David Ricardo’s 1817 comparative advantage logic in retrospect · Outline • David Ricardo’s...

David Ricardo’s 1817 comparative advantage logic in retrospect

Daniel M. Bernhofen American University

Washington, DC

1CESifo Munich Conference: Ricardo at 200

CESifo Munich Conference: Ricardo at 200

2

200th anniversary of David Ricardo’s Principles of Political Economy and Taxation

• David Ricardo’s 1817

Theory of comparative advantage:

first articulated in Chapter VII of his Principles, entitled “On Foreign Trade”.

Outline

• David Ricardo’s 1817 ‘puzzling’ formulation of comparative advantage and how it has been traditionally interpreted (for 185 years).

• Build on the Sraffa-Ruffin (1930-2002) interpretation of Ricardo’s four ‘mystical’ numbers and aim to convey Ricardo’s logic at his time.

• How Ricardo’s formulation can be integrated into the modern opportunity cost formulation of comparative advantage, which we owe to Gottfried Haberler (1930).

• How Ricardo’s pattern and gains from trade logic carries over to higher dimensions and how it can be empirically implemented.


Ricardo employed 4 ‘magical’ numbers

• ”The quantity of wine which she [Portugal] shall give in exchange for the cloth of England, is not determined by the respective quantities of labour devoted to the production of each, as it would be, if both commodities were manufactured in England, or both in Portugal.

• England may be so circumstanced, that to produce the cloth may require the labour of 100 men for one year; and if she attempted to make the wine, it might require the labour of 120 men for the same time. England would therefore find it her interest to import wine, and to purchase it by the exportation of cloth.

To produce the wine in Portugal, might require only the labour of 80men for one year, and to produce the cloth in the same country, might require the labour of 90 men for the same time, It[Portugal] would therefore be advantageous for her to export wine in exchange for cloth”.



5

Ricardo’s framework• Ricardo’s model assumptions:

2 countries, England and Portugal, are involved in trade.2 goods: cloth and wine.

• Ricardo’s logic : The value of a good is measured by the labour embodied in it.

“4 numbers”: England Portugalcloth 100 90wine 120 80.

Ricardo’s prediction: • Both England and Portugal will gain• England will export cloth and import wine.


6

James and John Stuart Mill (1840s)

• Ricardo’s passage seems incomplete. No mentioning of costs or prices at which trade takes place (i.e. terms of trade).

• James Mill’s (1844) reading of Ricardo’s 4 numbers: per unit labor costs:

acE /aw

E=100/120 < acP/aw

P=90/80

England exports cloth because of its lower relative production costs (formalized by J.S.Mill in 1848)

• However, under the Mill interpretation, Ricardo’s paragraph is illogical and makes little sense.

• This explains the historical controversy whether Ricardo deserves credit for the theory of comparative advantage at all.


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Ricardo’s logic involved three key ingredients

1. Ricardo’s understanding (assumption) that international trade is beneficial.

2. Ricardo’s need of a theory of value; and he developed a labor theory of value (probably in 1816).

3. Ricardo’s recognition that international trade is governed by different rules than domestic trade.

Perennial question: Is international trade beneficial (ingredient 1)?

• 18th century rule (or criteria) for when trade will be

beneficial: “…it pays to import commodities from abroad whenever they can be obtained in exchange for exports at a smaller real cost than their production at home would entail” (Viner, 1937, p. 440).

• 18th century rule was first used by Henry Martyns in 1701 in his Considerations of the East India Trade.

• Adam Smith employed it in his 1776 Inquiry into the Nature and Causes of the Wealth of Nations.

• The 18th century rule was also key in Ricardo’s formulation of comparative advantage.


8


9

Why a theory of value (ingredient 2)?

George Stigler, 1983, Nobel Lecture on “The Process and Progress of Economics”:

“A science requires for its very existence a set of fundamental and durable problems. In economics the most fundamental of these central problems is the theory of value.

The theory of value must explain how the comparative values of different goods and services are established. Until that problem is solved, it is not possible to analyzefor scientific purposes what will be produced and in what quantities, how the resources will be employed…and how the resources will be valued.

Without a theory of value, the economist can have no theory of international trade...”


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How does international trade differ from domestic trade (ingredient 3)?

“The same rule which regulates the relative value of commodities in one country does not regulate the relative value of commodities exchanged between two or more: …the labor of 100 Englishmen cannot be given for that of 80 Englishmen, but the labor of 100 Englishmen may be given for the labor of 80 Portugese”.

�� ℎ��

number of Englishmen in wine production

number of Englishmen in cloth production-100

100

Rules governing domestic exchange(say between Manchester and Brighton)


11

Ricardo applied his labor value theory to evaluate international exchange

• ”The quantity of wine which she [Portugal] shall give in exchange for the cloth of England…

• Note: Ricardo implicitly assumed that some (say X) units of cloth are exchanged for some (say M) units of wine on the (international) market for one year.

• England may be so circumstanced, that to produce the [the quantity of] cloth may require the labour of 100 men for one year if she attempted to make the [quantity of wine], it might require the labour of 120 men for the same time. England would therefore find it her interest to import wine, and to purchase it by the exportation of cloth.


�� ℎ��

number of Englishmen necessary for wine imports

number of Englishmen in cloth exports

-100

120

Rules governing international exchange (for England)


13

100

-120

number of Englishmen in cloth imports

number of Englishmen in wine exports

Gain 20 workers

Lose 20 workers

Ricardo applies the same logic separately to Portugal

• To produce the wine in Portugal, might require only the labour of 80 men for one year, and to produce the cloth in the same country, might require the labour of 90 men for the same time. It would therefore be advantageous for her to export wine in exchange for cloth.

