Smith’s absolute advantage theory looked convincing but trade was impossible when one country produced all commodities cheaper than the other. Ricardo dealt with this problem by developing the theory of comparative advantage. This demonstrated that both countries could benefit from specialisation in particular lines of production even where the costs o f production for all of the producers were initially higher in one country than in the other. What was required was for relative prices to differ. Ricardo revolutionised the foreign trade doctrine through a famous example: he compared the effects of the introduction of trade in two commodities between England and Portugal, where each was producing both commodities and the costs of both commodities were higher in England than in Portugal. Ricardo argued that even though the absolute prices of both commodities were lower in Portugal, trade was possible since the
6 Ironically, when Malthus argued against the ‘Poor Laws’ which increased the government’s budget deficit and annoyed the higher classes, he preferred not to see the productivity increase on land.
7 Hudson (1992: 113).
relative prices were different. As can be seen from table 2.1, wine is relatively cheaper in Portugal and cloth is relatively cheaper in England.
Table 2.1: Ricardian comparative advantage Production per worker Price (£)9
(productivity) Portugal England
Wine 1.25 0.83
Cloth 1.11 1.00
Wine to cloth ratio
Portugal England
0.80 1.20
0.90 1.00
0.89 1.20
Ricardo’s model is based on a number of simplifying assumptions. Hudson (1992: 120) summarises these assumptions as follows:
1. Constant returns to scale.
2. The traded goods are produced in both countries.
3. No trade in common factor inputs.
4. No underutilisation of labour, capital or land, and in particular no import- displacement o f domestic labour and capital.
5. No emigration or capital outflow.
6. No imbalance in international trade and payments.
7. No impact of monetary inflation or deflation or of domestic and foreign debt on comparative costs.
8. No conflict between private-sector interests and general (long-term) social utility.
To demonstrate the gains from trade, a simplified version o f Ricardo’s example will be used. Table 2.2 shows that the productivity level and, thus, the price of cloth are the same in the UK and the U S.10 The US, however, has an absolute advantage in wheat
8 So much so that Marx even completely excluded the agricultural sector from his analysis.
9 Commodity money (gold), expressed in pounds, i.e., ‘in England around Ricardo’s time, roughly 1/4 ounce of gold was known as a “pound” (£).’ (Shaikh, 1979: 285)
10 In Ricardo’s original example both commodities are cheaper in Portugal than England. Here, for the sake of the simplicity of the graphical demonstration one commodity is kept at the same price level.
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production since productivity is higher and the price is lower. The relative prices indicate that wheat is relatively cheap in the US and cloth is relatively cheap in the UK.
Table 2.2: Ricardian comparative advantage (modified) Production per worker Price (£)
(productivity)________ (inverse productivity) T otal production11
US UK US UK US UK
Wheat 1.8 0.6 0.55 1.66 180 60
Cloth 1.2 1.2 0.83 0.83 120 120
Wheat to cloth ratio
0.66 2.00
According to absolute advantage theory, there is no case for trade since the price of cloth is the same in both countries and wheat is cheaper in the US. Given these prices, the UK would benefit from importing the cheaper wheat from the US but this is not possible because the UK cannot export to the US. Ricardo argued against absolute advantage theory by demonstrating that if the US produces only wheat, in which it has a comparative advantage, and the UK produces cloth, both countries would gain from trade. Because total production would be higher. The relative price of cloth is cheaper in the UK and the relative price of wheat is cheaper in the US.
A graphical illustration of the gains from trade for both countries is displayed in figure 2 .1.12 In the absence of trade, a nation’s production possibility frontier is also its consumption frontier. The production patterns will be determined by domestic consumption patterns and productivity levels. Before trading, the US may choose to produce and consume a combination of the commodities at point A, and the UK at point A ’. With trade, the US specialises in wheat and the UK in cloth. After trading, the consumption pattern is different from the production pattern. There will be only one price for both commodities in both countries and relative prices will be the same in both countries.13 For the US, consumption increases from A to E, for the UK from A ’ to E \ The total quantity of the commodities (Ricardo’s 'sum of enjoyments') is increased. The increased consumption is the result o f increased production through specialisation.
11 When all workers, say 100, are employed.
12 This example is borrowed from Salvatore (1995).
Figure 2.1: Gains from trade
120 UK
SO 40
40 60 70
US
120
£ 70
o
O 60
110
90 160
Wheat W heat
Given the simplicity of the model and its assumptions, Ricardo believed that:
Under a system of perfectly free commerce, each country naturally devotes its capital and labour to such employment 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 which determines that wine shall be made in France and Portugal, that com shall be grown in America and Poland, and that hardware and other goods shall be manufactured in England.
(Ricardo, 1992: 81)
Even though various thinkers have developed this model, the basic principles have not changed. Ricardo's labour theory of value has been rejected, but his comparative advantage theory has become the cornerstone of neo-liberal trade theory. The idea that the free market's ‘admirable’ pursuit of individual advantage will produce the best results for each country became a quasi-religious belief. Influenced by this conviction, contemporary trade theories display corresponding problems and that is why it is worth spending a little more time analysing this model.
13 The slope of the BE line is equal to the slope of the B ’E ’ line.
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