Question

Ricardian Model of Trade

Assume that Chile has 600 units of labour and Brazil has 1,000 units of labour. Both countries produce cloth and wheat. In Chile, the labour requirement for a yard of cloth is 3 units, while a bushel of wheat requires 2 units. In Brazil, the labour requirement for a yard of cloth is 5 units, while a bushel of wheat requires 2 units. In both countries, there are constant costs of production.

1. Draw the production possibility curves for each country (wheat on x-axis, cloth on y-axis) on the same graph, and calculate the autarky or pre-trade price of wheat (in terms of cloth) in each country.

2. When these two countries engage in free trade, which country will export cloth? Wheat? Explain. Is it possible for the cloth exporting country to charge 3 bushels of wheat for each yard of its cloth? Explain.

3. Suppose instead that the unit labour requirement in Brazil’s cloth industry drops to 2 units per yard. Draw Brazil’s new production possibilities curve on your graph. What, if anything, will happen to the pattern of trade?

Answer 1

Let bushel of wheat be denoted by x and yard of cloth be denoted by y.

CHILE

Chile has 600 units of labour

In Chile, the labour requirement for a yard of cloth is 3 units, while a bushel of wheat requires 2 units. In other words, one labor can produce 1/3 units of cloth and ½ units of wheat.

If Chile decides to put its entire labor force in the production of cloth, then it can produce a maximum of 600*1/3 = 200 yards of cloth. This is the y-intercept of Chile’s production possibility curve.

If Chile decides to put its entire labor force in the production of wheat, then it can produce a maximum of 600*1/2 = 300 bushels of wheat. This is the x-intercept of Chile’s production possibility curve.

Join the points (300,0) and (0, 200) in order to get Chile’s production possibility curve as shown in blue color in figure 1.

In order to produce 300 x, Chile has to give up 200 y. In order to produce 1x, Chile has to give up 200/300 y or 0.67 yards of cloth. Autarky price of wheat in Chile = 0.67 yards of cloth.

BRAZIL

Brazil has 1,000 units of labour

In Brazil, the labour requirement for a yard of cloth is 5 units, while a bushel of wheat requires 2 units. In other words, one labor can produce 1/5 units of cloth and ½ units of wheat.

If Brazil decides to put its entire labor force in the production of cloth, then it can produce a maximum of 1000*1/5 = 200 yards of cloth. This is the y-intercept of Brazil’s production possibility curve.

If Brazil decides to put its entire labor force in the production of wheat, then it can produce a maximum of 1000*1/2 = 500 bushels of wheat. This is the x-intercept of Brazil’s production possibility curve.

Join the points (500, 0) and (0, 200) in order to get Brazil’s production possibility curve as shown in red color in figure 1.

In order to produce 500 x, Brazil has to give up 200 y. In order to produce 1x, Brazil has to give up 200/500 y or 0.4 yards of cloth. Autarky price of wheat in Brazil = 0.4 yards of cloth.

Figure 1

b) According to the comparative advantage theory, a country having a lower opportunity cost (or price) of a commodity should specialize in the production of that commodity. Therefore, Brazil should specialize in the production of wheat and Brazil should export wheat.

Chile has lower opportunity cost (or price) of cloth, so Chile should produce cloth. Chile exports cloth.

Price (Opportunity cost) of producing cloth in Brazil = 1 / price (Opportunity cost) of producing wheat in Brazil = 1/0.4 = 2.5 bushels of wheat.

If Chile charges a price of 3 bushels of wheat per unit of cloth, then Brazil will refuse to trade because Brazil can produce cloth at a lower price (2.5) in Brazil itself. Brazil will indulge in trade only if it gets a price of less than 2.5 bushels of wheat per unit cloth.

So, Chile cannot charge 3 bushels of wheat for each yard of its cloth.

c) the unit labour requirement in Brazil’s cloth industry drops to 2 units per yard.

Figure 2

Brazil has 1,000 units of labour

In Brazil, the new labour requirement for a yard of cloth is 2 units, while a bushel of wheat requires 2 units. In other words, one labor can produce 1/2 units of cloth and 1/2 units of wheat.

If Brazil decides to put its entire labor force in the production of cloth, then it can produce a maximum of 1000*1/2 = 500 yards of cloth. This is the y-intercept of Brazil’s production possibility curve.

If Brazil decides to put its entire labor force in the production of wheat, then it can produce a maximum of 1000*1/2 = 500 bushels of wheat. This is the x-intercept of Brazil’s production possibility curve.

Join the points (500, 0) and (0, 500) in order to get new Brazil’s production possibility curve as shown in green color in figure 2.

In order to produce 500 x, Brazil has to give up 500 y. In order to produce 1x, Brazil has to give up 500/500 y or 1 yards of cloth. Autarky price of wheat in Brazil = 1 yards of cloth.

Since price of wheat in Brazil has become greater than the price of wheat in Chile, this would mean that Chile is going to specialize in the production of wheat. So, Chile exports wheat and Brazil exports cloth now.

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