Lecture 2
The Ricardian Model

• Production Possibilities Frontier (ah yes, the familiar PPF)
• Autarky
• Specialization
• Pattern of trade
• Gains from trade
• Many-good case

• Two countries: Home and Foreign
• Two goods: Wine and cheese
• One input: Labor
• Fixed input-output (I/O) coefficients
• Perfect competition (CRTS technology)
• Full employment

2. Model

1. Parameters: Input-output coefficients, labor force

2. The PPF
   • The PPF is a straight line
   • Slope of PPF = Ratio of I/O coefficients

3. Perfect competition
   • Zero-profit condition: Price = Average Cost

4. If both goods are produced:
   • Relative price = Ratio of I/O coefficients

3. Condition for specialization

• Relative price does not equal Ratio of coefficients

4. Autarky

• Consumers' "budget constraint" is the same as the PPF
• Consumption and production points coincide
• MRS = Relative price

5. With trade

5.1 Assumptions

1. Let cheese be the numeraire good:
   This means setting Price of cheese (P_C) = 1

2. Let autarkic P_W/P_C be greater in Home than in Foreign

   Question: What does this imply about the I/O coefficients in the 2 countries?

5.2 Derive Home's import demand curve

• Obtain production and consumption at different prices

• Negative slope between P_W/P_C and M_W

• As P_W/P_C falls, quantity of wine imports increases

5.3 Derive Foreign's export supply curve

• As P_W/P_C falls, quantity of wine exports decreases

5.4 Equilibrium (relative) price

• Obtained at intersection of Home import demand and Foreign export supply curves

• Same relative price in Home and Foreign

6. Specialization

• World relative price does not equal Ratio of I/O coefficients

• Home produces one good, Foreign the other

7. Results of the model

1. Basis for comparative advantage:
   Differences in labor productivity

2. Pattern of trade:
   Who exports what?

3. Gains from trade
   • Consumers' budget constraint different from PPF
   • Bigger set of feasible choices
   • Greater welfare (utility) for EACH country