The Ricardian Theory of Comparative Advantage

Conozca las cinco razones por las que puede ocurrir el comercio entre países. Reconozca que los modelos de comercio separados incorporan diferentes motivaciones para el comercio. La primera sección de teoría de este curso desarrolla modelos que brindan diferentes explicaciones o razones por las que el comercio tiene lugar entre países. Las cinco razones básicas por las que puede tener lugar el comercio se resumen a continuación. El propósito de cada modelo es establecer una base para el comercio y luego usar ese modelo para identificar los efectos esperados del comercio sobre los precios, las ganancias, los ingresos y el bienestar individual. Razón para el comercio # 1: Diferencias en la tecnología Puede ocurrir un comercio ventajoso entre países si los países difieren en sus capacidades tecnológicas para producir bienes y servicios. La tecnología se refiere a las técnicas utilizadas para convertir los recursos (trabajo, capital, tierra) en productos (bienes y servicios). La base para el comercio en el modelo ricardiano de ventaja comparativa en el capítulo 2 "La teoría ricardiana de la ventaja comparativa" son las diferencias en la tecnología. Razón para el comercio n. ° 2: diferencias en la dotación de recursos Puede producirse un comercio ventajoso entre países si los países difieren en la dotación de recursos. La dotación de recursos se refiere a las habilidades y capacidades de la fuerza laboral de un país, los recursos naturales disponibles dentro de sus fronteras (minerales, tierras agrícolas, etc.) y la sofisticación de su capital social (maquinaria, infraestructura, sistemas de comunicaciones). La base del comercio tanto en el modelo de intercambio puro del capítulo 3 "El modelo de intercambio puro del comercio" como en el modelo de Heckscher-Ohlin del capítulo 5 "El modelo de Heckscher-Ohlin (proporciones de factores)" son las diferencias en la dotación de recursos. ----------------------------------------------------- Chapter 2 The Ricardian Theory of Comparative Advantage This chapter presents the first formal model of international trade: the Ricardian model. It is one of the simplest models, and still, by introducing the principle of comparative advantage, it offers some of the most compelling reasons supporting international trade. Readers will learn some of the surprising outcomes of the Ricardian model; for example, less productive nations can benefit from free trade with their more productive neighbors, and very low-wage countries are unlikely to be able to use their production cost advantage in many circumstances. Readers will also learn why so many people, even those who have studied the Ricardian theory, consistently get the results wrong. In other words, the Ricardian model is both one of the most misunderstood and one of the most compelling models of international trade. 2.1 The Reasons for Trade LEARNING OBJECTIVES Learn the five reasons why trade between countries may occur. Recognize that separate models of trade incorporate different motivations for trade. The first theory section of this course develops models that provide different explanations or reasons why trade takes place between countries. The five basic reasons why trade may take place are summarized below. The purpose of each model is to establish a basis for trade and then to use that model to identify the expected effects of trade on prices, profits, incomes, and individual welfare. Reason for Trade #1: Differences in Technology Advantageous trade can occur between countries if the countries differ in their technological abilities to produce goods and services. Technology refers to the techniques used to turn resources (labor, capital, land) into outputs (goods and services). The basis for trade in the Ricardian model of comparative advantage in Chapter 2 "The Ricardian Theory of Comparative Advantage" is differences in technology. Reason for Trade #2: Differences in Resource Endowments Advantageous trade can occur between countries if the countries differ in their endowments of resources. Resource endowments refer to the skills and abilities of a country’s workforce, the natural resources available within its borders (minerals, farmland, etc.), and the sophistication of its capital stock (machinery, infrastructure, communications systems). The basis for trade in both the pure exchange model in Chapter 3 "The Pure Exchange Model of Trade" and the Heckscher-Ohlin model in Chapter 5 "The Heckscher-Ohlin (Factor Proportions) Model" is differences in resource endowments. Reason for Trade #3: Differences in Demand Advantageous trade can occur between countries if demands or preferences differ between countries. Individuals in different countries may have different preferences or demands for various products. For example, the Chinese are likely to demand more rice than Americans, even if consumers face the same price. Canadians may demand more beer, the Dutch more wooden shoes, and the Japanese more fish than Americans would, even if they all faced the same prices. There is no formal trade model with demand differences, although the monopolistic competition model in Chapter 6 "Economies of Scale and International Trade" does include a demand for variety that can be based on differences in tastes between consumers. Reason for Trade #4: Existence of Economies of Scale in Production The existence of economies of scale in