International Economics

Universidad Carlos III

The Ricardian Model

1. Consider two countries, Home and Foreign and two goods appples and bananas. In the
Home country the unit labour requiremrents for apples and bananas are repectively 3 and
2. In the Foreign country the unit labour requirements for apples and bananas are 5 and 1
respectively. The Home country has a labour force of 1200 and the Foreign country has a
labour force of 800.

The unit labor requirements in Home and Foreign are given by:

Apples Bananas Labour

Home 3 2 1200
Foreign 5 1 800

a) Graph the Production Possiblity Frontiers for each of the two countries.
What are the prices of apples in terms of bananas in both countries in the absence of
trade? Why?
QB HOME Q* B FOREIGN
*
L
 800
aB*
L
 600
aB

L QA L* Q* A
 400  160
aA a *A
Figure 1
In the absence of trade we assume that both countries produce both goods
In the Ricardian model workers are homogeneous: there is no difference between
“apple workers” and “banana workers”!
In the Ricardian model workers are perfectly mobile between sectors
Then, the relative price in autarky is equal to the opportunity cost of the
production of both goods
If in the home country producing apples requires 3 workers, while producing bananas
requires only 2, then the cost (and the price) of producing apples is 3/2 the cost (and
the price) of producing bananas:

PA aA 3
= = (1)
PB aB 2

1
 Consequently, in the home country the relative price of apples is 3/2.
By a similar argument we can show that in the foreign country the relative price of
apples is 5.
PA∗ a∗A
= =5 (2)
PB∗ a∗B

b) Construct the world relative supply function.

SEE FIGURE 2.
To construct the world’s relative supply function:
First, we expect that after trade, prices will be:

3 PA aA PW a∗ P∗
= = ≤ AW ≤ ∗A = A∗ = 5 (3)
2 PB aB PB aB PB

Second, if we suppose that the price after trade lies in this interval, then Home is
specialized in producing apples and Foreign is specialized in producing bananas since
producing apples in Home is less costly.
Third, if this is the case then the total production of the two goods is:

L
QA + Q∗A = + 0 = 400 (4)
aA

L∗
QB + Q∗B = 0 + = 800 (5)
a∗B
Then, total relative production:

QA + Q∗A 400 1
= = (6)
QB + Q∗B 800 2

The following table resumes the specialization pattern of each country according to
the prices and the world’s total relative production.

Home Foreign Relative Supply

W
PA 3 QA +Q∗A
∈ 0, 21


W
PB
= 2 Both Bananas QB +Q∗B
W
PA 3

QA +Q∗A 1
W
PB
∈ 2, 5 Apples Bananas QB +Q∗B = 2
W
PA QA +Q∗A 1


W
PB
=5 Apples Both QB +Q∗B ∈ 2, ∞

2
 PA PB

5$ Rela*ve$Supply$

2$

1.5$
Rela*ve$Demand$

QA + QA*
400 QB + QB*
800
Figure'2'

c) Suppose that the world relative demand takes the following form: demand for ap-
ples/demand for bananas = banana price/apple price. Draw the world relative de-
mand curve superimposed on the world relative supply curve. What is the equilibrium
relative price of apples under free trade?
SEE FIGURE 2.
QD pB
To draw the relative demand schedule, note that A
QD
= pA means that for a relative
B
price of apples of x the relative demand for apples is 1/x.
This is the relative demand corresponding to a Cobb-Douglas utility function with
exponents 1/2 on apples and bananas.

QS 1
Assume both countries fully specialize in equilibrium, then: QSA = 2
B
QS QD pB 1 pA
In equilibrium, Supply=Demand, therefore A
QS
= A
QD
⇒ pA = 2 ⇒ pB =2
B B

pA
Does pB = 2 lie in the interval of prices where specialization occurs? → YES!
 
pA 3
=2∈ ,5
pB 2

QD
Therefore, the world’s relative demand function: A
QD
, crosses the relative supply fun-
B
ction in its vertical portion.
M
PA
Finally, the equilibrium relative price of apples is M
PB
= 2, Home is specia-
lized in producing apples and Foreign is specialized in producing bananas.

