International Trade - Theory and Policy, 2010a

2.7 Relationship between Prices and Wages
LEARNING OBJECTIVE
1. Learn how worker wages and the prices of the goods are related to each other in the
Ricardian model.
The Ricardian model assumes that the wine and cheese industries are both perfectly competitive. Among
the assumptions of perfect competition is free entry and exit of firms in response to economic profit. If
positive profits are being made in one industry, then because of perfect information, profit-seeking
entrepreneurs will begin to open more firms in that industry. The entry of firms, however, raises industry
supply, which forces down the product price and reduces profit for every other firm in the industry. Entry
continues until economic profit is driven to zero. The same process occurs in reverse when profit is
negative for firms in an industry. In this case, firms will close down one by one as they seek more
profitable opportunities elsewhere. The reduction in the number of firms reduces industry supply, which
raises the product’s market price and raises profit for all remaining firms in the industry. Exit continues
until economic profit is raised to zero. This implies that if production occurs in an industry, be it in
autarky or free trade, then economic profit must be zero.
Profit is defined as total revenue minus total cost. Let ΠC represent profit in the cheese industry. We can
write this as
ΠC=PCQC−wCLC=0,
where PC is the price of cheese in dollars per pound, wC is the wage paid to workers in dollars per
hour, PCQC is total industry revenue, and wCLC is total industry cost. By rearranging the zero-profit
condition, we can write the wage as a function of everything else to get
wC=PCQCLC.
Recall that the production function for cheese is QC=LCaLC. Plugging this in for QCabove yields
wC=PC(LCaLC)LC=PCaLC
or just
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