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Ricardian Theory of Income Distribution


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									        The Ricardian Theory of Trade
Trade is not always good. We need a theory to identify when there are
gains from trade and when there are not. David Ricardo produced an early,
simple and influential model that will help us evaluate whether current
popular arguments against trade make sense. For example, the architect of
the Seattle protests, Lori Wallach, believes trade is good when the two
countries produce different things. If the goods simply would not be
available without trade then it is beneficial. However, if the countries are
able to produce roughly equivalent products she tends not to favor trade.
Trade based on prison labor or child labor she finds particularly


    Lori Wallach Explains her
    (Exerpt from Interview with Moises
    Naim, Foreign Policy, Spring 2000)
LW: Good trade is activity that, ironically,
really meets the theory of why free trade
should make everyone happier. Things that
you can't make or grow in any vaguely
economically feasible way in one place can
be traded for things that are not available or
doable in another place.
MN: So are exports of blue jeans from China
to the United States good trade or bad trade?
LW: Well, it's bad trade, in the sense that,
ironically, what I'm for is comparative
advantage, not absolute advantage. That is,
when a country or region truly has an advantage in something, it should be
able to supply the rest of the world with that thing.
MN: What do you call absolute advantage?
LW: An example of absolute advantage is when a company can make an
arrangement with the Chinese government to have at a People's Liberation
Army work camp a bunch of Tiananmen Square college kids who are
incredibly smart, and literally under the gun, making blue jeans or toys, at
no expense to the company, except whatever it costs for the contract with
the People's Liberation Army. The profits are enormous.
MN: So you would be, for example, in favor of putting high tariffs on blue
jeans from China?
LW: I wouldn't. What I would do is I would try to change the conditions
under which those jeans are produced in China.
MN: And if that's not possible in the short run?
LW: Then I would keep them out.
MN: With high tariffs?
LW: No, I'd probably use some of the WTO's Article 20 exceptions, which
unfortunately have never been applied because they've been interpreted in
ways that make them useless. But for instance, there are some that have to
do with issues of morality, and slave labor in a prison camp is immoral. So I
would do it as an embargo in the same way you do it as a matter of national
security. I wouldn't use tariffs. I would just say: Until these conditions
change, these goods are not sellable here.

Lori Wallach has established herself as one of the most articulate and
effective opponents of trade. She is a skilled lawyer and excellent organizer,
even so, the quote above badly misstates theory and makes silly errors.
       For example she claims trade is good only if countries are reasonably
similar in their cost structure, what she refers to as comparative advantage.
If one country is so situated as to have dramatically reduced costs, say
through cheap labor organized by the army, then trade is bad.
       If she had taken even the most elementary trade course, she would
know she got the argument all tangled up. We will untangle it in two steps.
First we will present a sarcastic response to such claims penned over a
century ago and then present the theory of comparative and absolute
advantage developed by David Ricardo.

                      Frederic Bastiat (illustration at left) is our most
                      sarcastic spokesperson for free trade. His “A
                      PETITION From the Manufacturers of Candles, Tapers,
                      Lanterns, sticks, Street Lamps, Snuffers, and
                      Extinguishers, and from Producers of Tallow, Oil,
                      Resin, Alcohol, and Generally of Everything Connected
                      with Lighting. “ is a classic and is available at
                      http://www.bastiat.org/en/petition.html The most
                      often quoted paragraph is:

                        We are suffering from the ruinous competition of a
rival who apparently works under conditions so far superior to our own for
the production of light that he is flooding the domestic market with it at an
incredibly low price; for the moment he appears, our sales cease, all the
consumers turn to him, and a branch of French industry whose ramifications
are innumerable is all at once reduced to complete stagnation. This rival,
which is none other than the sun, is waging war on us so mercilessly we
suspect he is being stirred up against us by perfidious Albion (excellent
diplomacy nowadays!), particularly because he has for that haughty island a
respect that he does not show for us.

