INTERNATIONAL TRADE AND AGREEMENTS MODULE NO.

2
BA CORE COURSE 6 The Ricardian Theory of Comparative Advantage: PART 1

The Ricardian Theory of Comparative Advantage: PART 1

Lesson Outline and Learning Objectives:

1. Reasons for Trade

 Learn the five reasons why trade between countries may occur.
 Recognize that separate models of trade incorporate different motivations for trade.
2. The Theory of Comparative Advantage
 Learn how a rearrangement of production on the basis of comparative advantage, coupled
with international trade, can lead to an improvement in the well-being of individuals in all
countries.
 Learn the major historical figures who first described the effects of international trade:
Adam Smith, David Ricardo, and Robert Torrens.
3. Ricardian Model Assumptions
 Learn how to define labor productivity and opportunity cost within the context of the
Ricardian model.

MODULE NO. 2
 Learn to identify and distinguish absolute advantage and comparative advantage.
 Learn to identify comparative advantage via two methods: (1) by comparing opportunity
Week 2 and 3 costs and (2) by comparing relative productivities.
August 31 - September 4, 2020
1st Semester, AY 2020-2021 Lesson Requirements:

1. Activity Sheet 1 (Activity 1 and 2)

Brian K. Del Mundo, CPA 2. Practical Application (Activity 3 and 4)
Instructor
INTERNATIONAL TRADE AND AGREEMENTS MODULE NO. 2
BA CORE COURSE 6 The Ricardian Theory of Comparative Advantage: PART 1
reason, or one model, is sufficient to explain all outcomes. Instead, one must try to understand the
Lecture Notes: world by looking at what a collection of different models tells us about the same phenomenon.

2.1. Reasons for Trade For example, the Ricardian model of trade, which incorporates differences in technologies between
The first theory section of this course develops models that provide different explanations or reasons countries, concludes that everyone benefits from trade, whereas the Heckscher-Ohlin model, which
why trade takes place between countries. The five basic reasons why trade may take place are incorporates endowment differences, concludes that there will be winners and losers from trade.
summarized below. The purpose of each model is to establish a basis for trade and then to use that Change the basis for trade and you may change the outcomes from trade. In the real world, trade
model to identify the expected effects of trade on prices, profits, incomes, and individual welfare. takes place because of a combination of all these different reasons. Each single model provides only a
glimpse of some of the effects that might arise. Consequently, we should expect that a combination
A. Differences in Technology of the different outcomes that are presented in different models is the true characterization of the
Advantageous trade can occur between countries if the countries differ in their technological abilities real world. Unfortunately, because of this, understanding the complexities of the real world is still
to produce goods and services. Technology refers to the techniques used to turn resources (labor, more of an art than a science.
capital, land) into outputs (goods and services).
2.2. Theory of Comparative Advantage
B. Differences in Resource Endowments Historical Overview
Advantageous trade can occur between countries if the countries differ in their endowments of The theory of comparative advantage1 is perhaps the most important concept in international trade
resources. Resource endowments refer to the skills and abilities of a country’s workforce, the natural theory. It is also one of the most commonly misunderstood principles. There is a popular story told
resources available within its borders (minerals, farmland, etc.), and the sophistication of its capital among economists that once when an economics skeptic asked Paul Samuelson (a Nobel laureate in
stock (machinery, infrastructure, communications systems). economics) to provide a meaningful and nontrivial result from the economics discipline, Samuelson
quickly responded, “comparative advantage.”
C. Differences in Demand
Advantageous trade can occur between countries if demands or preferences differ between countries. The sources of the misunderstandings are easy to identify. First, the principle of comparative
Individuals in different countries may have different preferences or demands for various products. advantage is clearly counter-intuitive. Many results from the formal model are contrary to simple
For example, the Chinese are likely to demand more rice than Americans, even if consumers face the logic. Second, it is easy to confuse the theory with another notion about advantageous trade, known
same price. Canadians may demand more beer, the Dutch more wooden shoes, and the Japanese in trade theory as the theory of absolute advantage. The logic behind absolute advantage is quite
more fish than Americans would, even if they all faced the same prices. intuitive. This confusion between these two concepts leads many people to think that they
understand comparative advantage when in fact what they understand is absolute advantage. Finally,
D. Existence of Economies of Scale in Production the theory of comparative advantage is all too often presented only in its mathematical form.
The existence of economies of scale in production is sufficient to generate advantageous trade Numerical examples or diagrammatic representations are extremely useful in demonstrating the basic
between two countries. Economies of scale refer to a production process in which production costs results and the deeper implications of the theory. However, it is also easy to see the results
fall as the scale of production rises. This feature of production is also known as “increasing returns to mathematically without ever understanding the basic intuition of the theory.
scale.”
The early logic that free trade could be advantageous for countries was based on the concept of
E. Existence of Government Policies absolute advantages in production. Adam Smith wrote in The Wealth of Nations, “If a foreign country
Government tax and subsidy programs alter the prices charged for goods and services. These changes can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with
can be sufficient to generate advantages in production of certain products. In these circumstances, some part of the produce of our own industry, employed in a way in which we have some advantage”
advantageous trade may arise solely due to differences in government policies across countries. (Book IV, Section ii, 12).