3
d ) Describe the pattern of trade. Show that each of the two countries gain from trade.

Home specializes in apples, and foreign in bananas. The reason is that Home has
comparative advantage in apples:
a∗A
Home’s productivity in apples (compared to Foreign’s) is aA = 5/3, whereas Home’s
a∗B
productivity in bananas (relative to Foreign’s) is aB = 1/2.
Therefore, Home’s relative productivity is greater in apples.
As for the gains from trade, they occur because in both countries the relative price of
the exported good increases, i.e., in each country the terms of trade improve.
In Home the relative price of apples (which is the good it exports) increases from 3/2
to 2, whereas in Foreign the relative price of bananas (which is the good it exports)
increases from 1/5 to 1/2.
These gains from trade can be seen graphically as the budget constraints in both
countries tilt outwards, allowing both countries to move to a higher indifference curve.

QB HOME Q* B FOREIGN

800 800
After Trade
After Trade
600

400 QA 160 400 Q* A

Figure 3

e) Suppose that instead of 1200 workers the Home country has a labour force of 2400.
Find the equilibrium relative price. What can you say about the division of gains from
trade between the two countries.
The specialization pattern does not change, but the world’s relative supply does.

Home Foreign Relative Supply

W
PA 3 QA +Q∗A
W
PB
= 2 Both Bananas QB +Q∗B ∈ (0, 1)
W
PA 3

QA +Q∗A 800
W
PB
∈ 2, 5 Apples Bananas QB +Q∗B = 800 =1
W
PA QA +Q∗A
W
PB
=5 Apples Both QB +Q∗B ∈ (1, ∞)

4
 PA PB

5$ Rela*ve$Supply$

2$

1.5$
Rela*ve$Demand$

QA + QA*
400 800 QB + QB*
800 800
Figure'4'
QS
Assume both countries fully specialize in equilibrium, then: A
QS
=1
B
QS QD pB pA
In equilibrium, Supply=Demand, therefore A
QS
= A
QD
⇒ pA =1⇒ pB =1
B B

pA
Does pB = 1 lie in the interval of prices where specialization occurs? → NO!
 
pA 3
=1∈
/ ,5
pB 2

QD
Therefore, the world’s relative demand function: A
QD
, crosses the relative supply fun-
B
pA 3
ction at relative price pB = 2.
Home produces both goods (apples and bananas), whereas Foreign produces only
bananas.

What happens to the gains from trade? Home faces the same relative prices
before and after trade, thus it neither gains nor loses from trade. In other words,
Home’s terms of trade do not change. However, in Foreign the relative price of apples
has decreased more than before (or the relative price of bananas has increased more
than before) thus the gains from trade in Foreign are larger than before. This teaches
us a general lesson: small countries tend to gain more from trade than large ones.
Note one more thing: although in Home the budget constraint does not tilt outwards,
Home does produce more apples than before. In other words, the production point
moves in the direction of more apples, whereas the consumption point obviously
remains unchanged (since the budget constraint has not moved).

5
2. Suppose that Cuba and Montserrat, two Carribian island economies start trading with
each other. There are two goods in the economy: sugarcane and mangoes. The unit labour
requirements for sugarcane are 5 and 4 respectively for Cuba and Montserrat. The unit
labour requirements for mangoes are 20 and 10 respectively for Cuba and Montserrat. The
total labour force in Cuba is 1000 and it is 500 in Montserrat.

This question reviews the Ricardian trade model. The technology of the two countries has
the following unit labor requirements and labor endowments:

Sugar Cane (S) Mango (M) Labour

Cuba (C) aSC = 5 aM C = 20 LC = 1000
Montserrat (M) aSM = 4 aM M = 10 LM = 500

a) In which good(s) does Cuba have an absolute advantage? In which does it have a
comparative advantage? Who will be exporting what in a free trade equilibrium?
Absolute Advantage
Cuba does not have an absolute advantage in any good.
The unit labor requirements for both goods are higher in Cuba than in Montserrat
(aSC = 5 > aSM = 4 and aM C = 20 > aM M = 10).
Comparative Advantage
Cuba has comparative (or relative) advantage in sugarcane since it uses relatively
less labour in the production of sugarcane than Montserrat.

