The Ricardian Trade Model

Reasons for Trade

There is evidence that in prehistoric times people traded goods. For instance, pre-Chinese people who settled down in Hongshan (Red Mountain) region, now in Inner Mongolia, and later in Liangzhu (near Shanghai now) used to trade primitive jade artifacts. The latter also traded silk with neighboring peoples. Those who settled down in river basins were successful in agriculture, and these surpluses were exported to neighboring regions in return for other goods. The existence of a surplus of a product simply means that its autarky price is lower in the exporting country than in the importing economy.

	Liangzhu Cong (a ritual vessel) (3300 - 2200 BC), Liangzhu Culture Jade, 1989, Nanjing Museum et al, China. Shark teeth and bamboos were used to polish congs.
	Royal Seal (a modern imitation), Han dynasty style

Surplus was a reason

Source: British Museum	Sumerians exported beer to faraway countries, even Egypt. They were the first beer drinkers. They knew how to make beer and they had raw materials. Soon there were surplus of beers and that was the reason for their beer exports. Even in modern times, the Communist bloc countries exported surpluses to other members and avoided trading with free market economies. This Babylonian clay tablet is the first map of the world. Circles were used to denote city centers, and this method has been adopted by cartographers ever since. Babylonians were interested in geography because of their exports of beer and other agricultural surpluses. Even before the silk road was built, Babylonia during the Kassite dynasty (1595-1157 BC) imported cobalt for coloring glasses from China (Donald McKenzie, Myths of Babylonia and Assyria, 1915). This Babylonia-China trade resulted in harmony of time counting. Both Babylonia and China used the sexagesimal system. Chinese used a lunar calendar, dividing the day into 24 hours, each hour into 60 minutes. This is not a coincidence or accident, but the result of trade between the two regions.
	Sumerian devotees of Ishtar (BM, London and Hamburg). This is the typical attire of Sumerians as shown in the above Standard of Ur.

Modern Explanations for Trade

Adam Smith, a Scottish economist, published a book "Wealth of Nations." (1776) In this book he emphasized the importance of division of labor and specialization. He also ridiculed the fear of free trade by comparing nations and households. He argued that every household finds it worthwhile to produce only some of its needs, and to buy other commodities from others with its products. Smith argued that the same principle applies to nations.

"It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys them from the shoemaker. The shoemaker does not attempt to make his own clothes, but employs a tailor.

"What is prudence in the conduct of every private family, can scarcely be a folly in that of a kingdom. 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."

	Fall of Icarus by Pieter Bruegel (1558)
Max Libermann, Cobbler's workshop, Kunsthalle Museum, Hamburg.	The shoemaker makes only 2 pairs a day. Impact of industrial revolution, Montreal History Museum
Max Libermann, Flax barn at Lauren, Kunsthalle Museum, Hamburg. Flax fiber is used to make linen, which was used as clothes, table cloth, towels, and to cover dead bodies in ancient times.	Pont neuf (Auguste Renoir) depicting the city life during the period of industrial revolution. Washington National Gallery.
Bombing damages of Japanese cities and their equivalent cities in the US as of August 6, 1945.	Frauenkirche, Dresden. Sons of British bombers returned and participated in rebuilding after the fall of Berlin wall in 1989.

          Adam Smith's main idea: If countries have absolute advantages, each country should specialize in the commodities in which it has absolute advantages and export those products and import others in which it has absolute disadvantages.

ex: President Woodraw Wilson.

Question

          Smith assumed that each country had enough absolute advantage over its trading partners so that if free trade is allowed, each country would have a balance of trade.

What if a country had no absolute advantage? Wouldn't it become a slave economy to capital rich countries?
What if a country had absolute advantages in all industries? Will it gain from trading with inferior economies?

The Ricardian Trade Model: 2 × 2 × 1

1. Assumptions

1. two-countries, two commodities
2. Labor is the only factor of production =>one wage
3. Linear Production Functions:
   y_i = f(L_i) = c_iL_i, i = 1,2
4. homogeneous products (two countries produce identical goods)
5. Balanced Trade (value of imports = value of exports)
6. Labor productivities differ between countries: One country is more efficient than the other.
7. No transportation costs.

Input-output coefficients

Production Possibility Possibility Frontier

Figure 1. Production Possibility Frontier

(click for a larger image)

Absolute vs. Comparative Advantage