Summary The idea here is simple and intuitive. If our country can produce some set of goods at a lower cost
There are very few models of trade that include all five reasons for trade simultaneously. The reason than a foreign country and if the foreign country can produce some other set of goods at a lower cost
is that such a model is too complicated to work with. Economists simplify the world by choosing a than we can produce them, then clearly it would be best for us to trade our relatively cheaper goods
model that generally contains just one reason. This does not mean that economists believe that one for their relatively cheaper goods. In this way, both countries may gain from trade.
INTERNATIONAL TRADE AND AGREEMENTS MODULE NO. 2
BA CORE COURSE 6 The Ricardian Theory of Comparative Advantage: PART 1
either each country has the comparative advantage in one of the two goods or neither country has a
Ricardo’s Numerical Example comparative advantage in anything.
Because the idea of comparative advantage is not immediately intuitive, the best way of presenting it
seems to be with an explicit numerical example as provided by Ricardo. Indeed, some variation of Another way to define comparative advantage is by comparing productivities across industries and
Ricardo’s example lives on in most international trade textbooks today. countries. Suppose, as before, that Portugal is more productive than England in the production of
both cloth and wine. If Portugal is twice as productive in cloth production relative to England but
In his example, Ricardo imagined two countries, England and Portugal, producing two goods, cloth three times as productive in wine, then Portugal’s comparative advantage is in wine, the good in
and wine, using labor as the sole input in production. He assumed that the productivity of labor (i.e., which its productivity advantage is greatest. Similarly, England’s comparative advantage good is cloth,
the quantity of output produced per worker) varied between industries and across countries. the good in which its productivity disadvantage is least. This implies that to benefit from specialization
However, instead of assuming, as Adam Smith did, that England is more productive in producing one and free trade, Portugal should specialize in and trade the good that it is “most better” at producing,
good and Portugal is more productive in the other, Ricardo assumed that Portugal was more while England should specialize in and trade the good that it is “least worse” at producing.
productive in both goods. Based on Smith’s intuition, then, it would seem that trade could not be
advantageous, at least for England. Note that trade based on comparative advantage does not contradict Adam Smith’s notion of
advantageous trade based on absolute advantage. If, as in Smith’s example, England were more
However, Ricardo demonstrated numerically that if England specialized in producing one of the two productive in cloth production and Portugal were more productive in wine, then we would say that
goods and if Portugal produced the other, then total world output of both goods could rise! If an England has an absolute advantage in cloth production, while Portugal has an absolute advantage in
appropriate terms of trade (i.e., amount of one good traded for another) were then chosen, both wine. If we calculated comparative advantages, then England would also have the comparative
countries could end up with more of both goods after specialization and free trade than they each advantage in cloth and Portugal would have the comparative advantage in wine. In this case, gains
had before trade. This means that England may nevertheless benefit from free trade even though it is from trade could be realized if both countries specialized in their comparative and absolute advantage
assumed to be technologically inferior to Portugal in the production of everything. goods. Advantageous trade based on comparative advantage, then, covers a larger set of
circumstances while still including the case of absolute advantage and hence is a more general theory.
As it turned out, specialization in any good would not suffice to guarantee the improvement in world
output. Only one of the goods would work. Ricardo showed that the specialization good in each The Ricardian Model: Assumptions and Results
country should be that good in which the country had a comparative advantage in production. To The modern version of the Ricardian model and its results is typically presented by constructing and
identify a country’s comparative advantage good requires a comparison of production costs across analyzing an economic model of an international economy. In its most simple form, the model
