The Ricardian Trade Model


  1. Surplus was the Reason for Trade
Reasons for Trade

 (i) Surplus was the main reason for the peoples of the ancient world to trade.

(ii) Before WWII, comparative advantage was the reason for trade.

(iii) Dissimilar factor endowments are the major reason for international trade (The theory applies to trade in the modern world after the 1980s.)

 Surplus 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. Beer was produced circa 3500 BC in Mesopotamia.
Sumerians

Ishitar Gate, Babylon


the Standard of Ur, showing the use of chariots, and Sumerian devotees of Ishtar (BM, London and Hamburg). This is the typical attire of the Sumerians as shown in the above Standard of Ur.

Babylon's trade

 

Sumerians were the first beer drinkers. They knew how to make beer and they had the raw materials. Sumerians traded with peopl in the mountains. They needed wheat and barley, and they traded timber, copper and flax for wheat. (Barter trade) Silver and grains were used in payment.

Even in modern times, the Communist bloc countries exported surpluses to other members and avoided trading with free market economies.

Babylonians produced 20 different varieties of beer (Samuel Adams, 60 varieties), drinking beer with drinking straws. Babylonians exported beer to faraway countries, even to Egypt.

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.


Source: British Museum

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 (Shang dynasty) used the sexagesimal system. Spring and Autumn Annals used a sexagenary lunar calendar, dividing the day into 24 hours. This synchronicity may have been the result of trade between the two regions.

 

  2. The World Economy before 1820s
 


Codex Hammurabi, Pergammon Museum

boundary stone

As barbarians gathered in the river basins and began to form families and build cities, they found it necessary to regulate their own behavior. They adopted various codes (Codex Hammurabi, Ten Commandments, etc.), including property rights. Civilizations began.


Agricultural economy

icarus

Fall of Icarus, by Pieter Bruegel (1558), illustrates the agricultural economy before the industrial revolution in the 1820s. Farming can be combined with animal husbandry.

  Adam Smith's Explanation 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."

   3. The World Economy after 1820s (Industrialized)

Industrial Revolution


Max Libermann, Cobbler's workshop, Kunsthalle Museum, Hamburg.

Many secrets were lost. ⇒ slowed the pace of industrial development.


The shoemaker makes only 2 pairs a day.


Impact of industrial revolution, Montreal History Museum

Urban Development

Industrialization caused the migration of workers from the rural to the urban areas.

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 manufacturing sector and the migration of workers to the urban areas.

GDP per capita of GB rose from $2100 in 1820 to $3600 in 1870. (growth rate = 1%)

Rising wage

Pont neuf (Auguste Renoir, 1872) depicting the city life during the period of industrial revolution. Washington National Gallery.

 Absolute advantages

 AA matter in battles.

A hoplite's (Greek soldier) shield (Battle of Thermopylae, 480 BC)

Bombing damages of Japanese cities and their equivalents in the US as of August 6, 1945.

  Adam Smith's Idea
Absolute advantage 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.

example: 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.

alarm clock 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?

  4. Theories against Free Trade after WWII

Self-Sufficiency
and
 Salt March (March 12, 1930)

Even earlier, Mahatma Gandhi led the salt march in 1930, breaking the salt law. It began with 80 Indians, but the number grew to 4000 when he reached the shore. That was the beginning of India's independence movement.  He encouraged Indians to produce salt without paying taxes to the British government.

Prior to 1991, on the whole, India was a closed economy, and the average tariff exceeded 200%. Since the economic reform in 1991, India's economy improved maintly due to increased trade.

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. Keep out imported goods until the infant industries become competitive.

He proposed that poor countries adopt import substitution policy. LDCs usually export primary products, and the transition to manufacturing was difficult in LDCs.

Socrates (470-399BC): Know thyself
Sunzi (c. 544-496 BC): Know thyself and thine enemy (The Art of War)
Prebisch: Buy No Foreign Goods (No need to know about your neighbors)

WWII would not have happened had the Allies followed "love thy neighbors policy." Germany had to sign the Versaille Treaty to pay 132 billion gold marks ($33 billion, but actual payment by 1932 was about $5 billion)" (The financial cost to the Allies (excluding Russia, and excluding human cost) was about $1 trillion in 1945."

To survive in the Modern world: Know yourself and your neighbors (export promotion)

The Latin American countries that adopted the import substitution policy (1930s-1980s) grew at a slower rate (2%) than those Asian countries that adopted export promotion policy (3.5%) during the postwar period.

Import substitution is a move toward autarky.

 

  5. 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). Karl Marx wrote Das Kapital in 1867.
7 Assumptions
  1. two-countries, two commodities

  2. Labor is the only factor of production ⇒ one wage

  3. Linear Production Functions:
    yi = f(Li) = ciLi, i = 1, 2 (For instance, y1 = 3L1
    )

  4. homogeneous products (two countries produce identical goods)

  5. Balanced Trade (value of imports = value of exports)

  6. Labor productivities differ between countries : In any industry, one country is more efficient than the other.

  7. 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 aij = 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.

Li = the amount of labor used in industry i

yi = the amount of good i produced in industry i

aL1 = L1/y1

aK2 = 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 = aL1y1

For instance, assume that industry 1 produces automobiles. If it requires 2 auto workers (per year) to produce one automobile (aL1 = 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 = aL2y2

L1 + L2 = L (Aggregate demand for labor = aggregate labor supply)

aL1y1 + aL2y2 = L (Production Possibility Frontier)


max y2 = L/aL2,
max y1 = L/aL1.

   
   

 

  6. Absolute vs. Comparative Advantage
 Absolute Advantage If aL1 < aL1*,

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 aL1/aL2 < aL1*/aL2*,

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 aL1/aL2 = (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.

World outputs under two scenarios  
 

More outputs can be produced under free trade. Yet we need to prove that each country will be better off under free trade.

The gap between autarky and free trade points above measures the gains from trade.

How the gains are distributed between the two countries depends on the exchange rate.

When trade is balanced, both countries benefit from trade.