Originally published on 10/03/2007

In the Ricardian model, countries are assumed to differ only in their productive capacities. It was in this model that David Ricardo first formally demonstrated the principle of comparative advantage. When defined in terms of productivity differences, comparative advantage is regularly confused with a simpler concept that economists call absolute advantage. It is worth taking a few moments to illustrate the differences.

If the US has higher productivity in corn production compared to Switzerland, while Switzerland has higher productivity in watch production compared to the US, economists would say the US has an absolute advantage in corn production and Switzerland has an absolute advantage in watch production. In this case it is intuitive that if the US concentrates on corn production and Switzerland on watch production, then resources could be shifted from relatively lower productivity industries to higher productivity industries and the total combined output of corn and watches would rise. With greater output, and after an appropriate trading pattern is introduced, both countries could end up with more of both goods than before, meaning that both countries can gain from trade. For most who have studied economics this is what they remember as comparative advantage. However, they are only partially right.

It is correct that this example of trade is consistent with comparative advantage; however, CA also covers cases that are less obviously advantageous for countries. For example, one might ask what happens if the US had higher productivity in both corn and watches compared to Switzerland? This is the question that Ricardo tackled when he formalized CA. His answer to the question also substantially expanded the number of situations in which technology differences could result in advantageous trade.

Ricardo’s simple analysis demonstrated that even when one country is technologically superior in both goods, it could still be advantageous for countries to trade. In this circumstance, a comparative advantage is present for those products that the country can produce most-best in comparison to other countries, even if the most best product is produced less productively than in the other country. For example, suppose the US is 10X more productive in corn and only 2X more productive in watches compared to Switzerland. In this case the US is clearly most-best at producing corn (10x > 2x). At the same time though, Switzerland is ½X as productive in watches and (1/10)X as productive in corn. Thus, Switzerland’s most-best product and hence its comparative advantage is watches (since ½ > 1/10) even though it can’t produce them as effectively as the US.

The reason both countries can benefit in this case is because productivity is not the only determinant of industry advantage; instead it is the combination of productivity and average wages. In countries with lower productivity in all industries, they will also have lower average wages. However, average wages for similar workers will lie somewhere in the middle of the range of the country’s industry productivities. In the example above, wage differences between the US and Switzerland in the absence of trade will fall in the range between 10X and 2X; perhaps wages will be 5X higher in the US in this example (which implies they are 1/5 as high in Switzerland). This means that for the relatively highest productivity industry in Switzerland (watches), productivity (1/2 as productive) will sufficiently exceed the average wage (1/5 as high) to make production in watches profitable in comparison to the US.

Observers of this situation may well note that Switzerland’s advantage is due to low wages since wages are only 1/5 as high as in the US. However, it is a mistake to think that low wages gives an advantage in all industries. That’s because, as Ricardo showed, in the low wage country’s least productive industry (in this case corn), Switzerland’s wage advantage (1/5 as high) will be overwhelmed by its productivity disadvantage (1/10 as productive). This means that corn production will be unprofitable in Switzerland despite having lower wages.

Looking at this same situation from the US perspective, the US is most-best at producing corn (10X as productive) but its wages are only 5X higher. That implies it will be profitable for the US to produce corn and sell it in Switzerland. At the same time though, the US productivity advantage in watches is only 2X higher, which is not enough to compensate for its 5X higher wages. That’s why the US will find cheaper watches in Switzerland.

The most important conclusion from the Ricardian model is that advantages from trade do not disappear just because another country has lower wages; nor do they disappear just because another country is more productive in everything. Ricardo demonstrated that by specializing in producing the products that one has a comparative advantage (which MAY NOT be ones in which the country has an absolute advantage) the world can expand total world output with the same quantity of resources. The expansion of output is the realization of increased economic efficiency that economists always talk about. Finally, given the expanded output, international trade can assure that all countries in the model gain from the surplus that’s created. In other words, without raising the quantity of resources, the world economy would be able to produce greater output and generate higher living standards for everyone. Economic efficiency will rise both internationally and nationally. This is how all nations can benefit from free trade.

It is important to note at this stage that the Ricardian model does not say that countries WILL gain from international trade; only that countries CAN benefit from increased output and trade if production is reorganized between countries appropriately while all resources are kept fully employed. The model is a gross simplification compared to the real world though, and thus it clearly does not incorporate everything that might happen with trade. Nevertheless the model does provide an insight that quite likely carries over to more complex situations. For example, the model results should cause observers of international trade situations to hesitate when fears grow that low wage countries may soon take over production of the world’s output, or when developing countries protect their markets because of fears that they cannot compete with the more developed countries in the world. These commonly expressed fears about international trade are shown, by virtue of the Ricardian model, to be based on a misperception.