Comparative Advantages Theory

1. Comparative Advantages Theory By: David Ricardo

2. Biography of David Ricardo • David Ricardo was one of those rare people who achieved tremendous success and lasting fame. After his family disinherited him for marrying outside his Jewish faith, Ricardo made a fortune as a stockbroker and a loan broker. When he died, his estate was worth over $100 million in today's dollars. • At age of 27, after reading The Wealth of Nations, Ricardo got excited about economics. He wrote his first economics article at age of 37 and then spent fourteen years—his last ones—as a professional economist. • In 1814, at the age of 42, Ricardo retired from business and took up residence at Gatcombe Park in Gloucestershire, where he had extensive landholdings. • In 1819 he became MP for Portarlington. • Illness forced Ricardo to retire from Parliament in 1823 and he died on 11 September at Gatcombe Park at the age of 51. 1772~1823

3. Ricardo’s Doctrine of Free Trade • Ricardo published his Principles of Political Economy and Taxation in 1817. His legacy dominated economic thinking throughout the 19th Century. • David Ricardo maintained that the economy generally moves towards a standstill. His analysis is rooted in a modified version of the labor theory of value. Marx, in fact, based a great deal of his economic theory on Ricardo's writings. Marx identified capitalists as the source of societal grief and he also utilized Ricardo's forecast of economic stagnation in predicting a working class uprising. When capitalism eroded its own underpinnings the resulting misery was expected to bring social strife and revolution. It is unlikely that Ricardo would have supported Marx's revolutionary brand of political economics, but the ties between the schools of thought are undeniable. • Ricardo’s policy recommendations are grounded in the doctrine of free trade. Ricardo believed that the laws hindering free trade constituted a burden to the agricultural economy. He believed that these trade barriers kept food prices artificially high and encouraged a bloated rent rate. In Parliament Ricardo actively campaigned against such laws as well as other government interventions. • Essentially Ricardo’s economic stance mirrors Adam Smith's teachings: the market, although imperfect, is best left untouched. Government action only prevents the economy from righting itself. Although Ricardo did not share Smith's complete confidence in the market he recognized that tampering with the system would only result in further economic stagnation.

4. Ricardo’s Attainments of Trade Theory • On foreign trade, Ricardo set forth his famous comparative advantages theory. Using his famous example of two nations (Portugal and England) and two commodities (wine and cloth), Ricardo argued that trade would be beneficial even if Portugal held an absolute cost advantage over England in both commodities.  Ricardo's argument was that there are gains from trade if each nation specializes completely in the production of the good in which it has a "comparative" cost advantage in producing, and then trades with the other nation for the other good.  • Ricardo concluded that trade between countries was not dominated by relative costs of production and by differences in internal price structures that reflected the comparative advantages of the trading countries and made exchange desirable. • Ricardo successfully jumped out from the theoretical trap of Adam Smith’s assumption, revealing existence of the universal trade benefit and thus founding a rational basis for the mutually beneficiary trade.

5. Value determination of a commodity Ricardo quoted Adam Smith: The value of a commodity, or the quantity of any other commodity for which it will exchange, depends on the relative quantity of labor which is necessary for its production, and not on the greater or less compensation which is paid for that labor”. Ricardo differentiatedvalue in usefrom value in exchange.“The things which have the greatest value in use, have frequently little or no value in exchange; and on the contrary, those which have the greatest value in exchange, have little or no value in use”. To describe his idea Ricardo raised an example as the following. He wrote: “Water and air are abundantly useful; they are indeed indispensable to existence. Yet, under ordinary circumstances, nothing can be obtained in exchange for them. Gold, on the contrary, though of little use compared with air or water, will exchange for a great quantity of other goods.” “Utility then is not the measure of exchangeable value, although it is absolutely essential to it. Possession utility, commodities derive their exchangeable value from two sources: from their scarcity, and from the quantity of labor required to obtain it”.

6. Determinant factor of international production specialization • Generally speaking under a system of perfectly free commerce, each country naturally devotes its capital and labor to such employments as are most beneficial to each. This pursuit of individual advantage is admirably connected with the universal good of the whole. • It is this principle that determines that wine shall be made in France and Portugal, that corn shall be grown in America and Poland, and that hardware and other goods shall be manufactured in England.

