Ricardian Model

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Comparative advantage
Ricardian model as the foundation of trade theory

Comparative advantage concept

If Indonesia is an agrarian country, why import soybeans?
- “… (profit from planting soybean) far below planting corn and rice padi dan jagung.” (kompas)
Meanwhile, “Indonesian consumers have developed a preference for U.S. soybeans due in part to their uniform size, color and suitability for tempeh and tofu manufacturing.” (ussoy.org)
tempe exports to Jepang and Amerika Serikat

Ricardian model

1 factor: labour.
2 goods: Apple (A) and Banana (B).
Technology is represented by unit labor requirement $a_i,\ i \in {A,B}$
- How many man-hour required to produce a good.
- Lower number is better.
- $a_{A}$ for apel, $a_{B}$ for banana.

Ekonomi dengan 1 faktor produksi

Total labour supply $= L$
$a_{A}Q_A =$ total man-hour required to produce $Q_A$ amount of apples.
$a_{B}Q_B =$ total man-hour required to produce $Q_B$ amount of bananas.
Budget constraint:

$a_{A}Q_A + a_{B}Q_B \leq L$

Production Possibility Frontier

Let there be a country H where:
- $a_A=$ 1 and $a_B=$ 2.
- Country H has 1000 man-hour in total, i.e., $(L=1000)$
- If all L is dedicated to make A, then $Q_A,Q_B=\{1000,0\}$
- If it’s the opposite, then $Q_A,Q_B=\{0,500\}$
We have a case of linear PPF $\Rightarrow$ constant opportunity cost.
- Producing 1 A = not producing $\frac{1}{2}$ B
- Producing 1 B = not producing 2 As.

$1Q_A + 2Q_B \leq 1000$

PPF and Relative Prices

A simple labor theory of value:

In the absence of international trade, the relative prices of goods are equal to their relative unit labor requirements.

if $P_A=P_B$ , better concentrate on making A:
- wage $={1000\times P_A} \geq 500 \times P_B$
workers are better off making B only if $P_A < \frac{1}{2}P_B$
- workers only produce both iff $P_A = \frac{1}{2}P_B$
equilibrium is at $\frac{a_A}{a_B}=\frac{P_A}{P_B}$

Introducing trade

Suppose there are two economies, IDN and USA, and two goods, textiles (T) and soybean (S). Still 1 factor of production maxed 200.
Tech is the same but since now we have countries, we have $a^i_j=$ the number of man-hour required to make 1 good $i$ in country $j$ .
say we have $a^S_{IDN}=1$ , $a^T_{IDN}=4$ . $a^S_{USA}=a^T_{USA}=2$

$\begin{equation} \label{eq1} \begin{split} IDN: \ 1T+4S&=200 \\ USA: \ 2T+2S & = 200 \end{split} \end{equation}$

2 countries in autarky

$\begin{equation} \label{eq2} \begin{split} IDN: \ 1T+4S&=200 \\ USA: \ 2T+2S & = 200 \end{split} \end{equation}$

Produce	US opportunity cost	IDN opportunity cost
1 ton of textiles	1 ton of soybean	250 kg of soybean
1 ton of soybean	1 ton of textiles	4 ton of textiles

IDN is comparatively better at making textiles, while US is better at producing soybean:
- To make 1 ton of textiles, US needs to gave up resources which can be used to make 1 ton soybean, while IDN need only to give up 250 kg soybean.
- To make 1 ton of soybean, US needs to gave up resources which can be used to make 1 ton textiles, while IDN need only to give up 4 ton of textiles.
Note:

$\frac{a^T_{IDN}}{a^T_{US}}=\frac{1}{2} \leq \frac{4}{2}=\frac{a^S_{IDN}}{a^S_{US}}$

Some notes

before we go, to get a complete set of best production, we needs either preferences or prices of both countries.
To simplify things, we chose arbitrary number of initial allocations, and see if trade would improve those initials.
- i.e., the marginal thinking. Economists’ favorite.
- we can argue that these numbers of initial allocations were derived from a set of preferences.
- ergo, this simplification is still robust.

Suppose the two countries do not trade. IDN produces {T,S}={100,25}, While in US, it’s {50,50}.

Gains from trade

		in autarky		with trade
		production	consumption	production	consumption	Gains from trade
USA	textiles (ton)	50	50	0	75.0	+25
USA	soybean (ton)	50	50	100	62.5	+12.5
IDN	textiles (ton)	100	100	200	125.0	+25
IDN	soybean (ton)	25	25	0	37.5	+12.5

By concentrating production on one good and then trade, you can see that both ended up better-off:

with autarky, total production {textiles,soybean} $=\{150,75\}$
consumption=production, and $C_{USA} = \{50,50\},C_{IDN} = \{100,25\}$

Gains from trade

		in autarky		with trade
		production	consumption	production	consumption	Gains from trade
USA	textiles (ton)	50	50	0	75.0	+25
USA	soybean (ton)	50	50	100	62.5	+12.5
IDN	textiles (ton)	100	100	200	125.0	+25
IDN	soybean (ton)	25	25	0	37.5	+12.5

with trade, total production {textiles,soybean} $=\{200,100\}$
- Production $\Rightarrow Q_{USA}=\{0,100\}, Q_{IDN}=\{200,0\}$
- Consumption $\Rightarrow C_{USA}=\{75,62.5\}, C_{IDN}=\{125,37.5\}$

Gains from trade

In the autarky, we consume what we produce.
In trade, it is possible to produce more AND less than we consume
That is, the reason why IDN produce textiles much more than it can wear is because it also serves the US.
Then how it feed itself? By buying from the US.
In this model, the only reason to export is to import!

