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Old Sunday, December 17, 2006
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Economist In Equilibrium
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The Ricardian Model - Assumptions and Results
The modern version of the Ricardian model and its results are typically presented by constructing and analyzing an economic model of an international economy. In its most simple form the model assumes two countries producing two goods using labor as the only factor of production. Goods are assumed homogeneous (identical) across firms and countries. Labor is homogeneous within a country but heterogeneous (non-identical) across countries. Goods can be transported costlessly between countries. Labor can be reallocated costlessly between industries within a country but cannot move between countries. Labor is always fully employed. Production technology differences across industries and across countries and are reflected in labor productivity parameters. The labor and goods markets are assumed to be perfectly competitive in both countries. Firms are assumed to maximize profit while consumers (workers) are assumed to maximize utility. (See page 40-2 for a more complete description)

The primary issue in the analysis of this model is what happens when each country moves from autarky (no trade) to free trade with the other country - in other words what the effects of trade are. The main things we care about are trade's effects on the prices of the goods in each country, the production levels of the goods, employment levels in each industry, the pattern of trade (who exports and who imports what), consumption levels in each country, wages and incomes, and the welfare effects both nationally and individually.

Using the model one can show that, in autarky, each country will produce some of each good. Because of the technology differences, relative prices of the two goods will differ between countries. The price of each country's comparative advantage good will be lower than the price of the same good in the other country. If one country has an absolute advantage in the production of both goods (as assumed by Ricardo) then real wages of workers (i.e., the purchasing power of wages) in that country will be higher in both industries compared to wages in the other country. In other words, workers in the technologically advanced country would enjoy a higher standard of living than in the technologically inferior country. The reason for this is that wages are based on productivity, thus in the country that is more productive, workers get higher wages.

The next step in the analysis is to assume that trade between countries is suddenly liberalized and made free. The initial differences in relative prices of the goods between countries in autarky will stimulate trade between the countries. Since the differences in prices arise directly out of differences in technology between countries, it is the differences in technology that cause trade in the model. Profit-seeking firms in each country's comparative advantage industry would recognize that the price of their good is higher in the other country. Since transportation costs are zero, more profit can be made through export than with sales domestically. Thus each country would export the good in which they have a comparative advantage. Trade flows would increase until the price of each good is equal across countries. In the end, the price of each country's export good (its comparative advantage good) will rise and the price of its import good (its comparative disadvantage good) will fall.

The higher price received for each country's comparative advantage good would lead each country to specialize in that good. To accomplish this, labor would have to move from the comparative disadvantaged industry into the comparative advantage industry. This implies that one industry goes out of business in each country. However, because the model assumes full employment and costless mobility of labor, all of these workers are immediately gainfully employed in the other industry.

One striking result here is that even when one country is technologically superior to the other in both industries, one of these industries would go out of business when opening to free trade. Thus, technological superiority is not enough to guarantee continued production of a good in free trade. A country must have a comparative advantage in production of a good, rather than an absolute advantage, to guarantee continued production in free trade. From the perspective of a less developed country, the developed countries' superior technology need not imply that LDC industries cannot compete in international markets.


Another striking result is that the technologically superior country's comparative advantage industry survives while the same industry disappears in the other country, even though the workers in the other country's industry has lower wages. In other words, low wages in another country in a particular industry is not sufficient information to know which country's industry would perish under free trade. From the perspective of a developed country, freer trade may not result in a domestic industry's decline just because the foreign firms pay their workers lower wages.

The movement to free trade generates an improvement in welfare in both countries both individually and nationally. Specialization and trade will increase the set of consumption possibilities, compared with autarky, and will make possible an increase in consumption of both goods, nationally. These aggregate gains are often described as improvements in production and consumption efficiency. Free trade raises aggregate world production efficiency because more of both goods are likely to be produced with the same number of workers. Free trade also improves aggregate consumption efficiency, which implies that consumers have a more pleasing set of choices and prices available to them.

Real wages (and incomes) of individual workers are also shown to rise in both countries. Thus, every worker can consume more of both goods in free trade compared with autarky. In short, everybody benefits from free trade in both countries. In the Ricardian model trade is truly a win-win situation.
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