countries. However, one does not compare the monetary costs of production or even the resource assumes two countries producing two goods using labor as the only factor of production. Goods are
costs (labor needed per unit of output) of production. Instead, one must compare the opportunity assumed to be homogeneous3 (i.e., identical) across firms and countries. Labor is homogeneous
costs of producing goods across countries. within a country but heterogeneous (nonidentical) across countries. Goods can be transported
costlessly between countries. Labor can be reallocated costlessly between industries within a country
A country is said to have a comparative advantage in the production of a good (say, cloth) if it can but cannot move between countries. Labor is always fully employed. Production technology
produce it at a lower opportunity cost than another country. The opportunity cost of cloth differences exist across industries and across countries and are reflected in labor productivity
production is defined as the amount of wine that must be given up in order to produce one more parameters. The labor and goods markets are assumed to be perfectly competitive in both countries.
unit of cloth. Thus England would have the comparative advantage in cloth production relative to Firms are assumed to maximize profit, while consumers (workers) are assumed to maximize utility.
Portugal if it must give up less wine to produce another unit of cloth than the amount of wine that
Portugal would have to give up to produce another unit of cloth. The primary issue in the analysis of this model is what happens when each country moves from
autarky4 (no trade) to free trade with the other country—in other words, what are the effects of
All in all, this condition is rather confusing. Suffice it to say that it is quite possible, indeed likely, that trade? The main things we care about are trade’s effects on the prices of the goods in each country,
although England may be less productive in producing both goods relative to Portugal, it will the production levels of the goods, employment levels in each industry, the pattern of trade (who
nonetheless have a comparative advantage in the production of one of the two goods. Indeed, there exports and who imports what), consumption levels in each country, wages and incomes, and the
is only one circumstance in which England would not have a comparative advantage in either good, welfare effects both nationally and individually.
and in this case Portugal also would not have a comparative advantage in either good. In other words,
INTERNATIONAL TRADE AND AGREEMENTS MODULE NO. 2
BA CORE COURSE 6 The Ricardian Theory of Comparative Advantage: PART 1
Using the model, one can show that in autarky each country will produce some of each good. Because The movement to free trade generates an improvement in welfare in both countries individually and
of the technology differences, relative prices of the two goods will differ between countries. The price nationally. Specialization and trade will increase the set of consumption possibilities, compared with
of each country’s comparative advantage good will be lower than the price of the same good in the autarky, and will make possible an increase in consumption of both goods nationally. These aggregate
other country. If one country has an absolute advantage in the production of both goods (as assumed gains are often described as improvements in production and consumption efficiency. Free trade
by Ricardo), then real wages of workers (i.e., the purchasing power of wages) in that country will be raises aggregate world production efficiency because more of both goods are likely to be produced
higher in both industries compared to wages in the other country. In other words, workers in the with the same number of workers. Free trade also improves aggregate consumption efficiency, which
technologically advanced country would enjoy a higher standard of living than in the technologically implies that consumers have a more pleasing set of choices and prices available to them.
inferior country. The reason for this is that wages are based on productivity; thus in the country that
is more productive, workers get higher wages. Real wages (and incomes) of individual workers are also shown to rise in both countries. Thus every
worker can consume more of both goods in free trade compared with autarky. In short, everybody
The next step in the analysis is to assume that trade between countries is suddenly liberalized and benefits from free trade in both countries. In the Ricardian model, trade is truly a win-win situation.
made free. The initial differences in relative prices of the goods between countries in autarky will
