Revisiting Ricardo's Example Ricardo (1817) posited a world of two countries, England and Portugal, whiclh can make each of two goods, cloth and wine. What he assumed about how many workers it takes to make a unit of each good in each country appears in Table 1 Since the workers required to make one unit of a good are the same no matter hov many units are produced, Ricardo was assuming constant returns to scale Ricardo argued that trade could allow England to obtain a unit of wine with the effort of only 100 workers (instead of 120) and Portugal to obtain a unit of cloth with the effort of only 80 workers (instead of 90)-the outcome if international trade established an international price of 1 unit of cloth exchanging for 1 unit of wine Of course, to our twenty-first century eyes, Ricardo's example is very incomplete For example, he does not explain what assumptions about tastes, endowments, or competition are needed for this world price ratio of 1 to arise. However, in using this example Ricardo was advocating policy in a very modern way. He compared an actual world with one policytrade prohibited-with a counterfactual world of free trade. In making the comparison, he described each world in terms of a common set of parameters, the labor requirements in Table 1, that are plausibly exogenous to the policy in question, thus immunizing himself to the Lucas critique (1976) of the following century. Why, when the Ricardian model delivers such a slick demonstration of the gains from trade, did it hit such a dead end in terms of providing a framework for more sophisticated and quantitatively meaningful analysis? A major reason is that even this basic formulation gives rise to different types of equilibria that need to be analyzed separately. Even in Ricardo's minimalist setting, three types of outcomes are possible 1) England makes only cloth and Portugal only wine, 2) England makes both cloth and wine and Portugal only wine, or 3) England makes only cloth and Portugal both We were unable to transcribe this imageboth cloth and wine will be produced more cheaply in Portugal, leaving English labor out of work. Hence an English wage that is more than 90 percent of the Portuguese wage is not compatible with employment in England. At the other extreme, if w is smaller than 80/120, then both cloth and wine will be cheaper if made in England, putting Portuguese labor out of work. Hence we need to be somewhere in between 2/3 and 9/10. (Because Ricardo granted Portugal an absolute advantage in both goods, he doomed English workers to a lower wage in order to be employed.) The idea that a Ricardian equilibrium involves identifying the source that can supply a good at minimum cost is at the heart of taking the model to more goods and countries Any hope of applying this example to actual world trade requires adding more goods and countries. How can we do that? Let's proceed step by step More Goods Let's add another good, linen, while sticking with just our two countries. Say England needs 100 workers to make a unit of linen, and Portugal needs 100 workers as well. These numbers grant England an even stronger comparative advantage in linen than in cloth. We can extend the previous inequality to 100 100 90 100 80 120 (linen (cloth (ine) This ordering of goods in terms of England's relative productivity is called a chain of comparative advantage. Under free trade, the English relative wage w breaks this chain between goods for which England's relative productivity is above or below its relative wage. The goods to the left of the break are produced more cheaply in England and those to the right of the break are produced more cheaply in Portugal. For example, an ω of .95 breaks the chain between linen (produced more cheaply in England) and cloth and wine (cheaper from Portugal). An ω of .9 breaks it at cloth (costing the same from either country, with linen cheaper from England and wine cheaper from Portugal) what determines the relative wage ω that breaks the chain? In general, finding it can be quite complicated but, if the two countries spend their income the same way (specifically, if tastes are identical and homothetic), the problem simplifies. We can then use the chain of comparative advantage to construct the demand curve for English labor relative to world labor (on the x-axis) as it varies with the English wage w (on the y-axis Ifw>1, then English labor has priced itselfout of all goods. Hence, the demand curve is just a vertical line at zero for w above England's relative productivity for good i. At a wage ω-1, England is competitive in linen, and buyers are indifferent between England and Portugal as a source. The demand curve for English labor is then flat (perfectly elastic) between zero and the point at which the demand for linen is saturated at the price of 100. A decline in from this point renders England the sole producer of linen. Since the price of linen is 100w, a drop in w lowers the price 1. What creates benefits from trade? 2. In David Ricardo's international trade example, which country has the absolute advantage in making both wine and cloth? Which country has the comparative advantage in making wine? Which country has the comparative advantage in making cloth? 