Chapter 2

Extend the Ricardo’s Model

1. Loose the assumptions of Ricardo’s Model

A. Review the Assumptions of Ricardo’s Model, Loose those assumptions and see what will happen to Ricardo’s model

B. Summary

2. Other extensions

Chapter 2

Review the Main Assumptions

1. 2*2*1 model: One input(L), Two outputs, Two countries

2. Costs are constant and there are no economies of scale.

3. Factors of production are perfectly mobile.

4. Perfect Competition (Goods are identical)5. No transaction costs (No transport costs,

No tariffs or other trade barriers, Perfect knowledge, etc)

Chapter 2

Loose the Assumptions 1(1)

One input Two or more inputs

H-O Model Specific Factor Model

Talk about it later

Chapter 2

Loose the Assumptions 1(2)

Two outputs &Two countries

Ricardo Model with Many

Goods or Many Countries

Ricardo’s model no essential change

1. Many Goods and Two Countries

2. Many Countries and Two Goods

Chapter 2

Many Goods and Two Countries 1. Setting up the model: list relative

productivity by order (note: * is US)

2. Deriving the relative demand for labor3. Determining the relative wage4. Determining the comparative advantages

**LiLi ww *

*

w

wa

Li

Li

If or than china has

advantage in product i

*/ ww

αL1*/ αL1> αL2

*/ αL2>…… > αLi*/ αLi

Chapter 2

Example

If = 5 ， then China has advantage in apple and Banana, US has advantage in other three goods;

If =4,then China and US both can produce caviar; If =1 ， then China can export apple, banana, caviar and Dates.

*/ ww

*/ ww*/ ww

Chapter 2

Many Countries and Two Goods

1. Setting up the model: list relative costs by order

2. Deriving the relative supply3. Determining the relative price4. Determining the comparative

advantages

1

LW

LR

a

a

2

LW

LR

a

a

NLW

LR

a

a

< <…<

Chapter 2

Principle

In the case of two products and many countries, one

country’s comparative advantage is determined by

the relative costs of the products it produces

and the relative price in the world market .

If < , this country has comparative

advantage in product 1.

21 / LL

21 / PP

21 / LL 21 / PP

Chapter 2

Example

USAFrance

ChinaThailand

NationL per Unit Relative cost

Rice Wheat

Suppose the relative price of Rice in equilibrium is 2,

then Thailand and China produce and export Rice, while

USA and France produce and export Wheat.

Chapter 2

Determining the relative price

Relative productions of Rice

Relative Demand

Relative price of Rice

4

2.5

2

1.5

1

Relative Supply

Chapter 2

Determining the relative price

Relative price of Rice is determined by the produce capability of Thailand in Rice, that of USA in Wheat and the relative demand of 4 countries.

If the produce capability of Thailand in Rice is strong, while that of USA in Wheat is weak, the relative supply of Rice is large; or else it is small.

Chapter 2

Determining the relative price

When the relative demand of Rice is given, the larger the relative supply of Rice is, the lower the relative price of Rice in equilibrium, and the less countries Rice productions will need, even just Thailand is enough.

But if the produce capability of USA in Wheat is strong, while that of Thailand in Rice is weak, the relative price of Rice will be higher.

Chapter 2

Loose the Assumptions 2(1)

Costs are constant

Increasing opportunity costs or decreasing returns to scale

QC

QW

PPFQC

QW

PPF

Chapter 2

International Trade under Increasing Opportunity Cost

1. Autarky2. The Patten of Production and Tra

de3. Comparison4. Conclusion

Chapter 2

Autarky

4

1Ap

y

x

0E

Home

y

x

4Bp

0'E

Foreign

Chapter 2

The Patten of Production and Trade

4

1Ap

y

x

0E

Home

C

1WORLDPTOT=

Export

Import

P

x

y

4Bp0'E

Foreign

C’

1WORLDPTOT=

Export

Import

P’

Chapter 2

Comparison

Constant Cost Increasing Opportunity Cost

y

x4

1Ap

0E

Home

C

4

1Ap

y

x

0E

Home

C1WORLDPTOT=

1WORLDPTOT=

Import

Export

Export

Import

Chapter 2

Conclusion

The principle of comparative advantage is still effective under the increasing opportunity cost.

However, pure specialization is impossible.