production is sufficient to generate advantageous trade between two countries. Economies of scale refer to a production process in which production costs fall as the scale of production rises. This feature of production is also known as “increasing returns to scale.” Two models of trade incorporating economies of scale are presented in Chapter 6 "Economies of Scale and International Trade". Reason for Trade #5: Existence of Government Policies Government tax and subsidy programs alter the prices charged for goods and services. These changes can be sufficient to generate advantages in production of certain products. In these circumstances, advantageous trade may arise solely due to differences in government policies across countries. Chapter 8 "Domestic Policies and International Trade", Section 8.3 "Production Subsidies as a Reason for Trade" and Chapter 8 "Domestic Policies and International Trade", Section 8.6 "Consumption Taxes as a Reason for Trade" provide several examples in which domestic tax or subsidy policies can induce international trade. Summary There are very few models of trade that include all five reasons for trade simultaneously. The reason is that such a model is too complicated to work with. Economists simplify the world by choosing a model that generally contains just one reason. This does not mean that economists believe that one reason, or one model, is sufficient to explain all outcomes. Instead, one must try to understand the world by looking at what a collection of different models tells us about the same phenomenon. For example, the Ricardian model of trade, which incorporates differences in technologies between countries, concludes that everyone benefits from trade, whereas the Heckscher-Ohlin model, which incorporates endowment differences, concludes that there will be winners and losers from trade. Change the basis for trade and you may change the outcomes from trade. In the real world, trade takes place because of a combination of all these different reasons. Each single model provides only a glimpse of some of the effects that might arise. Consequently, we should expect that a combination of the different outcomes that are presented in different models is the true characterization of the real world. Unfortunately, because of this, understanding the complexities of the real world is still more of an art than a science. KEY TAKEAWAYS The five main reasons international trade takes place are differences in technology, differences in resource endowments, differences in demand, the presence of economies of scale, and the presence of government policies. Each model of trade generally includes just one motivation for trade. EXERCISES List the five reasons why international trade takes place. Identify which model incorporates differences in technology, presence of economies of scale, differences in demand, differences in endowments. 2.2 The Theory of Comparative Advantage: Overview LEARNING OBJECTIVES Learn how a rearrangement of production on the basis of comparative advantage, coupled with international trade, can lead to an improvement in the well-being of individuals in all countries. Learn the major historical figures who first described the effects of international trade: Adam Smith, David Ricardo, and Robert Torrens. Historical Overview The theory of comparative advantage is perhaps the most important concept in international trade theory. It is also one of the most commonly misunderstood principles. There is a popular story told among economists that once when an economics skeptic asked Paul Samuelson (a Nobel laureate in economics) to provide a meaningful and nontrivial result from the economics discipline, Samuelson quickly responded, “comparative advantage.” The sources of the misunderstandings are easy to identify. First, the principle of comparative advantage is clearly counterintuitive. Many results from the formal model are contrary to simple logic. Second, it is easy to confuse the theory with another notion about advantageous trade, known in trade theory as the theory of absolute advantage. The logic behind absolute advantage is quite intuitive. This confusion between these two concepts leads many people to think that they understand comparative advantage when in fact what they understand is absolute advantage. Finally, the theory of comparative advantage is all too often presented only in its mathematical form. Numerical examples or diagrammatic representations are extremely useful in demonstrating the basic results and the deeper implications of the theory. However, it is also easy to see the results mathematically without ever understanding the basic intuition of the theory. The early logic that free trade could be advantageous for countries was based on the concept of absolute advantages in production. Adam Smith wrote in The Wealth of Nations, “If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage” (Book IV, Section ii, 12).For more information, see Rod Hay, “Adam Smith,” McMaster University Archive for the History of Economic Thought, http://socserv.mcmaster.ca/econ/ugcm/3ll3/smith/wealth/index.html. The idea here is simple and intuitive. If our country can produce some set of goods at a lower cost than a foreign country and if the foreign country can produce some other set of goods at a lower cost than we can produce them, then clearly it would be best for us to trade our relatively cheaper goods for