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The importance of the Ricardian theory of international trade

Essay 2007 11 Pages

Economics - International Economic Relations

Excerpt

I. Introduction

Does international trade generate benefits for a country? This question still causes controversion between economists, company leaders and policy makers all over the globe. Over two centuries ago the pioneer of classical economics, Adam Smith ex- pressed the following statement promoting trade between nations: “If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry employed in a way in which we have some advantage.” (Smith, 1776, p. 457). Today, among other trade theories, the widely known Ricardian model of comparative advantage between economies is used by economists to explain how trade affects the prosperity of nations. Ricardo (1817) suggested that countries specializing in the production of the commodities in which they have a comparative advantage, can achieve higher standards of consumption and living by trading these goods with other countries.

Indeed, international trade has been rising steadily over the past decades. Propo- nents of Ricardo’s theory argue that trade can create industries and jobs, particularly in less developed nations, and increase the spectrum of economic opportunities, such as innovation and entrepreneurship. The aim of the paper is to give a brief glace at the theoretical framework and the importance of the Ricardian theory of international trade.1

II. Ricardo’s Theoretical Framework

Ricardo’s basic assumption is that countries produce goods with only one factor of production, notably labour, which is assumed to be immobile between countries but mobile within sectors, has constant returns of scale and on the markets prevails perfect competition. Each good produced in an economy requires a crucial amount of units of labour a i, e.g. the hours of labour needed to produce one unit of a product i. Further- more, each country has limited resources of production denoted by the amount of work- ers available on the domestic labour market L. Therefore the production possibilities of each country depend on the domestic labour force L and its productivity in producing a particular good ai. If one country specialises in the production of one product, the maxi- mum amount of its output is L. In a two good model the production is limited by the a i labour constraint La Q + a Q, where Q is defined as the quantity of a good i pro- 1 1 2 2 i a duced by a country. Thus the opportunity cost of good 1 in terms of good 2 is a. Panel

1 illustrates that a country is allowed to choose a menu of production possibilities along the labour constraint line. The concept of relative prices, in other words the price of one good in terms of another one, is necessary to identify what an economy produces. In a competitive environment where individuals try to maximize their incomes, the supply of labour will be determined by the wages workers receive. Wages are determined by the P i of a good i and productivity of and individual a i producing good i. Since there are no profits the wage w equals i P. Hence an economy producing two goods will con- a i P 1 a 1 P 1 a 1 centrate on the production of good 1, since > and on good 2, since < , be- P 2 a 2 P 2 a 2 cause wages are higher in sector 1 than in sector 2. In the absence of international trade the opportunity costs of each product are equal to their relative prices and therefore the country will produce both goods. In the case of two countries trading with each other, the pattern of production might change. Both countries again have only one factor of production, namely labour. The labour force of country 2 now is denoted by L * and its ratio of labour requirement a a. The production possibility frontier is shown in panel 2. The relative productiv- a a ity of country 1 in good 1 is higher than it is in good 2, if a < a. Thus country 1 has a comparative advantage in producing good 1 because its opportunity cost of good 1 in terms of good 2 are less than the opportunity cost of country 2. As mentioned above, in the absence of trade the relative prices in each country are determined by the relative labour requirements. Because the relative prices differ between both countries trade P a P a might be profitable. If [Abbildung in dieser Leseprobe nicht enthalten] , country 1 would specialize in the pro- duction of good 1 and country 2 would specialize in the production of good 2. As a consequence both countries gain from specializing because international trade increases the consumption possibilities of each country, as panel 3 shows for country 1.

