Productivity and Comparative Advantage: Ricardian Model

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 Productivity and Comparative Advantage: Ricardian Model

Executive Summary

Ricardo introduced the concept of comparative advantage in order to describe why nations engage in cross-border trade even when they can produce all goods more efficiently than other countries. The model describes trade benefits that countries gain from their differences in labor productivities. Ricardo states that a country or firm is said to have a comparative advantage over others in the manufacture of a given commodity if it can produce that good at a relatively lower opportunity cost. The theory does not compare the resource or monetary cost of production but rather the opportunity cost of manufacturing particular goods.

The model of comparative advantage states that under free trade, a country or industry produces more commodities in which it has a comparative advantage over others. Ricardo demonstrated that if two nations capable of producing two goods engage in trade, each country will enlarge its production and consumption possibilities by exporting products in which it has a comparative advantage and import the other as long as these countries have differences in labor productivities. Ricardo’s model implies that comparative advantage is the key driver of foreign trade. Therefore, all trade agents gain from trade regardless of differences in wage rates or productivity.                

Countries engage in foreign trade for two main reasons. First thing, countries trade to benefit from one another. Zhang (2008) asserts that countries can benefit from their differences by coming up with business arrangements where each country specializes in areas in which it does relatively well or has a comparative advantage. Countries also engage in international trade to gain economies of scale in their field of specialization (Feenstra, 2004). In other words, if a state manufactures particular goods, it can make these products more efficiently and at a larger scale than if it tried to produce many goods. The international trade patterns indicate these motives in the real world.  

Various economic models focus on these motives of international trade. However, it is advisable to use simplified models that focus only on one of these motives to easily understand the cause and effect of trade. One of the simplified models is that of Ricardo which focuses on comparative advantage (Boyes & Melvin, 2013). This paper uses the Ricardian model to understand how labor productivity differences between nations drive trade between them and how all the countries gain from trade.

The study begins with a general introduction into the Ricardian model and then proceeds to assess how the concept portrays the notion of comparative advantage and trade benefits. The paper further focuses on common myths regarding cross-border trade and the idea that wages indicate productivity while trade patterns symbolize relative productivity. The paper provides valuable information to those looking forward to understanding how the model operates and how it portrays the idea of comparative advantage.

The Ricardian framework uses the concepts of comparative advantage and opportunity cost. According to Boyes and Melvin (2013), the opportunity cost of manufacturing a given product measures the cost of not being in a position to produce something else. Huggins and Izushi (2011) elaborate Boyes and Melvin’s (2013) point by asserting that a nation faces opportunity cost when it uses resources to manufacture goods and services. For example, a country can employ a particular number of workers to produce computers or roses. The opportunity cost of trading roses is the value computers not made. Similarly, the opportunity cost of making computers is the quantity of roses not traded or produced. A nation faces a trade-off in any of these scenarios.

A country considers the amount of roses or computers it can produce with the limited available resources (Kenen, 2006). For example, suppose that Australia can produce 5 million computers using the same resources which can produce 100 million roses while the United States can produce 5 million computers using the same resources which could manufacture 75 million roses. In this case, employees in the U.S. will be less productive compared to those in Australia in producing roses. Therefore, the U.S. has a lower opportunity cost of producing roses.

From Ricardo’s perspective, a nation is said to have a comparative advantage in manufacturing a particular product if the opportunity cost of manufacturing such product is lower in the nation compared to opportunity cost in other countries (Schumacher, 2012; Deresky & Christopher, 2008). Therefore, in our example, the U.S. has a comparative advantage in computer manufacturing. According to Huggins and Izushi (2011), a nation with a comparative advantage in manufacturing a particular product can use its resources more efficiently to produce the good than in producing of any other type of goods. For example, Australia has a comparative advantage in flower production. As such, the country can use its resources more efficiently to produce roses than in other purposes. On the other hand, the U.S. has a comparative advantage in producing computers thus it can use the available resources more efficiently in manufacturing computers than other products. Therefore, both nations will be made better off if the U.S. produces computers and Australia produces roses, but the two countries want to consume roses and computers. The table illustrates how the nations will be better off.

Table 1: Trade and Comparative Advantage  

 

Computers (Millions)

Roses (Millions)

Australia

-5

100

The U.S.

5

-75

Total

0

+25

Source: (Schumacher, 2012)

The table indicates that when nations specialize in the areas of production they have comparative advantages; more products will be produced in the international market. Initially, the two nations could produce and consume only 5 million computers and 75 million roses. However, when each country concentrates on the area of production in which it has comparative advantage, the countries will still consume 5 million computers, but still consume 100,000,000 – 75,000,000 = 25,000,000 more roses. This illustration provides an important insight into the international trade and comparative advantage. That is, trade between two or more nations can be mutually beneficial if these countries export or produce goods in which they have comparative advantages.  

Countries and individuals benefit in various ways from trade. First and foremost, trade is an indirect production method (Vaidya, 2006; Deresky & Christopher, 2008). For example, a country can produce computers directly in which it has a comparative advantage, but trading with foreign countries allows it to “produce” roses by producing computers and then trading them for roses in other nations. This indirect method of “production” is more efficient than direct production (Kenen, 2006).  Indeed, a country can acquire more roses using fewer resources than it could get producing them directly. Similarly, a nation can “produce” roses more efficiently by making computers and trading them. As such, both countries gain from trade. Trade also enlarges production as well as consumption possibilities. According to Schumacher (2012), production and consumption possibilities are the same in the absence of trade.  However, trade enables people in each nation to consume different products including ones not produced domestically. In other words, trade enlarges the range of choice hence making residents in each country better off. 