their relatively cheaper goods. In this way, both countries may gain from trade. The original idea of comparative advantage dates to the early part of the nineteenth century.For a more complete history of these ideas, see Douglas A. Irwin, Against the Tide: An Intellectual History of Free Trade (Princeton, NJ: Princeton University Press, 1996). Although the model describing the theory is commonly referred to as the “Ricardian model,” the original description of the idea (see Chapter 2 "The Ricardian Theory of Comparative Advantage", Section 2.12 "Appendix: Robert Torrens on Comparative Advantage") can be found in the 1815 Essay on the External Corn TradeSee Robert Torrens, Essay on the External Corn Trade (London: J. Hatchard, 1815). by Robert Torrens. David Ricardo formalized the idea using a compelling yet simple numerical example in his 1817 book On the Principles of Political Economy and Taxation.See David Ricardo, On the Principles of Political Economy and Taxation, McMaster University Archive for the History of Economic Thought, http://socserv2.socsci.mcmaster.ca/ ~econ/ugcm/3ll3/ricardo/prin/index.html. The idea appeared again in James Mill’s 1821 Elements of Political Economy.See James Mill, Elements of Political Economy (London: Baldwin, Cradock & Joy, 1821). Finally, the concept became a key feature of international political economy upon the 1848 publication of Principles of Political Economy by John Stuart Mill.See John Stuart Mill, Principles of Political Economy, McMaster University Archive for the History of Economic Thought, http://socserv2.socsci.mcmaster.ca/~econ/ugcm/3ll3/mill/index.html. Ricardo’s Numerical Example Because the idea of comparative advantage is not immediately intuitive, the best way of presenting it seems to be with an explicit numerical example as provided by Ricardo. Indeed, some variation of Ricardo’s example lives on in most international trade textbooks today. In his example, Ricardo imagined two countries, England and Portugal, producing two goods, cloth and wine, using labor as the sole input in production. He assumed that the productivity of labor (i.e., the quantity of output produced per worker) varied between industries and across countries. However, instead of assuming, as Adam Smith did, that England is more productive in producing one good and Portugal is more productive in the other, Ricardo assumed that Portugal was more productive in both goods. Based on Smith’s intuition, then, it would seem that trade could not be advantageous, at least for England. However, Ricardo demonstrated numerically that if England specialized in producing one of the two goods and if Portugal produced the other, then total world output of both goods could rise! If an appropriate terms of trade (i.e., amount of one good traded for another) were then chosen, both countries could end up with more of both goods after specialization and free trade than they each had before trade. This means that England may nevertheless benefit from free trade even though it is assumed to be technologically inferior to Portugal in the production of everything. As it turned out, specialization in any good would not suffice to guarantee the improvement in world output. Only one of the goods would work. Ricardo showed that the specialization good in each country should be that good in which the country had a comparative advantage in production. To identify a country’s comparative advantage good requires a comparison of production costs across countries. However, one does not compare the monetary costs of production or even the resource costs (labor needed per unit of output) of production. Instead, one must compare the opportunity costs of producing goods across countries. A country is said to have a comparative advantage in the production of a good (say, cloth) if it can produce it at a lower opportunity cost than another country. The opportunity cost of cloth production is defined as the amount of wine that must be given up in order to produce one more unit of cloth. Thus England would have the comparative advantage in cloth production relative to Portugal if it must give up less wine to produce another unit of cloth than the amount of wine that Portugal would have to give up to produce another unit of cloth. All in all, this condition is rather confusing. Suffice it to say that it is quite possible, indeed likely, that although England may be less productive in producing both goods relative to Portugal, it will nonetheless have a comparative advantage in the production of one of the two goods. Indeed, there is only one circumstance in which England would not have a comparative advantage in either good, and in this case Portugal also would not have a comparative advantage in either good. In other words, either each country has the comparative advantage in one of the two goods or neither country has a comparative advantage in anything. Another way to define comparative advantage is by comparing productivities across industries and countries. Suppose, as before, that Portugal is more productive than England in the production of both cloth and wine. If Portugal is twice as productive in cloth production relative to England but three times as productive in wine, then Portugal’s comparative advantage is in wine, the good in which its productivity advantage is greatest. Similarly, England’s comparative advantage good is cloth, the good in which its