Ricardian Trade Theory - Literature review Example

Critical Examine of the Ricardian Trade Theory Introduction International trade is a process that facilitates exchange of capital goods and services in across nations and enhances the gross domestic product of the countries involved in the exchange system. Therefore, international trade theories are an important aspect of development economics. Exercises of such theories in practical have enabled the consumer to get an access to the new established markets and products such as foods, cloths, oil, gems and jewelleries etc and services such as baking and tourism. The process of selling domestically produced goods and service in other countries is known as export of goods and services and similarly, the process of buying products and services producing in other countries is known as import (Krugman and Maurice, 2012). The evolution and expansion of today’s international trade is highly based on the contribution from David Ricardo’s theory of free trade and comparative advantage. In this paper, the classical theory of international trade, as suggested by eminent economist David Ricardo, will be critically analysed. Discussion The Ricardian model on international trade states that a country exports that commodity in which it has a comparative advantage in terms of the production process. Assumptions of Ricardo’s Trade Theory Perfect Competition The trade theory proposed by Ricardo is based on the assumption that perfect competition prevails in the market which means factors of production are perfectly mobile. All firms are price taker and are operating in the market with a profit maximization objective. Hence, firms tend to set price at a point where the price level is identical to their marginal cost. Free entry and exit prevails in the economy. All produced goods are homogeneous i.e. the outputs are non-differentiated and identical in nature and are perfect substitutes to each other. Perfect information is available to all the producers and consumers; hence no firm can earn supernormal profit by altering the price level (Todaro and Smith, 2012). Two Countries For simplification, the model is also based on the assumption of two countries. That means exchange takes place between two countries only. The only difference between the two countries is the different production technologies used by them. Two Goods Here, it is also assumed that barter economy prevails in the countries. Two countries produce two different goods and these two goods are produced and exchanged between the countries. No monetary transaction is involved in this aspect and the economies are involved in trading of one good in exchange of the other. One factor of Production It is also assumed that the economy involves only one factor of production and that is labour which is homogeneous and perfectly mobile. Homothetic Preferences The consumption function is homothetic i.e. both the countries consume the two goods at a fixed proportion, regardless of the level of income. More specifically, two countries with homothetic preferences will involve same price level and consumption proportion, as free trade is presumed (Ruffin, 2002). General Equilibrium Ricardo’s model is also based on general equilibrium that incorporates circular flow of money in exchange of goods and services. Therefore, the revenue generated from selling goods and services is used for paying wages to the labours. The wages in turn is used to buy the same goods and services produced by the firm. In this way, the cycle becomes a simultaneous process of achieving general equilibrium. Exogenous and Endogenous Variables Ricardian model holds good in a market economy where no transaction and taxation cost exist. Factor of production i.e. labour and the quantity produced by the two countries are exogenous variables i.e. the variables are process driven and not described within the model. In contrast, the unit of labour used for producing one unit of goods as well as total labour required for producing the aggregate amount of products and services in both the countries is endogenous variable which indicates that values of those variables are determined within the model (Todaro and Smith, 2012). The Model Ricardo’s model of comparative advantage shows that a country will produce that product in which it has a comparative advantage and accordingly it will trade that good in exchange of other good produced by the country, that holds competitive advantage in producing that particular good. For simplification in calculation, it is considered that there are two countries in the world i.e. home country (H) and foreign country (F) producing two goods such as Food (F) and Manufacturing (M) respectively. The only factor of production is labour which is domestically mobile but such mobility is restricted in international context. Therefore, the total of labour required for producing one unit of Food in Home country is aLF and the labour required for producing Manufacturing good in the Home country is aLM. The total quantity of Food and Manufacturing good produced by the Home country are QF and QM respectively. Similarly, for the Foreign Country, the total amount of labour required for producing Food and Manufacturing good is a’LF and a’LM respectively (Krugman and Maurice, 2012). Now, it is assumed that Home country has a competitive advantage over producing Food that can be presented as aLF < a’LF. Consequently, it is also assumed that Foreign country has a competitive advantage over producing Manufacturing good. Therefore, aLF / a’LF < aLM/ a’LM holds to establish relative productivity of Home market in producing Food as compared to Foreign market. Equivalently, in case of producing manufacturing good, comparative advantage of foreign country is indicated by the equation aLM / a’LM < aLF/ a’LF. Hence, according to the Ricardian Theory, Home country should continue to produce the Food products as it is having a competitive advantage and acquire manufacturing good by engaging in international trade with the foreign country. Similarly, the foreign country should continue to produce the manufacturing good and obtain food in exchange of their domestically produced good with home country. Critical Examination of the Ricardian Theory of International Trade Several arguments have been formed among economists regarding justification of the classical theory of international trade initiated by David Ricardo. Most of the economists are of the opinion