3. In the trade scenarios you have dealt with so far, wages are left out of the picture. Thus, even after completing some of the exercises in the textbook, you might still retain the incorrect belief that a rich country cannot possibly gain from trade with a low-wage country. So let's consider wages, just as Ricardo did. The authors of this article assume Portugal's wage is set at 1, then they investigate which wages in England would give rise to beneficial trade agreements between the two countries. So, first question: Would England and Portugal both agree to trade with each other if England's wage is also w 1-100/100? Why or why not? 4. Now suppose that England's wage is w = 0.75 = 90/ 120, Would the two countries agree to trade with each other now? 5. Explain why the two countries will not agree to trade if England's wage is w- 0.5- 60/120. Revisiting Ricardo's Example Ricardo (1817) posited a world of two countries, England and Portugal, whiclh can make each of two goods, cloth and wine. What he assumed about how many workers it takes to make a unit of each good in each country appears in Table 1 Since the workers required to make one unit of a good are the same no matter hov many units are produced, Ricardo was assuming constant returns to scale Ricardo argued that trade could allow England to obtain a unit of wine with the effort of only 100 workers (instead of 120) and Portugal to obtain a unit of cloth with the effort of only 80 workers (instead of 90)-the outcome if international trade established an international price of 1 unit of cloth exchanging for 1 unit of wine Of course, to our twenty-first century eyes, Ricardo's example is very incomplete For example, he does not explain what assumptions about tastes, endowments, or competition are needed for this world price ratio of 1 to arise. However, in using this example Ricardo was advocating policy in a very modern way. He compared an actual world with one policytrade prohibited-with a counterfactual world of free trade. In making the comparison, he described each world in terms of a common set of parameters, the labor requirements in Table 1, that are plausibly exogenous to the policy in question, thus immunizing himself to the Lucas critique (1976) of the following century. Why, when the Ricardian model delivers such a slick demonstration of the gains from trade, did it hit such a dead end in terms of providing a framework for more sophisticated and quantitatively meaningful analysis? A major reason is that even this basic formulation gives rise to different types of equilibria that need to be analyzed separately. Even in Ricardo's minimalist setting, three types of outcomes are possible 1) England makes only cloth and Portugal only wine, 2) England makes both cloth and wine and Portugal only wine, or 3) England makes only cloth and Portugal both both cloth and wine will be produced more cheaply in Portugal, leaving English labor out of work. Hence an English wage that is more than 90 percent of the Portuguese wage is not compatible with employment in England. At the other extreme, if w is smaller than 80/120, then both cloth and wine will be cheaper if made in England, putting Portuguese labor out of work. Hence we need to be somewhere in between 2/3 and 9/10. (Because Ricardo granted Portugal an absolute advantage in both goods, he doomed English workers to a lower wage in order to be employed.) The idea that a Ricardian equilibrium involves identifying the source that can supply a good at minimum cost is at the heart of taking the model to more goods and countries Any hope of applying this example to actual world trade requires adding more goods and countries. How can we do that? Let's proceed step by step More Goods Let's add another good, linen, while sticking with just our two countries. Say England needs 100 workers to make a unit of linen, and Portugal needs 100 workers as well. These numbers grant England an even stronger comparative advantage in linen than in cloth. We can extend the previous inequality to 100 100 90 100 80 120 (linen (cloth (ine) This ordering of goods in terms of England's relative productivity is called a chain of comparative advantage. Under free trade, the English relative wage w breaks this chain between goods for which England's relative productivity is above or below its relative wage. The goods to the left of the break are produced more cheaply in England and those to the right of the break are produced more cheaply in Portugal. For example, an ω of .95 breaks the chain between linen (produced more cheaply in England) and cloth and wine (cheaper from Portugal). An ω of .9 breaks it at cloth (costing the same from either country, with linen cheaper from England and wine cheaper from Portugal) what determines the relative wage ω that breaks the chain? In general, finding it can be quite complicated but, if the two countries spend their income the same way (specifically, if tastes are identical and homothetic), the problem simplifies. We can then use the chain of comparative advantage to construct the demand curve for English labor relative to world labor (on the x-axis) as it varies with the English wage w (on the y-axis Ifw>1, then English labor has priced itselfout of all goods. Hence, the demand curve is just a vertical line at zero for w above England's relative productivity for good i. At a wage ω-1, England is competitive in linen, and buyers are indifferent between England and Portugal as a source. The demand curve for English labor is then flat (perfectly elastic) between zero and the point at which the demand for linen is saturated at the price of 100. A decline in from this point renders England the sole producer of linen. Since the price of linen is 100w, a drop in w lowers the price 1. What creates benefits from trade? 2. In David Ricardo's international trade example, which country has the absolute advantage in making both wine and cloth? Which country has the comparative advantage in making wine? Which country has the comparative advantage in making cloth? 3. In the trade scenarios you have dealt with so far, wages are left out of the picture. Thus, even after completing some of the exercises in the textbook, you might still retain the incorrect belief that a rich country cannot possibly gain from trade with a low-wage country. So let's consider wages, just as Ricardo did. The authors of this article assume Portugal's wage is set at 1, then they investigate which wages in England would give rise to beneficial trade agreements between the two countries. So, first question: Would England and Portugal both agree to trade with each other if England's wage is also w 1-100/100? Why or why not? 4. Now suppose that England's wage is w = 0.75 = 90/ 120, Would the two countries agree to trade with each other now? 5. Explain why the two countries will not agree to trade if England's wage is w- 0.5- 60/120.