productivity disadvantage is least. This implies that to benefit from specialization and free trade, Portugal should specialize in and trade the good that it is “most better” at producing, while England should specialize in and trade the good that it is “least worse” at producing. Note that trade based on comparative advantage does not contradict Adam Smith’s notion of advantageous trade based on absolute advantage. If, as in Smith’s example, England were more productive in cloth production and Portugal were more productive in wine, then we would say that England has an absolute advantage in cloth production, while Portugal has an absolute advantage in wine. If we calculated comparative advantages, then England would also have the comparative advantage in cloth and Portugal would have the comparative advantage in wine. In this case, gains from trade could be realized if both countries specialized in their comparative and absolute advantage goods. Advantageous trade based on comparative advantage, then, covers a larger set of circumstances while still including the case of absolute advantage and hence is a more general theory. The Ricardian Model: Assumptions and Results The modern version of the Ricardian model and its results is typically presented by constructing and analyzing an economic model of an international economy. In its most simple form, the model assumes two countries producing two goods using labor as the only factor of production. Goods are assumed to be homogeneous (i.e., identical) across firms and countries. Labor is homogeneous within a country but heterogeneous (nonidentical) across countries. Goods can be transported costlessly between countries. Labor can be reallocated costlessly between industries within a country but cannot move between countries. Labor is always fully employed. Production technology differences exist across industries and across countries and are reflected in labor productivity parameters. The labor and goods markets are assumed to be perfectly competitive in both countries. Firms are assumed to maximize profit, while consumers (workers) are assumed to maximize utility. The primary issue in the analysis of this model is what happens when each country moves from autarky (no trade) to free trade with the other country—in other words, what are the effects of trade? The main things we care about are trade’s effects on the prices of the goods in each country, the production levels of the goods, employment levels in each industry, the pattern of trade (who exports and who imports what), consumption levels in each country, wages and incomes, and the welfare effects both nationally and individually. Using the model, one can show that in autarky each country will produce some of each good. Because of the technology differences, relative prices of the two goods will differ between countries. The price of each country’s comparative advantage good will be lower than the price of the same good in the other country. If one country has an absolute advantage in the production of both goods (as assumed by Ricardo), then real wages of workers (i.e., the purchasing power of wages) in that country will be higher in both industries compared to wages in the other country. In other words, workers in the technologically advanced country would enjoy a higher standard of living than in the technologically inferior country. The reason for this is that wages are based on productivity; thus in the country that is more productive, workers get higher wages. The next step in the analysis is to assume that trade between countries is suddenly liberalized and made free. The initial differences in relative prices of the goods between countries in autarky will stimulate trade between the countries. Since the differences in prices arise directly out of differences in technology between countries, it is the differences in technology that cause trade in the model. Profit-seeking firms in each country’s comparative advantage industry would recognize that the price of their good is higher in the other country. Since transportation costs are zero, more profit can be made through export than with sales domestically. Thus each country would export the good in which it has a comparative advantage. Trade flows would increase until the price of each good is equal across countries. In the end, the price of each country’s export good (its comparative advantage good) will rise and the price of its import good (its comparative disadvantage good) will fall. The higher price received for each country’s comparative advantage good would lead each country to specialize in that good. To accomplish this, labor would have to move from the comparative disadvantage industry into the comparative advantage industry. This means that one industry goes out of business in each country. However, because the model assumes full employment and costless mobility of labor, all these workers are immediately gainfully employed in the other industry. One striking result here is that even when one country is technologically superior to the other in both industries, one of these industries would go out of business when opening to free trade. Thus technological superiority is not enough to guarantee continued production of a good in free trade. A country must have a comparative advantage in production of a good rather than an absolute advantage to guarantee continued production in free