David Ricardo: The Comparative Advantage

David Ricardo: The Comparative Advantage As a successful classical economist of the 1700 to 1800s, David Ricardo is known for many of his contributions to political and classical economics including the theory of comparative advantage. The theory of comparative advantage suggests that a person can have a comparative advantage at producing something if he or she can produce it at a lower cost than anyone else. On a larger scale, the comparative advantage has played a large role in free trade, and providing markets with goods and services that would have otherwise been unavailable (Library of Economics and Liberty, 2007). This report will discuss the complications and advantages of the comparative advantage, David Ricardo’s background and theories, the comparative advantages effect on the economy, the political aspect of the theory of comparative advantage, and how it has developed over time. The Comparative Advantage The Comparative Advantage has had a direct effect on international trade and voluntary trade. The theory explores how to create mutually beneficial gains through trade between countries through comparing opportunity costs. Consider the following equation for opportunity cost:, if both China and Canada produce steel and wool, but China produces steel at a lower opportunity cost than Canada (meaning that they give up less monetary assets, goods, or labour costs to produce it), and Canada produces wool at a lower opportunity cost than China, each country has a comparative advantage against one another. This is where mutually beneficial gains of each country comes into play, if Canada chooses to trade some of the wool they have produced for metal, they are gaining more metal then they would have if they had chosen to create both the wool and metal themselves (Cohen Howe, Scarcity, opportunity cost, and trade, 2010). The benefits of the comparative advantage are simple, when a person wak es up in Canada on a cold winter morning and enjoys a glass of orange juice and a cup of coffee, they are enjoying the benefits of the comparative advantage theory. This is because Canada is not able to produce cocoa beans or grow oranges, therefore countries such as Brazil and the USA have a comparative advantage, and Canada must import these goods from them. In Canada much of what makes up the gross domestic product comes from exports and imports, in fact Canada’s import 34% of their goods, and export 36% of GDP. Considering the GDP equation: it becomes apparent of the direct impact this theory has on the Canadian economy, and how it is detrimental for its continuation and growth (Cohen Howe, Globalization and Trade Policy, 2010). Although there are many clear benefits regarding the comparative advantage, there are a few complications and criticisms that must be taken into consideration. The main issues with this theory are the effects of trade on the country doing the trading, these concerns include prices of goods in the country, production levels of said goods, employment levels, who exports and imports what, consumption levels, wages and incomes and welfare effects. These issues can be affected both positively and negatively by uncontrollable forces such as technology and government and can have a direct impact on a countries GDP (Suranovic, 2007). Some other areas of concern include relative prices and exchange rates not being taken into consideration, overstating of benefits and ignora nce of costs such as transport costs and sea and air pollution, as well as the complexity of the real world in comparison to the simplistic example of two countries trading goods (Economics Online, n.d.). David Ricardo David Ricardo began as a stock broker for the London stock exchange in the late 1700s, during this time he gained great wealth that allowed him to further develop other interests such as science and economics. At the age of 27 Ricardo read The Wealth of Nations by Adam Smith, and this commenced ten years of studying and by the age of 37 David Ricardo his first published work called The High Price of Bullion, a Proof of the Depreciating Bank Notes (Spengler, 2014). Ricardo was a true believer in the quantity theory of money, which is the belief that money supply has a direct relationship with price. In 1815 Ricardo published an article called Essay on the Influence of a Low Price of Corn on the Profits of Stock, during which he expressed his opposition to Corn Laws, which at the time caused a restriction on the importation of wheat. As a result of this, Ricardo developed the idea of comparative costs, which is now known as the comparative theory or the Ricardian Model (Library of Econ omics and Liberty, 2008). In his book On the Principles of Political Policy and Taxation Ricardo suggested that by having an absolute advantage (where a country makes their own goods and does not trade) a countries profits can never increase. He advocates that foreign trade can increase profits by bringing food and necessities into the market at a lower price thereby reducing wages and increasing profits. Ricardo asserts that this theory provides advantages to all consumers, as well as producers as they gain more product but costs remain the same (Ricardo, 1817). Ricardo suggests that a country can benefit greatly from trade through the realization and optimization of their comparative, and absolute advantage goods (Suranovic, 2007). Economic Aspect The comparative theory has had ample effect on the global and Canadian economy. For the purposes of this report the focus will be on the Canadian economies effects pertaining to the comparative theory and free trade. In 1989 Canada created a Free Trade Agreement (FTA) which allowed them to trade their goods globally with other countries, five years later the North American free-trade agreement (NAFTA) was implemented to allow free trade between Canada, Mexico and the United States of America. These events have drastically reformed the Canadian economy to what it is today (Schwanen, 2013). Canada relies heavily on free trade to maintain its GDP, specifically through exports and imports. Canada has become the ideal example of how the comparative theory can benefit a country, this is because Canada has much better technology then other countries and has many resources to create its own products and services, but through free-trade Canada is able to grow economically and provide an abundance of goods to its residents. International trade has the ability to increase incomes, saving and investment, all of which have the ability to positively affect the economy. There are many determinants that must be taken into consideration when determining a countries comparative advantage, these include; resource endowments (availability of resources), human skill (such as engineers, programmers, etc.), technology, demand patterns, specialization, business practices, and government policies (Gupta, n.d.). In recent years Canadian exports and imports have been increasing steadily. Exports are