Chapter 2

Loose the Assumptions 2(2)

Costs are constant

Decreasing opportunity costs or decreasing returns to scale

QC

QW

PPFQC

QW

PPF

Chapter 2

Trade gains under decreasing costs

QC

QW

PPF

A

B

A’

B’C’

CTrade gain TOT

Chapter 2

Loose the Assumptions 2(3)

No economies

of scale

Economics-of-scale and imperfect

competition model

Talk about it later

Chapter 2

Loose the Assumptions 3

Factors of production are

perfectly mobile

Factors of production can’t move freely among sectors

Transfer Costs

Industry Obstruct

Increasing the production costs of export

Reduce the volume of

international trade

Chapter 2

Loose the Assumptions 4

Goods are identical

Goods are idiosyncratic

Intra-sector Trade

Talk about it later

Chapter 2

Loose the Assumptions 5(1)

Perfect knowledge

Imperfect knowledge

More difficult to find the right goods and reach contractions

Reduce the volume of

international trade

Chapter 2

Loose the Assumptions 5(2)

No transport costs

transport costs

Non-traded Goods

Reduce the volume of

international trade

Chapter 2

Loose the Assumptions 5(3)

No tariffs or other trade

barriers

Trade Barriers

Increasing the Transaction

Costs

Reduce the volume of

international trade

Talk about it later

Chapter 2

Summary

1. Loosing some assumptions of Ricardian Model will not affect the Law of Comparative Advantage substantially, but increase the transaction costs in international trade, and lead to imperfect specialization, reduce the volume of international trade.

2. But loosing the assumptions that goods are identical and there are no economies of scale is the base of intra-sector trade and economics-of-scale model.

Chapter 2

Increasing Transaction Costs

1. What is transaction costs?—— expenses of searching for a trading

partner, specifying the product(s) to be traded, negotiating the price and contract,and the ex post costs.

2. Who find the “transaction costs”?3. Reasons of transaction costs especially in IT Imperfect Information(Knowledge) Transport Cost Trade Barrier Political Risk

Chapter 2

Ronald H. Coase1. Great Britain

2. University of Chicago, USA

3. Major Work

“The Firm ， the Market ， and the Law”

“The Nature of the Firm”

Chapter 2

Trade gains with transaction costs

Before trade (autarky) A country: 1 Wheat=a Cloth B country: 1 Wheat=b Cloth1 Cloth=1/b Wheat

After tradeTOT: 1 Wheat=P Cloth1 Cloth=1/P Wheat Transaction costs: F per unit Wheat or Cloth

A country: exchange 1 Wheat not less than a Cloth, ie P-F>a

B country: exchange 1 Cloth not less than 1/b Wheat, ie (1/P)-F>1/b

Chapter 2Trade with transaction costs and increasing opportunity

costs

y

xO

A

P

P’

CC’

A: no trade

P & C: Productions & Consumptions under trade without transaction costs

P’ & C’: Productions & Consumptions under trade with transaction costs

TOTTOT-F

Chapter 2

Imperfect Specialization

1. Increasing Opportunity Cost2. Transaction Costs3. The Size of Trader (talk about it later)4. The existence of more than one factor

of production reduce the tendency toward specialization

Chapter 2

Other Extensions for Ricardian’s Model

1. Trade Between Big Country and Small Country

2. Trade with Currency (not barter)

Chapter 2

Trade Between Big Country and Small Country

There is an implicit assumption in Ricardian two-country model that the size of the two countries are similar, so they can give up the productions without comparative advantage, and input all the resources to the production with comparative advantage.

But in reality, the size of the trading countries may be very different. For example, China’s population as well as land is hundreds of times of Sri Lanka’s, so even China has comparative advantage in Cloth, while Sri Lanka in Wheat, China can’t produce Cloth only under free trade. Because even all Wheat produced by Sri Lanka are exported to China, they still can’t meet the consumption need in China.

Chapter 2

Trade Between Big Country and Small Country

So， If trade happens between big country and small country, small country can only produce the product with comparative advantage, but big country still need to produce both products.

Case Study:Who will feed China?

Chapter 2

Imperfect Specialization for Big and Small Countries

QCO QC

P

Qw

Qw

O

C

P

China

Sri Lanka

TOT

TOT

Chapter 2

Trade with Currency

Suppose RMB/Dollar=X

For Bicycle, if 100X>400(ie X>4), no trade in Bicycle and Toy(25×4 ＝ 100>50);

For Toy, if 25X<50(ie X<2), no trade in Toy and Bicycle(100×2 ＝ 200<400).

So X must be between 2 and 4, if there is trade

Bicycle Toy

USA (Dollar)

100 25

China (RMB)

400 50