Unit 2: Why Trade?
Part 4: David Ricardo
Refines Smith’s Theory
Smith did not consider
a more difficult question, however: What if one country
is more efficient at producing everything? How can developing
countries, who have no absolute productivity advantage over
developed ones, be included in the gains from trade?
David Ricardo answered this question in his On The Principles
of Political Economy and Taxation, 1817. In “Chapter
7: On Foreign Trade,” Ricardo argues that it isn’t
absolute productivity that drives the gains from trade,
but rather the relative, or comparative advantage.
WEBSITES: For more information on David
Ricardo and his ideas, check out:
David Ricardo
http://www.econlib.org/library/Enc/bios/Ricardo.html
Chapter 7: On Foreign Trade
http://www.systemics.com/docs/ricardo/Chapter_7
Ricardo’s Theory of Competitive Advantage.
To illustrate Ricardo’s theory of comparative advantage,
let’s reconsider our previous example, but with a
particularly skilled baker capable of producing three pairs
of shoes or six loaves of bread in an hour, giving her the
absolute advantage in the production of both goods. Ricardo’s
insight was to explore what each worker, or nation, gave-up
(in terms of goods) in order to make more of another. In
economics jargon, we call this the opportunity cost, or
relative cost, of doing one thing instead of another. So,
for the baker the opportunity cost, or relative cost, of
producing six loaves of bread is giving up the opportunity
to produce three pairs of shoes (or, one loaf of bread costs
half a pair of shoes). If the baker chose instead to produce
shoes, then the opportunity cost of three pairs of shoes
would be six loaves of bread (or, one pair of shoes costs
two loaves of bread).
For the shoemaker, on the other hand, the opportunity cost
of making two pairs of shoes is two loaves of bread (or,
one pair of shoes cost one loaf of bread). If the shoemaker
chose instead to make bread, then the opportunity cost of
making two loaves of bread is two pairs of shoes (or, one
loaf of bread costs one pair of shoes). Clearly, the baker
gives up relatively fewer pairs of shoes to make bread and
the shoemaker gives up relatively fewer loaves of bread
to make shoes. In other words, the baker has a comparative,
or relative cost, advantage in making bread and the shoemaker
in making shoes—and these comparative advantages can,
and should, be exploited.
For
the baker to gain from trade, she would need to receive
more shoes from trade than she gave up to make the
bread. For the shoemaker to gain from trade, he would need
to give up fewer shoes in trade than the shoes it would
cost him to make his own bread. The cost to make a loaf
of bread for the baker is half a pair of shoes, so she’d
need to get more than half a pair of shoes to be willing
to trade her loaf of bread. And the cost of making a loaf
of bread for the shoemaker is one pair of shoes, so he’d
need to give up less than one pair of shoes for a loaf of
bread. In other words, as long as the baker gets more than
half a pair of shoes and the shoemaker pays less than one
pair of shoes for a loaf of bread, they’d both benefit
from trade. If the baker and the shoemaker agreed to trade
one loaf of bread for three-fourths of a pair of shoes,
for example, the baker would end up with one-quarter of
pair of shoes more than it cost her to bake the bread and
the shoemaker would give up one-quarter of a pair of shoes
less than it would have cost to bake the bread himself.
Comparative
Advantage Table
|
Shoemaker Output/Hr. |
Opportunity Cost |
Baker
Output/Hr. |
Opportunity Cost |
Shoes |
2 |
1
Comparative Advantage |
3 |
2 |
OR |
|
|
|
|
Bread |
2 |
1 |
6 |
½ Comparataive Advantage |
In the above example,
it’s not the absolute time cost of making bread or
pairs of shoes that matters, but their cost relative to
each other—and that’s the true basis on which
trade occurs. According to this theory, no matter the total
productivity advantage of one nation over another, there
will always be an exploitable relative cost difference for
developed and developing nations which will allow each to
gain from trade with the other.
If Ricardo’s insights into relative cost are actually
the story behind mutual gains from trade, this leaves us
with the question of whether Smith got it wrong. Well, we
must remember that Smith’s theory, although not quite
on target in a most general application, clearly showed
for the first time that trade could be win-win. This insight
set the stage for all who followed. Additionally, Smith’s
theory was the first to explain that what fundamentally
determines a nation’s wealth is its labor’s
productivity, not its ability to accumulate gold. Using
our example, although though both the baker and shoemaker
can benefit from trade, it is the baker who will be the
wealthier of the two—or she will be able to buy more
shoes with her time than the shoemaker will be able to buy
bread with his.
VIDEO: Empirical
Test for Evidence of Comparative Advantage
