The Ricardian Trade Model

1. Surplus was the Reason for Trade

Reasons for Trade	(i) Surplus was the main reason for ancient peoples to trade. (ii) Until the 19th century, comparative advantage was the reason for trade. (iii) Dissimilar factor endowments are a reason for international trade (The theory applies to trade in the modern world after the 1980s.)
Surplus	There is evidence that in prehistoric times people traded goods. For instance, pre-Chinese people who settled down in Hongshan (Red Mountain) region, now Inner Mongolia, and later in Liangzhu (near Shanghai now) used to trade primitive jade artifacts. The latter also traded silk with neighboring peoples. Those who settled down in river basins were successful in agriculture, and these surpluses were exported to neighboring regions in return for other goods. Surplus of a product simply means that its autarky price is lower in the exporting country than elsewhere.
Babylonia Source: British Museum	Babylonians produced 20 different varieties of beer, drinking beer with drinking straws. Babylonians exported beer to faraway countries, even to Egypt. They were the first beer drinkers. They knew how to make beer and they had raw materials. Soon there were a surplus of beers and that was the reason for their beer exports. Even in modern times, the Communist bloc countries exported surpluses to other members and avoided trading with free market economies. This Babylonian clay tablet is the first map of the world. Circles were used to denote city centers, and this method has been adopted by cartographers ever since. Babylonians were interested in geography because of their exports of beer and other agricultural surpluses. Even before the silk road was built, Babylonia during the Kassite dynasty (1595-1157 BC) imported cobalt for coloring glasses from China (Donald McKenzie, Myths of Babylonia and Assyria, 1915). This Babylonia-China trade resulted in harmony of time counting. Both Babylonia and China used the sexagesimal system. Chinese used a lunar calendar, dividing the day into 24 hours, each hour into 60 minutes. This is not a coincidence or accident, but the result of trade between the two regions.
	Ishitar Gate Sumerian devotees of Ishtar (BM, London and Hamburg). This is the typical attire of Sumerians as shown in the above Standard of Ur.

2. Adam Smith's Explanations for Trade

Adam Smith	Smith thought that countries export the commodities in which they have an absolute advantage and import those goods in which other countries have an absolute advantage. (wrong)
	Adam Smith, a Scottish economist, published a book "Wealth of Nations." (1776) In this book he emphasized the importance of division of labor and specialization. He also ridiculed the fear of free trade by comparing nations and households. He argued that every household finds it worthwhile to produce only some of its needs, and to buy other commodities from others with its products. Smith argued that the same principle applies to nations. "It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys them from the shoemaker. The shoemaker does not attempt to make his own clothes, but employs a tailor. "What is prudence in the conduct of every private family, can scarcely be a folly in that of a kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage."
	Fall of Icarus, by Pieter Bruegel (1558), illustrates the agricultural economy before the industrial revolution in the 1820s.
Max Libermann, Cobbler's workshop, Kunsthalle Museum, Hamburg.	The shoemaker makes only 2 pairs a day. Impact of industrial revolution, Montreal History Museum
	Max Libermann, Flax barn at Lauren, Kunsthalle Museum, Hamburg. Flax fiber is used to make linen, which was used as clothes, table cloth, towels, and to cover dead bodies in ancient times. This painting illustrates the emerging manufacturinging sector and the migration of workers to urban areas.
	Pont neuf (Auguste Renoir, 1872) depicting the city life during the period of industrial revolution. Washington National Gallery.
Absolute advantages matter in battles.	Bombing damages of Japanese cities and their equivalent cities in the US as of August 6, 1945. Frauenkirche, Dresden. Sons of British bombers returned and participated in rebuilding after the fall of Berlin wall in 1989.
Adam Smith's main idea	If countries have absolute advantages, each country should specialize in the commodities in which it has absolute advantages and export those products and import others in which it has absolute disadvantages. ex: President Woodraw Wilson.
Question	Smith assumed that each country had enough absolute advantage over its trading partners so that if free trade is allowed, each country would have a balance of trade. What if a country had no absolute advantage? Wouldn't it become a slave economy to capital rich countries? What if a country had absolute advantages in all industries? Will it gain from trading with inferior economies?
Dependency Theory	This theory was proposed by Raul Prebisch in the 1950s. He claimed that developing countries become exploited and do not benefit from trade. He proposed that poor countries adopt import substitution policy. LDCs usually export primary products, and the transition to manufactures was difficult. The Latin American countries that adopted the import substitution policy grew at slower rate (2%) than those Asian countries that adopted export promotion policy. Import substitution is a move toward autarky.

Ricardian Trade Model

3. Assumptions of The Ricardian Trade Model: 2 × 2 × 1

	Ricardo wrote Principles of Political Economy and Taxation in 1817. Most countries in Europe then were agricultural economies with some maufacturing. The Ricardo's model is useful in explaining trade patterns with different technologies (until 1980s)
	two-countries, two commodities Labor is the only factor of production =>one wage Linear Production Functions: y_i = f(L_i) = c_iL_i, i = 1,2 homogeneous products (two countries produce identical goods) Balanced Trade (value of imports = value of exports) Labor productivities differ between countries: One country is more efficient than the other. No transportation costs.
Ricardo's Model
Heckscher-Ohlin Model	The HO model is applicable to countries that have similar technologies but factor endowments are dissimilar. (since 1980s)
Input-output coefficients	a_ij = the amount of input i required to produce 1 unit of good j = fixed in the Ricardian Trade model. = variable, and responsive to changes in factor prices in the Heckscher-Ohlin trade model. L_i = the amount of labor used in industry i y_i = the amount of good i produced in industry i a_L1 = L₁/y₁ a_K2 = K₂/y₂
Production Possibility Frontier	A PPF shows various maximum output combinations the economy can possibly produce from given technology and resources, including capital (K) and labor (L) inputs. Only one of these points will ultimately be chosen. Labor Demand in Sector 1 L₁ = a_L1y₁ For instance, assume that industry 1 produces automobiles. If it requires 2 auto workers (per year) to produce one automobile (a_L1 = 2) and 10 million automobiles (y₁ = 10 million) are produced per year, the total number of auto workers required is L₁ = 2 × 10 million = 20 million. Similarly, L₂ = a_L2y₂ L₁ + L₂ = L (Aggregate demand for labor = aggregate labor supply) a_L1y₁ + a_L2y₂ = L (PPF) max y₂ = L/a_L2, max y₁ = L/a_L1.

4. Absolute vs. Comparative Advantage

Absolute Advantage	If a_L1 < a_L1*, then the HC is said to have an AA in industry 1. HC = Home country, FC = Foreign country
Different productivities due to weather and other conditions	Ricardo: Labor productivities differ between countries workers in the Home country workers in the Foreign country
Comparative Advantage	If a_L1/a_L2 < a_L1/a_L2, then the HC is said to have a CA in industry 1 [The autarky (relative) price of good 1 in HC is less than that in FC].
	Note that a_L1/a_L2 = (p₁/p₂)^A is the relative price of good 1 in autarky. Remark: A country may have AAs in both commodities, but it cannot have CAs in both commodities. Similarly, a country may have AAs in many commodities, but it cannot have CAs in all commodities.