Comparative Advantage Ricardo
10 important questions on Comparative Advantage Ricardo
Theories of trade can be grouped into two categories. Name them.
(1) Models emphasizing differences between countries as the main driver of trade
- differences in labor skills, natural resources, physical capital and technology create productive advantages for countries
- examples: norway trades frish for oranges and saudi arabia trades oil for ipad
(2) Models emphasizing economies of scale
- no a priori differences between countries, but more efficient if each country specializes in a few products only, benefitting from economies of scale
- Examples: sweden trades volvo's for audi's and italy trades sunglasses for TV's
In the real world trade patterns are determined by all these forces. To understand the causes and effects of trade it is useful to look at models that focus on one particular motive for trade separately.
Each model has predicitions whose relevance can be verified empricially. No model can explain everything, but each has important things to say about trade and its effects. Name four different models with a short definition.
- Ricardian model = trade arises because of differences in relative labor productivity between countries (due to e.g. technological differences)
- Specific factors model = allows us to assess the effects of trade on the distribution of income within a country
- Heckscher- Ohlin Model = Trade arises because of differences in the relative endowment of factors of production between countries (e.g. land, labor, skills)
- Economies of scale = can explain why a priori similar countries end up producing different goods, trading them with each other
Example for opportunity costs: A limited amount of workers could be employed to produce either roses or computers. Explain the opportunity costs in this case.
The opportunity cost of producing computers is the amount of roses not produced with the workers now used to produce computers. The opportunity cost of producing roses is the amount of computers not produced with the workers now used to produce roses.
The country faces a trade off: how many roses and computers to produce using the limited amount of resources that it has?
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Explain the link between opportunity cost and comparative advantage.
Opportunity cost and comparative advantage are two crucial concepts in the Ricardian Model.
Opportunity cost are the crucial ingredients to say something about comparative advantage. A country has a comparative advantage in producing goods if the opportunity cost of producing that good is lower in that country than in other countries.
Describe the connection between trade and comparative advantage. What are the gains of trade?
When countries specialiue in production in which they have a comparative advantage, and trade, more goods and services can be produced and consumed, compared to the situation where each country makes all goods and services itself.
Describe the assumptions in the one-factor Ricardian Model.
Assumptions:
- Labor is the only factor of production
- Labor productivity varies across countries due to differences in technology, but labor productivity in each country is constant
- The supply of labor in each country is constant
- The only two goods are important for production and consumption
- Perfect competition between firms
- Perfect labor mobility between sectors
- The world consists of two countries: home and foreign
Explain the dependency of production possibilities in one country.
The production possibility in each country depends on:
- the amount of labor available in the country
- how many hours of work are needed to produce in one unit of cheese or one unit of wine (unit labor requirement)
- a high unit labor requirement = low productivity
Describe the components of the production possibilities frontier of the home economy: aLCQC + aLWQW ≤ L
QC = Total pounds of cheese produced
aLW = Labor required for each gallon of wine produced
QW = Total gallons of wine produced
L =Total amount of labor resources
The production possibilities frontier describes what an economy can produce, but to determine what an economy does produce, we must know the prices of the goods. Why?
Because prices determine how many hours people will spend working in producing each good
Even if a country is the most or least efficient producer of all goods, it can still benefit from trade. Why?
It is comparative advantage, not absolute advantage that matters.
Remember: a country with a comparative advantage in producing a good uses its resources most efficiently when it produces that good compared to producing other goods. A country may be more efficient in producing both goods, but can only have a comparative advantage in one good.
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