trade. From the perspective of a less-developed country, the developed country’s superior technology need not imply that less-developed country (LDC) industries cannot compete in international markets. Another striking result is that the technologically superior country’s comparative advantage industry survives while the same industry disappears in the other country, even though the workers in the other country’s industry have lower wages. In other words, low wages in another country in a particular industry is not sufficient information to determine which country’s industry would perish under free trade. From the perspective of a developed country, freer trade may not result in a domestic industry’s decline just because the foreign firms pay their workers lower wages. The movement to free trade generates an improvement in welfare in both countries individually and nationally. Specialization and trade will increase the set of consumption possibilities, compared with autarky, and will make possible an increase in consumption of both goods nationally. These aggregate gains are often described as improvements in production and consumption efficiency. Free trade raises aggregate world production efficiency because more of both goods are likely to be produced with the same number of workers. Free trade also improves aggregate consumption efficiency, which implies that consumers have a more pleasing set of choices and prices available to them. Real wages (and incomes) of individual workers are also shown to rise in both countries. Thus every worker can consume more of both goods in free trade compared with autarky. In short, everybody benefits from free trade in both countries. In the Ricardian model, trade is truly a win-win situation. Defending against Skeptics: The Intuition behind the Theory of Comparative Advantage Many people who learn about the theory of comparative advantage quickly convince themselves that its ability to describe the real world is extremely limited, if not nonexistent. Although the results follow logically from the assumptions, the assumptions are easily assailed as unrealistic. For example, the model assumes only two countries producing two goods using just one factor of production. No capital or land or other resources are needed for production. The real world, on the other hand, consists of many countries producing many goods using many factors of production. In the model, each market is assumed to be perfectly competitive when in reality there are many industries in which firms have market power. Labor productivity is assumed to be fixed when in actuality it changes over time, perhaps based on past production levels. Full employment is assumed when clearly workers cannot immediately and costlessly move to other industries. Also, all workers are assumed to be identical. This means that when a worker is moved from one industry to another, he or she is immediately as productive as every other worker who was previously employed there. Finally, the model assumes that technology differences are the only differences that exist between the countries. With so many unrealistic assumptions, it is difficult for some people to accept the conclusions of the model with any confidence, especially when so many of the results are counterintuitive. Indeed, one of the most difficult aspects of economic analysis is how to interpret the conclusions of models. Models are, by their nature, simplifications of the real world and thus all economic models contain unrealistic assumptions. Therefore, to dismiss the results of economic analysis on the basis of unrealistic assumptions means that one must dismiss all insights contained within the entire economics discipline. Surely, this is neither practical nor realistic. Economic models in general and the Ricardian model in particular do contain insights that most likely carry over to the more complex real world. The following story is meant to explain some of the insights within the theory of comparative advantage by placing the model into a more familiar setting. A Gardening Story Suppose it is early spring and it is time to prepare the family backyard garden for the first planting of the year. The father in the household sets aside one Sunday afternoon to do the job but hopes to complete the job as quickly as possible. Preparation of the garden requires the following tasks. First, the soil must be turned over and broken up using the rototiller. Then the soil must be raked and smoothed. Finally, seeds must be planted, or sowed. This year, the father’s seven-year-old son is anxious to help. The question at hand is whether the son should be allowed to help if one’s only objective is to complete the task in the shortest amount of time possible. At first thought, the father is reluctant to accept help. Clearly each task would take the father less time to complete than it would take the son. In other words, the father can perform each task more efficiently than the seven-year-old son. The father estimates that it will take him three hours to prepare the garden if he works alone, as shown in Table 2.1 "Father’s Task Times without Son". Table 2.1 Father’s Task Times without Son Task Completion Time (Hours) Rototilling 1.0 Raking 1.0 Planting 1.0 Total 3.0 On second thought, the father decides to let his son help according to the following procedure. First, the father begins the rototilling. Once he has completed