The Ricardian Model of Trade and Non-Traded Goods 3. Consider the U.S. in the ex

Question

The Ricardian Model of Trade and Non-Traded Goods 3. Consider the U.S. in the example we discussed in class where the U.S. had a comparative advantage in the production of guns (therefore producing and exporting guns while importing butter). As a reminder, here are the unit input requirements for the U.S. from the class lecture notes: alB-0.5 aLG 0.125 We also showed that perfect competition would drive profits down to zero which would result in the following condition to hold in both markets (but here just shown for guns): a) Suppose the U.S. produces a non-traded good labeled Z (which you can think of as haircuts), and the U.S. requires 0.75 workers to make one unit of good Z. Using the above relationship between wages, prices and the unit input requirement, what must be the relative price of good Z in terms of guns (i.e. Pz / PG) in the U.S? Typically, productivity in the traded sector good increases more quickly than productivity in the non-traded sector. If auG falls to 0.1, what has happened to labor productivity in guns? b) c) What does the increase in labor productivity in guns do to the relative price of 2Z (assuming no increase in labor productivity in Z)? d) Assuming developed countries (like the U.S.) have faster labor productivity growth than developed countries, what do the results of this problem imply about the price level of goods in developed countries vs. developing countries? This is known as the Balassa-Samuelson effect.

Explanation / Answer

a) The condition given in the question is P = w * aL

Therefore, PG = wG * aLG (1) and PZ = wZ * aLZ (2). Dividing (2) by (1), we get,

PZ / PG = wz aLZ / wG aLG = 0.75 wZ / 0.125 wG = 6 wz / wG = relative price of Z in terms of G.

b) When aLG falls to 0.1, one unit of gun can be now produced with 0.1 units of labour compared to 0.125 units of labour earlier. Therefore, with less labour, more is produced now. So, the labour productivity in guns has increased.

c) If aLG falls to 0.1, we get Pz / PG = 0.75wz / 0.1 wG = 7.5 wZ / wG

% change in relative price of Z in terms of G = [(7.5 - 6)/ 6] *100 = 25%

Therefore, the relative price of Z increases by 25% when the labour productivity of G increses to 0.1 from 0.125.

d) If the labour productivity growth is higher in developing countries than developed countries, it means that the price levels will be lowered down in developing countries as compared to developed countries. This can be seen clearly from the condition P = w * aL. If aL grows faster then the labour productivity will increase faster in developing countries which will decrease the price levels in developing countries compared to developed countries. That is why people from developed countries generally buy he non traded goods and services like haircuts when they visit developing countries as the prices are cheaper.

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