stimulate trade between the countries. Since the differences in prices arise directly out of differences A Gardening Story
in technology between countries, it is the differences in technology that cause trade in the model. Suppose it is early spring and it is time to prepare the family backyard garden for the first planting of
Profit-seeking firms in each country’s comparative advantage industry would recognize that the price the year. The father in the household sets aside one Sunday afternoon to do the job but hopes to
of their good is higher in the other country. Since transportation costs are zero, more profit can be complete the job as quickly as possible. Preparation of the garden requires the following tasks. First,
made through export than with sales domestically. Thus each country would export the good in which the soil must be turned over and broken up using the rototiller. Then the soil must be raked and
it has a comparative advantage. Trade flows would increase until the price of each good is equal smoothed. Finally, seeds must be planted, or sowed. This year, the father’s seven-year-old son is
across countries. In the end, the price of each country’s export good (its comparative advantage good) anxious to help. The question at hand is whether the son should be allowed to help if one’s only
will rise and the price of its import good (its comparative disadvantage good) will fall. objective is to complete the task in the shortest amount of time possible.
At first thought, the father is reluctant to accept help. Clearly each task would take the father less
The higher price received for each country’s comparative advantage good would lead each country to time to complete than it would take the son. In other words, the father can perform each task more
specialize in that good. To accomplish this, labor would have to move from the comparative efficiently than the seven-year-old son. The father estimates that it will take him three hours to
disadvantage industry into the comparative advantage industry. This means that one industry goes prepare the garden if he works alone, as shown in Table 2.1 "Father’s Task Times without Son".
out of business in each country. However, because the model assumes full employment and costless
mobility of labor, all these workers are immediately gainfully employed in the other industry. Table 2.1 Father’s Task Times without Son
TASK COMPLETION TIME (HRS)
One striking result here is that even when one country is technologically superior to the other in both Rototilling 1.0
industries, one of these industries would go out of business when opening to free trade. Thus Raking 1.0
technological superiority is not enough to guarantee continued production of a good in free trade. A Planting 1.0
country must have a comparative advantage in production of a good rather than an absolute TOTAL 3.0
advantage to guarantee continued production in free trade. From the perspective of a less-developed
country, the developed country’s superior technology need not imply that less-developed country On second thought, the father decides to let his son help according to the following procedure. First,
(LDC) industries cannot compete in international markets. the father begins the rototilling. Once he has completed half of the garden, the son begins raking the
rototilled section while the father finishes rototilling the rest of the garden plot. After the father
Another striking result is that the technologically superior country’s comparative advantage industry finishes rototilling, he begins planting seeds in the section the son has already raked. Suppose that the
survives while the same industry disappears in the other country, even though the workers in the son rakes slower than the father plants and that the father completes the sowing process just as the
other country’s industry have lower wages. In other words, low wages in another country in a son finishes raking. Note this implies that raking takes the son almost two hours compared to one
particular industry is not sufficient information to determine which country’s industry would perish hour for the father. However, because the son’s work and the father’s work are done simultaneously,
under free trade. From the perspective of a developed country, freer trade may not result in a it does not add to the total time for the project. Under this plan, the time needed to complete the
domestic industry’s decline just because the foreign firms pay their workers lower wages. tasks is shown in Table 2.2 "Father’s Task Times with Son".
INTERNATIONAL TRADE AND AGREEMENTS MODULE NO. 2
BA CORE COURSE 6 The Ricardian Theory of Comparative Advantage: PART 1