half of the garden, the son begins raking the rototilled section while the father finishes rototilling the rest of the garden plot. After the father finishes rototilling, he begins planting seeds in the section the son has already raked. Suppose that the son rakes slower than the father plants and that the father completes the sowing process just as the son finishes raking. Note this implies that raking takes the son almost two hours compared to one hour for the father. However, because the son’s work and the father’s work are done simultaneously, it does not add to the total time for the project. Under this plan, the time needed to complete the tasks is shown in Table 2.2 "Father’s Task Times with Son". Table 2.2 Father’s Task Times with Son Task Completion Time (Hours) Rototilling 1.0 Raking and Planting 1.0 Total 2.0 Notice that the total time needed to prepare the garden has fallen from three hours to two hours. The garden is prepared in less time with the son’s help than it could have been done independently by the father. In other words, it makes sense to employ the son in (garden) production even though the son is less efficient than the dad in every one of the three required tasks. Overall efficiency is enhanced when both resources (the father and son) are fully employed. This arrangement also clearly benefits both the father and son. The father completes the task in less time and thus winds up with some additional leisure time that the father and son can enjoy together. The son also benefits because he has contributed his skills to a productive activity and will enjoy a sense of accomplishment. Thus both parties benefit from the arrangement. However, it is important to allocate the tasks correctly between the father and the son. Suppose the father allowed his son to do the rototilling instead. In this case, the time needed for each task might look as it does in Table 2.3 "Task Times with Incorrect Specialization". Table 2.3 Task Times with Incorrect Specialization Task Completion Time (Hours) Rototilling 4.0 Raking 1.0 Planting 1.0 Total 6.0 The time needed for rototilling has now jumped to four hours because we have included the time spent traveling to and from the hospital and the time spent in the emergency room! Once the father and son return, the father must complete the remaining tasks on his own. Overall efficiency declines in this case compared with the father acting alone. This highlights the importance of specializing in production of the task in which you have a comparative advantage. Even though the father can complete all three tasks quicker than his son, his relative advantage in rototilling greatly exceeds his advantage in raking and planting. One might say that the father is “most better” at rototilling, while he is “least better” at raking and planting. On the other hand, the son is “least worse” at raking and planting but “most worse” at rototilling. Finally, because of the sequential nature of the tasks, the son can remain fully employed only if he works on the middle task, namely, raking. Interpreting the Theory of Comparative Advantage The garden story offers an intuitive explanation for the theory of comparative advantage and also provides a useful way of interpreting the model results. The usual way of stating the Ricardian model results is to say that countries will specialize in their comparative advantage good and trade it to the other country such that everyone in both countries benefits. Stated this way, it is easy to imagine how it would not hold true in the complex real world. A better way to state the results is as follows. The Ricardian model shows that if we want to maximize total output in the world, then we should fully employ all resources worldwide, allocate those resources within countries to each country’s comparative advantage industries, allow the countries to trade freely thereafter. In this way, we might raise the well-being of all individuals despite differences in relative productivities. In this description, we do not predict that a result will carry over to the complex real world. Instead, we carry the logic of comparative advantage to the real world and ask how things would have to look to achieve a certain result (maximum output and benefits). In the end, we should not say that the model of comparative advantage tells us anything about what will happen when two countries begin to trade; instead, we should say that the theory tells us some things that can happen. KEY TAKEAWAYS Trade based on comparative advantage can make everyone in both countries better off after trade. Superior technology in developed countries need not imply that industries in less-developed countries cannot compete in international markets. Firms in developed countries can sometimes compete in international markets even when foreign firms pay their workers much lower wages. EXERCISES Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?” The term used to describe workers who have the same productivity in multiple industries. The term used to describe a product when it is identical across multiple firms. The term used to describe a product, like wine, that is produced by different firms, each with slightly different characteristics. The assumption made about labor employment in the Ricardian model. The term used to describe the amount of goods that can be produced using all the available world resources. What three things must be achieved to maximize world output? In the gardening story, if the son can do the rototilling in four hours, the raking in two hours, and the planting in three hours, which activity is the son “least worse” in producing compared with his father? 