In the comparative advantage model with two countries and many goods a chain[Abbildung in dieser Leseprobe nicht enthalten] illus- trates which country specializes in which products. Country 1 will produce the goods in the low end and country 2 will produce the goods in the high end of the chain. Further- more the pattern of trade depends on the ratio of productivity and the relative wages of both countries. In that model w is the wage rate of country 1 and w * is the wage rate of country 2. Goods will be produced in that country where production is cheaper. If the production cost of a good i in country 1 are wa i and the production cost of country 2 are wa * , it will be cheaper to produce the good in country 1 if [Abbildung in dieser Leseprobe nicht enthalten] and vice [Abbildung in dieser Leseprobe nicht enthalten] versa. Thus any good for which a i [Abbildung in dieser Leseprobe nicht enthalten] > will be produced in country 1, while any[Abbildung in dieser Leseprobe nicht enthalten] good for which [Abbildung in dieser Leseprobe nicht enthalten] will be produced in country 2. In other words a country has a cost advantage in producing a good if its relative productivity is higher than its relative wage.

III. The Importance of the Ricardian Model of International Trade

Certainly the Ricardian model is one of the most promoted economic ideas to defend the benefits of international trade. Whereas Smith’s theory of labour division only works if there is an absolute advantage of a country, Ricardo’s theory claims that countries gain from trade if there is a comparative advantage (Yang, 1994). Indeed, there is empirical evidence that the Ricardian theory is very useful for explaining the reasons for and effects of trade between countries. MacDougall (1951), in a first empiri- cal study about the productivity of British and American industries and its exports, tested the postulation of the theory of the comparative advantage and found that “where American output per worker was more than twice the British, the United States had in general the bulk of the export market, while for products where it was less than twice as high the bulk of the market was held by Britain” (MacDougall, 1951, p. 698). In other words, despite the British labour productivity being less than the American in most in- dustries, Britain’s exports at that time were as large as American exports. Furthermore, Stern (1962) in his work reinforced MacDougall’s results by analysing the relative Brit- ish and American export performance in 1950 and 1959 and found that the comparative advantage adjusted over time. This observed development suggested that countries with high productivities will be confronted with a challenge in order to maintain their pre- eminence. Today similar observations can be made for China and America. Although the Chinese average labour productivity is only a fraction of the American, China, espe- cially after its accession to the WTO in 1998, exports plenty of goods to the United States (panel 4 and 5). Because of the low wages Chinese manufacture workers receive (panel 6), China has a comparative advantage in producing labour intensive products such as textiles and toys.

However, despite the empirical evidence asserting the explanatory power of the Ricardian model, there are several doubts of the model’s ability to explain real world’s trade. The free-trade, two-commodity, two-country model loses its significance if there are many goods and many countries (Baghwati, 1964; Deardorff, 1980). Only one factor of production reduces the complexity of the model, but as a consequence, its implica- tions neglect other factors of production such as capital and natural resources (Krug- man; Obstfeld, 2006). The Heckscher-Ohlin model, also known as the factor- proportions theory, deals with the problem of the availability of different factors of pro- duction by explaining how differences in resources can affect international trade. Fur- thermore, the assumption of constant returns to scale neglects the existence and impor- tance of increasing economies of scale and fixed cost degression of export sectors. Ad- ditionally, today’s markets are characterized by imperfect competition (Samuelson, 2004).

Free trade is certainly called for by many economists and policy makers today, but international trade is still faced with trade barriers that influence input-factor prices and thus can distort trade patterns. Besides the costs of trade barriers and quotas, trans- portation costs might affect the relative prices and as a consequence deteriorate the rela- tive advantage of the sector a country is specialized in. Therefore trade patterns depend on the geography and costs of trade (Eaton; Kortum, 2002; Deardorff, 2005). However, the fact that a country fully specializes in the production of one good is quite far from reality. On the one hand, non-tradable goods cannot be imported from other countries. On the other hand market foreclosure in crucial sectors, such as defence and agriculture, are observable all over the globe. Reasons for that phenomenon might be the prohibition of knowledge transfer and the avoidance of shortages in the provision of goods.

[...]


1 A detailed overview of Ricardo’s theoretical framework is provided by Kenen (1971) and Krugman (2006).

Details

Pages
11
Year
2007
ISBN (eBook)
9783638034838
File size
364 KB
Language
English
Catalog Number
v88873
Institution / College
University of Hull – Business School
Grade
1,3
Tags
Ricardian International Economics David Ricardo International Trade

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Title: The importance of the Ricardian theory of international trade