7. Factor movements and value determination • Profit equalization in the home country derived from free movement of production factors. • Unequal profits among countries because of no such movement. • Experience, however, shows that the fancied or real insecurity of capital, when not under the immediate control of its owner, together with the natural disinclination which every man has to quit the country of his birth and connections, and entrust himself, with all his habits fixed, to a strange government and new laws, check the emigration of capital. These feelings induce most men of property to be satisfied with a low rate of profit rather than seek a more advantageous employment for their wealth in foreign nation.（经验表明，种种因素阻碍着资本劳动的转移。如资本转移到了别国以后，将不在其所有者的直接控制之下，以及每一个人不得不离开生他养他的国家和他所熟悉的环境，带着业已养成的习惯而置身于一个陌生的国度和该国的法律之下等等，都会使人们产生不安全感，而且也会带来实际的风险。这些感觉使大多数有产者都不愿到外国去为自己的财富寻找更为有利可图的用途，而宁愿满足于本国较低的利润率。）

8. Value of particular commodity different in two countries • “The same rule which regulates the relative value of commodities in one country, dose not regulate the relative value of the commodities exchanged between two or more countries”. That is to say that in the case of that Portugal exchange from England for the cloth with its own product, wine, “The quantity of wine she (Portugal) shall give in exchange for the cloth of England, is not determined by the respective quantities of labor devoted to the production of each, as it would be, if both commodities were manufactured in England, or both in Portugal”.（支配一个国家中商品相对价值的法则不能支配两个或更多国家间互相交换的商品的相对价值。也就是说，葡萄牙用多少葡萄酒来交换英国的毛呢，不是由各自生产上所用的劳动量决定的，情形不象两种商品都在英国或葡萄牙生产那样。）

9. Important assumptions of comparative advantages theory • To simplify analysis the following assumptions should be held. • There are no transport costs. • Costs are constant and there are no economies of scale. • There are only two economies producing two goods. • The theory assumes that traded goods are homogeneous. • Factors of production are assumed to be perfectly mobile within a country but no movement internationally. • There are no tariffs or other trade barriers.

10. Comparative advantages and the mutually beneficiary exchanges between individuals • Two men can both make shoes and hats, and one is superior to the other in both employments; but in making hats, he can only exceed his competitor by one-fifth or 20 per cent, and in making shoes he can excel him by one-third or 33 per cent. Will it not be for the interest of both, that the superior man employs himself exclusively in making shoes, and the inferior man in making hats?（如果两个人都生产鞋和帽子。其中一人在两种商品的生产上都比另一个人具有优势，不过在帽子生产上只领先于其竞争对手1/5，或20%，而在鞋的生产上却要领先于其竞争对手1/3，或33％；那么，这个具有优势的人专门生产鞋子，而那个处于劣势的人专门生产帽子，难道不是对于他们双方都有利吗?）

11. Comparative advantages and the mutually beneficiary exchanges between countries • England may be so circumstanced, that to produce the cloth may require the labor of 100 men for one year; and if she attempts to make the wine, it might require the labor of 120 men for the same time”. Whereas “to produce the wine in Portugal, might require only the labor of 80 men for one year, and to produce the cloth in the same country, might require the labor of 90 men for the same time. • The two countries must acquire their respective benefit if they exchange with each other.

12. Typical Ricardian “2×2 Model” Labor Requirements in Portugal and England in Production of the Given Amount of Wine and Cloth Portugal is superior to England in the two trades since she could produce the both products with less labor input. On the contrary, England is inferior to Portugal in the two industries because she has to employ more labor to produce the given amount of the products. In accordance with the absolute advantage theory there would no opportunity for the two countries to execute the mutual benefit trade since the above model dose not satisfy the requirement of the “assumption of Adam Smith”. England in the above model, even has no industry in which it could produce at least one commodity with the absolutely lower cost of labor it necessarily can obtain its trade benefit by taking an active part in the free trade. For Portugal that enjoys the absolute advantages in the both industries, it can also maximize its benefit from the free trade.

13. Key to understand such mutual benefit of trade • Difference in degrees of advantages of Portugal over England and the difference in degrees of disadvantages of England over Portugal in the two industries. In producing wine labor requirement in Portugal is 2/3 of that in England and in production of cloth the relevant ratio is 9/10. That is to say the advantage of Portugal in producing wine is much larger than in cloth. This concludes that Portugal is much greater advantageous over England in producing wine than in cloth since 2/3 is smaller than 9/10 whereas England suffers from less disadvantages in producing cloth than in wine since 1/2 is larger than 1/9. In England, on the contrary, labor requirement in producing cloth is 1/9 more than that in Portugal while labor requirement in producing wine is 1/2 more than that in Portugal. Portugal has its comparative advantages in the wine industry while England could be considered to be comparatively advantageous in the cloth industry.