that the concept of free trade does not hold good in the real business scenario. For instance, Tomohiro (2015) in his research has shown that in reality perfect competition does not exist. In fact, imposition of export restrictions and import subsidies encourages high competition which in turn influences the strategic trade policies of home countries as well as foreign countries. In this regard, it has also been highlighted that most of the assumption on the basis of which the Ricardo’s model of competitive advantage stands, does not hold good in reality. Wilfried and Jože (2004) have identified the model as a restrictive one as the model shows trade relationship only between two countries producing two specific goods. They are on the opinion that as the number of countries participating in international trade increases in the real world, the complexities in international trade also increases. The concept of barter economy has been nullified in the economics framework long years ago. Moreover, the need of the individuals in the world constitutes of numerous goods and services, increasing the complexity of Ricardian model to a great extend. Golub and Hsieh (2002) argued on the ground that, according to the labour theory of value proposed by Adam Smith, the value of goods and services is directly related to the involvement of quality and quantity of labour in the production process. The Ricardian theory is also influenced by this consideration and hence assumes that labour is the only factor of production. However, in real world, labour and capital both are equally important inputs and the value of goods and services is also expressed in terms of money. Assumption of circular flow of money and existence of full employment has been invalidated by many economists such as Pugel (2004) who had shown that most of the economies lie far behind for full employment and all the economies strive to move towards full employment level from different level of employments existed in those economies. To be more specific, the condition of full employment is only a theoretical aspect and it does not hold in the real world. Moreover, if the model emphasises on full employment, then it should be assumed that Ricardo’s model is not meant for developing countries. The model has also ignored the transaction cost where, in today’s global business operations and international trade, the total system of trade and exchange is based on sound logistics and smooth supply chain management. Hence, transaction cost is inevitable which had been ignored by Ricardo. In fact, Ricardo emphasised only on supply of goods and has taken demand for granted. However, if no structured demand in the market exists then there is no point of providing uninterrupted supply of goods. According to Altzinge and Damijan (2009), the most important area of consideration in Ricardian theory is his assumption of free trade. Free trade indicates a situation where no restriction is imposed on the movement of goods between the two countries. However, in real world, cross border trade is restricted in every step through obligations of several tariff and non tariff barriers. As a result, it becomes difficult for the poor counties to take opportunity of the comparative advantage of production due to application of the protectionist policies of developed countries. The static theory of Ricardo talks about complete specialization. In contrast, the views of Kemp (2008) regarding the theory reveal that complete specialization is unrealistic even if the assumption of two country- two commodity model holds in reality. No country can completely specialize in production of a particular good and it will be possible only if the demand and size of the two countries involved in trade are identically equal (Peach, 2003). Frederking (2010) argued that the doctrine of constant returns to scale and therefore, constant cost of production that Ricardo projected in his theory also cannot be attained in practical. According to the theory, if a country expertises in production of a good or service, the country should concentrate on producing that good and tend to import all other goods and services. However, in practice, if a country produces a particular commodity, it also has the right to import a part of that commodity produced. In fact, if the pattern of international trade is examined it can be found that a country is producing multiple goods and services at a time and importing and exporting a part of the total production as well. Conclusion From the above analysis it is justified that the theory of international trade and development proposed by David Ricardo does not hold good in today’s real business scenario. The concept of free trade does not exist in real world. The simplified version of international trade, involving two countries and two commodities has also been nullified on the ground of participation of a large number of countries in international trade as well as existence and requirement of abundant goods and services in the real world. In spite of all these factors, contribution of Ricardo for showing the world economy the way towards international trade through his classical theory of comparative advantage cannot be denied. Reference List Frederking, J., 2010. Comparative Cost Advantage and Factor Endowment. Munchen: GRIN Verlag. Golub, S. S. and Hsieh, C.T., 2002. Classical Ricardian Theory of Comparative Advantage Revisited. Journal of International Economics, 8(2), pp. 142-153. Kemp, M., 2008. International Trade Theory: A Critical Review. London: Routledge. Krugman, P. and Maurice, O., 2012. International Economics, Theory and Practice. New Jersey: Pearson-Prentice Hall. Peach, T., 2003. David Ricardo: Critical Responses. New York: Psychology Press. Pugel, T. A., 2004. International Economics. New York: McGraw-Hill-Irwin. Ruffin, R. J., 2002. David Ricardo’s Discovery of Comparative Advantage. History of Political Economy, 34(4), pp. 125-154. Todaro, M.P. and Smith, S.C., 2012. Economic Development. New Jersey: Pearson-Prentice Hall. Tomohiro, A., 2015. Comparative Advantage, Monopolistic Competition, and Heterogeneous Firms in a Ricardian Model with a Continuum of Sectors. The Research Institute of Economy, Trade and Industry, 1(1), pp. 1-24. Wilfried, A. and Jože, P. D., 2004. Revisiting Ricardo: Can productivity differences explain the pattern of trade between EU countries? LICOS Centre for Institutions and Economic Performance, 1(1), pp. 3-14. Read More