aSC 5 aSM 4
= < = (7)
aM C 20 aM M 10

Remember that the labor productivity is the inverse of the unit labor require-
aSM
ment.Cuba’s labor productivity in sugarcane (relative to Montserrat’s) is aSC =
4/5, whereas Cuba’s labor productivity in mangoes (relative to Montserrat’s) is
aM M
aM C = 1/2.
This implies that Cuba’s relative disadvantage is smaller in sugarcane than in
mangoes.
Free Trade
PM C aM C
In Cuba the relative price of mangoes under autarky is PSC = aSC =4

PM M aM M
In Montserrat the relative price of mangoes under autarky is PSM = aSM = 2, 5

The Ricardian model says that a country exports the good in which it has a
comparative advantage. Then under free trade Cuba will export sugarcane and
Montserrat will export mangoes.

6
b) Draw the supply and demand schedules for mangoes relative to sugarcane for the
economy as a whole i.e. taking both countries together. Note that the relative supply
curve can be determined with precision while the representation of the demand curve
is slightly random.
FIGURE 5 represents the relative supply and the relative demand. We know that
the relative price of mangoes has to be somewhere in between 2.5 and 4. (To see
this, follow the argument of the previous exercise). For example, in Cuba 5 workers
are needed to produce one unit of sugarcane, and 20 workers to produce one mango.
Therefore, Cuba requires 4 times more workers to produce mangoes. This implies 4
times the cost and 4 times the price.
For part (c) let’s assume that the relative price of mangoes is equal to 3.

Cuba Montserrat Relative Supply

PMW
10 QM +Q∗M
PSW
< 4 = 2,5 Sugar Cane Sugar Cane QS +Q∗S =0
PMW QM +Q∗M
∈ 0, 14


PSW
= 2,5 Sugar Cane Both QS +Q∗S

PMW QM +Q∗M 1
PSW
∈ (2,5, 4) Sugar Cane Mango QS +Q∗S = 4

PMW QM +Q∗M 1


PSW
=4 Both Mango QS +Q∗S ∈ 4, ∞
W
PM 20 QM +Q∗M
W
PS
> 5 =4 Mango Mango QS +Q∗S =∞

PM PS

4$ Rela+ve$Supply$

3$

2.5$
Rela+ve$Demand$

QM + QM*
50 1 QS + QS*
=
200 4
Figure'5'

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c) Suppose that the relative price of mangoes is 3. Show that both countries gain from
Trade.
To show that both countries gain from trade we follow the same methodology as
exercise 1 part (d). That is:
As we saw Cuba has comperative advantage in producing and exporting sugarcanes.
PSC aSC 1
The relative price of sugarcane in Cuba under autarky is PM C = aM C = 4. The
PSM
relative price after trade is now PMM = 13 . We see that the price of sugar goes up and
that is why Cuba benefits from trade.
Same logic for Montserrat; it has comperative advantage in producing and exporting
PM M aM M
mangoes. Relative price of mangoes under autarky PSM = aSM = 2, 5. Relative price
PMM
of mangoes after trade is PSM
= 3, which is bigger than 2.5. Then, Montserrat also
benefits from trade.

d ) Determine the wage level in Cuba relative to the wage level in Montserrat. Why
would Montserrat want to trade with cuba if the latter is simply taking advantage of
the former’s lower wages? Is there a contradiction between free and fair trade?
Given that markets are competitive, we know that the price equals marginal cost.
In the case of Cuba, this means that the price of sugarcane is equal to the cost of
producing sugarcane (the wage multiplied by the unit labour requirement:

PS = wC aSC = 5wC

By analogy, in Montserrat, the price of mangoes is equal to the cost of producing

mangoes:
PM = wM aM M = 10wM

Dividing one by the other gives the wage in Cuba relative to Montserrat:

wC PS
M
=2 (8)
w PM

If, as assumed before, PM /PS = 3, then wC /wM = 2/3.