       We already have a partial answer to Lori Wallach. The sun clearly has
an absolute advantage in the production of light and therefore, according to
her logic, is bad trade. Her reasoning would have us embargo light!
Bastiat’s example even captures the sense that something unfair is involved.
Albion is a reference to England, and the British Isles are often shrouded in
fog. Therefore the English producers of light have an unfair advantage just
like the Chinese producers of jeans have an unfair advantage. Of course,
cutting ourselves off from the sun is a stupid policy recommendation no
matter how many local producers of light would benefit or how unfairly
foreign light producers are shielded from the competition. The stupidity is
so obvious Bastiat does not bother to explain it and simply assumes the
reader will know.
       However the reason cutting off the sun is stupid is worth exploring. If
we did block the sun, we would be forced to create more coal, nuclear or
hydro-electric generating plants. The operators of these plants would
benefit and be happy. They would pressure their respective Congress people
to continue the policy. But wouldn’t it be better to simply accept the free
gift of light and use these expensive machines and natural resources for
something else? Bastiat has hit on a particularly effective way to explain
opportunity cost. Sunlight is free, its absolute cost is zero, but the
opportunities given up by blocking the sun are high.

                                    Therefore, it cannot be always bad to
                              trade given an absolute advantage. The one
                              example of the sun shows Ms. Wallach’s
                              argument cannot be general. However we are
                              not yet able to claim it is always good to trade
                              even given an absolute advantage. For that,
                              we need the theory developed by David
                              Ricardo (illustrated at left). In Ricardo’s day
                              the question was whether Britain should allow
                              agricultural trade with the continent,
                              especially countries like Portugal whose sunny
                              climate gave them a natural and absolute
                              advantage in producing both wheat and wine.
Let’s assume both countries have 300 hours of labor available and wheat
and wine are produced using only labor. We also assume perfect
            Table 1:                      According to the table, an English
       Units produced by            worker may produce two units of wheat
        one hour of labor           or one of wine in an hour. Portuguese
            Wheat     Wine          workers are more productive and can
  England 2           1             produce 3 units of wheat or 6 of wine.
  Portugal 3          6             Portugal has an absolute advantage in
                                    both products because it can produce
more with a single hour of labor.

      However, if we think in terms of opportunity costs the situation is
more subtle. England can produce a bushel of wheat with half an hour of
labor so in England the opportunity cost of wheat is ½ wine. If a Portuguese
worker shifts from wine to wheat, 2 units of wine are lost for every unit of
wheat gained, and the opportunity cost of 1 wheat = 2 wine.       We say
England has a comparative advantage in wheat production because it gives
up less wine per unit wheat.

       Now consider trade. If England and Portugal were to produce in
isolation and not trade, prices would reflect opportunity costs. Wheat in
England would be half the price of wine (assuming workers in both industries
get the same wage and profits are zero) and wheat in Portugal would be
twice the price of wine. If wine costs $1, then the wheat price in England
before trade would be $0.50 and the wheat price in Portugal would be $2.
Assume trade splits the difference and the global wheat price is $1.00. (Any
number between the opportunity costs would work but this number is easy.)
The English find that internationally wheat sells for $1 but locally it sells for
$0.50. English wheat producers rejoice and export until the local price is
also $1.00. Note that in order to expand wheat production workers must be
shifted from wine to wheat. This is good because while a worker used to
produce 1 wine they now produce 2 wheat and the value of the worker’s
output rises from $1 to $2. The increased value of output is one way to
represent the gains from trade for England. Remember, England gains from
trade in the sense it is able to produce more output with the same time,
even though Portugal is blessed with natural sunlight and therefore has an
absolute advantage. The gains from trade come from specializing in the
good with a comparative advantage.

      Ricardo explained the situation verbally however graphical tools have
since been developed that allow the argument to be presented and
generalized easily. The PPF (production possibilities frontier) is plotted
                                            If England has 10 hours of labor
         20                                 and 1 hour produces 2 wheat
                                            then 10 hours produces 20
         15                                 wheat. Or, if it used all units

                                            of labor to produce wine, it
         10                                 could produce 10(1)= 10 units.
         0                                  Finally, if it devoted half the
                                            labor to wine and half to wheat,
         5                                  then production is 5(2) =10
                                            wheat and 5(1) = 5 wine. Note
               5                            that this point is on our linear
                       10      15      20   PPF.

       Specialization and the gains from trade are easily represented. We
assumed wheat and wine both sold for $1. Therefore England is presented
with the choice of making $10 worth of wine or $20 worth of wheat. The
obvious solution is to specialize in whatever earns the most and then trade
for the commodities consumers want the most. The blue line from 20 wheat
to 20 wine represents all the possible choices consumers could make. The
blue line is clearly outside the PPF and this expanded choice set represents
the gains from trade.


