Ricardian Model of Trade

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Introduction

The Ricardian Model of Trade is developed by English political economist David Ricardo in his magnum opus On the Principles of Political Economy and Taxation(1817). It is the first formal model of international trade. Before Ricardo, the benefit of has already been propounded by Adam Smith. Ricardo strengthens the case for free trade by giving it a theoretical framework based on the logic of comparative advantage. This concept is of such historical importance in the field of economics that when Nobel laureate Paul Samuelson was once questioned by a self-important mathematician to "name one proposition in all of the social sciences which is both true and non-trivial, he responded confidently, "comparative advantage."

The Ricardian Model

Like all other economic theories, the Ricardian Model makes a number of basic assumptions to construct an imaginary world.

1. There are only 2 countries.

2. They produce 2 goods.

3. Production requires only 1 input, labor, which is limited in amount in both countries and is perfectly immobile (i.e. strict border control).

4. opportunity cost between the goods is constant in each country. (Graphically, the production possibility frontier is a straight line.)

5. There is neither transaction cost nor transportation cost.[1]

By definition, a country has absolute advantage over the other if it is more efficient at producing both goods than the other country. A country has comparative advantage in producing a certain good if the opportunity cost of producing that good is lower than in the other country. Ricardo observes that an absolute advantage does not necessarily imply a comparative advantage. As long as the relative cost of production is different in the 2 countries, comparative advantage exists.[2]

Under autarky condition (no trade), each of the two countries produces some combination of the 2 goods. Once trade becomes possible, they are motivated to specialize fully in the production of the good in which they have a comparative advantage, thus allocating their scarce resources (labor) to its most productive uses. In the aggregate, people in both countries end up consuming more of both goods than they did in the absence of trade. Since more consumption means greater satisfaction (using economic jargon, equilibrium shifts to a higher indifference curve), trade allow both countries to improve their welfare. The Ricardian Model concludes therefore that international trade benefits all participants.

Limitations of the Model

The model is limited in several ways: 1. Having only 1 factor of production is way too simplistic a view of manufacturing. 2. In real world, almost no country produces only the goods in which they have a comparative advantage. 3. Opportunity costs between goods are unlikely to be constant, but should rather be increasing. 4. Most significantly, the model does not explain the source of comparative advantage: why can some countries produce some goods more cheaply than other countries?[3]

In addressing these problems, scholars of international trade after Ricardo would make adjustments on his model to come up with better models, the most notable being the Heckscher-Ohlin Model), which allows multiple factors of production and explains the source of comparative advantage by relative abundance of resources.

References

  1. Grieco & Ikenberry, Ch 2: “The Economics of International Trade.” p. 31.
  2. Krugman & Obstfeld, Ch.2, "Labor Productivity and Comparative Advantage: The Ricardian Model", International Economics, p. 31
  3. Grieco & Ikenberry, Ch 2: “The Economics of International Trade” p. 36