Lecture 3

DAVID RICARDO’S CASE FOR FREE TRADE RESTS ON SOME BASIC ECONOMIC PRINCIPLES, BUT ALSO HAS A BIG PUBLIC POLICY BLIND SPOT

One survey of professional economists in the United States found that 93% would agree with the claim that restrictions on free trade through tariffs and import quotas would reduce economic welfare.

Yet, I’m certain those advocating for free trade are often accused of having a blind spot. Is there something in the economic method, which can legitimately lay claim to being scientific, that also blinds its practitioners to what others see so clearly?

The case for free trade rests upon a logic derived from scarcity, opportunity costs, and marginal reasoning applied to a two-good world. With two goods there is the possibility of exchange, of trading. In effect, we are asking the more general question: are there gains from trade?

David Ricardo is the starting point for the economic analysis of international trade. He made a very strong statement about the advantages of free trade, at a time when it was a politically charged issue.

“Under a system of perfectly free commerce,” Ricardo wrote, “each country naturally devotes its capital and labour to such employments as are most beneficial to each.”

And he went on to forcefully claim that free trade is a win-win proposition that promotes the efficient use of scarce resources and hence economic well-being for all countries.

This pursuit of individual advantage is admirably connected with the universal good of the whole. By stimulating industry, by rewarding ingenuity, and by using most efficaciously the peculiar powers bestowed by nature, it distributes labour most effectively and most economically: while, by increasing the general mass of productions, it diffuses general benefit, and binds together by one common tie of interest and intercourse, the universal society of nations throughout the civilized world. It is this principle which determines that wine shall be made in France and Portugal, that corn shall be grown in America and Poland, and that hardware and other goods shall be manufactured in England.

[David Ricardo (1817). On the Principles of Political Economy and Taxation. Volume I of The Works and Correspondence of David Ricardo. Piero Sraffa (editor). Cambridge: Cambridge University Press. Pages 133-34.]

This is as provocative now as it was 200 years ago. That trade is a positive sum game, win-win, making everyone better off is still a hard to understand proposition. This is because Ricardo’s description of the underlying principle—that of comparative advantage—is still not fully part of public discourse.

The “corn laws”: public policy spurs the economic theorist!

But the logic remains as valid now as it was then, and is the reason his name is still the starting point for any serious discussions of international trade.

Ricardo was writing in the aftermath of the Napoleonic wars. England had been pretty well continuously at war with France from the French revolution in 1789 until the defeat of Napoleon in 1815. These wars had the effect of disrupting international trade.

At that time England was an exporter of manufactured goods and an importer of agricultural goods, but maritime transport was disrupted by state sponsored pirates and a French blockade. This restricted the supply of agricultural products coming into England, and as a result made the price of food relatively high. English landowners were the main beneficiaries, and manufacturers—who had to pay more for the labour they employed while at the same time selling less of their production—the losers.

But after the war food prices fell as foreign supplies of agricultural products were brought back onto the English market. This threat to their fortunes led the politically influential landowners to get legislation passed that, in essence, imposed a tariff on grain imports, with the result that supply was again restricted and relative prices maintained at higher rates.

Ricardo was arguing for the repeal of these “Corn Laws,” and he cast his argument in a way that showed society as a whole would gain from “free commerce,” or “free trade” as we would call it today.

Absolute advantage is not the basis for free trade

He used a hypothetical example of trade between Portugal and England that involved just two goods, cloth and wine, and one factor of production, labour. This set of assumptions explains trade by differences in the relative productivities of labour that arise from differences in natural endowments. Two countries trade with each other because they are different in these endowments.

We can think of the endowment as being associated with geography or climate, though its sources might be more general also reflecting cultural and institutional advantages or the results of public policy. Think, for example, of the advantage that a country whose population is English speaking might have in a world that increasingly uses English as the language of trade, commerce, and cultural exchange.

The important point is that in Ricardo’s example the two countries differ in their opportunity costs of producing the goods they are interested in consuming. The example is set up in a very specific way.

England may be so circumstanced, that to produce the cloth may require the labour of 100 men [yes men again!] for one year; and if she attempted to make the wine, it might require the labour of 120 men for the same time. … 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. [Ricardo (1817), page 135.]

