUTE ADVANTAGE in producing Cheese. * And vice versa: aLc *< aLc (foreign<home) Foreign has an ABSOLUTE ADVANTAGE in producing Cheese.
Comparing opportunity costs * If aLc/aLw
One factor economy * 2 countries (home, foreign) * 2 goods (cheese, wine)
We will focus on HOME 1st.
One factor – LABOUR (homogeneous)
Lc: Labor used in Cheese production
Lw: Labor used in Wine production
Exogenous total endowment of labor : L
Resource Constraint: Lc + Lw = L (1)
Production Functions: Qc = Lc / aLc Qw= Lw / aLw (2)
aLc = amount of labor needed to produce one unit of cheese aLw = amount of labor needed to produce one unit of wine
(aLc + aLw – exogenous)
These production fuctions are characterized by constant returns to scale (CRS) * If you double Lc it would also double Qc
Are there production possibilities for this economy? Substitute production function into the resource constraint (2) into (1)
aLc x Qc + aLw x Qw = L
How do we find the PPF?
Let Qw = 0 Qc = Lc / aLc
Let Qc =0 Qw= Lw / aLw
Slope of the PPF = opportunity cost of producing an extra unit of cheese in terms of wine (rise/ run)
Ie:- to produce one extra unit of cheese, we have to give up aLc/ aLw units of wine.
Why? note: In the absence of international trade, a country’s consumption possibility set = production possibilities set.
Terminology a country that does not engage in international trade is referred to as a closed economy or in a state of autarky. Free trade: allow for possibility of trade between Home and Foreign.
Where will the economy end up producing on its PPF?
Well, it depends on DD and how the economy is organized.
FOREIGN COUNTRY
It has the same structure as the Home country, however just different in values.
[aLc* aLw* L*]
Now, how does Home’s and Foreign’s PPF’s compare?
Terminology * If aLc < aLc* (home<foreign) than Home has an ABSOLUTE ADVANTAGE in producing Cheese. * And vice versa: aLc *< aLc (foreign<home) Foreign has an ABSOLUTE ADVANTAGE in producing Cheese.
Comparing opportunity costs * If aLc/aLw