THE CLASSICAL MODEL OF INTERNATIONAL TRADE
Topic 3.4
Trade and wages
If labor is the only factor of production then in pretrade equilibrium the price of a good is simply the number of hours to produce it.
Psa = Wa x 3
Pta = Wa x 6
Psb = Wb x 12
Ptb = Wb x 8
Suppose both countries use the same currency.
Then for trade to occur the pretrade price of S must be lower in country A than in country B. And the opposite must be true for T.
Psa < E x Psb
Pta > E x Ptb
Where the exchange rate E converts country B currency into country A currency.
Then
Wa/(E x Wb) < 4
Wa/(E x Wb) > 4/3
that is 4/3 < Wa/(E x Wb) < 4
The middle term is the relative wage ratio.
Workers in A must earn more than in country B as measured in country A currency.
Differences in labor productivity explain the wage differences. Labor in A is 4/3 times as productive as labor in B (in textiles) and 4 times as productive in S production. These numbers set the limits for wage differences.
If the wage rate for labor in country A is more than four times the wage rate in country B then that would erase the advantage of buying goods from A. The extra high wage in A would erase any price advantage for S goods imported from A.
For good T, if wages in country B are more than ¾ the wages in A, it wipes out the productivity advantage of country B in the production of T.
To summarize, the wage rate in a country cannot be so high that it wipes out the natural comparative advantage that country has in its export good.
Another way of thinking about it: we know that productivity determines the standard of living in a country. It makes sense that relative productivity determines the relative wage rate between two countries. So the relative advantage A has in its export good sets the upper bound on its wage premium.
But, and this is truly surprising – it is not absolute advantage that sets the (limits for) the wage premium. It is comparative advantage. Being the lowest cost producer of a good in terms of labor costs does not raise your relative wage. It is the structure of comparative advantage (lowest opportunity cost) that matters.
Another remarkable result: it is the trade sector that drives relative wages. Because trade in this model drives both countries to specialize completely (by assumption), the whole production pattern of an economy is determined by comparative advantage.
