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 objectionable. __________________________________________ Lori Wallach Explains her policy (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 competition. 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 below. 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 Wheat 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. wine 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. 2 0 15 Wheat 1 0 5 5 10 1 2 5 0 wine 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 http://www.systemics.com/docs/ricardo/david.html Problems 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 . http://www.freethechildren.org/campaigns/ind 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: http://www.people.cornell.edu/pages/kb40/ 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 http://www.indians.org/welker/columbu1.htm 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 http://www.victorianweb.org/history/empire/opiumwars/opium wars1.html 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. Exercises: 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 $1. Technology is represented in the table. One hour of labor produces Wheat Wine England 1 1 Portugal 2 6 2) How does your diagram illustrate specialization according to comparative advantage and the gains from trade? 3) What are the wages paid in England and Portugal? Why aren’t they equal? 4) If technology is as shown, are there gains from trade? Do gains from trade require a level playing field? Hours of labor per unit produced Wheat Wine England 1 1 Portugal 2 2 5) Use production and consumption possibilities to illustrate the effect of minimum output requirements in goods that would otherwise not be produced. That is, countries sometimes specify that minimum levels of computers or food or steel be produced locally. For example, use the figure you constructed in the first question but assume a minimum of 2 units of wine must be produced in England. This might be done to allow Protestants to use wine in their religious ceremonies produced by fellow Protestants. What happened to income? The consumption possibilities frontier? 6) Use the directions below to construct an excel file that draws these diagrams for you. You will find a completed file on the class web. a) Begin by opening a new excel workbook and enter the headings below (for example the label “prices” is in row 3 column D or in cell D3). A B C D E F 1 2 Autos Food 3 Prices 1 1 4 home output per hour 2 3 5 foreign output per hour 5 2 6 7 Home L(autos) L(food) Q(autos) PPF CPF b) Next, in cell B8 enter “+0”. c) In cell B9 enter “+1+B8”. d) Autofill to B18. You should have the numbers 0-10 in order. e) In cell C8 enter “+10-B8”. Autofill to C18. You should have the numbers 10 to 0. f) In cell D8 enter “+B8*$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 above.