Labor Productivity and Comparative Advantage: The Ricardian Model

Study Abroad (UAB) International Economics Labor Productivity and Comparative Advantage: The Ricardian Model Professor: Alicia Gómez Tello

Contents Introduction The Concept of Comparative Advantage A One-Factor Economy Production Possibilities Relative prices and Supply Trade in a One-Factor World Determining the Relative Price After Trade The Gains from Trade A Note On Relative Wages Box: Do Wages Reflect Productivity? Misconceptions About CA Productivity and Competitiveness The Pauper Labor Argument Exploitation Empirical Evidence 2

Introduction Countries engage in international trade for two main reasons: Countries are different from each other (topics 3 5) Each does the things it does relatively well Important concept: Comparative advantage Economies of scale in production (topic 6) If each country produces only a limited range of goods Large scale of production efficiency In the real world, patterns of international trade reflect the interaction of both those motives. 3

Important concept. The Concept of Comparative Advantage P. Samuelson: An economic principle that is undeniably true yet not obvious to intelligent people. February 1996: Republican presidential candidate P. Buchanan stopped at a nursery to buy a dozen roses for his wife. In a speech her denounced the growing imports of flowers into the United States mostly from South America. Roses need specific conditions to grow. Trade-off: In order to produce roses, the U.S. economy must produce fewer of other things The opportunity cost of good 1 (e.g., flowers) in term of good 2 is the number of good 2 that could have been produced with the resources used to produce a given number of good 1 (roses). 5

The Concept of Comparative Advantage Imagine that with a specific number of resources the United States and Columbia can produce roses or computers: Roses Computers United States 10,000,000 100,000 Colombia 10,000,000 30,000 United States: The opportunity cost of 10 million roses is 100,000 computers. The opportunity cost of 100,000 computers is 10 million roses. Colombia: The opportunity cost of 10 million roses is 30,000 computers. The opportunity cost of 30,000 computers is 10 million roses. 6

The Concept of Comparative Advantage The difference in opportunity costs offer the possibility of a mutually beneficial arrangement of world production. Let the United States stop growing winter roses (and uses the resources to produce computers). Let Colombia stop producing computers (and uses the resources to grow roses). Result: The world is producing just as many as roses as before, but it is now producing more computers. International trade allows each country to specialize in producing the good in which it has a comparative advantage. 7

The Concept of Comparative Advantage A country has a comparative advantage (CA) on 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 example, Colombia has a CA in winter roses and the United States has a CA in computers. Important statement: Trade between two countries can benefit both countries if each country exports the goods in which it has a comparative advantage. This is a statement about possibilities, not about what will actually happen. Will the United States and Colombia actually end up producing the goods in which each has a CA? Will the trade between them actually make both countries better off? 8

The Concept of Comparative Advantage In this chapter we will develop a model of international trade originally developed by the British economist David Ricardo, who introduced the concept of CA in the early 19 th century. Ricardian model: International trade is solely due to international differences in the productivity of labor. 9

One-Factor Economy Assumptions: 1. Two economies: Home and Foreign(*) 2. Two goods: wine and cheese. 3. One factor of production: labor The supply of labor in each country is constant. Labor is mobile across industries, but internationally immobile. 4. Technology is summarized by labor productivity in each industry. Productivity (units per hour) Labor productivity varies across countries. Labor productivity in each country is constant. 5. Perfect competition Competitive wages Workers can work in the industry that pays the highest wage. 11

One-Factor Economy Unit labor requirement (al): The constant number of hours of labor required to produce one unit of output. alc is the unit of labor requirement for cheese in the Home country. alw is the unit of labor requirement for wine in the Home country Labor requirement Labor productivity A = 1/a Cheese (a) alc = 1 (b) ALC = 1/1 = 1 Wine (c) alw = 2 (d) ALW = ½ = 0.5 (a) 1 hour of labor produces one pound of cheese. (b) 1 pound of cheese is produced in one hour of labor. (c) 2 hours of labor produce one gallon of wine. (d) 0,5 gallon of wine is produced in one hour of labor. A high unit labor requirement means low labor productivity. a A 12

One-Factor Economy Production Possibilities The production possibilities frontier (PPF) of an economy shows the maximum amount of goods that can be produced for a fixed amount of resources. The PPF on the Home country is: where a LC Q C a LW Q W L (3.1) Variable Definition Example alc Labor requirement for each pound of cheese. 1 hour QC Total pounds of of cheese produced. Max: L/aLC = 1000 pounds alw Labor required for each gallon of wine produced. 2 hours QW Total gallons of wine produced. Max: L/aLW = 500 gallons L Total amount of labor resource. 1000 hours 13