For the sake of clarity, I’ve presented these labour productivities in the following table. The first thing to notice is that both countries are capable of producing both goods on their own. It is easy to rationalize trade if a country has no capacity to produce a good. The only way it can have any of the good is to trade for it. Bananas don’t grow in Canada; if Canadians want to eat bananas they have to trade something for them. But that is not the case here.

Further, it might also be easy to rationalize trade if one country was very productive in one good, and the other country very productive in the other. Okay I suppose if you really tried hard, and spent a lot of time and money you could grow bananas in Canada. But the country is much more efficient at designing and manufacturing Blackberries. Similarly, I suppose if you really tried hard, and spent a lot of time and money you could produce telecommunications equipment in Costa Rica. But the country is much more efficient at growing bananas.

It is easy to see that these two countries should trade manufactured goods for agricultural products. But again this is not how Ricardo set things up.

The case for trade rests on comparative advantage

What the table shows is that Portugal is more productive than England in the production of both goods: it takes less labour to produce one unit of wine in Portugal, and it also takes less labour to produce one unit of cloth.

Does it make sense for these countries to trade even if one of them is more productive in everything? What does England have to offer Portugal? And if there was free trade don’t the Portuguese pose a threat to the jobs of all English workers, whether they work in vineyards or in factories?

Even under these conditions the two countries will find it mutually advantageous to trade. To see this play with the numbers a bit. Assume each country wants to consume one unit of wine and one unit of cloth. Then under autarky this would require the English to use a total of 220 units of labour, and the Portuguese to use 170 units. Total world output is two units of wine and two units of cloth, based on the work performed by a total of 390 workers.

Contrast this with a situation in which each country produces only one good, specializing in the good for which it is relatively more productive, and then they trade one unit of wine for one unit of cloth.

It is true that Portugal is more productive in both goods, but comparatively speaking it is more productive in wine than in cloth. It is true that England is less productive in both goods, but not as much so in the production of cloth. So Portugal produces all of the world’s wine. Two units of wine require 160 units of labour. And similarly England produces all the world’s cloth, these two units requiring 200 units of labour. Total world output is still two units of each good, but now only 360 units of labour was used to produce it.

The Portuguese have used 10 units less of labour than under autarky; the English 20 units less. They each have as much to consume as under the previous scenario of no trade, but they have used less labour. The labour they saved could be used to produce a bit more of something thereby increasing overall production and consumption. When production is specialized on the activity that each does best, and trade permitted, everyone is better off.

This happens because the opportunity costs of producing an extra unit of the goods differs in the two countries. The opportunity cost of one unit of wine in Portugal is 8/9ths of a unit of cloth. To produce one extra unit of wine the Portuguese must transfer 80 workers from cloth production to wine production. As a result, the production of cloth falls; but it falls by less than one unit, to be precise it falls by 80/90, or 8/9ths of a unit.

In England the opportunity cost of an extra unit of wine in terms of cloth is greater. Fully 120 labourers must be transferred from cloth production in order to get an extra unit of wine. But if this many labourers leave cloth production the amount produced falls by more than one unit: it falls by 120/100, or 1 and 1/5th units.

While the opportunity cost of wine production is lower in Portugal than in England, the opposite is the case with respect to cloth production. In Portugal an extra unit of cloth implies the country must forego 9/8 units of wine; in England only 5/6ths of a unit of wine needs to be given up.

Ricardo’s hypothetical example illustrates that the same amount of output—two units of wine and two units of cloth—can be produced using less labour if each country specialized in just the good for which its opportunity costs are lower compared to the other country: wine for Portugal, and cloth for England.

The important phrase is “compared to”; and we therefore speak of having a comparative advantage in the production of a good. To determine where the comparative advantage lies requires us to examine all four of the labour productivities.

This is why the English have something to offer the Portuguese. It is true that the Portuguese have an absolute advantage in both goods—something we can determine by pairwise comparisons of the labour productivities across the two countries—but this does not make a case against international trade.

Rather, the English offer the Portuguese the opportunity to focus on the good in which they are relatively more productive, and with the extra output they produce make use of the English production technology to make the amount of the other good they desire.

In a similar way imagine the situation from the perspective of the English. Why are the Portuguese not a threat because they are more productive, in an absolute sense, in both goods?