The Ricardian model also helps to understand whether or not wage reflects relative productivity of different countries in international trade. From Ricardo’s understanding, low wages lead to low productivity while productivity increases as wage rises. For example, Schumacher (2012) found that wages in South Korea were about 5 percent of the wages in the U.S in 1975. However, as labor productivity in South Korea rose to about 50% of the U.S’s labor productivity in 2007, the wage in South Korea also increased significantly. Therefore, wages reflect productivity.    

On the other hand, trade pattern reflects productivity differences. Ricardian model illustrates that countries export goods they can produce more efficiently and with countries that do not have comparative advantage in such goods. Rivera-Batiz and Oliva (2003) hold a similar view that countries trade in goods they can produce using fewer resources. Therefore, trade pattern indicates the country’s productivity in these goods. For example, a state that exports large quantities of computers implies that the nation has high production capacity for computers. Similarly, a country which imports computers or roses has low production capabilities in these goods (Yang & Sachs, 2003). Therefore, there is evidence supporting Ricardo’s theory that trade pattern in international trade illustrate productivity.     

There are various fallacies about international trade. The first fallacy is that a nation can only gain from trade if it can survive competition from foreign countries (Boehm, 2002). The other myth is that international trade is unfair and harms other nations when it is based on low wages. There is also a fallacy that foreign trade exploits nations and makes them worse off if employees in some nations get lower wages than those in other countries. The Ricardian model can help to understand why these myths are not correct.

The first statement based productivity and competitiveness is conceivable to many people. For example, Bissa (2009) criticized free trade arguing that it does not occur in reality. The author is worried that some countries might not be able to produce any good more efficiently than any other nation except by lowering the cost of labor. Bissa (2009) seems not to understand the main idea behind Ricardian theory that gain from any form of trade depends on comparative advantage rather than an absolute advantage. Bissa (2009) concluded that a nation might not have an absolute advantage. A country might require lower units of labor and higher productivity in both roses and computers than the trade partner yet, both nations gain from trade. Although some people might believe that a nation should have an absolute advantage in productivity to export goods, an absolute productivity advantage over other trade partners is neither sufficient nor necessary for a country to have a comparative advantage in a particular product. In other words, the competitive edge of any industry or country does not depend only on its productivity compared to other nations, but also on other factors such as domestic wages compared to wage rates in other nations. 

The other myth that international competition is unfair is commonly used in labor unions in search of protection from international competition (Carbaugh, 2009). Those who hold this belief feel that nations should not be subjected to competition with foreign countries which are inefficient but pay workers low wages. A simple example based on Ricardian model can reveal fallacy in this argument. For example, a nation might be productive than other countries in all industries. A foreign country can also lower the cost of producing a similar good if it has a lower wage rate. However, the wage rate in the foreign nation is irrelevant to whether or not the home country gains from the trade. In other words, whether the low cost of production in the international industry is due to low wages or high productivity does not matter (Carbaugh, 2009). The most important thing is that the home country has a low cost of production in terms of its labor for it to produce a particular good and trade for the other than to produce all the goods. Therefore, the idea that trade is fair only if workers receive high wages is a fallacy.

The third myth in which trade is termed as an exploitation strategy is emotional. If an individual is assessing the viability of free trade, the main point is not whether or not employees should be paid high wages. Instead, it is important to consider whether or not such employees and their nations are worse exploiting products based on low wages than they will be if they did not enter into trade (Ricci & Trionfetti, 2011). Moreover, an individual should not declare low wages as a sign of exploitation unless he/she provides the alternative. A country that prohibits people from trading with foreign industries to prevent them from “exploitation” makes the people worse off.

In a nutshell, the Ricardo’s framework explains how differences between nations results to trade and how countries benefit from trade. The theory focuses on labor as the only production factor. Nations have different productivities of labor in different sectors. The model states that countries trade goods which they can produce more efficiently and import goods which they cannot produce efficiently. That is, a nation’s pattern of production depends on their comparative advantages. Countries gain from trade in some ways. First thing, trade can be understood as an indirect method of production. That is, a country can produce goods in which the nation has a comparative advantage, low opportunity cost, and trade for other desired products in which the nation has no comparative advantage. Countries use indirect “production” because it helps them to acquire goods using less labor than direct production.

Trade also enlarges nation’s consumption possibilities. The statement that free trade is not beneficial is not qualified. There is no requirement that trade should be fair or a nation should be competitive to engage in trade. A country can gain from trade even if it has lower productivity than other nations. The prediction of Ricardo’s model that, nations tend to export products in which they have high productivity and imports goods in which they have relatively low productivity holds for many studies. Therefore, comparative rather than absolute advantage drives foreign trade.  

References

Bissa, E. M. A. (2009), Leiden: Brill. Intervention by the government in archaic and classical Greece for foreign trade.

Boehm, S. (2002), Cheltenham, U.K: E. Elgar. Is there progress in economics? Knowledge, truth and the history of economic thought

Boyes, W. J., & Melvin, M. (2013). Economics. Australia: Cengage Learning South-Western.

Carbaugh, R. J. (2009). International economics. Mason, Ohio: South-Western Cengage Learning.

Deresky, H., & Christopher, E. M. (2008). International management: Managing across borders and cultures. Frenchs Forest, N.S.W: Pearson Education Australia.

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Huggins, R., & Izushi, H. (2011). Competition, competitive advantage, and clusters: The ideas of Michael Porter. Oxford: Oxford University Press.

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Zhang, W.-B. (2008). International trade theory: Capital, knowledge, economic structure, money, and prices over time. Berlin: Springer.