One-Factor Economy Production Possibilities Figure 3.1: Home s production possibility frontier Q W L a LW a LC - QC alw (3.1') a - a LC LW *This figure has been extracted from Krugman et al (2012), page 28. 14

One-Factor Economy Production Possibilities Figure 3.1 The line PF shows the maximum amount of cheese Home can produce given any production of wine, and vice versa. When the PPF is a straight line, the opportunity cost of a pound of cheese in terms of wine is constant. Opportunity cost: Numbers of gallons of wine the economy would have to give up in order to produce an extra pound of cheese. To produce another pound: Each of these person-hours could in turn have been used to produce: alc person-hours 1/aLW gallons of wine Opportunity cost (cheese in terms of wine): alc/alw = ½ = 0.5 The opportunity cost of each pound of cheese is half a gallon of wine. 15

One-Factor Economy Relative Prices and Supply Supply decision (perfect competition) To maximize profits: q* MC = MR = price Labor (the only factor of production) is crucial to determine the supply. Labor moves to the sector which pays the highest wage. wage (1h) = productivity x price The wage is equal the value of what a workers can produce in an hour. There are no profits. Example: Productivity (units/h) A = 1/a Price ($/units) P Wage ($/h) Cheese (C) 1 4 4 Wine (W) ½ 7 7/2 = 3.5 Workers will do better by producing cheese, and the economy as a whole will specialize in cheese production. But what if the cheeses prices drop to $3? 16

One-Factor Economy Relative Prices and Supply Workers compare: wagec versus wagew wagec > wagew PC/aC > PW/aW PC/PW > ac/aw Specialization: cheese wagec < wagew PC/aC < PW/aW PC/PW < ac/aw Specialization: wine wagec = wagew PC/aC = PW/aW PC/PW = ac/aw Both godos will be produced. What is the significance of a ac/aw? Crucial preposition (relationship between prices and production): The economy will specialize in the production of cheese if the relative price of cheese exceeds its opportunity cost in terms of wine, and it will specialize on the production of wine if the relative price of cheese is less than its opportunity cost in terms of wine. In the absence of international trade Home would have to produce both goods. The relative prices of goods are equalto their relative unit labor requirements. 17

Assumption 1: two economies Trade in a One-Factor World Home variables: alc, QC, alw, QW, and L Foreign variables: a*lc, Q*C, a*lw, Q*W, and L* The unit labor requirement can follow any pattern, for instance: a LC a LW a * LC a * LW (3.2) a LC a * LC a LW a * LW (3.3) (3.2): The ratio of the labor required to produce a pound of cheese to that required to produce a gallon of wine is lower in Home than it is in Foreign. (3.3): Home s relative productivity in cheese is higher than it is in wine. A * LC A * LW (3.3)' Ratio of labor requirements opportunity costs CA LC According to (3.2) and (3.3): Home has a CA in cheese. A A LW 19

Trade in a One-Factor World Important point: The condition under which Home has this CA involves all four unit labor requirement, not just two. Imagine we know that alc < a*lc, but alw and a*lw are unknown variables. Then, we say that Home has an absolute advantage in producing cheese. We cannot determine thee pattern of trade from absolute advantage only. One of the most important sources of error in discussing international trade is to confuse CA with absolute advantage. 20

Trade in a One-Factor World Numerical example Cheese Wine Opportunity cost (cheese in terms of wine) Home alc=1h, A=1 pound alw=2h, A=1/2 gallon ½ Foreign a*lc=6h, A=1/6 pound a*lw=3h, A=1/3 gallon 6/3 = 2 Absolute advantage versus comparative advantage: Home Foreign Cheese Absolute advantage CA Wine Absolute advantage CA 21

Trade in a One-Factor World Given L and a in the two countries, we can draw the PPF for each country. Figure 3.1 for Home and Figure 3.3 for Foreign Home has a lower opportunity cost in producing cheese (in terms of wine) than Foreign. The opportunity cost is the slope of the PPF. Then, Foreign s frontier is steeper than Home s. 22

Trade in a One-Factor World Figure 3.2: Foreign s production possibility frontier a - a * LC * LW *This figure has been extracted from Krugman et al (2012), page 30. 23

In the absence of trade, relative prices are determined by labor requirements. [PC/PW]H = alc/alw [PC/PW]F = a*lc/a*lw Trade in a One-Factor World One we allow for the possibility of international trade, however, prices will no longer be determined purely by domestic considerations If [PC/PW]H < [PC/PW]F To ship cheese from Home to Foreign. Eventually Home will export enough cheese and Foreign enough wine to equalize the relative price [PC/PW]. But what determines the level at which that price settles? 24

