Ricardo

A One-factor World: The Ricardian Model

The Production Possibility Frontier (PPF)

This is a simple way of thinking about what a nation can produce and consume. Under conditions of no trade (sometimes called "autarky") what a country produces and what it consumes must be identical. Trading provides the possibility of consuming a different "bundle" of goods and services from that which you produce.

Start with the small country of Utopia -- a country that represents a small enough part of world markets that international market prices will not change appreciably whether it trades or not. Let's start with a simple straight-line ppf, based on the assumption that Utopia has a fixed endowment of 1,000 units of labor, and that it requires 100 units to build a motor car, and 1 unit to make a bar of chocolate. (Assume that these are the only commodities in existence.)

In that case, its ppf, and the shaded are that repesents the set of (motor car, chocolate) bundles that it can consume, can be drawn as follows:

If you are not clear on how we got this graph, take a look at these notes on the PPF.

(If you already know some microeconomics you might want to look at this note on indifference curves, but it's not essential here.)

Trade

Now suppose that Utopia decides to trade. It will find that cars and chocolate are traded at some price ratio in the international economy. Since there are only 2 goods, it's easy enough just to assume a barter economy, with prices for cars being quoted in terms of chocolate and vice versa. Thus the price within Utopia, prior to trade, would be that one car sells for 100 chocolate bars, and vice versa.

Let us suppose that in the international economy, one car sells for 200 chocolate bars. In that case Utopia can maximize its set of consumption possibilities by specializing in cars, producing no chocolate, and trading cars for chocolate. Thus is shown below.

If instead the international price ratio were one car to 50 chocolate bars, then Utopia would be better off specializing in chocolate and trading for cars. If by chance the international price ratio were one car to 100 chocolate bars, then Utopia would gain nothing by trading. But it still would be no worse off. The core point is that under trade, the set of points representing Utopia's possible consumption bundles is no smaller than the set before trade, and is almost certainly larger.

(If you know some microeconomics you can the effects of trade with a set of indifference curves here.)

Be able, if given information about the international price ratio, to show on a graph what the country should produce, and what are its possible consumption points. Also be able to say what the slope of the pre-trade ppf shows (essentially the ability to substitute between goods, given existing technology and the assumption that we produce as much of both goods as we can) and what the slope of the "trading line" shows -- the international price ratio. Be clear on the difference between being on and inside your ppf.

Comparative, Not Absolute, Advantage

Now please notice something else. All Utopia cares about, in international trade, is the ratio at which it can trade chocolate for cars (and vice versa) or terms of trade. It does not care what lies behind those ratios in terms of how other countries use their resources. Take the international price ratio of 200 chocolate bars to one motor car that we supposed above. Suppose

the international economy can produce a car with 50 units of labor and a bar of chocolate with 1/4 of a unit of labor (i.e. it's more efficient in both goods)
the international economy can produce a car with 150 units of labor and a bar of chocolate with 3/4 of a unit of labor (i.e. it's more efficient in chocolate than Utopia, less efficient in cars)
the international economy can produce a car with 2000 units of labor and a bar of chocolate with 5 units of labor (i.e. the international economy is way less efficient in both)

All of these possibilities produce the same international price ratio, which is all Utopia cares about. Example b above corresponds to Adam Smith's "absolute advantage." But a,b, and c all fall under David Ricardo's broader notion of "comparative advantage."

Be able to define comparative advantage and distinguish it from absolute advantage. Here's one definition of comparative advantage, adapted from Todaro’s textbook: "A country has a comparative advantage over another if in producing a commodity it can do so at a relatively lower opportunity cost in terms of the foregone alternative commodities that could be produced. Taking two countries, A and B, each producing two commodities, X and Y, country A is said to have a comparative advantage in producing X if, in order to make another unit of X, it has to give up fewer units of Y than would be the case in country B.

To summarize: without trade, getting more of one good means giving up some of the other good according to a fixed ratio. With trade, you have the possibility of another ratio: the international price ratio of the two goods. If this ratio is at all different from the domestic ratio, you can gain from trade. The core result of this theory is theory is that all that matters is the ratios, not the absolute amounts of labor required to produce the goods. No matter how wretched you are, you will almost certainly have a comparative advantage in one or the other good, and you should produce that and trade for the other good. Hence this is more general and powerful than Smithian “absolute advantage.”

Assessment

The core insight of Ricardo is that trade gives a country more options in terms of what to do with its productive apparatus. Without trade, if we want more chocolate, we have to pull resources out of making something else and put them to work on chocolate. With trade we have the additional possibility of making something that is in demand abroad and trading it for chocolate.

But there are also a couple of blind spots that this theory has in common with a lot of trade theories. First, we talk rather loosely about “us” or the well-being of an entire country. But countries are made up of a lot of different people, and the benefits or costs of a change in trade policy are seldom very evenly spread. Second, this theory only makes sense if countries use their resources fully — in graphical terms, if they are on their PPF. If there are idle resources, then the effects of trade are not clear.

Also remember that the Ricardian comparative advantage model assumes:

constant costs: no matter whether Utopia is making a lot of cars or very few, the amount of labor per car is the same. A more formal way of putting this is constant returns to scale.
easy movement of factors of production between different industries: when Utopia decides to specialize in cars and stop making chocolate, the chocolate workers have no trouble finding employment in car-making. Many anti-liberalization arguments focus in on this question.
factors of production cannot move between countries.

What does the comparative advantage approach predict? Nations should specialize in making what they are relatively good at, and import other things. For that reason you would expect countries to import and export very different things. What policies tend to follow from a comparative advantage approach? Broadly, that nations should not try to restrict imports.