Ricardo and the Gains from Trade in Graphs

Summary: Ricardo didn’t write what most economists think he did.

Warning! This post is going to be particularly nerdy—about halfway between Mr. Wizard and your first economics professor. But if you have a propeller on your head read on.

What the Textbooks Tell You Ricardo Said

Free trade Equilibrium and the Gains from Trade

Economists cite David Ricardo as the source of the principle of Comparative Advantage—the bedrock of free trade arguments. Before trade, in the above graph, England chooses to produce and consume at point A on its Production Possibility Curve. With trade, England can shift production to point B and consume at Point C by selling cloth for wine according to the terms of trade (relative price) indicated by the slope of the red line. In free trade equilibrium, England exports X=CB-CC cloth and Imports M=WC-WB Wine and consumes the combination of wine and cloth at Point C. Point C is above and to the right of the pre-trade Production Possibility Curve, therefore unobtainable in the absence of trade. Yay!

What Ricardo Really Said

Three pages before Ricardo laid out his famous comparative advantage argument, he made the qualifying statement that what he was about to tell you assumes that capital cannot move between countries. That may have made sense at the time, when moving capital involved moving heavy objects on ships, but it makes no sense today when it can be done instantly, at low cost, via optical fiber.

If capital can be redeployed to seek its highest return, the whole story changes. In this case, we assume that England is more capital-rich than Portugal, i.e., returns are higher in Portugal. Under these conditions, owners of capital will redeploy it from England to Portugal. With less capital, England’s Production Possibility Curve shifts left to the yellow curve, from which none of the points A, B, or C can be reached.

If Capital is Mobile, All Bets are Off

It is important to note that the last graph showing free-trade equilibrium with mobile capital no longer allows us to make statements about the level of economic welfare in England. That’s because, in addition to collecting their share of output produced in England (which is larger because the return on capital is not higher) the owners of capital are now also collecting returns on the capital they have deployed to Portugal.

We can, however, say that English owners of capital are better off and English workers are worse off that before trade. That’s because English capital owners and English workers no longer share the same fate. In a very real sense, trade has changed the definition and composition of the British nation.

I think this is a pretty good representation to what has happened in the US, Europe, Japan, and other rich countries in recent decades. And the flip side is a pretty good description of China, India, and other low-income countries. It explains why workers are so angry in some places and not others, and the rise of populism in rich countries. Try as they might, I don’t think that governments are going to have any success stopping these changes. This has profound implications for investors in the coming years.

Dr. John

The views and opinions expressed in this article are those of Dr. John Rutledge. Assumptions made in the analysis are not reflective of the position of any entity other than Dr. Rutledge’s. The information contained in this document does not constitute a solicitation, offer or recommendation to purchase or sell any particular security or investment product, or to engage in any particular strategy or in any transaction. You should not rely on any information contained herein in making a decision with respect to an investment. You should not construe the contents of this document as legal, business or tax advice and should consult with your own attorney, business advisor and tax advisor as to the legal, business, tax and related matters related hereto.