Trade in a One-Factor World Determining the Relative Price After Trade Prices of internationally traded goods, like other prices, are determined by supply and demand. Partial equilibrium analysis: single market General equilibrium analysis: linkages between both markets (cheese and wine) One useful way to keep track of two markets at once is to focus on the relative supply and demand (that is, on the number of pounds of cheese supplied or demanded divided by the number of gallon of wine supplied or demanded). See Figure 3.3. 25

Trade in a One-Factor World Determining the Relative Price After Trade Figure 3.3: World relative supply and demand *This figure has been extracted from Krugman et al (2012), page 31. 26

Figure 3.3 Trade in a One-Factor World Determining the Relative Price After Trade It shows world supply and demand for cheese relative to wine as functions of the price of cheese relative to that of wine. Relative demand curve (RD) Relative supply curve (RS) World general equilibrium: RD=RS Relative supply curve RS The striking feature of this figure is the funny shape of RS curve: It is a step with a flat section linked by a vertical section. Remember that according to (3.2) Home has a CA in cheese. a LC a LW a * LC a * LW 27

Trade in a One-Factor World Determining the Relative Price After Trade Figure 3.3 (cont.) (1) If PC/PW < alc/alw (< a*lc/a*lw) Both Home and Foreign will specialize in wine production. There will no be cheese production. PC/PW < alc/alw PC/aLC < PW/aLW PCAC < PWAW wagec < wagew (2) If PC/PW = alc/alw (< a*lc/a*lw) Workers in Home can earn exactly the same amount making either cheese or wine. Home will be willing to supply any relative amount of two goods. Flat section (3) If alc/alw < PC/PW < a*lc/a*lw Home will specialize in the production of cheese. QC = L/aLC Foreign will continue to specialize in producing wine. Q*W = L*/a*LW (4) If alc/alw < PC/PW = a*lc/a*lw Foreign workers are indifferent between producing cheese and wine. Flat section (5) If PC/PW > a*lc/a*lw: Both Home and Foreign will specialize in cheese production. There will no be wine production. 28

Figure 3.3 (cont.) Relative demand curve RD Trade in a One-Factor World Determining the Relative Price After Trade Downward slope: substitution effects As the relative price of cheese rises, consumers will tend to purchase less cheese and more wine. Relative demand for cheese falls Equilibrium: Intersection RS and RD Point 1 alc/alw (=1/2) < PC/PW < a*lc/a*lw (=4) Each country specializes in the production of the good in which it has a CA. Home produces only cheese and Foreign produces only wine. Point 2 PC/PW = alc/alw Home must be producing both some wine and some cheese. The relative supply of cheese (Q ). Foreign does specialize completely in producing wine (the good in which it has a CA). For the moment, let s leave aside the possibility that one of the two countries does not completely specialize. Point 1 29

Trade in a One-Factor World Determining the Relative Price After Trade The normal result of trade is that the price of a traded good (cheese) relative to another good (wine) ends up somewhere in between its pretrade levels in the two countries. Convergence in relative prices Each country specializes in the production of that good in which it has relatively lower unit labor requirement. 30

Trade in a One-Factor World The Gains from Trade Assumption 4: Labor productivity varies across countries. Countries whose relative labor productivities differ across industries will specialize in the production of different goods. Specialization Gains from trade (1) Trade as an indirect method of production Home could produce wine directly: 1 hour of labor: 1/aLW gallons of wine (i.e., ½ gallons of wine) But trade with Foreign allows it to produce wine by producing cheese and then trading these cheese for wine. 1 hour of labor: 1/aLC pounds of cheese (i.e., 1 pound of cheese). This cheese can be traded for wine. Each pound trading for PC/PW gallons: (1/aLC)(PC/PW) gallons of wine Units: PC ($/pound), PW ($/gallon) This will be more wine than the hour could have produced directly as long as: (1/aLC)(PC/PW) > 1/aLW PC/PW > alc/alw 31

Trade in a One-Factor World The Gains from Trade Assumption 4: Labor productivity varies across countries. Countries whose relative labor productivities differ across industries will specialize in the production of different goods. Specialization Gains from trade (2) To examine how trade affects each country s possibilities for consumption. Autarky: consumption possibility frontier = PPF Home (solid line PF in Figure 3.4a). Foreign (solid line in P*F* in Figure 3.4b) Free trade Home s consumption possibilities (colored line TF in Figure 3.4a) Foreign s consumption possibilities (colored line T*F in Figure 3.4b) Trade has enlarged the range of choice, and therefore it must make residents of each country better of. 32

