Mutual gains from trade: The Ricardian model
Since January I have talked about economics as a way of analyzing and modeling choice as a comparison of feasible alternatives as ways of fulfilling an objective or objectives.
I have talked about the opportunity cost of an option being the value to one of the most desirable forgone option, in accordance with one's objectives.
I have talked about the set of feasible alternatives as coming from any or all of endowed options, production possibilities, and exchange options.
I have talked about markets, contracts, and firms as social technologies for exchange.
I'd like to take this week to talk about David Ricardo's demonstration of the mutual benefits of trade between agents-- nations or persons. Nobel laureate Paul Samuelson said that it combines simplicity and counter-intuitiveness, and that that makes it a powerful demonstration.
Here are some things human beings seem to find intuitive about trade(s):
- someone (smart) wins; someone (less smart) loses
- a unproductive agent is not worth trading with
- a small country is not worth trading with
None of those things are true, and the Ricardian model demonstrates it.
So here is David Ricardo's famous example showing the grounds for mutually advantageous trade.
Suppose, he said, it requires 15 units of labor to make a unit of wheat in England, and 30 units of labor to make a unit of wine. And suppose it takes 10 units of labor to make a unit of wheat in Portugal, and 15 units of labor to make a unit of wine.
Poor England! So unproductive as compared with Portugal! What's wrong with English labor? We don't know. Is England doomed to be unable to trade?
Well, suppose you are in a fully-employed England and want to make an extra unit of wine. You need to move 30 units of labor out of wheat production and into wine production, because it takes thirty units of labor to make a unit of wine in England. But those thirty units of labor were making two units of wheat. So in England the opportunity cost of one wine is two wheat. (Conversely, the opportunity cost of one wheat in England is 1/2 wine.)
In a fully-employed Portugal, making an additional unit of wine requires 15 units of labor, who have to be moved from producing 1.5 units of wheat. So in Portugal, the opportunity cost of one wine is 1.5 wheat. (And the opportunity cost of one wheat is 2/3 units wine.)
Now, suppose England sidles up to Portugal and says, "How's about we give you 1.75 units of wheat to give us a wine?" Would England do this? Sure! At home in England, making another wine costs 2 wheat. England is better off in trade so long as it can buy wine at any price less than 2 wheat per wine.
Would Portugal accept an offer of 1.75 units of wheat for a unit of wine? Sure! In Portugal, making another wheat costs 2/3 of a unit of wine. Portugal is better off trading wine for wheat at any price greater than 2/3 units of wheat per unit wine.
So despite English ineptitude, England and Portugal can both gain from trading with each other.
We say that England has a comparative advantage in wheat production, while Portugal has a comparative advantage in wine production, based on their opportunity costs.
(But if there is unemployment in either nation, the first smart move is to get to full employment. With unemployment the national opportunity cost of more production is zero.)
The differing opportunity costs of wine (wheat) in the two countries also means that each country could consume absolutely more of both goods through trade than in isolation.
In the graphic you can see here, I suppose that England possesses 3000 units of labor and Portugal 7500.. Each country's Production Possibility Frontier (PPF) shows its consumtion possibilities without trade-- the slope of each PPF is the opportunity cost of wheat. But if England and Portugal both agree to trade 1.75 units of wheat per unit of wine, Portugal specializes in producing wine and England in producing wheat, their trade possibility frontiers lie strictly outside their PPFs.
Both countries-- potentially better off by mutual gains through trade.
Facebook posts incorporated:
Mutual gains from trade: Building blocks and myths
The Ricardian example of comparative advantage: opportunity cost emphasis
The Ricardian example of comparative advantage: consumption possibility emphasis
I have talked about the opportunity cost of an option being the value to one of the most desirable forgone option, in accordance with one's objectives.
I have talked about the set of feasible alternatives as coming from any or all of endowed options, production possibilities, and exchange options.
I have talked about markets, contracts, and firms as social technologies for exchange.
I'd like to take this week to talk about David Ricardo's demonstration of the mutual benefits of trade between agents-- nations or persons. Nobel laureate Paul Samuelson said that it combines simplicity and counter-intuitiveness, and that that makes it a powerful demonstration.
Here are some things human beings seem to find intuitive about trade(s):
- someone (smart) wins; someone (less smart) loses
- a unproductive agent is not worth trading with
- a small country is not worth trading with
None of those things are true, and the Ricardian model demonstrates it.
So here is David Ricardo's famous example showing the grounds for mutually advantageous trade.
Suppose, he said, it requires 15 units of labor to make a unit of wheat in England, and 30 units of labor to make a unit of wine. And suppose it takes 10 units of labor to make a unit of wheat in Portugal, and 15 units of labor to make a unit of wine.
Poor England! So unproductive as compared with Portugal! What's wrong with English labor? We don't know. Is England doomed to be unable to trade?
Well, suppose you are in a fully-employed England and want to make an extra unit of wine. You need to move 30 units of labor out of wheat production and into wine production, because it takes thirty units of labor to make a unit of wine in England. But those thirty units of labor were making two units of wheat. So in England the opportunity cost of one wine is two wheat. (Conversely, the opportunity cost of one wheat in England is 1/2 wine.)
In a fully-employed Portugal, making an additional unit of wine requires 15 units of labor, who have to be moved from producing 1.5 units of wheat. So in Portugal, the opportunity cost of one wine is 1.5 wheat. (And the opportunity cost of one wheat is 2/3 units wine.)
Now, suppose England sidles up to Portugal and says, "How's about we give you 1.75 units of wheat to give us a wine?" Would England do this? Sure! At home in England, making another wine costs 2 wheat. England is better off in trade so long as it can buy wine at any price less than 2 wheat per wine.
Would Portugal accept an offer of 1.75 units of wheat for a unit of wine? Sure! In Portugal, making another wheat costs 2/3 of a unit of wine. Portugal is better off trading wine for wheat at any price greater than 2/3 units of wheat per unit wine.
So despite English ineptitude, England and Portugal can both gain from trading with each other.
We say that England has a comparative advantage in wheat production, while Portugal has a comparative advantage in wine production, based on their opportunity costs.
(But if there is unemployment in either nation, the first smart move is to get to full employment. With unemployment the national opportunity cost of more production is zero.)
The differing opportunity costs of wine (wheat) in the two countries also means that each country could consume absolutely more of both goods through trade than in isolation.
In the graphic you can see here, I suppose that England possesses 3000 units of labor and Portugal 7500.. Each country's Production Possibility Frontier (PPF) shows its consumtion possibilities without trade-- the slope of each PPF is the opportunity cost of wheat. But if England and Portugal both agree to trade 1.75 units of wheat per unit of wine, Portugal specializes in producing wine and England in producing wheat, their trade possibility frontiers lie strictly outside their PPFs.
Both countries-- potentially better off by mutual gains through trade.
Facebook posts incorporated:
Mutual gains from trade: Building blocks and myths
The Ricardian example of comparative advantage: opportunity cost emphasis
The Ricardian example of comparative advantage: consumption possibility emphasis