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Monday, March 27, 2017

Why Even Wealthy Countries Benefit from International Trade

David Ricardo's classic example explained.

Next month is the 200th anniversary of the publication of David Ricardo’s “On the Principles of Political Economy and Taxation,” the second great English-language book in economics. The first is Adam Smith’s “The Wealth of Nations,” published in 1776.

Ricardo identified an aspect that Smith overlooked: the principle of comparative advantage.

Unlike the professorial Smith, Ricardo was not an academician. A successful man of affairs, Ricardo made a fortune in London’s financial markets by speculating on British securities at the time of the Battle of Waterloo. He later became a member of Parliament. But like Smith, Ricardo staunchly supported free trade. Both carefully studied trade’s economics and saw clearly the interest-group politics at the root of all trade restrictions.

Although lacking Smith’s eloquence, Ricardo (with help from his friend James Mill) famously strengthened the case for free trade by identifying an aspect that Smith overlooked: the principle of comparative advantage.

Until Ricardo published his “Principles,” the belief was that a country that can produce a greater quantity of every good and service than any other country has nothing to gain — and will only lose — by trading internationally. Intuitively, this seems correct. If Portugal can produce more cloth and more wine than Great Britain can, the Portuguese appear to be better at producing both. How could the Portuguese possibly benefit by importing one of these goods from Britain?

Ricardo showed how. He explained that a country’s ability to produce more of some good than can be produced elsewhere does not mean that country necessarily is that good’s most efficient producer. Efficiency in producing some good — say, cloth — is reflected not in how much cloth can be produced but, instead, in how many other goods must be sacrificed to produce cloth.

Assume (as Ricardo did) that the Portuguese can produce more wine and more cloth than the British can. Yet also recognize, along with Ricardo, that in each country, producing more wine means producing less cloth, and producing more cloth means producing less wine. What matters, said Ricardo, is the amount of wine Portugal gives up to produce more cloth compared to the amount of wine Britain gives up to produce more cloth.

Suppose producing an additional bolt of cloth causes Portuguese wine production to fall by four gallons, but causes British wine production to fall by only two gallons. Under these circumstances, the British produce cloth at a lower cost than the Portuguese do, even though Portugal is capable of producing absolutely more cloth than Britain is.

So if the British sell the Portuguese a bolt of cloth for, say, three gallons of wine, both gain. Producing the bolt of cloth cost the British only two gallons of wine, while they sell it for three gallons. The Portuguese get a bolt of cloth by sacrificing only three gallons of wine rather than sacrificing four gallons to produce the cloth themselves.

Ricardo’s brilliant insight reveals that the citizens of even the most economically advanced countries will always be able to find opportunities to gain from international trade.

Republished from TribLIVE.

  • Donald J. Boudreaux is a senior fellow with the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics at the Mercatus Center at George Mason University, a Mercatus Center Board Member, and a professor of economics and former economics-department chair at George Mason University.