David Ricardo theory of comparative advantage

Introduction:

Since first illustrated the theory of comparative advantage in the early 19 century. He solved a problem that had eluded Comparative advantage explains why a country might produce and export something its citizens don't seem very skilled at producing when compared directly to the citizens of another country. The explanation of the apparent paradox is that the citizens of the importing country must be better at producing something else, making it worth it for them to pay to have work done by the exporting country. Amazingly, the citizens of each country are better off specializing in producing only the goods at which they have a comparative advantage, even if one country has an absolute advantage at producing each item.

Although most models and theories of trade suggest that some people would benefit and some lose from free trade, the Ricardian model shows that everyone could benefit from trade. This can be shown using an aggregate representation of welfare (national indifference curves) or by calculating the change in real wages to workers. However, one of the reasons for this outcome is the simplifying assumption that there is only one factor of production.

The analysis of this model can explain what happens when each country moves from autarky (no trade) to free trade with the other country. In other words what are the effects of trade. The main things should care about are trade's effects on the prices of the goods in each country, the production levels of the goods, employment levels in each industry, the pattern of trade (who exports and who imports what), consumption levels in each country, wages and incomes, and the welfare effects both nationally and individually.

Theory of comparative Advantages:

The modern version of the Ricardian Model assumes Firstly that there is two countries, producing two goods, using one factor of production, usually labor such as (2 x 2 x 1) model. Secondly the model is a general equilibrium model in which all markets (i.e., goods and factors) are perfectly competitive. Third the goods produced are assumed to be homogeneous across countries and firms within an industry. Fourth the shipping fee must be very cheap between countries (i.e., there are no transportation costs). Fifth labor is homogeneous within a country but may have different productivities across countries. This implies that the production technology is assumed to differ across countries. No exists upgrades of technology or economic growth, labor is costless mobile across industries within a country but is immobile across countries. Sixth Full employment of labor is also assumed. Consumers (the laborers) are assumed to maximize utility subject to an income constraint. (New international economic 2004)

Ricardo showed that the specialization good in each country should be that good in which the country had a comparative advantage in production. To identify a country's comparative advantage good requires a comparison of production costs across countries. The basis of trade is comparative and not absolute advantages.

Usefulness of Ricardo’s theory of comparative Advantages:

The country who hold absolute advantages do not need produce all products, should concentrate its productive power on most profitable products, and another country who hold absolute disadvantages should stop produce the least profitable products.

Ricardo demonstrated numerically that if England specialized in producing one of the two goods, and if Portugal produced the other, then total world output of both goods could rise; a greater efficiency can be found through the trade of these two products between 2 countries.

Tab 1: Before trade

From table 1, ...

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Usefulness of Ricardo’s theory of comparative Advantages:

Tab 1: Before trade

From table 1, compare with England, Portugal hold absolute advantage in both 2 products, however, England has a comparative advantages on producing cloth (100/90) compare with producing wine (120/80), then after specialize England only produce cloth and Portugal only produce wine (see tab 2).

Tab 2: After specialize

Table 2 shows after specialize in the product each country in which they enjoy comparative advantages. The units of these two products all increase, cloth greater 0.2 unit, wine greater 0.125. The total efficiency of producing products has grown up.

How these two countries gain from trade, assume the ratio, which was agreed England and Portugal. Use 1 unit cloth exchange to 1 unit wine, at present England use 1 unit cloth trade to 1 unit wine, or Portugal use 1 unit wine trade to 1 unit cloth. After trade, the benefit of these two countries can be seen in below table.

Tab 3: After trade

Obviously, Both countries gain from specialisation and trade, even though one country is better at both activities. But important thing is the terms of trade must lie between each country’s pre-trade cost ratios.

Another way to define comparative advantage is by comparing productivities across industries and countries. (The Theory of Comparative Advantage – Overview/1997-2004) Thus suppose, as before, that Portugal is more productive than England in the production of both cloth and wine. If Portugal is twice as productive in cloth production relative to England but three times as productive in wine, then Portugal's comparative advantage is in wine, the good in which its productivity advantage is greatest. Similarly, England's comparative advantage good is cloth, the good in which its productivity disadvantage is least. This implies that to benefit from specialization and free trade, Portugal should specialize and trade the good in which it is "most best" at producing, while England should specialize and trade the good in which it is "least worse" at producing.

The theory of comparative advantages is also one of the most commonly misunderstood principles. (Steven Suranovic 1997-2004) The sources of the misunderstandings are easy to identify.

First, the principle of comparative advantage is clearly counter-intuitive. Many results from the formal model are contrary to simple logic.

Secondly, the theory is easy to confuse with another notion about advantageous trade, known in trade theory as the theory of absolute advantage. The logic behind absolute advantage is quite intuitive. This confusion between these two concepts leads many people to think that they understand comparative advantage when in fact, what they understand, is absolute advantage. To recognize this 2 different theory can use below table 4

Tab 4:

Sources: (M.V.Charles/international trade and world economy, Chapter 3)

From the table, both imports and exports can be seen. The EU has considerably higher productivity than Kenya. Based on the theory of absolute advantages, the EU should only be exporting to Kenya, and not import anything at all. However, as is evident from the table, the EU does import goods from Kenya, which could be based on trade in accordance with comparative. (C.V. Marrewijk). The table above fully evident that the theory of comparative advantage does better in terms of explanatory power than the theory of absolute advantage.