For England, trade should be seen as just another way of producing wine. England can produce wine using English labour, or using English labour to produce the requisite amount of cloth to buy it from the Portuguese. In this model there is only one resource, labour, and while it can be used in two ways—in the production of wine or in the production of cloth—its use is subject to constraints of technology, and in the amount that is available.

Labour is scarce, and as a result the act of producing wine and cloth involves a trade-off. The terms of this trade-off are going to be different according to whether the goods are produced domestically or obtained through international trade. That is what a comparison of opportunity costs between the two countries tells us.

All of this is an ingenious piece of logic with a certain political appeal. Everyone wins under free trade. And on the basis of this logic Ricardo became an influential politician who contributed to the repeal of the Corn Laws.

The theorist’s methods have a public policy blind spot

There is a certain truth to this model that has stood up for 200 years or so. The underlying assumption that countries trade with each other because of differences in relative productivities leads to the prediction that we should observe trade of different goods. The exports of a country should be made up of goods with relatively high labour productivity. Indeed, much trade is of this sort.

For example, China has a comparative advantage in labour-intensive manufacturing, while the United States has a comparative advantage in human capital-intensive goods and services. The trade patterns between this pair of countries and many other pairs reflect these relative advantages.

However, on other important aspects the model is entirely mute. While it gives some indication of inequalities at the world level between countries, it says nothing, for example, about the distribution of the surplus within a country: what happened to the landowners and their rents?

The only factor of production in this model is labour, so by construction the model cannot speak to this issue. This simplification allows a focus on the idea of comparative advantage and the resulting gains from trade, but as you can imagine this is not exactly what the landowners of Ricardo’s time had in mind. A move to free trade may generate a surplus, but public policy may still be interested in who gains, who loses, and by how much.

Evaluating changes in public policy in this way requires a certain caution on the behalf of the economic theorist because the method being used involves a comparison of different equilibrium outcomes, rather than charting out a process of change from one equilibrium to another.

This method of analysis is called comparative statics. The label is telling. It involves a comparison of market outcomes that are at rest. It is not a method that incorporates historical time. An appreciation of this limitation allows us to interface more naturally with actual political processes: our economic models illustrate that there are potentially significant gains in moving from one equilibrium to another, that these gains represent incentives in market-based economies that generate a force for change, but at the same time our models do not describe the process of change. They leave the door open to politics as the art of moving or for that matter not moving from one equilibrium to another.

Ricardo’s way of thinking assumes that labour can be re-allocated between the two sectors without any costs. It can be cold comfort to some that this is a long-run model describing the nature of two different equilibria after all adjustments and changes have taken place.

The assumption that workers can move costlessly between sectors—that there is no specificity in the use of workers in each sector associated with where they are located, the skills they have, or their age—is a reflection of the focus on long- run outcomes. But how long is the long-run? Is it a week, or is it a life-time?

Other models theorists have since developed recognize that there may be significant changes in the distribution of the surplus if “labour” is not a homogeneous entity that can be reallocated between sectors without costs. They show that there will be gains from trade but that even in the new equilibrium there will be both winners and losers.

Listen to Paul Krugman, the economist who was awarded a Nobel Prize for his work on international trade, express about 16 minutes and 40 seconds into a February 14th 2020 interview on the BBC a certain amount of he calls “regret” in the way the argument for free trade was framed in the 1990s.

If we appreciate the two great questions that economics helps answer, then we also appreciate that any public policy change will imply not just a change in the overall size of the surplus but also a change in its distribution. Every change in public policy implies that there will be winners and losers, and often the arguments these groups make for or against a particular policy will be couched in terms of the public good in a way that masks underlying normative positions.

Indeed, as has been suggested, Ricardo did as much himself, a wealthy stock-broker somewhat on the outside of mainstream British society whose personal interests were much more closely aligned with the growing entrepreneurial class than with the landed gentry. His focus on comparative advantage placed the emphasis on the good of the whole, abstracting entirely from the issue of income distribution. And this from an economist who began his great book on the principles of economics by stating that distributional issues were at the very core of the subject!

The presentation for this class continues from that for Lecture 2. Download the slides from that lecture again if you need to.

[Revised February 9th, 2021.]