Relationship between Prices and Wages

This is “Relationship between Prices and Wages”, section 2.7 from the book Policy and Theory of International Trade (v. 1.0). For details on it (including licensing), click here.

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2.7 Relationship between Prices and Wages

Learning Objective

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 Π_C represent profit in the cheese industry. We can write this as

Π_{C} = P_{C} Q {}_{C} - w_{C} L_{C} = 0,

where P_C is the price of cheese in dollars per pound, w_C is the wage paid to workers in dollars per hour, P_CQ_C is total industry revenue, and w_CL_C is total industry cost. By rearranging the zero-profit condition, we can write the wage as a function of everything else to get

w_{C} = \frac{P_{C} Q_{C}}{L_{C}} .

Recall that the production function for cheese is $Q_{C} = \frac{L_{C}}{a_{L C}}$ . Plugging this in for Q_C above yields

w_{C} = \frac{P_{C} (\frac{L_{C}}{a_{L C}})}{L_{C}} = \frac{P_{C}}{a_{L C}}

or just

w_{C} = \frac{P_{C}}{a_{L C}} .

If production occurs in the wine industry, then profit will be zero as well. By the same algebra we can get

w_{W} = \frac{P_{W}}{a_{L W}} .

Key Takeaways

The assumption of free entry and exit in perfect competition implies that industry profit will be zero when the market is in equilibrium.
Nominal wages (meaning wages measured in dollars) to workers in each industry will equal the output price divided by the unit labor requirement in that industry.

Exercise

Starting with the zero-profit condition in the wine industry, show why the winemaker’s wage depends on the price of wine and wine productivity.