There is nothing unfair about trade: both countries gain.
Montserrat should not view wages in Cuba to be unfairly low (in the same way that
Europe should not view Chinese wages to be unfairly low). Cuba is not competing
Montserrat out of the market. Indeed, Montserrat is actually the low-cost producer
of mangoes. (To see this, just show that 10wM < 20wC .)

e) Now assume that due to volcanic activity 3/5 of Montserrat’s population migrates
to Cuba. What happens to the relative price of mangoes? What happens to the gains
from trade in each country?

8
The labour endowment in Cuba increases to 1300 and the labour endowment in
Montserrat drops to 200. This shifts the vertical portion of the relative supply schedule
in FIGURE 5 to the left. The relative production of mangoes now is:

QM + Q∗M 20
= (9)
QS + Q∗S 260

leading the relative price of mangoes to increase. And most likely leading the relative
price of mangoes to increase to 4, so that Cuba now produces both goods, whereas
Montserrat continues to produce only mangoes.

PM PS

4$ Rela+ve$Supply$

3$

2.5$
Rela+ve$Demand$

QM + QM*
20 50 QS + QS*
260 200
Figure'6'

9
3. Consider two countries, Spain and Russia and two goods, wine and vodka. Labour is the
only factor of production. The per unit labour requirements for wine is 2 in Spain and 5
in Russia. Meanwhile the per unit labour requirements for vodka is 2 in each of the two
countries. The wages in Spain are 50 % higher than the wages in Russia.

a) What is the cost of producing wine in Spain relative to the cost of producing wine in
Russia? What is the cost of producing vodka in Spain relative to the cost of producing
vodka in Russia?
We know that the salaries in Spain (ω) are 50 % higher than Russia (ω ∗ ): ω
ω∗ = 1,5
Cost of producing wine in Spain is 2ω = 2 ∗ 1,5ω ∗ = 3ω ∗
Cost of producing wine in Russia is 5ω ∗
Relative cost of wine(Spain/Russia)= 3/5

Cost of producing vodka in Spain is 2ω = 2 ∗ 1, 5ω ∗ = 3ω ∗

Cost of producing vodka in Russia is 2ω ∗
Relative cost of vodka (Spain/Russia)= 3/2

b) In the absence of transport costs will there be trade? If yes, then who will specialize
in what? Illustrate your answer numerically.
In the absence of transport costs, Spain exports wine (because it produces wine mo-
re cheaply than Russia) and Russia exports vodka (because it produces vodka more
cheaply than Spain).

c) Now introduce transport costs: Exporting wine and vodka abroad increases the initial
cost by 100 %. What happens to the trade between Spain and Russia? Illustrate your
answer numerically.
Price of Spanish wine in Russia= Cost of production∗2 = 6 ∗ ω ∗
Price of Russian wine in Russia= 5 ∗ ω ∗
Conclusion: Russians have no incentive to import Spanish wine.

Price of Russian vodka in Spain= Cost of production∗2 = 4 ∗ ω ∗

Price of Spanish vodka in Spain= 3 ∗ ω ∗
Conclusion: Spaniards have no incentive to import Russian vodka.

Both goods become nontradable. For example, consider the case of wine. Wine used
to be exported from Spain to Russia. To produce wine in Spain and transport it to
Russia now costs 4w (the production cost is 2w and transportation adds a 100 % to
this cost), whereas producing wine in Russia costs 5w∗ . The relative cost is therefore
4/5w/w∗ = 6/5.

10
4. Consider two countries, Spain and Gibraltar and two industries, ham and monkeys. The
unit labour requirements for producing ham in Spain and Gibraltar are 2 and 10 res-
pectively. Meanwhile, the unit labour requirements for producing monkeys in Spain and
Gibraltar are 10 and 12 respectively. Spain has 10000 workers and Gibraltar has 100. The
1/2 1/2
two countries have identical Cobb-Douglas preferences: U = CH CM , where CH is the
consumption of ham and CM is the consumption of monkeys.

