1. The Ricardian model elucidates the simple, but profound, idea that the pattern of trade is determined by comparative advantage.
2. All countries gain from trade, but the gains from trade are larger the more trade causes a country’s terms of trade to increase.
3. Ricardo assumes one factor and constant marginal products. The next chapter will introduce other factors of production and permit diminishing returns. Trade will benefit the owners of some factors, but hurt others.
The Ricardian model was devised to respond to the mercantilist idea that exports are good and imports are bad. Not so, said David Ricardo, and to prove his point, he considered an example in which trade between two countries (England and Portugal) is balanced; that is, the value of imports equals the value of exports for each country. The reason that England and Portugal trade with each other in Ricardo’s example is that their technologies for producing wine and cloth are different. Portugal has an absolute advantage in both goods, but England has a comparative advantage in cloth. That is, the opportunity cost of producing cloth in England (measured by how much wine would have to be given up) is lower than in Portugal. Based on this comparative advantage, the no-trade relative price of cloth is also lower in England than in Portugal. When trade is opened, cloth merchants in England export to Portugal, where they can obtain a higher price, and wine vintners in Portugal export to England. Thus, the pattern of trade is determined by comparative advantage, and both countries gain from trade.
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For simplicity, the Ricardian model is presented with just a single factor of production—labor. We have used a lesson from microeconomics to solve for wages as the marginal product of labor times the price of each good. It follows from this relationship that the ratio of wages across countries is determined by the marginal product of labor in the goods being produced and by the prices of those goods. Because wages depend on the marginal products of labor in each country, we conclude that wages are determined by absolute advantage—a country with better technology will be able to pay higher wages. In addition, wages depend on the prices prevailing on world markets for the goods exported by each country. We have defined the “terms of trade” as the price of a country’s exports divided by the price of its imports. Generally, having higher terms of trade (because of high export prices or low import prices) will lead to higher real wages and therefore will benefit workers.
The fact that only labor is used in the Ricardian model, with a constant marginal product of labor, makes it special. Because of this assumption, the PPF in the Ricardian model is a straight line, and the export supply and import demand curves each have a flat segment. These special properties do not occur in other models we consider in the following chapters, where in addition to labor, industries will use capital and land. Once we allow for the more realistic assumption of several factors of production, the gains from trade become more complicated. Even if there are overall gains for a country, some factors of production might gain as other factors of production lose due to opening trade. That is the topic we explore in the next chapter.