Trade in a One-Factor World Determining the Relative Price After Trade Figure 3.4: Trade expands consumption possibilities *This figure has been extracted from Krugman et al (2012), page 34. 33

Trade in a One-Factor World A Note on Relative Wages Remember: alc/alw < PC/PW < a*lc/a*lw Specialization Sector in which the country specializes Labor requeriments Productivity Home Cheese a=1 h/pound A=1 pound/h Foreign Wine a=3 h/gallon A=1/3 gallon/h Each worker should earn The value of one pound of cheese per hour. The value of 1/3 of a gallon of wine per hour To convert these numbers into dollar figures, we need to know the prices of cheese and wine. PC PW PC/PW wageh wagef Relative wages 12 12 1 12 12/3=4 12/4=3 Home is six times as productive as Foreign in cheese. Home is one-and-a-half times as productive in wine. BUT Home end up with a wage rate three times as high as Foreign s. 34

Trade in a One-Factor World A Note on Relative Wages The relative wage is between the relative productivities that each country end up with a cost advantage in one good. wage wage * a a * LW LC P P C W wage 3 wage * Cost advantage in the sector Reason Productivity Wage Home Cheese high high Foreign Wine low low 35

Box Do Wages Reflect Productivity? In our numerical example we assume that the relative wage of the two countries reflects the ratio of Home to Foreign wages is in a range that gives each country a cost advantage in one of the two goods. wage wage * a a * LW LC P P C W This is a necessary implication of our theoretical model. But rapid increases in productivity in emerging economies like China had worried some Western observes, who argue that these countries will continue to pay low wages even as their productivity increases putting high-wage countries at cost disadvantage. What is the evidence? 36

Box Do Wages Reflect Productivity? The figure compares estimates of productivity with estimates of wage rates. Year: 2007 Measures: percentages of U.S. levels. Productivity: GDP per workers measured in U.S. dollars. Wage rates: Wages in manufacturing. Real or nominal variables? Source: International Monetary Funds, Bureau of Labor Statistics, and the Conference Board. *This figure has been extracted from Krugman et al (2012), page 39. 37

Box Do Wages Reflect Productivity? If wages were exactly proportional to productivity, all the points would lie along the 45-degree line. The fit is not bad: A country s wage rate is strongly proportional to the country s productivity. China We are considering all manufactures. Theory of CA: Countries export the goods in which they have relatively high productivity. South Korea In 1975 South Korean wages were only 5 percent those of the United States. But when South Korea s productivity rose, so did its wage rate. In short, the evidence strongly supports economic models: productivity increases are reflected in wage increases. 38

Misconceptions About CA We have developed the simplest of all models of international trade. Even though the Ricardian one-factor model is far too simple to be a complete analysis of either the causes or the effects of international trade, a focus on relative labor productivities can be a very useful tool for thinking about trade issues. This simple model is a good way to deal with several common misconception about international trade. 40

Misconceptions About CA Productivity and Competitiveness Myth 1: Free trade is beneficial only if your country is strong to stand up to foreign competition. Even an unproductive country benefits from free trade by avoiding the high cost for goods it would otherwise have to produce domestically. High costs derive from inefficient use of resources. Essential point of Ricardo s model: gains from trade depend on comparative rather absolute advantage. CA: specializing in industries that use resources most efficiently. It is always tempting to suppose that the ability to export depends in your country having absolute advantage in productivity. The competitive advantage of an industry depends not only on its productivity relative to the foreign industry, but also on the domestic wage rate relative to foreign wage rate. 41

Misconceptions About CA The Pauper Labor Argument Myth 2: Foreign competition is unfair and hurts other countries when it is bases onlow wages. Argument used by labor unions seeking protection from foreign competition. High wage countries Trade may reduce wages for some workers Distribution of income. Trade benefits consumers and other workers. In our example: Home is more productive than Foreign in both industries. Foreign has a lower cots of wine production (due to low wages). All what matter to Home is that it is cheaper in term of its own labor to produce cheese and trade it for wine than to produce wine for itself. 42

Misconceptions About CA Exploitation Myth 3: Trade exploits a country and makes it worse off if its workers receive much lower wages than workers in other nations. Are low-wage workers and their country worse off exporting goods based on low wages than they would be if they refused to enter into such demeaning trade? What is the alternative? Let s see our example: Cheese Wine Other variables Home alc=1h, A=1 pound alw=2h, A=1/2 gallon PC/PW=1 Foreign a*lc=6h, A=1/6 pound a*lw=3h, A=1/3 gallon wageh=3wagef Foreign export wine (3h of work) and import cheese (1h of work). Thanks to the free trade Foreign can get 1 pound of cheese with 3 hours of works. In autarky it had needed 6 hours of work to produce that pound of cheese. 43