2.3 Ricardian Model Assumptions LEARNING OBJECTIVE Learn the structure and assumptions that describe the Ricardian model of comparative advantage. The Ricardian model shows the possibility that an industry in a developed country could compete against an industry in a less-developed country (LDC) even though the LDC industry pays its workers much lower wages. The modern version of the Ricardian model assumes that there are two countries producing two goods using one factor of production, usually labor. The model is a general equilibrium model in which all markets (i.e., goods and factors) are perfectly competitive. The goods produced are assumed to be homogeneous across countries and firms within an industry. Goods can be costlessly shipped between countries (i.e., there are no transportation costs). Labor is homogeneous within a country but may have different productivities across countries. This implies that the production technology is assumed to differ across countries. Labor is costlessly mobile across industries within a country but is immobile across countries. Full employment of labor is also assumed. Consumers (the laborers) are assumed to maximize utility subject to an income constraint. Below you will find a more complete description of each assumption along with a mathematical formulation of the model. Perfect Competition Perfect competition in all markets means that the following conditions are assumed to hold. Many firms produce output in each industry such that each firm is too small for its output decisions to affect the market price. This implies that when choosing output to maximize profit, each firm takes the price as given or exogenous. Firms choose output to maximize profit. The rule used by perfectly competitive firms is to choose the output level that equalizes the price (P) with the marginal cost (MC). That is, set P = MC. Output is homogeneous across all firms. This means that goods are identical in all their characteristics such that a consumer would find products from different firms indistinguishable. We could also say that goods from different firms are perfect substitutes for all consumers. There is free entry and exit of firms in response to profits. Positive profit sends a signal to the rest of the economy and new firms enter the industry. Negative profit (losses) leads existing firms to exit, one by one, out of the industry. As a result, in the long run economic profit is driven to zero in the industry. Information is perfect. For example, all firms have the necessary information to maximize profit and to identify the positive profit and negative profit industries. Two Countries The case of two countries is used to simplify the model analysis. Let one country be the United States and the other France. Note that anything related exclusively to France in the model will be marked with an asterisk. The two countries are assumed to differ only with respect to the production technology. Two Goods Two goods are produced by both countries. We assume a barter economy. This means that no money is used to make transactions. Instead, for trade to occur, goods must be traded for other goods. Thus we need at least two goods in the model. Let the two produced goods be wine and cheese. One Factor of Production Labor is the one factor of production used to produce each of the goods. The factor is homogeneous and can freely move between industries. Utility Maximization and Demand In David Ricardo’s original presentation of the model, he focused exclusively on the supply side. Only later did John Stuart Mill introduce demand into the model. Since much can be learned with Ricardo’s incomplete model, we proceed initially without formally specifying demand or utility functions. Later in the chapter we will use the aggregate utility specification to depict an equilibrium in the model. When needed, we will assume that aggregate utility can be represented by a function of the form U = CCCW, where CC and CW are the aggregate quantities of cheese and wine consumed in the country, respectively. This function is chosen because it has properties that make it easy to depict an equilibrium. The most important feature is that the function is homothetic, which implies that the country consumes wine and cheese in the same fixed proportion at given prices regardless of income. If two countries share the same homothetic preferences, then when the countries share the same prices, as they will in free trade, they will also consume wine and cheese in the same proportion. General Equilibrium The Ricardian model is a general equilibrium model. This means that it describes a complete circular flow of money in exchange for goods and services. Thus the sale of goods and services generates revenue to the firms that in turn is used to pay for the factor services (wages to workers in this case) used in production. The factor income (wages) is used, in turn, to buy the goods and services produced by the firms. This generates revenue to the firms and the cycle repeats again. A “general equilibrium” arises when prices of goods, services, and factors are such as to equalize supply and demand in all markets simultaneously.