14. Basic principle of comparative advantages theory • For the country enjoying overall advantages in the both industries, choose one in which it is comparatively more advantageous, while for the other country with overall disadvantages in the both industries, choose one in which it is comparatively less disadvantageous. • 比较优势理论的基本原理可以概括为：“两优择其甚，两劣权其轻”。

15. Relations between Absolute advantages theory and comparative advantages theory • From such principle we see that the trade based on absolute advantages introduced by Adam Smith is actually a special case of the phenomena illustrated by Ricardo’s comparative advantages. In other word, one can say that absolute advantages, in fact, are some special comparative advantages under the specific circumstances. Comparative advantages Absolute advantages

16. Ricardo’s contribution in trade theory • Based on the co-called comparative advantages illustrated by Ricardo and actually enjoyed by all the possible trading countries each of them must have the universal motivation to exchange with the other countries because of real benefit. • Such real benefit constitutes the practical solid foundation for rationality of free trade policy argument. • The significant difference between Adam Smith and David Ricardo is that Ricardo developed free trade philosophy and made such philosophy very much wider applicable. • Ricardo developed classical trade theory from what that merely analyzed some special cases, for instances trade of England and such countries, into the theory which might function as the guidance of trade of almost all countries. • That must be a great theoretical contribution of David Ricardo in development of the pure theory of international trade.

17. Trade benefit based on comparative advantages theory • Trade benefit based on comparative advantages theory also derived from comparing domestic exchange ratios between the two commodities in the two countries with the exchange rate in international market. • Because the same rule which regulates the relative value of commodities in one country dose not regulate the relative value of the commodities exchanged between two or more countries domestic exchange ratio between the two goods in one country must be different from that in another country. • Such difference prepares possibility for the two countries to initiate bargaining for determining an exchange ratio between the two goods prevailing in international market which represents real benefit for the both countries.

18. Exchange ratios in an autarky economy Labor Requirements in Portugal and England in Production of the Given Amount of Wine and Cloth • Domestic exchange ratio between wine and cloth in Portugal is 1W：8/9C or 1C：9/8W. • That exchange ratio in domestic market in England is 1W：6/5C or 1C：5/6W. • The relative price of wine in terms of cloth is lower in Portugal than in England. 8/9C﹤6/5C. • The relative price of cloth in terms of wine is lower in England than in Portugal. 5/6W﹤9/8W.

19. Requirements of the two countries and bargaining between them The exporter of wine, Portugal requires to exchange 1W for more than 8/9C. The importer of wine, England is only willing to give up less than 6/5C for importing 1W from Portugal. The exporter of cloth, England wants to exchange 1C for more than 5/6W. The importer of cloth, Portugal, is only willing to pay 1C with less than 9/8W. 

20. Exchange ratio in an opening world There must be an obvious range between the subjective requirements of the two countries toward the relative prices of the two goods in international market. For wine, its international exchange ratio would fall into the range between 8/9C till 6/5C. For cloth, its international exchange ratio would fall into the range between 5/6W till 9/8W.  No matter any point in the respective range at which the international exchanges would be actually executed there must be some gains from trade for the both countries.

21. Production Possibility Curve (Frontier) C One of production points that cannot be reached • One of efficient choices of production equilibrium point c P Inefficient choice of production • O F f

22. Social consumption indifference curve map

23. Efficiency of an autarky economy

24. Classical Ricardian Model

25. Trade equilibrium between two countries

26. Illustration of trade equilibrium • Domestic price lines show that Country A has comparative advantages in Good F. Country B has comparative advantages in Good C. • In an opening economy the two countries accept the prevailing international price and trade with each other. • They can acquire their respective trade benefits in terms of a higher utility from consumption. Trade triangular of Country A is Trade triangular of Country B is International market is entirely cleared. Trade is in equilibrium. Country A increases its social consumption on an upper located indifference curve so does Country B.

27. Widely application of the principle • The principle of comparative advantages theory: For those enjoying overall advantages choose one in which they are comparatively more advantageous, while for the others with overall disadvantages choose one in which they are comparatively less disadvantageous. • This principle could be widely applicable in many different walks of life. Professor vs. teaching assistant Doctor vs. nurse Manager vs. secretary Master vs. apprentice

28. Defect of Ricardian Model • When “two-country-two-commodity model” is used there invariably exist some cases in which there is no differences in degrees of advantages and disadvantages just like in the following model. Labor Requirements in the Two Industries In the Two Countries

29. The above mentioned case could be termed “equal advantages” or “equal disadvantages” in which comparative advantages principle does not work since no choice could be made because of no differences in the degrees of advantages and disadvantages.   • The reason for such defect of Ricardo lies on the too simplified theoretical assumptions of Ricardian model. This defect would be overcome when the model is extended from bilateral into multilateral trade and from two goods into many different sorts of goods as trade goes in the real world.

30. Questions and problems • Why we say completely no immigration of production factors among countries must be one of the important prerequisites of Ricardian Model? • What are the keys to understand the principle of comparative advantages theory? • Raise an example to illustrate trade benefits acquired by both sides when they trade on the basis of comparative advantages. • Try to describe a typical Ricardian Model with widely used tools in economics. • Why we say Ricardian Model is a theoretical progress compared with Adam Smith? • What is the main defect of Ricardian Model, where does it derive from and how to surmount it?