Empirical Evidence on the Ricardian Model Is the Ricardian model a good fit to the real world? Does the Ricardian model make accurate predictions about actual international trade flows? The answer is YES. Although, the model makes misleading prediction: 1) Extreme degree of specialization. 2) Countries as a whole will always gain from trade. International trade has strong effects on income distribution. 3) It does not take into account: Differences in resources among countries (Topic 4). Economies of scale (Topic 6) Transport costs and nontraded goods 45

Empirical Evidence on the Ricardian Model Two principal implications: 1) Productivity differences play an important roles in international trade. 2) It is comparative rather than absolute advantage that matters. Several classic tests of the Ricardian model, performed using data from the early post-wwii period, compared British with American productivity and trade. British labor productivity was lower than American productivity in almost every sector. The United States had an absolute advantage in everything. Nevertheless, the amount of overall British exports was about as large as the amount of American exports at the time. Britain had a CA in some sectors. 46

Empirical Evidence on the Ricardian Model Figure 3.6: Productivity and exports It uses data presented in a paper by Bela Balassa (1963).Year: 1959, manufacturing industries: 26 *This figure has been extracted from Krugman et al (2012), page 45. 47

Figure 3.6 Empirical Evidence on the Ricardian Model x-axis: Ratio of U.S. to British labor productivity (log) y-axis: Ratio of U.S: to British exports (log) The scatterplot lies quite close to an upward-sloping line. The higher the relative productivity in the U.S. industry, the more likely U.S. rather than U.K. firms would export in that industry. The evidence confirms the basic that trade depends on comparative, not absolute advantage. U.S: industry had much higher labor productivity than British economy on average about twice high. Commonly held misconception: Having high productivity in an industry compares with that of foreigner is not enough to ensure that a country will export that industry s products. The relative productivity must be high compared with relative productivity in other sectors. 48

Empirical Evidence on the Ricardian Model More recent evidence on the Ricardian model had been less clear-cut. In the world economy of the 21 st century, countries often do not produce goods for which they are at comparative disadvantage, so there is no way to measure their productivity in those sector. The emergence of China as an export powerhouse in some industries. Chinese labor productivity in manufacturing, although rising, remain very low by American or European standard. In some industries, however, the Chinese productivity disadvantage in not as large as it is on average and in these industries, China has become one of the world s largest produces and exporters. 49

Empirical Evidence on the Ricardian Model Table 3.3: China versus Germany, 1995 *This table has been extracted from Krugman et al (2012), page 47. 50

Empirical Evidence on the Ricardian Model Table 3.3 All manufacturing Apparel (clothing) -On average, Chinese productivity was only 5 percent that of Germany. -Total Chinese manufacturing output was almost 30 percent less than Germany s total manufacturing production. - Chinese productivity was closer to German levels. - Total China s appeal industry was eight times the size of Germany s apparel industry. -China still had an absolute disadvantage in clothing production. - But because China s relative productivity in apparel was so much higher than in other industries, China had a strong CA in apparel. 51

Empirical Evidence on the Ricardian Model Costinot and Donadlson (2012) Key explanatory variable in Ricardo s theory: relative productivity. Problem: Relative productivity is not always observed. They propose an original empirical strategy to test the Ricardo ideas. Agricultural sector Agronomic model potential productivity Database: 55 countries, 17 crops, year 1989 Identification strategy Parcels of land To compute a potential production (key variables: potential productivity and price) To compare the potential production and the actual production. Main result: They find a positive correlation between two variables. Then, the output predicted by Ricardo s theory of CA agree reasonably well with actual data on worldwide agricultural production. 52

Empirical Evidence on the Ricardian Model Example: Productivity wheat Variable: Potential production capacity. Technology: High. Water supply: irrigation. Source: GAEZ project 53

Empirical Evidence on the Ricardian Model Example: Productivity citrus Variable: Potential production capacity. Technology: High. Water supply: irrigation. Source: GAEZ project 54

Sources Costinot, A. and Donaldson, D. (2012): Ricardo s Theory of Comparative Advantage: Old Idea, New Evidence, American Economic Review: Papers and Proceeding, Vol. 102(3), pp. 456 458. Krugman, Obstfeld, and Melitz (2012): International Economics. Theory & Policy, Addison-Wesley, 9th ed., Chapter 3. 55