Ricardo’s trade paradigm — a formerly true theory

21 July, 2017 at 10:59 | Posted in Economics | 6 Comments

Two hundred years ago, on 19 April 1817, David Ricardo’s Principles was published. In it he presented a theory that was meant to explain why countries trade and, based on the concept of opportunity cost, how the pattern of export and import is ruled by countries exporting goods in which they have comparative advantage and importing goods in which they have a comparative disadvantage.

Heckscher-Ohlin-HO-Modern-Theory-of-International-TradeAlthough a great accomplishment per se, Ricardo’s theory of comparative advantage, however, didn’t explain why the comparative advantage was the way it was. In the beginning of the 20th century, two Swedish economists — Eli Heckscher and Bertil Ohlin — presented a theory/model/theorem according to which the comparative advantages arose from differences in factor endowments between countries. Countries have a comparative advantages in producing goods that use up production factors that are most abundant in the different countries. Countries would mostly export goods that used the abundant factors of production and import goods that mostly used factors of productions that were scarce.

The Heckscher-Ohlin theorem — as do the elaborations on in it by e.g. Vanek, Stolper and Samuelson — builds on a series of restrictive and unrealistic assumptions. The most critically important — beside the standard market clearing equilibrium assumptions — are

(1) Countries use identical production technologies.

(2) Production takes place with a constant returns to scale technology.

(3) Within countries the factor substitutability is more or less infinite.

(4) Factor-prices are equalised (the Stolper-Samuelson extension of the theorem).

These assumptions are, as almost all empirical testing of the theorem has shown, totally unrealistic. That is, they are empirically false. 

That said, one could indeed wonder why on earth anyone should be interested in applying this theorem to real world situations. As so many other mainstream mathematical models taught to economics students today, this theorem has very little to do  with the real world.

Using false assumptions, mainstream modelers can derive whatever conclusions they want. Wanting to show that ‘free trade is great’ just e.g. assume ‘all economists from Chicago are right’ and ‘all economists from Chicago consider free trade to be great’  The conclusions follows by deduction — but is of course factually totally wrong. Models and theories building on that kind of reasoning is nothing but a pointless waste of time.

What mainstream economics took over from Ricardo was not only the theory of comparative advantage. The whole deductive-axiomatic approach to economics that is still at the core of mainstream methodology was taken over from Ricardo. Nothing has been more detrimental to the development of economics than going down that barren path.

Ricardo shunted the car of economic science on to the wrong track. Mainstream economics is still on that track. It’s high time to get on the right track and make economics a realist and relevant science.

This having been said, I think the most powerful argument against the Ricardian paradigm is that what counts to day is not comparative advantage, but absolute advantage.

David_RicardoWhat has changed since Ricardo’s days is that the assumption of internationally immobile factors of production has been made totally untenable in our globalised world. When our modern corporations maximize their profits they do it by moving capital and technologies to where it is cheapest to produce. So we’re actually in a situation today where absolute — not comparative — advantages rules the roost when it comes to free trade.

And in that world, what is good for corporations is not necessarily good for nations.

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6 Comments

  1. Comparing portwine production in Portugal with textile manufacturing in England made it seem that comparative advantage was the result of some God-given endowments. The obvious question would be to ask what happens if we compare textile manufacturing in England with textile manufacturing in Ireland? Ireland’s damp climate was indeed better suited to 18th century textile machiney than northern England’s. So English manufacturers lobbied hard to impose protectionist policies, achieved partly through England’s abolition of the Irish Parliament, and thus effectively eliminated Irish textiles, apart from linen in Belfast.

  2. Somewhere I read that somebody – perhaps Malthus? – pointed at the same thing as you, i.e. that Ricardo’s assumptions didn’t fit with reality. To which Ricardo answered: Well, so much worse for reality. I don’t vouch for the truth of the story, however.

  3. Dear Lars,
    Can you please name a single proposition of Ricardo’s trade paradigm that is not valid anymore?
    A caveat: It should be a direct quote from the Principles or any other of Ricardo’s writings – and not what other scholars have attributed to Ricardo.

    It has been my experience so far that most of what has been written about Ricardo – particularly his trade theory – is simply wrong.

    Best,

    Jorge

    • On the assumption of capital immobility, which I think is the most critical and today the one that fits reality the least:
      .
      “If the profits of capital employed in Yorkshire, should exceed those of capital employed in London, capital would speedily move from London to Yorkshire, and an equality of profits would be effected; but if in consequence of the diminished rate of production in the lands of England, from the increase of capital and population, wages should rise, and profits fall, it would not follow that capital and population would necessarily move from England to Holland, or Spain, or Russia, where profits might be higher.” (W&C:I:134)
      .
      “The labour of 100 Englishmen cannot be given for that of 80 Englishmen, but the produce of the labour of 100 Englishmen may be given for the produce of the labour of 80 Portuguese, 60 Russians, or 120 East Indians. The difference in this respect, between a single country and many, is easily accounted for, by considering the difficulty with which capital moves from one country to another, to seek a more profitable employment, and the activity with which it invariably passes from one province to another in the same country.” (W&C:I:135-6)
      .
      “It would undoubtedly be advantageous to the capitalists of England, and to the consumers in both countries, that under such circumstances, the wine and cloth should both be made in Portugal, and therefore that the capital and labour of England employed in making cloth, should be removed to Portugal for that purpose.” (W&C:I:136)
      .
      “Experience, however, shews, that the fancied or real insecurity of capital, when not under the immediate control of its owner, together with the natural disinclination which every man has to quit the country of his birth and connexions, and intrust himself with all his habits fixed, to a strange government and new laws, check the emigration of capital. These feelings, which I should be sorry to see weakened, induce most men of property to be satisfied with a low rate of profits in their own country, rather than seek a more advantageous employment for their wealth in foreign nations.” (W&C:I: 136-7)

      • Thanks for accepting the challenge, Lars.

        I think that we both agree that the quoted paragraphs from the Principles should not be interpreted as perfect international factor immobility, the unrealistic assumption wrongly attributed to him. He merely describes in these paragraphs the realistic observation in his times that capital was less mobile internationally than within a country’s borders. Some people may consider this to be a reasonable observation even nowadays.

        But the interesting question is: what is the purpose and role of this assumption in Ricardo’s trade theory? Why is it important? Because Ricardo explained with the relative immobility of capital the fact that “the same rule which regulates the relative value of commodities in one country, does not regulate the relative value of the commodities exchanged between two or more countries” (p. 133). Thus, his labor theory of value does not apply to international exchanges (see the second paragraph of your quote). This proposition is completely accurate and quite easy to prove empirically.

        So coming back to the assumption of (relative) capital immobility: either capital is still less mobile internationally than nationally, or there is an additional factor that explains why Ricardo’s labor theory of value does not apply for international exchanges yet.


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