Table 2.2 Father’s Task Times with Son Interpreting the Theory of Comparative Advantage
TASK COMPLETION TIME (HRS) The garden story offers an intuitive explanation for the theory of comparative advantage and also
Rototilling 1.0 provides a useful way of interpreting the model results. The usual way of stating the Ricardian model
Raking and Planting 1.0 results is to say that countries will specialize in their comparative advantage good and trade it to the
TOTAL 2.0 other country such that everyone in both countries benefits. Stated this way, it is easy to imagine how
it would not hold true in the complex real world.
Notice that the total time needed to prepare the garden has fallen from three hours to two hours.
The garden is prepared in less time with the son’s help than it could have been done independently A better way to state the results is as follows. The Ricardian model shows that if we want to maximize
by the father. In other words, it makes sense to employ the son in (garden) production even though total output in the world, then we should:
the son is less efficient than the dad in every one of the three required tasks. Overall efficiency is 1. fully employ all resources worldwide;
enhanced when both resources (the father and son) are fully employed. 2. allocate those resources within countries to each country’s comparative advantage industries; and
3. allow the countries to trade freely thereafter.
This arrangement also clearly benefits both the father and son. The father completes the task in less
time and thus winds up with some additional leisure time that the father and son can enjoy together. In this way, we might raise the well-being of all individuals despite differences in relative
The son also benefits because he has contributed his skills to a productive activity and will enjoy a productivities. In this description, we do not predict that a result will carry over to the complex real
sense of accomplishment. Thus both parties benefit from the arrangement. world. Instead, we carry the logic of comparative advantage to the real world and ask how things
would have to look to achieve a certain result (maximum output and benefits). In the end, we should
However, it is important to allocate the tasks correctly between the father and the son. Suppose the not say that the model of comparative advantage tells us anything about what will happen when two
father allowed his son to do the rototilling instead. In this case, the time needed for each task might countries begin to trade; instead, we should say that the theory tells us some things that can happen.
look as it does in Table 2.3 "Task Times with Incorrect Specialization".
2.3. Ricardian Model Assumptions
Table 2.3 Task Times with Incorrect Specialization The Ricardian model shows the possibility that an industry in a developed country could compete
TASK COMPLETION TIME (HRS) against an industry in a less-developed country (LDC) even though the LDC industry pays its workers
Rototilling 4.0 much lower wages.
Raking 1.0
Planting 1.0 The modern version of the Ricardian model assumes that there are two countries producing two
goods using one factor of production, usually labor. The model is a general equilibrium model in
TOTAL 6.0
which all markets (i.e., goods and factors) are perfectly competitive. The goods produced are assumed
to be homogeneous across countries and firms within an industry. Goods can be costlessly shipped
The time needed for rototilling has now jumped to four hours because we have included the time
between countries (i.e., there are no transportation costs). Labor is homogeneous within a country
spent traveling to and from the hospital and the time spent in the emergency room! Once the father
but may have different productivities across countries. This implies that the production technology is
and son return, the father must complete the remaining tasks on his own. Overall efficiency declines
assumed to differ across countries. Labor is costlessly mobile across industries within a country but is
in this case compared with the father acting alone.
immobile across countries. Full employment of labor is also assumed. Consumers (the laborers) are
assumed to maximize utility subject to an income constraint.
This highlights the importance of specializing in production of the task in which you have a
comparative advantage. Even though the father can complete all three tasks quicker than his son, his
Below you will find a more complete description of each assumption along with a mathematical
relative advantage in rototilling greatly exceeds his advantage in raking and planting. One might say
formulation of the model.
that the father is “most better” at rototilling, while he is “least better” at raking and planting. On the
other hand, the son is “least worse” at raking and planting but “most worse” at rototilling. Finally,
Perfect Competition
because of the sequential nature of the tasks, the son can remain fully employed only if he works on
Perfect competition in all markets means that the following conditions are assumed to hold.
the middle task, namely, raking.
INTERNATIONAL TRADE AND AGREEMENTS MODULE NO. 2
BA CORE COURSE 6 The Ricardian Theory of Comparative Advantage: PART 1
1. Many firms produce output in each industry such that each firm is too small for its output If two countries share the same homothetic preferences, then when the countries share the same
decisions to affect the market price. This implies that when choosing output to maximize profit, each prices, as they will in free trade, they will also consume wine and cheese in the same proportion.
firm takes the price as given or exogenous.
2. Firms choose output to maximize profit. The rule used by perfectly competitive firms is to choose General Equilibrium
the output level that equalizes the price (P) with the marginal cost (MC). That is, set P = MC. The Ricardian model is a general equilibrium model. This means that it describes a complete circular
3. Output is homogeneous across all firms. This means that goods are identical in all their flow of money in exchange for goods and services. Thus the sale of goods and services generates
characteristics such that a consumer would find products from different firms indistinguishable. We revenue to the firms that in turn is used to pay for the factor services (wages to workers in this case)
could also say that goods from different firms are perfect substitutes for all consumers. used in production. The factor income (wages) is used, in turn, to buy the goods and services
4. There is free entry and exit of firms in response to profits. Positive profit sends a signal to the rest produced by the firms. This generates revenue to the firms and the cycle repeats again. A “general
of the economy and new firms enter the industry. Negative profit (losses) leads existing firms to exit, equilibrium” arises when prices of goods, services, and factors are such as to equalize supply and
one by one, out of the industry. As a result, in the long run economic profit is driven to zero in the demand in all markets simultaneously.
industry.
5. Information is perfect. For example, all firms have the necessary information to maximize profit Production
and to identify the positive profit and negative profit industries. The production functions in Table 2.4 "Production of Cheese" and Table 2.5 "Production of Wine"
represent industry production, not firm production. The industry consists of many small firms in light
Two Countries of the assumption of perfect competition.
The case of two countries is used to simplify the model analysis. Let one country be the United States
and the other France. Note that anything related exclusively to France in the model will be marked Table 2.4 Production of Cheese
with an asterisk. The two countries are assumed to differ only with respect to the production United States France
technology.