Ham Monkeys Labour

Spain 2 10 10000
Gibaltrar (*) 10 2 100

a) Draw the production possibilty frontiers for both Spain and Gibraltar and determine
the relative prices i.e. ppM
H
in each of the two countries under autarky.
pH p∗H
Autarky prices: in Spain pM = 15 , in Gibraltar p∗M =5

QM HOME Q* M FOREIGN
*
L
 50
aM*

L
 1000
aM

L QH Q* H
 5000 L*
aH  10
a H*
Figure 7

b) Calculate the demand for ham and and monkeys in each of the two countries under
autarky.
We call M the quantity of monkeys produced and H the quantity of ham produced.
In autarky CM = M and CH = H and the constraint is the PPF, aM M + aH H = L.
Therefore, the demand in Spain is the solution of maximizing

1/2 1/2
U = CH CM

subject to

10M + 2H = 10000
CH = H
CM = M

11
 This can be solved by either:
a) Substituing the restrictions into the utility function. In this case, we would
obtain:

1/2
U = (5000 − 5CM )1/2 CM

The first order condition is:

1 1/2 1 −1/2
(5000 − 5CM )−1/2 CM (−5) + (5000 − 5CM )1/2 CM = 0
2 2

Solving it we obtain CM = 500 and substituting it into the restrictions we get that
CH = 2500.
pH CM
b) Using M RSHM = pM , that is, CH = 51 .
Subsituting it into the restrictions we would find, again, CM = 500 and CH = 2500.
Similarly, the demand in Gibraltar is the solution of maximizing

∗1/2 ∗1/2
U = CH CM

subject to

2M ∗ + 10H ∗ = 100
∗
CH = H∗
∗
CM = M∗

∗ = 25 and C ∗ = 5.
We obtain that CM H

c) Calculate the indirect utility of the representative agents in each of the two countries
under autarky.
U 25001/2 5001/2
L = 10000 = 0, 1118

U∗ 251/2 51/2
L∗ = 100 = 0, 1118

pH
d ) Determine the relative price, pM under free trade.
The free trade price is determined by the equilibrium of relative demand and relative
supply. Cobb-Douglas prefences give us an inverse demand function of:

pH qM
=
pM qH

As for relative supply: if the price is between 0 and 1/5, relative supply is equal to
0; if the price is equal to 1/5, relative supply is between 0 and 100; if the price is

12
 between 1/5 and 5, relative supply is equal to 100.

The equilibrium is found by equalizing relative demand and relative supply.

 S  D
If both countries specialize qqM = 100 → qqM 1 pH 1


H
H
= 100 = pM ∈
/ 5 , 5
pH
It is obvious that the free trade price is pM = 1/5.

e) Calculate the demand for ham and and monkeys in each of the two countries under
free trade. Compare your answer with part (b).
pH
Since the price after trade is pM = 1/5, this means that Spain will continue to pro-
duce both goods (ham and monkeys) and Gibraltar will be specialized in producing
monkeys. Then,
Spain: PPF=CPF ⇒ M = 500, H = 2500
Gibraltar: PPF<CPF ⇒ MP∗ rod = 50
∗
If MCons = 25 as in autarky, then the other 25 monkeys are sold to buy ham
H ∗ = 5 ∗ 25 = 125

f ) Calculate the indirect utility of the representative agents in each of two countries
under free trade. Compare your answer with part (c) and comment on the gains from
trade.
In Spain the representative agent’s utility is still 0.1118. In Gibraltar, however, the
representative agent now consumes 1/2w∗ /pH of ham and 1/2w∗ /pM of monkeys.
Given that w∗ = 1/2,pM = 1 and pH = 1/5, we get a utility equal to (5/4)0,5 (1/4)0,5 ,
which is equal to 0.559.
Consumption in Spain has not changed (since relative prices are unchanged), but
production has become more specialized in ham. Gibraltar has become fully specia-
lized in monkeys, and its consumption has also changed (since it now faces different
relative prices). This implies that Spain does not gain (nor does it lose) from free
trade, whereas Gibraltar gains.

g) What effect does free trade have on the inequality between Spain and Gibraltar? (The
indirect utility can be interpreted as the real per capita GDP.)
Inequality goes up.