Comparative advantage

In reality, we will need country’s preferences to establish proper equilibrium quantity and prices.
In this model, we have no price. But from the opportunity cost, we can calculate the relative prices:
- In the US, opportunity cost to produce 1 soybean is 1 textile. That means, $P^{soybean}_{USA} = P^{textile}_{USA}$
- In IDN, opportunity cost to make 1 soybean is 4 textiles. That means, the price of soybean must be four times price of textile.

Comparative advantage

Note that in autarky, both countries consume (and produce) with the same proportion as their unit labor cost.
With trade, both countries produce with 1:2 proportion
- their consumptions are skewed toward 1:2
This reflects the change in relative prices:
- with trade, textile gets relatively cheaper in US.
- in IDN, soybean gets a bit cheaper (from 1:4 to around 1:3.33)

Comparative VS Absolute advantage

A country is said to have a comparative advantage of good i over another country if said country have lower opportunity cost of making good i compared to the other country.
This is different than absolute advantage: a country is said to have an absolute advantage of good i if that country is more efficient at making good i than other countries.
In our example, IDN has absolute advantage on T, while US on S.
What if US has absolute advantage on both? Would trade still better for US?

Absolute advantage

Suppose USA dominates IDN in both:

$\begin{equation} \label{eq3} \begin{split} IDN: \ 2.5T+4S&=200 \\ USA: \ 2T+2S & = 200 \end{split} \end{equation}$

Autarky: $Q_{USA}=\{50,50\}, Q_{IDN}=\{40,25\}$
Trade: $Q_{USA}=\{10,90\}, Q_{IDN}=\{80,0\}$
Total: $Q_{autarky}=\{90,75\}, Q_{trade}=\{90,90\}$
Since trade produces more global goods, both can improve their consumption bundles.

A note on absolute advantage

You may notice that absolute advantage is just a version of Walras’ Law.
that is, even if one party has more on both goods, contract curve & better allocation still exist (hence pareto improvement).
- Absolute advantage is basically the same as a country having more allocation on both goods.
trade is pareto improving in the sense that we compare country A before trade with country A after trade.
- we do not compare country A with country B.

Taking from the poor?

In short, because IDNsians are less productive compared to the US, it’s better to US to buy cheaper goods to IDN.
This is not to say that US take advantage from IDN:
- Since IDN labour is less productive anyway, they will still have low wage even if they sell domestically.
- In fact, serving US market may give them higher wage.
For example, if you feel ordering go-food is taking advantage from tukang ojeg, the alternative is even worse:
- if you ended up stop ordering go-food, their income is gone.

What determines a?

Differences in climate is the reason why Indonesians are so good at producing CPO and rubber, but sucks at producing soybean and wheat.
Differences in Factor Endowment. Some countries are endowed with natural resource, some with cheap labour. Countries which has no both has to find something else, such as:
Differences in technology. Japan, South Korea and Taiwan are good examples. While technology can be transferred, opportunity cost of investing in high-tech products are more production of CPOs.

Trade is Good

So, absolute advantage does not prevent trade.
Even if it does prevent trade, autarky will happen anyway.
- autarky isn’t bad per se. It’s forced autarky that’s the problem.
Is this true though? If trade and specialisation is so good, why we don’t always observe this?

What prevents specialisation?

More than 1 factors
Protectionisms.
- more on this later.
Transportation cost.
- Some places are inherently difficult to reach.
- Some goods are harder to move.
at the extreme, a good can be nontradable good.
- most services are like this.

What prevents specialisation?

Ricardian model: 1 very mobile factor of production.
In reality, trade matters in distribution of income.
- short-run: moving factors are costly.
- long-run: shift in factor demand.
Factor owners (land, labor, capital, etc) receive different gains from trade!

Japanese rice farmer case:

Land scarcity -> rice is expensive (even compared to US).
Free trade means higher real wage.
Farmers may need to move industries.
- reskilling is costly.
- land value drops.
- machines & infrastructure become useless.
Better spend money to organize politically!

Specific factors

Next, we add one more factor to the model: a specific factor.
Labor can move between sectors, but this one other factor is specific to the sector, hence can’t move freely.
- just like our Japanese farmers!
We will also discuss a bit what is this specific factor of production in reality.

via GIPHY