Q L
Q  L
*
Two Goods  c

a
C
c

a
*
Two goods are produced by both countries. We assume a barter economy. This means that no money LC C
LC
is used to make transactions. Instead, for trade to occur, goods must be traded for other goods. Thus
we need at least two goods in the model. Let the two produced goods be wine and cheese.
Where:
Qc = quantity of cheese produced in US
One Factor of Production
LC = amount of labor applied to cheese production in the United States
Labor is the one factor of production used to produce each of the goods. The factor is homogeneous
aLC = unit labor requirement in cheese production in the United States (hours of labor necessary to
and can freely move between industries.
produce one unit of cheese)
∗ All starred variables are defined in the same way but refer to the process in France.
Utility Maximization and Demand
In David Ricardo’s original presentation of the model, he focused exclusively on the supply side. Only
Table 2.5 Production of Wine
later did John Stuart Mill introduce demand into the model. Since much can be learned with Ricardo’s
United States France
incomplete model, we proceed initially without formally specifying demand or utility functions. Later
in the chapter we will use the aggregate utility specification to depict an equilibrium in the model.
Q L
Q L
*
 W

a
W
When needed, we will assume that aggregate utility can be represented by a function of the form U = W

a
LW W *
CcCw, where Cc and Cw are the aggregate quantities of cheese and wine consumed in the country, LW
respectively. This function is chosen because it has properties that make it easy to depict an
equilibrium. The most important feature is that the function is homothetic, which implies that the Where:
country consumes wine and cheese in the same fixed proportion at given prices regardless of income. QW = quantity of wine produced in US
LW = amount of labor applied to wine production in the United States
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BA CORE COURSE 6 The Ricardian Theory of Comparative Advantage: PART 1
aLW = unit labor requirement in wine production in the United States (hours of labor necessary to exogenous variables are taken as fixed parameters whose values are known. They are variables over
produce one unit of wine) which the agents within the model have no control. In the Ricardian model, the parameters (L, aLC, aLW)
∗ All starred variables are defined in the same way but refer to the process in France. are exogenous. The corresponding starred variables are exogenous in the other country. Endogenous
variables are those variables determined when the model is solved. Thus finding the solution to a
The unit labor requirements5 define the technology of production in two countries. Differences in model means solving for the values of the endogenous variables. Agents in the model can control or
these labor costs across countries represent differences in technology. influence the endogenous variables through their actions. In the Ricardian model, the variables (LC, LW,
QC, QW) are endogenous. Likewise, the corresponding starred variables are endogenous in the other
Resource Constraint country.
The resource constraint in this model is also a labor constraint since labor is the only factor of
production (see Table 2.6 "Labor Constraints").

United States France

L L
C W
L
L L  L
C* W* *

Where:
L = the labor endowment in the United States (the total number of hours the workforce is willing to
provide)

When the resource constraint holds with equality, it implies that the resource is fully employed. A
more general specification of the model would require only that the sum of labor applied in both
industries be less than or equal to the labor endowment. However, the assumptions of the model will
guarantee that production uses all available resources, and so we can use the less general
specification with the equal sign.

Factor Mobility
The one factor of production, labor, is assumed to be immobile across countries. Thus labor cannot
move from one country to another in search of higher wages. However, labor is assumed to be freely
and costlessly mobile between industries within a country. This means that workers working in the
one industry can be moved to the other industry without any cost incurred by the firms or the
workers.

Transportation Cost
The model assumes that goods can be transported between countries at no cost. This assumption
simplifies the exposition of the model. If transport costs are included, it can be shown that the key
results of the model may still be obtained.

Exogenous and Endogenous Variables

In describing any model, it is always useful to keep track of which variables are exogenous and which
are endogenous. Exogenous variables6 are those variables in a model that are determined by
processes that are not described within the model itself. When describing and solving a model,
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BA CORE COURSE 6 The Ricardian Theory of Comparative Advantage: PART 1