Technology and Trade

The Ricardian Model

Dr. Anwesha Aditya
IIT Kharagpur
 Ricardian Model
• David Ricardo (1817) argued that the pattern of trade will be determined by the
methods of production available in the trading nations, and that trade will increase
the “mass of commodities and, therefore, the sum of enjoyments.

• Technology asymmetry across countries as a basis of trade was emphasized in

Adam Smith’s doctrine of absolute advantage, Ricardo offered a more general
explanation in his doctrine of comparative cost advantage.
 Structure of Ricardo Model
2X2X1 structure : Two Countries producing two goods, computers and cotton
textiles using only one factor of production labour with a fixed coefficient
technology.

T C

L
 Assumptions

• Fixed coefficient technology.

• Homogeneous labour can move freely between two sectors (Implication: workers earn the same wage).

• Different production technology across the two sectors.

• Production functions are characterized by constant cost & CRS.

• Perfectly competitive market.

• Production Technology is different for two sectors of production which is reflected in different labour-output ratios.
 Cntd.
Suppose aLj units of labour are required to produce one unit of jth good.

A technological improvement in the computer sector means a smaller number of workers can produce one unit of computer.
Output levels:

LC
XC =
a LC

LT
XT =
a LT
 The Model
Zero profit conditions under perfectly competitive market conditions

PC = aLC W
PT = aLT W

PC a LC
=
Pre-trade price ratio: PT a LT

Labour theory of value: the relative price of commodities reflect the ratio of labour embodied in these
commodities.
Note that pre-trade price ratio is independent of the domestic demand condition (follows from the
assumption of constant costs).

The fixed coefficient production function implies that the marginal cost of production is invariant
with the increase in the scale of production, and thus the cost-price under perfectly competitive
condition is constant for any given money wage.
 Post-Trade

The trade between HC and FC will be determined entirely by the technology asymmetry across these
countries.

Assuming similar production conditions prevailing in Foreign country, the pre-trade relative price ratios there
would be, PC* a LC
*
=
PT* *
a LT *
a LC a LC
Suppose, the FC has a relatively superior technology in the production of computer: > *
a LT a LT

That is, FC has comparative cost advantage in producing computers whereas HC has comparative cost
advantage in producing textiles.
Thus, through arbitrage, the Home country exports textiles and imports computers.
A higher relative price of textiles in the Foreign country encourages producers to
expand textiles production at Home whereas cheaper imports of computers from
abroad lowers production of computers there.

Workers thus move out of the computers sectors and into the textiles sector.

Initial price differences are wiped out through arbitrage and consequent movements of
goods across these countries.
A larger labour force of the Home country shifts out its PPF, as the economy would now be able to produce
larger quantities of both goods.

L = a LC X C + a LT X T
*
L = a LC
*
X C* + a LT
*
X T*

For this post-trade equilibrium with completely specialization in different goods by the Home and the Foreign
countries, the relevant zero profit conditions in the two countries imply the following equality:

PTW a LT w
W
= * . *
PC a LC w

PTW
is the world relative price of textiles or the commodity TOT
PCW
The pre-trade and post-trade equilibria

Computers

M*

M
B* A* E

Textiles
B N* N
 MN and M*N* are the PPFs of HC and FC, respectively.

The pre-trade production points are A and A* for HC and FC, respectively.
The post trade uniform relative price is shown by (the absolute slope of) the broken line M*N.
Production in HC shifts to N with complete specialization in textiles and in the FC to M* with complete
specialization in computers.

The post-trade consumption shifts to E, with the Home country exporting BN units of textiles in exchange for
B*M* (= BE) units of computers.
The Home wage relative to the Foreign wage, known as the double factoral TOT, is determined by
the production technologies for the goods in which they completely specialize and by the
commodity TOT:

*
w a LC PTW
*
=
w a LT PCW
 Role of Relative Size of Trading Nations and Distribution of GFT

• Ricardo argued that all the gains from trade will accrue to such a small country when it trades
with nation that export and import relatively larger volumes.
• The larger country in this sense cannot specialize completely, because if it does, then its demand for
the other good cannot be met by imports from a smaller trading partner. Consequently, it will
not experience any terms of trade improvement after trade and therefore will not gain.

Home Imports of Computers

K1*
H
F′
E

K 0*
F
K

Figure 5.2: Country Size and Terms of Trade