                5       10     1      2
                               5      0

The gains come from a simple proposition - one worth remembering.

Countries gain from trade by specializing in
whatever earns the most and then exchanging for
whatever they want the most.
While the Ricardian model is very special, the ideas in the box above
generalize quite well. Trade represents two reinforcing freedoms: the
freedom to produce whatever the world values most and then to use the
proceeds to buy what you want the most. Without trade, countries are
forced to produce what they want the most. If they happen to be Arabs and
want water they are out of luck. However with trade Arabs can sell oil to the
rest of the world and import water.

      The gains from trade occur naturally, without any planning or
government intervention required. Given perfect competition English wine
producers will pay the dollar they earn out as wages for the 1 hour of labor
they employ. So the wage is $1. English wheat producers earn $2 per hour
of labor and therefore the wage is $2. English wine workers quit and become
wheat workers. Individual workers pursuing their own self-interest assure
that England specializes correctly. It is as if an invisible hand guides the
workers: individual greed leads to collective gain! (Calculate the Portuguese
wages. Why aren’t they equal to English wages?)

      This ends our discussion of the pure Ricardian model. We have not
covered every conceivable point. Those interested in reading the original or
the particulars of Ricardo’s life should visit

      Despite what we just said, it is not always true that everyone in all
places gains from trade. There are many known reasons why individuals,
and even entire countries, may lose from trade.

1. What about slave, convict or child labor?
   To be concrete, consider the story of a particular child. (Downloaded
   from .
   ex.html )
Iqbal Masih.
~ a 12 year old activist from Pakistan
~ murdered 1995
When Iqbal Masih was 4 years old, his parents
sold him into slavery for less than $16. For the
next six, years, he remained shackled to a
carpet-weaving loom most of the time, tying tiny
knots hour after hour. By age 12, he was free
and travelling the world in his crusade against
the horrors of child labour.
On Sunday, Iqbal was shot dead while he and two friends were riding their
bikes in their village of Muritke, 35 kilometres outside the eastern city of
Lahore. Some believe his murder was carried out by angry members of the
carpet industry who had made repeated threats to silence the young activist.
"We know his death was a conspiracy by the carpet mafia," said Ehsan Ullah
Khan, chairman of the Bonded Labour Liberation Front (BLLF), a private
group that fights against child labour in Pakistan.

           We will deal with this in some detail later. However the basic
argument that child labor ought to be banned is that it would raise adult
wages perhaps enough that parents would not need to send their children to
work. The home page of the economist best known for this work is:

2. American Indians do not believe trade with Europe improved their
   lives. Indeed, Christopher Columbus is
   considered by AIM to be a criminal. How is this
   consistent with the gains from trade?
   Our model assumes perfect competition and
   production of products through wage labor. The
   Indians had a much different culture with no clearly
   defined property rights or even clear concepts of
   private property let alone wage labor. The institutional prerequisites we
   assume simply did not exist. Without the ability to define or defend
   property rights, Columbus, and other Europeans, ignored what we now
   consider to be fundamental human rights.     Read about it at

3. Are their gains from the cocaine trade? Should we encourage the
   import of Columbian cocaine? Were the British right to forcibly
   defend their sales of opium in China? (You can read about the
   opium wars at

                          The gains from trade come from specializing in
                          whatever earns the most and letting people buy
                          what they want. But what if they want something
                          that is bad for them? I have watched people fairly
                          close to me both personally and professionally
                          sacrifice personal health, wealth, family and career
  for one more fix of an addictive drug. Economists argue that if the drug
  itself alters desires then the presumption the consumer knows best is
   suspect. However, there are many economists that believe people should
   be allowed to make the fully informed choice to risk addiction. The issue
   is one of personal freedom and the right to make decisions for ourselves.
   The British use of force to introduce opium in China is indefensible.
   Decisions made at the point of a gun are not free decisions and there can
   be no presumption of gain.

4. What if production shifts to a country with weak environmental
   laws but no other production advantage? The possibility that
   greenhouse gases produce global warming is quite real. If some
   countries act irresponsibly and allow easily avoided emissions this may
   increase risks for all of us. This is an externality. The gasses affect
   people that do not buy or sell the product produced and are therefore not
   reflected in supply or demand. The typical economist’s response is to
   create markets to price greenhouse gas emissions.

