by Shruti Rajagopalan
Today is the 200th anniversary of David Ricardo’s On the Principles of Political Economy and Taxation, published on April 19, 1817. This remarkable, and rather unintuitive idea, is an essential component of every economist’s arsenal. When challenged by the mathematician Stan Ulam to name one proposition in the social sciences that was both true and non-trivial, Paul Samuelson said it was the theory of comparative advantage.
The idea that trade is mutually beneficial to all participants may not have penetrated popular press even in present times, but among economists the idea was well established in 1817 when Ricardo wrote On the Principles of Political Economy and Taxation.
In the Wealth of Nations Adam Smith explained that trade can be mutually advantageous. In book IV, chapter 2, para 12, Smith argues:
“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.”
Smith’s insight is quite easy to grasp. When I suggest to my students, that Portugal is better than England at producing wine and England is better than Portugal at producing cotton, and that there is basis for England and Portugal to trade wine for cotton, I see a lot of nodding heads in my principles of economics class.
However, Ricardo’s insights are not just about mutually beneficial trade when each trading party has an advantage in producing the specialized good. Ricardo’s theory of comparative advantage is a richer idea – that both parties can benefit from trade even if one party is better than the other at producing everything. In chapter 7, paras 15 and 16, Ricardo details this idea using a numerical example:
“England may be so circumstanced, that to produce the cloth may require the labour of 100 men for one year; and if she attempted to make the wine, it might require the labour of 120 men for the same time. England would therefore find it her interest to import wine, and to purchase it by the exportation of cloth.
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. It would therefore be advantageous for her to export wine in exchange for cloth. This exchange might even take place, notwithstanding that the commodity imported by Portugal could be produced there with less labour than in England. Though she could make the cloth with the labour of 90 men, she would import it from a country where it required the labour of 100 men to produce it, because it would be advantageous to her rather to employ her capital in the production of wine, for which she would obtain more cloth from England, than she could produce by diverting a portion of her capital from the cultivation of vines to the manufacture of cloth.”
The idea that even if Portugal is better at producing both wine and cotton, she will still benefit from specializing in wine (which she can produce better than she can produce cotton), and importing cotton from England; is not an obvious insight. And while Ricardo’s observation was incredibly insightful, his clunky example is not as helpful for communicating it. In The Economist as Preacher and other Essays, George Stigler, with his typical wit, joked that “The import this layman is likely to embrace is not the English theory of free trade but a bottle of Portuguese wine.”
While detailing this example, Ricardo doesn’t actually use the phrase comparative advantage. That comes later in the book, in chapter 19, para 1, while describing the effect of a tax on certain goods on international trade. And even the use of the phrase comparative advantage does not help communicate the insight very easily. One must quickly resort to numerical demonstrations, or real world examples, to illustrate the point. Krugman in his 1996 essay titled Ricardo’s Difficult Idea, highlights this problem.
“And yet if one tries to explain the basic model to a non-economist, it soon becomes clear that it really isn’t that simple after all. Teaching the model, to docile students, is one thing: they get the model in the course of a broader study of economics, and in any case they are obliged to pay attention and learn it the way you teach it if they want to pass the exam. But try to explain the model to an adult, especially one who already has opinions about the subject, and you continually find yourself obliged to backtrack, realizing that yet another proposition you thought was obvious actually isn’t.”
Krugman also makes the broader point that the theory of comparative advantage is not so obvious, and to explain it to the lay person as well as other economists, assumptions that economists (labor mobility, full employment, flexible wages and prices, balanced trade, etc.) must be unpacked.
In present times, we need to perhaps communicate this “Ricardo’s Difficult Idea” better. Understanding the dynamics of international trade is once again in vogue, with international events like Brexit, and the nationalist anti-trade rhetoric in many countries today.
Even among academic economists Ricardian comparative advantage has made a comeback. Last week the American Economic Association announced Dave Donaldson as the recipient of this year’s John Bates Clark Medal. One of Donaldson’s contributions listed in the AEA announcement is his “original work providing empirical evidence on the theory of comparative advantage.” The AEA said Donaldson, brings “careful data work and credible identification combined with state-of-the-art structural methods” in his work testing the theory of comparative advantage.
In his 2012 paper (with Costinot) Ricardo’s Theory of Comparative Advantage: Old Idea, New Evidence, they first establish how total output of various crops should vary across countries as a function of endowment of fields and the allocation of fields across different crops and then combine these theoretical predictions with productivity and price data from the Food and Agriculture Organization. They find that “Ricardo’s theory of comparative advantage, is not just mathematically correct and nontrivial; it also has significant explanatory power in the data.”
In the 2015 paper “Comparative Advantage and Optimal Trade Policy,” Donaldson and his coauthors (Costinot, Vogel, and Werning) explore the implications of the Ricardian model to create an optimal trade policy. They argue that export goods featuring weaker comparative advantage should be taxed less (or subsidized more) relative to those featuring stronger comparative advantage.
In the coming years, I expect we will see a lot more empirical research testing Ricardo’s insights to explain inter-country, and intra country trade.
To conclude on a lighter note, one of my favorite examples of comparative advantage in action is the Beatles. Apparently, when asked if Ringo Starr is the best drummer in the world, John Lennon quipped, “Ringo isn’t the best drummer in the world. He isn’t even the best drummer in the Beatles.” And while Lennon may have fancied himself a better singer, guitarist, songwriter, and drummer, than Ringo, the Beatles are still better off with Ringo at the drums.
Tonight I’ll listen to the Beatles and drink some Portugese wine to celebrate the 200th anniversary of one of the most important ideas in economics.