David Ricardo and the theory of comparative advantage

David Ricardo (1772-1823), a Netherlands-born British economist, developed the theory of comparative advantage, to try and put on a sound theoretical basis the study of international commerce, and, in particular, to demonstrate the advantage of international trade between countries over autarky.

Here it is, in its simplest version: let's consider two countries France (F) and Italy (I). Both produce corn and cars. There is only one production factor: labor.

First we need the productivity data: suppose that to produce one unit of corn France uses 2 units of labor, and Italy uses 5 units of labor. And suppose that to produce one car France uses 3 labor units, and Italy 4. In table form this gives the following:

 Car Corn France 3 2 Italy 4 5

Productivity data (unit: one unit of local labor)

Relative prices: we can say that in France a car costs 1,5 units of corn. In Italy the cost of a car is 0,8 units of corn.

We say that I has a comparative advantage in cars and F has a comparative advantage in corn (even though the absolute advantage is for both products on F side).

Total labor available: suppose France has a total of 6 000 units of labor at its disposal, and Italy has 10 000.

If there is no trade between F and I, here are the production choices each country can make :

France

 Corn 0 750 1500 2250 3000 Cars 2000 1500 1000 500 0

For instance, if France chooses to produce 750 units of corn, it needs 1500 labor units for that. 4500 remain, which allow the production of 1500 cars.

Italy

 Corn 0 500 1000 1500 2000 Cars 2500 1875 1250 625 0

Now we turn to consumption considerations.

Still with no trade, assume French consumers spend 75% of their resources on corn, and 25% on cars. And assume the Italian consumers have the exact opposite proportions.

Total resources can be measured with three possible units: labor, corn or cars.

In France, the measures give this:

 in labor unit in corn unit in car unit Total resouces 6000 3000 2000

That is in France the demand for corn is 3000 x 75% = 2250 and the demand for cars is 500 cars.

Similarly, in Italy, the demand for corn is 2000 x 25% = 500 units of corn, and the demand for cars is 1875 cars.

Here is Ricardo's point:

Trade can improve the well-being of both countries!

Let's see how.

We saw that in Italy a car "costs" 0.8 units of corn, whereas in France a car "costs"1.5 units of corn.

It turns out that any price, between 0.8 and 1.5, to exchange cars for corn between Italy and France will improve the wealth of each country.

Without going into the (simple) details, let's look at the best price of exchange. Some further calculations show that it is 1.2 : i.e. let Italy sell cars to France at a price of 1.2 units of corn for one car.

Obviously it's a good price for Italy; and it's also a good price for France.

Suppose that France specializes entirely into corn, and Italy entirely into cars.

France produces 3000 units of corn, consumes 2250 units (this is the internal demand), and therefore holds another 750 units of corn for sale to anyone. These will bring more cars to France, via trade, than if they were produced in autarky.

Indeed a car is worth 1.5 units of corn in France, and we can  purchase them from Italy for 1.2 : that's better! And indeed France will buy 625 cars from Italy (instead of producing itself only 500).

And Italy will produce 2500 cars. It will consume 1875 (internal demand) cars, and have 625 available for trade. These 625 cars will be exchanged for 750 units of corn (more than the 500 units of corn that Italy would have produced by itself).

Conclusion

Without trade, France had 2250 units of corn and 500 cars. And Italy had 500 units of corn and 1875 cars.

With trade France has 2250 units of corn and 625 cars. And Italy has 750 units of corn and 1875 cars.

That is Ricardo's theory in its simplest form.

It is somewhat simplistic. For example, if for some reason the price of corn goes up, Italy may go into starvation.

Further work

It lead to research work into two main directions :

1. try to extend it to many countries, many products, and several production factors (mostly labor and capital), and
2. try to verify it in real life.

The first objective was undertaken by many scholar economists. It lead to a theory named "the Heckscher, Ohlin, Samuelson model".

Samuelson (born in 1915) received the Nobel Prize in Economics in 1970

The second objective - more ambitious - was undertaken by some other economists. More or less convincing results were achieved:

Dougall, Stern and Balassa, in a work published in 1963, found some good empirical evidence of Ricardo's ideas in the study of the exchanges between the US and the UK in the early fifties.

Some other studies (eg. Kreinin: the study of the exports of Canada and of Australia to other countries) did not find as much evidence.

But, anyhow, Ricardo's ideas are useful. Economics by its very nature deals with extremely intricate phenomena. (It involves human behaviour, sociology, the attitude vis à vis anticipations, etc.) What Ricardo suggested, in summary, is that trade is better than autarky.

It is still the subject of a heated debate: "To which extent is it better than autarky?"