Foreign trade and comparative advantage

Like Adam Smith before him, Ricardo advocated free trade (setting aside a number of exceptions), but found the Scotsman’s advocacy of it wanting. In the tensely written chapter VII, “On Foreign Trade”, all major threads of which the fabric of Ricardo’s theory is made meet and are being discussed in a quick succession on just a few pages.

Table 1 Number of men whose labour is required for one year in order to produce a given quantity of cloth and wine

This fact is partly responsible for the frequent misapprehension of Ricardo’s argument and its distortion beyond recognition in textbook presentations. (The misapprehension started with James and John Stuart Mill; see Sraffa, 1930, who corrected their error.) It was only recently that new attempts were made to come to grips with Ricardo’s argu­ment; see the entries by Faccarello, Maneschi and Parrinello in Kurz and Salvadori (2015); see also Faccarello (2015), Gehrke (2015) and Kurz (2015: s. 8). Here only the gist of Ricardo’s argument can be given.

Assume with Ricardo in terms of his famous numerical example here reproduced in Table 1 - his “four magic numbers” (Samuelson 1969) - that all commodities can be produced at lower labour costs abroad, in Portugal, than at home, in England. Does this mean that there are no opportunities for mutually beneficial trade? Ricardo’s answer is a resounding no: it would be advantageous for England to export cloth in exchange for wine imported from Portugal, and for Portugal to export wine in exchange for cloth from England. Under these circumstances “England would give the produce of the labour of 100 men, for the produce of the labour of 80” (Works I: 135).

A stockjobber, versed in seeking out arbitrage opportunities, Ricardo could easily see the profitable business to merchants in view of the fact that the price of cloth relative to wine differs in the two countries. Assume now that the numbers represent domestic currencies, Real (R) in Portugal and Pounds (£) in England, that are non-convertible. Take the case of an English merchant. He may buy for £100 a given quantity of cloth at home, ship it to Portugal and sell it there for 90 R. With this sum of money he may then buy wine from a Portuguese wine grower and get altogether 90/80 = 9/8 units of wine, where one unit costs 80 R. This quantity of wine he then ships to England and sells it for 9/8 ∙ £120 = £135. He thus obtains a profit of £135 - £100 = £35 or a rate of profit of 35 per cent on an investment of £100 over the time it took to export cloth and import wine. An analogous consideration applies to a Portuguese merchant. Both the English and the Portuguese merchant can use one and the same ship to export and to import goods. The remarkable fact here is that while goods are exported and imported, the currencies of the two countries do not cross borders. As Ricardo stressed with regard to a different case: “without the necessity of money passing from either country, the exporters in each country will be paid for their goods” (Works I: 138).

We may now look at the problem also from the perspective of another monetary regime. Assume specie (gold coins) to be the universal means of exchange and unit of account. The total amount of gold (a producible commodity) in the system (compris­ing the two countries) is given and fixed. The four numbers now refer to the gold prices of given quantities of cloth and wine in autarky in Portugal and England. Both com­modities are more expensive in England, which again implies profitable business for mer­chants: goods will be shipped from the country in which they are cheaper (Portugal) to the country in which they are dearer (England).

Portugal would experience a trade surplus and England a trade deficit. This would imply a flow of specie from England to Portugal. The quantity of money in Portugal (England) would increase (decrease) and money prices rise (fall). Foreign trade would thus affect prices and the value of money in the two countries.

This, however, brings about “such a state of prices as would make it no longer profit­able to continue these transactions” (Works I: 139). This is indeed the case, as the fol­lowing consideration shows. Assume for simplicity that prices in each country increase or decrease proportionately, leaving relative (domestic) prices unaffected. Then it is clear that a point will come when English cloth will become less expensive than Portuguese cloth, while English wine will still be substantially more expensive than Portuguese wine. At that point the direction of the cloth trade would be redirected from England to Portugal. A new distribution of the precious metals, Ricardo emphasized, “would in some degree have changed [the value of money] in the two countries, it would be lowered in [Portugal] and raised in [England]. Estimated in money, the whole revenue of [England] would be diminished; estimated in the same medium, the whole revenue of [Portugal] would be increased.” (Works I: 141)

These considerations show that Portugal’s (England’s) original absolute advantages (disadvantages) in the production of both commodities will not prevail: the specie-flow mechanism will undermine the initial situation and lead to a new pattern of specializa­tion. The important point to note is this. The direction of change in absolute cost advan­tages will bring to the fore the principle of comparative advantage: as prices rise in Portugal and fall in England, the point will come where English cloth becomes less expensive than Portuguese cloth, while English wine is still more expensive than Portuguese wine.

What applies to the specialization among countries (or regions within countries) applies also to that among people. The glad tidings of joy of Ricardo’s theorem of comparative advantage read: if a person happens to be inferior to some other person in each and every respect, he or she may nevertheless enter a mutually advantageous division of labour with his or her counterpart. Ricardo thus adds an important verse to Adam Smith’s hymn on the beneficial effects of the division of labour.

Malthus challenged Ricardo’s stance in favour of free trade by emphasizing a conflict with national security. Against this Ricardo insisted that restrictions on corn export are not sustainable, especially if trade expectations have induced large investments in agriculture; see Salvadori and Signorino (2015).