Transcript Comparative Advantages Theory

Comparative Advantages
Theory
Biography
of David
Ricardo
1772~1823
• 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.
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.
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.
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 differentiated value in use from 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”.
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.
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.
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”.
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.
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 onethird 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?
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.
Typical Ricardian “2×2 Model”
Labor Requirements in Portugal and England
in Production of the Given Amount of Wine and Cloth
Portugal
England
Wine
80 men/year
120 men/year
Cloth
90 men/year
100 men/year
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.
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.
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.
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.
Portugal has its comparative advantages in the wine industry while England
could be considered to be comparatively advantageous in the cloth industry.
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.
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
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.
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.
Exchange ratios in an autarky economy
Labor Requirements in Portugal and England
in Production of the Given Amount of Wine and Cloth
Portugal
England
Wine
80 men/year
120 men/year
Cloth
90 men/year
100 men/year
• 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.
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.
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.
8
6
C 1W  C
9
5
For cloth, its international exchange
ratio would fall into the range
between 5/6W till 9/8W.
5
9
W 1C  W
6
8
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.
Production Possibility Curve (Frontier)
C
One of production points
that cannot be reached
• P2
c
P
Inefficient
choice of
production
O
One of efficient choices
of production
equilibrium point
• P1
f
F
Social consumption indifference curve map
C
N
d
c4
c
c3
Un
b
c2
c1
U3
a
U2
U1
O
f1
f2
f3
f4
F
Efficiency of an autarky economy
C
P
a
E
c
U2
UE
b
O
f
U1
F
Classical Ricardian Model
C
P1
P0
U
cu
a
E0
c0
U2
UE
cb
O
U1
b
T
fu
f0
fb
F
Trade equilibrium between two countries
C
Ua
E1b
U 1a
E0a
U 0a
E0b
Ub
Ta
E1a
Pa
Tb
U 1b
P
U 0b
Pb
O
P
F
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
Ta E1a  TbUb  X af  M bf
E1aTaU a
E1bTbU b
TaU a  Tb E1b  X cb  M ca
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.
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
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
Country A
Country B
Good F
1
3
Good c
2
6
• 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.
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?