13
5. Spain has two types of workers Catalans and Castillians and produces two goods, beer and
wine. The Catalans need 4 workers to produce a beer and 5 workers to produce a bottle of
wine. The Castillians on the other hand need 5 workers to produce a beer and 4 to produce
a bottle of wine. The relative demand in Spain is Q(beer)/Q(wine)=p(wine)/p(beer). There
are 6 million catalans and 25 million Castillians. Solve this exercise assuming free trade.

Beer Wine Labour ∗ /α∗

αB W
Catalans 4 5 6 4/5
Castillians (*) 5 4 25 5/4
a) Draw the relative demand and supply curves for Spain.
Supply curve is given by the table below:

Catalans Castillians Relative Supply

PMW
4 QB +Q∗B
PSW
< 5 Wine Wine QW +Q∗W =0
W
PM 4 QB +Q∗B 6


W
PS
= 5 Both Wine QW +Q∗W ∈ 0, 25
W
PM 4 5

QB +Q∗B 6
W
PS
∈ 5, 4 Beer Wine QW +Q∗W = 25

PMW
5 QB +Q∗B 6


PSW
= 4 Beer Both QW +Q∗W ∈ 25 , ∞

PMW
5 QB +Q∗B
PSW
> 4 Beer Beer QW +Q∗W =∞

PB PW

5 Relative
4
Supply
4
5
Relative Demand

QB  QB*
6 QW  QW*
25
Figure 8

14
 Demand curve:
1) Q(beer) /Q(wine) = p(wine) /p(beer)
2) catalanes have comperative advantage in producing beer ⇒ if they use all their
labour in producing beer: Q(beer) = 6mil/4 = 1, 50
3) castellanos have comperative advantage in producing wine ⇒ if they use all their
labour in producing wine: Q(wine) = 25mil/4 = 6, 25
⇒ QB /QW = pW /pB = 1, 50/6, 25 = (6/4)/(25/4) ⇒ pB /pW = 25/6 > 5/4 ⇒ De-
mand crosses the supply as shown in the graph.

b) Calculate with precision the relative price of beer in Spain.

DB pW
We know that relative demand of beer for all Spanish is: DW = pB and since
4 aCat pSpain aCast pSpain 5
= B
aCat
≤ B
≤ B
= 5/4 ⇒ B
=
5 W pSpain
W
aCast
W pSpain
W
4

c) Calculate with precision how much beer and how much wine is produced in Spain.
We see that under free trade Cataluña will be specialized in producing beer whereas
Castilla will be producing both beer and wine.
Then, QCat Cat
W = 0, QB = 6/4 = 1, 5

QCat Cast
B + QB 4
Cat Cast
=
QW + QW 5

LCast LCast
where QCat Cast =
W + QW
W
aCast
= W
4
W

LCast 25−LCast
and QCat Cast =
B + QB
B
aCast
+ 1, 5 = ( 5
W
) + 1, 5
B

25−LCast
( W
)+ 1, 5 4
5
Cast = ⇒ LCast
W = 16, 25mil, LCast
B = 8, 75mil
LW 5
4
LCast
⇒ QCat Cast =
W + QW
W
4 = 16,25
4 = 4, 0625
Cast
LB
⇒ QCat Cast =
B + QB ( 5 ) + 1, 5 = 1, 75 + 1, 50 = 3, 25

d ) Calculate with precision the wage of a Catalan worker relative to a Castillian worker.
pB
pB pW pB ω Cat 5
ω Cat = 4 and ω Cast = 4 = 5 then, ω Cast
= 4
pB = 4
5

15
e) Calculate with precision how much beer and how much wine is respectively consumed
by a Catalan and a Castillian worker.
DB pW
The relative demand schedule has the form DW = pB and correspondes to a Cobb-
Douglas utility function with exponents 1/2 on consumtion of bith goods.

w w
CB = & CW =
2PB 2PW

Catalans
PB
Since wCat = 4 , then

Cat PB /4 1
CB = wCat /2PB = =
2PB 8
Cat PB /4 PB 1 5
CW = wCat /2PW = = =
2PW PW 8 32

Castillians
PB PW
Since wCast = 5 = 4 , then

Cast PB /5 1
CB = wCast /2PB = =
2PB 10
Cast PW /4 1
CW = wCast /2PW = =
2PW 8

16