• Note: Ricardo’s formulation took advantage of the separation property of the law of comparative advantage (i.e. the logical structure applies to any number of countries or goods).


�� ℎ��

number of Portugesenecessary for wine imports

number of Portugese in cloth exports

-90

80

Separate treatment for Portugal


15

90

80

number of Portugesenecessary for cloth imports

number of Portugese in wine exports

lose 10 workers

gain 10 workers


16

Ricardo’s labor value formulation loses its prominence after 1870

• Ricardo’s model remained the dominant trade model until the early 1930s.

• Ricardo’s labour theory of value became also the foundation of Marxian philosophy and economics.

• Emergence of a consumption society => Emergence of ‘utility theory’ (Jevons, Menger,Walras), 1871-74: “The value of a good is determined by the utility it provides to consumers”.

• Zeitgeist of the 1920s: Labour theory of value has become old-fashioned since it ignores the other factors of production and says nothing about consumption.J.M. Keynes (1928): “The free trade case must be based in the future, not on abstract principles of laissez faire, which few now accept.”


17

1930: Gottfried Haberler’s reformulation of comparative advantage

Reconciled the tension between the classical writers and and the utilitarians.

“The value of a commodity is what you have to give up to obtain it”.

Value (=opportunity cost) concept that allows to integrate production with consumption .


18

Gottfried Haberler

• Neglected pathbreaking paper by Gottfried Haberler:”Die Theorie der komparativen Kosten und ihre Auswertungfür die Begründung des Freihandels”. WeltwirtschaflichesArchiv 32, (1930): 349-370.

• not translated into English until 1987.• Haberler wrote the first textbook in international trade

(also in German):Der Internationale Handel, 1930.• In 1936 Haberler moved to the US, translated his book

into English where it became a classic:The theory of international trade, 1936.• Haberler become the Doktorvater of Paul Samuelson and

Robert Baldwin (father of Richard Baldwin).

��

��

��

��

Haberler (1930) employs a concave PPF to reformulate CA in terms of opportunity costs

PPF

good 2

good 1

C�

C�

P�


19

��

��

��

��

Standard equivalent variation (EV) consumer expenditure measure of the gains from trade (based on Samuelson (1939))

PPF

wine

cloth

C�

C�

P�

∆I��

�

��


20

Ricardo’s metric: trade is equivalent to a laborgrowth of 20 workers (=growth of the PPF)

PPF(L)

wine

cloth

C�

C�

P�


21

PPF(L+20)

Xc (100)

Mw (120)

Ricardo’s comparative advantage formulation

• The gains are expressed in a cost-benefit framework where the costs are the workers lost from exporting and the benefits are the ‘workers gained’ from importing.

• Because the labor augmentation is revealed by labor embodied in trade, the labor value of trade is a sufficient statistic for the gains from trade.

• In contrast to Samuelson’s consumer expenditure measure, Ricardo’s metric does not require autarky or free trade consumption data and does not rely on the weak axiom of revealed preference.

• Ricardo’s gains from trade metric allows us to illustrate the role of trade costs.


Ricardo’s comparative advantage formulation

• Fundamental question: when will trade occur?

• Standard theoretical (textbook) answer: countries’ relative opportunity costs need to be different.

• Historical/empirical answer: Reduction in international shipping costs.

• Assume Lship workers are required to ship (and protect) the exports from England to Portugal.

• Condition for trade to be beneficial: Lship <20.

• Technological progress causing a decline in Lship or rule of law improvements (getting rid of pirates, North,1958) will stimulate trade.

• Ricardo’s logic holds in higher dimensions.


Domestic exchange at autarky prices paT=0

Imports of wine

exports of cloth

Deardorff-Dixit-Norman’s (1980) general comparative advantage prediction: paT>0


24

Imports of cloth

Exports of wine

Gain

Loss

Terms of trade line ptT=0HyperplanePrediction paT>0

labor

land

L{labor and land endowment}

L1

L2

Laug {enables free trade consumption Ct}

Export loss (AxX)

Import gain (AmM)

Ricardo’s gains from trade idea if we allow for labor and land


25

labor

land

��

��

��

�

�� (� = �, �)

L{Ca}

L1

L2

Laug{Ct}

Export loss

Import gain

gains in units of labor

Valuing the endowment augmentation


26

Revealed factor gains for pre-industrial Japan (in % of Japan’s actual labor and land endowment)

27

0.07

Skilled male workers

female workers

Poor Harvestperiod

∆��

��

Land


Gains in factor income

• Assuming that the economy continued at the 1800-1850 growth rate: gains range from 3-10 percent (assuming balanced trade) to 5-14 percent [depends upon estimate waL] of total factor income.

• Similar in magnitude to Bernhofen and Brown’s (2005) application of Samuelson’s consumer expenditure metric.

• Gains rise towards end of trading period

– Reduction of information barriers to trade: better matching of western woolens with Japanese consumer tastes

– Effect of Suez Canal Opening in 1869

28CESifo Munich Conference:

Ricardo at 200

Conclusions

• Ricardo’s comparative advantage formulation was an amazing intellectual achievement.

• Key features:

– Ricardo’s logic on comparative advantage is intuitive and general.

– Ricardo’s logic makes the growth equivalent dimension of trade explicit.

– It can be implemented empirically and will remain an evergreen to justify the case for free trade.


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