The benefit after trade also can be seen at worker’s wage. The real wage depends on the amount of consumption of an hour worker’s wage, see the table 4

Tab: 5 US vs. UK

Production: (hour)

From table, US spend fewer hours on both products it means the US efficiency is 2 times more than UK at cloth, 3 times more at food. So US will specialize food production and UK will produce more cloth. Assume that 1 unit cloth and 1 unit wine, before trade one US worker must spend 3 hours wage and 7 for UK worker. Obviously after trade the price of cloth will be I unit 3$ and food will be 1 unit 2$, a US worker still have to work 1 hour to buy 1 unit food because food was produced domestic but only need worked 1.5 hour to buy 1 unit UK cloth, therefore after trade a US worker only spent 2.5 hours wage to buy 3 hours products, this means the real wage of US worker has increased by 20%.

For UK worker to produce 1 unit cloth still have to spend 4 hours but after trade only produce 2/3 unit cloth then trade as 2/3cloth=1unit US food, now to have this group of products. UK worker have to spend 4+2(2/3)=6(2/3) hour. Hence the wage after trade increases 5% compare with wage before trade.

In perfect competition market, if every country specialize the products or industries which they have comparative advantages, then after trade, every country would be better than before, compare with no trade, workers can now produce comparative advantages products then trade to some products which they do not produce, all workers work the same amount of time but can gain more wage or goods

Terms of trade and gains from trade:

The terms of trade must lie between each country’s pre-trade ratios for both countries to gain. If the terms of trade are below than pre-trade cost ratio, trade will not happened. However, it really matters exactly where the terms of trade lie. If the terms of trade closed to the pre-trade cost ratio of a country, the less gain from trade and also the other countries will gain more. (Nigel Grimwade 2008). To determine the terms of trade must find law of reciprocal demand. It measures the demand for one product of what a country will offer of the other good in return.

Validity of Ricardo’s theory of comparative Advantages:

Empirical tests of the Ricardian Theory:

The pioneering work was done by MacDougall who computed simple measure of average labor productivities in the US and the UK for the year 1937. Based on the observation that the wage rate in the US was approximately twice the wage rate in UK, he hypothesized that US firms should have an export advantages in manufacturing sectors for which US exports to UK exports of 25 products to countries other than themselves. Britain must be expected to specialize in those industries in which US productivity was less than twice as high. The result was supportive for the Ricardian model. Twenty of the 25 products satisfied the simple prediction that, in cases where US productivities exceeded twice the UK level; the ratio of US exports exceeded one.

Many people who learn about the theory of comparative advantage quickly convince themselves that its ability to describe the real world is extremely limited, if not, non-existent. Although the results follow logically from the assumptions, the assumptions are easily assailed as unrealistic. For example, the model assumes only two countries producing two goods using just one factor of production. There is no capital or land or other resources needed for production. The real world, on the other hand, consists of many countries producing many goods using many factors of production. Each market is assumed to be perfectly competitive, when in reality there are many industries in which firms have market power. (Paul A. Samuelson) Labor productivity is assumed fixed, when in actuality it changes over time, perhaps based on past production levels. Full employment is assumed, when clearly workers cannot be immediately and costless moved to other industries. Also, all workers are assumed identical. This means that when a worker is moved from one industry to another, he or she is immediately as productive as every other worker who was previously employed there. Finally, the model assumes that technology differences are the only differences that exist between the countries.

With so many unrealistic assumptions it is difficult for some people to accept the conclusions of the model with any confidence, especially when so many of the results are counterintuitive. Indeed one of the most difficult aspects of economic analysis is how to interpret the conclusions of models. Models are, by their nature, simplifications of the real world and thus all economic models contain unrealistic assumptions. Therefore, to dismiss the results of economic analysis on the basis of unrealistic assumptions means that one must dismiss all insights contained within the entire economics discipline. Surely, this is not practical or realistic. Economic models in general and the Ricardian model in particular do contain insights that most likely carry over to the more complex real world.

Interpreting the Theory of Comparative Advantage:

The usual way of stating the Ricardian model results is to say that countries will specialize in their comparative advantage good and trade them to the other country such that everyone in both countries benefit. Stated this way it is easy to imagine that it would not hold true in the complex real world. A better way to state the results is as follows. The Ricardian model shows that if any country want to maximize total output in the world then, first, fully employ all resources worldwide; second, allocate those resources within countries to each country's comparative advantage industries; and third, allow the countries to trade freely thereafter. In this way might raise the well being of all individuals despite differences in relative productivities. In this description, do not predict that a result will carry over to the complex real world. Instead to carry the logic of comparative advantage to the real world and have to look to achieve a certain result (maximum output and benefits)..