Introduction

• Trade is not a generator of poverty but rather a great generator of economic

well-being, which allows companies and workers to specialize in what they do
best, making them more productive and ultimately benefiting consumers with
cheaper and better goods and services.
• Imports are the real fruits of trade, as they represent the end goal of economic
activity, consumption, while exports represent resources that are not
consumed domestically.
• Mercantilism, with its mania for exporting, lost favour for good reason, and
being wrongheaded on trade risks making bad choices that can hurt our
economy and sour relations with other nations.
• The underlying basis for these words is comparative advantage, which is
unfortunately still widely misunderstood today.
• David Ricardo introduced the concept of comparative advantage in 1817,
stressing that the potential gains from international trade were not confined
to Adam Smith's absolute advantage.
• The chapter will focus on the assumptions underlying the modern expositions
of the Ricardian model, which will be relaxed later and do not invalidate the
basic conclusions of the analysis.
• The chapter aims to demonstrate the gains from trade according to the
Classical model, showing that trade is a positive-sum game where all trading
partners benefit from it.

ASSUMPTIONS OF THE RICARDIAN MODEL

The Ricardian model of international trade makes several assumptions that serve as
the foundation of the analysis. These assumptions include:

1. Fixed endowment of resources: The amount of land, labour, and capital

available in each country is assumed to be fixed and unchanging.
2. Factors of production are completely mobile (internally): Within each country,
labour and capital can move freely from one industry to another.
3. Factors of production are completely immobile (externally): Labour and capital
cannot move between countries.
4. Labour theory of value: The value of a good is determined by the amount of
labour that goes into producing it.
5. Level of technology is fixed: The technology used to produce goods does not
change over time.
6. Unit costs of production are constant: The cost of producing each unit of a
good remains constant, regardless of how much of it is produced.
7. There is full employment: All available resources are employed in the
production of goods and services.
 8. There is perfect competition: All firms in each industry are assumed to be price
takers, and no single firm can influence the market price of a good.
9. No government intervention: There are no trade barriers, subsidies, or other
government policies that affect trade.
10. Transport costs are zero: There are no costs associated with moving goods
between countries.
11. The model is based on a 2-country, 2-commodity "world": The model assumes
that there are only two countries producing two goods.

While some of these assumptions may seem unrealistic, they are necessary
simplifications to allow for a clear and concise analysis of the gains from trade.

RICARDIAN COMPARATIVE ADVANTAGE

• Ricardian comparative advantage: theory that a country should specialize in
producing goods that it can produce at a lower opportunity cost than other
countries, and then trade with other countries for goods that have a higher
opportunity cost of production.
• Autarky pre-trade price ratios: the ratio of the price of one good in terms of
another in a country that is not trading with other countries.
• Terms of trade: the ratio of export prices to import prices. It represents the
amount of imports that can be obtained for a unit of exports.

Formula for opportunity cost: Opportunity cost of producing good X = (units of

other good that could have been produced with the same resources) / (units of X
produced)

Formula for autarky pre-trade price ratio: Price of good X / Price of good Y = (unit
labour requirement of good X) / (unit labour requirement of good Y)

Formula for terms of trade: Terms of trade = (export price index) / (import price
index)

COMPARATIVE ADVANTAGE AND THE TOTAL GAINS FROM TRADE

WHAT ARE THE GAINS FROM TRADE?

• Trade allows countries to consume more goods than they could produce on
their own.
• Countries can benefit from trade even if they have an absolute disadvantage
in producing all goods.
 • The gains from trade are due to comparative advantage, which is the ability of
a country to produce a good at a lower opportunity cost than another
country.
• Trade allows countries to specialize in producing the goods they have a
comparative advantage in, leading to increased efficiency and productivity.
• Trade leads to increased competition, which also promotes efficiency and
productivity.

• RESOURCE CONSTRAINTS

• Each country has a fixed endowment of resources, including labour and

capital.
• The production possibilities frontier (PPF) illustrates the maximum amount of
each good a country can produce given its resources and technology.
• The slope of the PPF represents the opportunity cost of producing one good
in terms of the other good.
• The PPF is bowed outward due to the law of diminishing returns, which means
that as more resources are devoted to producing a good, the marginal
product of each additional unit of resources decreases.

• COMPLETE SPECIALIZATION

• In the Ricardian model, countries specialize completely in the production of

the good in which they have a comparative advantage.
• This leads to a complete division of labour, where each country produces only
one good and trades with other countries for the other goods.
• The terms of trade represent the ratio at which a country can trade its exports
for its imports.
• The terms of trade depend on the relative supply and demand for each good
in the world market.

RICARDIAN MODEL – PPF (Check the graph)

• PPF: Production Possibility Frontier
• Shows the maximum combination of two goods that a country can produce
with its given resources and technology.
• Slope of PPF represents the opportunity cost of producing one good in terms
of the other.
• Points on PPF are efficient, points inside the PPF are inefficient, and points
outside the PPF are unattainable.
• Trade allows a country to consume at a point outside its PPF.
• Maximum gains from trade occur when a country specializes in producing the
good in which it has a comparative advantage and trades for the other good.
 • Gains from trade are measured by the increase in consumption that results
from trading at world prices rather than producing only for domestic
consumption at autarky prices.
• Formula for gains from trade: (Consumption with trade - Consumption
without trade) / Consumption without trade x 100%

COMPARATIVE ADVANTAGE - SOME CONCLUDING OBSERVATIONS

• Resource and cost differences are the basis for comparative advantage.
• Production conditions determine the extent of specialization and the gains
from trade.
• Trade allows for movement towards full employment and more efficient
allocation of resources.
• Comparative advantage can contribute to economic growth and development.
• All countries can benefit from trade, even those with an absolute disadvantage
in all goods.
Summary
In summary, the Ricardian model suggests that countries should specialize in producing
goods and services in which they have a comparative advantage and trade with other
countries. By doing so, countries can increase their production efficiency, expand their
markets, and enjoy the benefits of lower prices and greater variety of goods and services.
However, the Ricardian model has some limitations, and it assumes a fixed set of conditions,
such as technology, production costs, and perfect competition. Nevertheless, the model
provides a useful framework for understanding the benefits of international trade.