5. What if Americans find that their jobs producing textiles are
   replaced by imports of cheaper Chinese products? Or their jobs
   producing TV’s are endangered by Japanese imports? One answer
   is to refer back to Bastiat and the example of the sun. If we did block out
   the sun, we would need more power plant workers, so imports of sunlight
   can be said to reduce the demand for power plant workers. This could
   have a long-term affect on their wages but should not produce
   generations of unemployed nuclear workers. Eventually people do
   relocate or retrain. Still, the impact on wages is real and a valid long-
   term policy concern. The next two chapters focus on the income
   distribution effects of trade. Fights over trade policy are often fights over
   the redistribution effects of trade.

6. There is a growing literature suggesting that trade has much
   broader gains than we have discussed. Trade may lead to more
   democratic political systems, pressure for more education, and
   may reduce the likelihood of warfare. Think about this a bit.
   What mechanism can you imagine?
   http://www.nber.org/papers/11117 contains a recent academic article on
   the subject.


1) Plot the consumption and production possibilities if both England and
   Portugal have 10 hours of labor, the price of wheat is $2 and the price of
   wine is $1. Technology is represented in the table.
           One hour of labor produces
               Wheat      Wine
      England 1           1
      Portugal 2          6

2) How does your diagram illustrate specialization according to comparative
   advantage and the gains from trade?

3) What are the wages paid in England and Portugal? Why aren’t they

4) If technology is as shown, are there gains from trade? Do gains from
   trade require a level playing field?

       Hours of labor per     unit produced
                Wheat         Wine
      England 1               1
      Portugal 2              2

5) Use production and consumption possibilities to illustrate the effect of
   minimum output requirements in goods that would otherwise not be
   produced. That is, countries sometimes specify that minimum levels of
   computers or food or steel be produced locally. For example, use the
   figure you constructed in the first question but assume a minimum of 2
   units of wine must be produced in England. This might be done to allow
   Protestants to use wine in their religious ceremonies produced by fellow
   Protestants. What happened to income? The consumption possibilities

6) Use the directions below to construct an excel file that draws these
   diagrams for you. You will find a completed file on the class web.

    a) Begin by opening a new excel workbook and enter the headings below
       (for example the label “prices” is in row 3 column D or in cell D3).

        A       B         C         D         E           F
2                                             Autos       Food
3                                   Prices            1          1
4               home      output per hour             2          3
5               foreign   output per hour             5          2
7             Home        L(autos)    L(food)   Q(autos) PPF   CPF

    b)    Next, in cell B8 enter “+0”.
    c)   In cell B9 enter “+1+B8”.
    d)   Autofill to B18. You should have the numbers 0-10 in order.
    e)   In cell C8 enter “+10-B8”. Autofill to C18. You should have the
         numbers 10 to 0.
    f)   In cell D8 enter “+B8*$E$4” The dollar signs tell the program not to
         change that row or column when completing an autofill. Autofill to
         D18. You should have the numbers 0 to 20 in order. Change the
         entry in E4 to 3. Now the number should be 0 to 30. This gives the
         amount of auto production possible given the allocation of labor.
         Change the entry in E4 back to 2
    g)   In cell E8 enter “+C8*$F$4”. Autofill to C18. This should range from
         30 to 0.
    h)   Now we construct a table to show maximum income. First we calculate
         incomes specializing in food and autos then pick the larger. In cells
         h2-j2 enter the labels “autos food max “ . In cell g3 enter “home” in
         cell g4 enter “foreign” .
    i)   In cell h3 enter “+E$3*E4*10” Autofill to i4. (This will make a 2x2
         table.) In cell j3 enter “+IF(H3>I3,H3,I3)” autofill to j4. The if
         command evaluates the expression h3>i3 and returns h3 if true , i3 if
         false. The table should be
         20          30          30
         50          20          50

    j) Now we construct the cpf given specialization in the high income
       product. In cell f8 enter “+($J$3-$E$3*D8)/$F$3”. Autofill to f18.
    k) Construct the chart for home. Select cells d7 to f18. Click the insert
       tab near the top of the page, click scatter, select the third graph,
       select layout number 1, and place the finished graph wherever you
       want. Click on Chart title, change title to home. Click x axis change to
       Autos, click y axis, change to Food. You are done with home.
    l) Make a chart and graph for foreign as well. All the steps you need are

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