In 1776, Adam Smith in his An Inquiry into the Nature and Causes of the Wealth of Nations illustrated how trade increase the welfare of nations who are engaged in trading with one another (Smith, 1776). While Smith’s work gained popularity, critisised merchantilism and promoted free trade, in practice many nations were still engaged with policies that imposed dfferent tariffs on exports and imports alike.
While Smith’s findings were based on the concept of absolute advantage, in 1817, David Ricardo came up with a model that provided evidence how trade between two parties could benefit both, even in the absence of absolute advantage. In contrast with Smith, Ricardo focuses on the comperative advantages of the countries. The principle of comperative advantage refers to phenomena when for instance a country produces two goods, and it can produce one of the goods at a lower relative opportunity cost than the than another country that is also engaged in the production of the same two goods. According to Ricardo, when both country became specialised in the production of a product they have comperative advantage, trading those goods on an estimated a relative price that is located somewhere between the two countries’ relative opportunity costs, would eventually result higher utility in both country (Krugman et al, 2011). In Ricardo’s classical example, he exaxmined the cloth and wine production of England and Portugal. The standard ricardian model assumed perfect competition, and contained only a few variables such as labour, cost of production, and the number of goods can be produced from their combinations.
For both countries there is a Possibility Frontier (shortly, PPF), a linear function, which shows all the combinations of good 1 and good 2, that a country could produce given their labour endowment and cost of production. If Home country has comperative advantage in producing good 1, and Foreign has CA in good2, meaning c1/c2 < c1 c2csillag, then trading can be executed at c1/c2 < P1P2< c1 c2csillag (Krugman et al, 2011)
The model implies that both countries benefit from the specialisation and the free trade. Furthemore, it also indicates that tariff imposed on export and import would increase the price of import goods, therefore the trade would be hindered.
While Ricardo supported the repeal of the 1815 Corn Laws, in the middle of the 19th century once they repealed it, the incoming imported grain drastically reduced the british market price for grain, and the british landowners were unable to keep up with the competetion, ultimately led them to bankruptcy. In contrast, the repeal of the Corn Laws benefitted the factory owners, since the reduce grain prices allowed them to decrease the employees’ wages.
According to Ricardo, free trade should have benefitted the whole country, nevertheless the historical evidence suggest otherwise. This failure of Ricardo’s model can be explained with it’s simplicity, as the labour was assumed to be the sole factor of production.
In order to eliminat the shortcomings of the ricardian model, Paul Samuelson and Ronald Jones (1974) further developed the concept and incorporated additional factors of production. This version of the ricardian model, commonly called Specific Factor model or 2 good 3 factor model, incorporates additional factors of production, such as capital or land, and these factors are assumed to be industry specific.The model is generally used to show how labour distribution ,factor returns and output level changes as a consequence of particular changes in the economy such as trade liberalization, or imposing tariffs.
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