2.1 Comparative advantage and the Ricardian model

The Ricardian model explains how countries benefit from trade by specializing in goods they produce most efficiently. It introduces the concept of comparative advantage, where nations focus on making products with the lowest opportunity cost relative to other countries.

This model simplifies trade to two countries and two goods, assuming labor as the only production factor. By specializing and trading based on comparative advantage, both nations can consume beyond their own production possibilities, leading to increased global output and welfare gains.

Comparative Advantage and the Ricardian Model

Concept of comparative advantage

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• Comparative advantage arises when a country can produce a good at a lower opportunity cost compared to another country
  • Opportunity cost represents the amount of other goods that must be forgone to produce one additional unit of a particular good
  • Measured in terms of the units of one good given up to produce an extra unit of another good (wine vs. cloth)
• Plays a crucial role in determining the pattern of international trade
  • Countries should specialize in producing and exporting goods for which they have a comparative advantage (France: wine)
  • Countries should import goods for which they have a comparative disadvantage (England: cloth)
• Specialization based on comparative advantage results in increased global output and welfare gains for all countries engaged in trade
  • Allows countries to consume beyond their domestic production possibilities frontier (PPF)

Ricardian model assumptions

• Simplified model of international trade based on the concept of comparative advantage
• Key assumptions:
  • Two countries (England and Portugal) and two goods (wine and cloth)
  • Labor is the only factor of production and is homogeneous within each country
  • Constant returns to scale in production, meaning doubling inputs doubles output
  • Perfect competition in both product and factor markets, ensuring price equals marginal cost
  • No transportation costs or trade barriers, allowing for frictionless trade
  • Labor productivity differs across countries due to technological differences (Portugal is more productive in both goods)
• These assumptions allow for a clear analysis of comparative advantage and the benefits of specialization and trade

Opportunity costs in trade

• Opportunity cost is the key determinant of comparative advantage in the Ricardian model
• Calculated as the ratio of units of one good given up to produce an additional unit of another good
  • $\text{Opportunity cost} = \frac{\text{Units of good y given up}}{\text{Units of good x produced}}$
  • If Portugal must give up 1.5 units of cloth to produce 1 unit of wine, its opportunity cost of wine is 1.5 units of cloth
• Comparative advantage is determined by comparing opportunity costs across countries
  • The country with the lower opportunity cost for a good has a comparative advantage in producing that good (Portugal: wine, England: cloth)
  • Countries should specialize in producing and exporting the good for which they have a comparative advantage

Specialization and trade gains

• Specialization occurs when countries allocate resources towards producing goods for which they have a comparative advantage
  • Enables countries to produce these goods more efficiently by exploiting their relative productivity differences
• Gains from trade arise as specialization allows countries to consume beyond their domestic production possibilities
  • Countries export goods they produce efficiently and import goods they produce less efficiently (Portugal exports wine, England exports cloth)
  • Trade based on comparative advantage leads to increased global output and consumption, benefiting all countries involved
• The Ricardian model demonstrates how differences in labor productivity lead to comparative advantage and gains from trade
  • By engaging in trade and specializing based on comparative advantage, countries can achieve higher welfare than in autarky (no trade)
  • Consumers gain access to a wider variety of goods at lower prices, while producers can expand their markets beyond domestic borders