Lecture 6: Ricardo model: Relative wages and productivity

Lecture 6: Ricardo model: Relative wages and productivity

ECO 3024F

Structure• Wages and productivity• Limitations of Ricardo Model• Empirical evidence

• Readings– Ch 1 , 2 & 3 of Krugman and Obstfeld– Golub, S. 1998. Does trade with low wage

economies hurt American workers [READER]? – Edwards, L & Golub, S. 2003. South Africa’s

international cost competitiveness: A sectoral analysis. [READER]

– Krugman. P. Ricardo’s difficult idea [READER]

QuestionCan South Africa compete against China where wages are

between 5 and 10 times lower?Will trade force down SA workers wages down to those of

China?Some views:“Companies that produce goods in foreign countries to take

advantage of cheap labor should not be permitted to dictate the wages paid to American workers”

“Impose a tax or tariff on goods brought into this country equal to the wage difference”

Quotes cited in Golub (1998)

What are your views on this? Can the Ricardo model provide any insight into this?

Discussion

• Golub (1998)– Wages are determined by absolute advantage – Trade is determined by comparative

advantage

• What is cost of product?– Cost = wage*unit labour requirement

– In our example: Costx = Wxx

Costy = Wyx

Relative wages & productivity

• Home will produce a good if cost home < cost competitor

• Home produces and exports X if CostHX = WHH < WFF = CostFX

• i.e. if WH/WF < F/H

– Recall: 1/H = MPLXH

F/H = MPLXH/MPLXF

Home exports if Relative wage < Relative productivity

SA vs DEVELOPED Countries

0

0.1

0.2

0.3

0.4

0.5

0.6

1970-79 1980-89 1990-94 1995-98

wages productivity

South African cost competitiveness

Source: Edwards and Golub (2003)

South African cost competitiveness

SA against DEVELOPING Countries

00.5

11.5

22.5

33.5

1970-79 1980-89 1990-94 1995-98

wages productivity


Although in the simple Ricardian model, we never directly referred to wages (only to productivity),

the relative wage – relative productivity relationship existed

behind the scenes.

Data recap

Unit labour per unit outputIndustry Home Foreign

X (coffee) h = 1 f = 6

Y (cloth) h = 2 f = 3

When: 1/2 < PX/PY < 2 :

Home specializes in X & Foreign specializes in Y

Other insights?Home: 6 times as productive in X (MPLXH/MPLXF = f/h )

Home: 1.5 times as productive in Y (MPLYH/MPLYF = f/h )

Relative wages

New world price ratio P* = 1

Assume: price of X = R 30 = price of Y

What is the wage in each country?

Wage = MPL * Price (or P/unit labour cost)

Home: WH = MPLX *PriceX = 1*R30 = R30

Foreign: WF = MPLY *PriceY = 1/3*R30 = R10

Relative wage: WH/WF = R30/R10 = 3

Lets plot relative wages & relative productivity

Relative wage is between productivity ratios:

Each country has Cost Advantage in production

Home:in X: 6 times more efficient but only 3 times more expensiveForeign:in Y: 2/3 as productive, but pays 1/3 the wageSolution: Each product gets produced where it is the cheapest to produce!Question: What happens if Px rises?

Relative productivity in Y = 1.5

Relative wage = 3

Relative productivity

in X = 6

Multiple goods model

Do the results change if we introduce Multiple Goods?

Unit labour requirementsIndustry Home Foreign Rel Prod

X (coffee) h = 1 f = 6 6

Y (cloth) h = 2 f = 3 1.5

Z (apples) 1 10 10

W (leather) 1 1 1

Order these by ratios of industries' productivities:

MPL1H/MPL1F < MPL2H/MPL2F < … < MPLnH/MPLnF

And plot on the relative w and relative productivity scale

Multiple Goods model

Relative wage = WH/WF

If relative wage (WH/WF) lie here, then Home exports coffee

and apples and imports cloth and leather

If relative wages (WH/WF) fall to here, then Home exports

coffee, apples and cloth and imports leather

Increasing relative productivity of Home

Relative productivity in Y (cloth)


in X (coffee)

61.5


in Z (apples)


in W (leather)

101

Discuss the adjustment process if relative wages are too low

Note: We can construct our multiple Goods model as follows (see K&O)

apples

coffee

cloth

leather

10

6

1.5

1

Wh/Wf

Lh/Lf

Relative L supply

RS*

Sub-conclusions

The competitiveness of an industry depends not only on relative wages but also on relative productivity

Relative wages generally follow relative productivity

Export products where relative productivity > relative wages

Declining terms of trade (Pexport/Pimport) negatively affect relative wages

Limitations of model• What are the limitations of model?

– Model assumes full specialization– What are the sources of labour

productivity? Capital? – Need to include other factors of

production– What about transport costs?– Income distribution: Model predicts that

all factors gain– Cannot explain intra-industry trade

Schematic: Transport costs

Relative wage = WH/WF

Relative productivity in Y (cloth)


in X (coffee)


in Z (apples)


in W (leather)

With transport costs, goods at the margin no longer become profitable to

trade

Non-tradable products produced by both Home

and Foreign

Empirical evidence

• Is there any support for the Ricardo model? i.e. Does it predict trade flows?

• Read– Golub, S. 1998. Does trade with low wage

economies hurt American workers? – Edwards, L & Golub, S. 2003. South Africa’s

international cost competitiveness: A sectoral analysis.

Does SA cost competitiveness affect exports?

1970-79

0.00

0.50

1.00

1.50

2.00

2.50

3.00

0 500 1000 1500 2000 2500 3000 3500

Real exports (R million)

RU

LC

1980-89

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

1.80

2.00

0 500 1000 1500 2000 2500 3000 3500 4000


RU

LC

1990-98

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

1.80

2.00

0 1000 2000 3000 4000 5000 6000 7000


RU

LC

1990-98

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

1.80

2.00

0.00 0.10 0.20 0.30 0.40 0.50 0.60

Exports/Output

RU

LC

Does SA cost competitiveness affect exports?

Impact on exports from a 1% increase in wages or labour productivity

-4

-3

-2

-1

0

1

2

3

Natural resource Labour Chemical Machinery & metalproducts

% c

ha

ng

e i

n e

xp

ort

s

Rel Prod Rel Wage


ConclusionInternational competitiveness• SA competitive, as measured by RULC, in most sectors vis-à-

vis developed countries, but not developing countries• SA competitiveness improved during the 1990s• but improvement substantially reflects the large depreciation of

the rand against other currencies

• No clear pattern of competitiveness at the sectoral level over time

Effect of competitiveness on exports• South African exports respond strongly to labor cost

competitiveness (relative wages and relative productivity) (particularly L-intensive)

• Growth in exports during the 1990s in large measure due to improved relative unit labor costs

Lecture 6: Ricardo model: Relative wages and productivity

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