Economic Theories David Ricardo Comparative Advantage

David Ricardo 1772 – 1823 Expanded Adam Smith’s theory Absolute advantage Advocate for free trade

Theory of Comparative Advantage CountryWheatWine Cost per unit in man hours England1530 Portugal1015

Absolute Advantage In Table 1 Portugal has the absolute advantage in both commodities It can make both products cheaper (less man hours) England – 1 unit of wine = 2 units of wheat - opportunity cost of 1 unit of wine = 2 units of wheat Portugal – 1 unit of wine = 1.5 units of wheat - opportunity cost of 1 unit of wine = 1.5 units of wheat Even though Portugal has Absolute Advantage - beneficial if both trade

Comparative Advantage Portugal is better at making wine than wheat – comparative adv. in making wine England is better at making wheat than wine – comparative adv. In making wheat Specializing will produce more of a good than the other

Production CountryBefore Trade After Trade WheatWineWheatWine England85180 Portugal96012 Total

Important Assumptions There are no transport costs. Costs are constant and there are no economies of scale. There are only two economies producing two goods. The theory assumes that traded goods are homogeneous (ie identical). Factors of production are assumed to be perfectly mobile. There are no tariffs or other trade barriers. There is perfect knowledge, so that all buyers and sellers know where the cheapest goods can be found internationally.

Iron law Wages Relied heavily on Thomas Malthus Idea of diminishing returns Wages will always fall near the subsistence levels Fall too low discontent to worker class

Theory of Land Rent Rent is proportional to productivity More Fertile land = higher rent Less fertile = lower rent

Theory today Comparative advantage Iron law of wages Theory of land rent Noticed in trade today Fails to take in account to many variables – too many things are assumed Evident today – wages are at subsistence levels – hourly basis (70 hour work weeks) – (gov intervention) Evident today – not based on fertile land, based on business productivity (land value)