Ricardo’s theory of trade

David Ricardo was one of the most influential economists of the early nineteenth century, but he came to economics by a circuitous route. Born to a Jewish family in Amsterdam, he left the country and broke off relations with his family (and they with him) to avoid an arranged marriage — he married a Quaker instead. He set himself up in London as a government securities dealer and became, in his words, “sufficiently rich to satisfy all my desires and the reasonable desires of all those about me.” Looking for something to occupy his time, he developed the modern theory of international trade.

Many people of Ricardo’s day (and ours!) regarded trade as a zero-sum activity: if you gain from trade, then I must lose. As Adam Smith in his Wealth of the Nations puts it:

All political writers since the time of Charles II had been prophesying that in a few years we would be reduced to an absolute state of poverty [by international trade], but we find ourselves far richer than before.

That trade is good for consumers is easy to understand; more trade means more choices and having more choices is at least as good as not having them. That trade is good for producers is a bit less immediate. The argument uses the idea of specialization. Take Minnesota and Florida: Minnesota is good at producing corn and Florida’s good in producing oranges and both Minnesotans and Floridians like to consume oranges and corn. In absence of trade some oranges will be produced in greenhouses in Minnesota and some corn will be grown in the Florida swamps: but productivity in those two activity is not very high and thus producers in those two sectors will not be doing very well. When Florida and Minnesota open up to trade Minnesota can specialize in corn and Florida in oranges, meaning, for example, that producers of oranges in Minnesota can turn to producing corn. The demand for their corn will come from Florida and they will have higher productivity so they are also better off. But this story relies on absolute advantage (Florida on oranges and Minnesota on corn) and that was Smith had in mind. What if Florida is better than Minnesota in both oranges and corn?

Ricardo insight was that trade is advantageous even in this situation. What matter is not absolute advantage but comparative advantage, that is as long as Minnesota is better than Florida in the corn to orange ratio (even though it is worst than Florida in both) then trade will be advantageous to both. This result has been referred to one of the few in results economics which is neither trivial nor false, so in class we will discuss the Economist’s note “The miracle of trade” in detail.

The note develops Ricardo’s theory in a particularly simple setting: two countries produce and consume two products, and both products are produced with labor alone. In many respects this version of the theory is unrealistic, but the lack of realism is exactly what makes the analysis simple and understandable. We’ll discuss later whether the lack of realism plays an undue role in our conclusions. (For the most part, it does not.)

Bottom line

• The driver of trade are differences in prices. In absence of trade wine is expensive in the North and cheap in the south. That calls for the North to buy wine from the South. The symmetric holds for bread.
• Why is South producing and exporting wine when the North could do it more efficiently? Because wages of wine producer in the South are lower. Think like this: how much bread does it cost in the North to switch one worker from bread to wine? 1 loaf. How much in South? only 1/3 of a loaf.
• Consumers are better off in both countries with free trade because they both take advantage of cheap goods.
• Free trade changes the distribution of production. In this case, the North shifted out of wine into bread, and the US did the reverse. In other models, the change in production may not be so extreme, but it’s generally true that they predict that every country will stop producing some products, and import them instead. The result is a far more efficient system of production, as each country produces those goods for which its relative productivity is the highest.
• Moving to free trade is similar to an increase in productivity: when you shift production to high productivity products, aggregate productivity rises. The impact is similar to our discussion of capital markets. Countries with good capital markets allocate capital more effectively to the high-return projects and increase aggregate productivity as a result. This is a natural feature of trade models. If we were NIPA people, we might compute GDP like this: sum production of wine and bread, valued at a fixed set of prices. In this case we’ll use the free trade prices, which is similar to PPP adjustment (apply the same prices in every country). GDP at world prices (in bottles of wine) is Free Trade No Trade.
  

Once trade shows up in GDP, it shows up in aggregate productivity, too. We don’t have capital in this model, so the production function is Y = AL. Since L is unchanged across trade regimes, the change in Y reflects an increase in TFP.

• No jobs were lost — or found. In our example, every unit of labor was used whether trade was possible or not. This is only a little extreme: no trade models suggest that trade will have much long run impact on employment. Any effect there might be comes from the impact on labor supply of an increase in the wage. So when you read the newspaper, especially in an election year, remember: trade has an impact on what the jobs are, not on how many there are.