comprised of all goods leaving the country such as all goods grown, produced, gathered or manufactured within said country). In 2013 the Canadian merchandise export values increased 3.6% from the previous year, and 1.5% in the last 10 years. Exports to the United States have also been steadily increasing to a current 75.8% of all exports (See Figure 1), and the total value of all exports in Canada in 2013 was $471.4 billion. Imports are comprised of all goods that have entered the country, these include any goods that have crossed boundaries. In 2013 the Canadian merchandise imports increased 2.8% from 2012, and 3.3% in the last 10 years. This data displays a clear increase in imports over exports, which has created a trade deficit in 2013(See Figure 3) (Statistics Canada, 2013). Political Aspect Political decisions have a considerable amount of power regarding the comparative theory and free-trade. These decisions include political pressures regarding trading agreements, creation and implementation of policies, export and import interests, and negotiation between countries (Grossman Helpman, 1993). In Canada, the comparative advantage lies within industries that excerpt natural resources and raw materials. These include wheat, meat, seeds, natural gas, metals, wood and paper. In order for Canada to sustain this comparative advantage it must maintain continual green development to ensure natural resources are still competitive in comparison to other countries resources. Political policies must address these concerns and ensure the prosperity of Canada’s natural resources while still maintaining a high level of exports and imports, as they directly impact the country’s gross domestic product. Canada also has a comparative advantage within the auto industry, as well as aerospace, insurance and communication industries (The Conference Board of Canada, 2013). It is detrimental to Canada’s future economic growth as well as their strengthening of the comparative advantage to ensure technological advances are being made and trade agreements with technologically inn ovative countries are being made. Technology accounts for 5% of Canada’s GDP, and must be able to compare in such a competitive global market. Political figures are responsible for determining and advising on sanctioning policies and identifying emerging businesses to strengthen Canada’s digital advantage (ICTC, 2013). Development of the Comparative Advantage Through the generations the comparative advantage has created growth and innovation in many industries, while it has had great impact on international trade and free trade, there have been hypothesis that the comparative advantage has weakened over time. A recent study named The Evolution of Comparative Advantage: Measurement and Implications suggests that countries with a comparative disadvantage have a faster economic growth than those with a comparative advantage, in both refined and unrefined countries. The study also suggests that the comparative advantage has stayed the same from the 1960s to the 2000s due to productivity levels increasing, and an increase of 15% in GDP in the 2000s that could have been higher had the comparative advantage not been weakening. Finally, the authors have reported that trade patterns have been impacted and have become more similar across countries, such as log and wood. This study suggests that there is still ample work to be done to restore the co mparative advantage and refine it to be more beneficial in today’s economy (Levchenko Zhang, 2014). Conclusion In closing, I consider David Ricardo’s theory to be innovative and well-intended, the world and country I have grown up in would not be what it is today if not for the comparative advantage and free-trade. In this report many aspects of the comparative advantage theory were discussed, what the comparative advantage theory is in regards to opportunity costs and international/free trade, as well as who benefits from the theory and what effects it has on Canada. The history of David Ricardo and his ideals for the future including the Ricardian model. The economic and political aspects and effects of the comparative advantage theory and free-trade in Canada. As well as the evolution of the comparative advantage, and its current place in economics now. Considering the increase in technology and the limited natural resources the world is currently facing, I believe it is important to work towards refining the comparative advantage to help countries better contribute to other country ’s needs, while still mutually benefitting from the trade. In the coming years it will be quite interesting to see how the world handles future innovations and changes in trade and how the Ricardian Model will contribute to those advancements. Bibliography Cohen Howe, A. J. (2010). Globalization and Trade Policy. In A. J. Cohen Howe, Economics for Life (pp. 334-335). Pearson. Cohen Howe, A. J. (2010). Scarcity, opportunity cost, and trade. In Economics for Life (p. 399). Pearson. Economics Online. (n.d.). Comparative Advantage. Retrieved from http://www.economicsonline.co.uk/Global_economics/Comparative_advantage.html Grossman Helpman, G. M. (1993). The Politics of Free Trade Agreements. Retrieved from The National Bureau of Economic Research: http://www.nber.org/papers/w4597.pdf Gupta, S. D. (n.d.). Comparative Advantage and Competitive Advantage: An Economics Perspective and a Synthesis. Retrieved from economics.ca: http://economics.ca/2009/papers/0534.pdf ICTC. (2013). Strengthening Canadas comparative advantage. Retrieved from Information and Communications Technology Council: http://www.ictc-ctic.ca/?p=9821 Levchenko Zhang, A. A. (2014). The Evolution of Comparative Advantage: Measurement and Welfare Implications. Retrieved from The National Bureau of Economic Research: http://www.nber.org/papers/w16806.pdf Library of Economics and Liberty. (2007). Comparative Advantage. Retrieved from Library of Economics and Liberty: http://www.econlib.org/library/Topics/Details/comparativeadvantage.html Library of Economics and Liberty. (2008). The Concise Encyclopedia of Economics: David Recardo . Retrieved from http://www.econlib.org/library/Enc/bios/Ricardo.html Ricardo, D. (1817). On the Principles of Political Economy and Taxation. Retrieved from Library of Economics and Liberty: http://www.econlib.org/library/Ricardo/ricP2a.html#Ch.7, On Foreign Trade, comparative advantage Schwanen, D. (2013). Free trade transformed Canadas economy. Retrieved from The Globe and Mail: http://www.theglobeandmail.com/globe-debate/free-trade-transformed-canadas-economy/article16124601/ Spengler, J. J. (2014). Encyclopedia Britannica. Retrieved from David Ricardo: http://www.britannica.com/EBchecked/topic/502193/David-Ricardo Statistics Canada. (2013). International Trade Canadian Economy . Retrieved from Industry Canada: http://www.ic.gc.ca/eic/site/cis-sic.nsf/eng/h_00029.html Suranovic, S. M. (2007). The Theory of Comparative Advantage. Retrieved from International Trade Theory and Policy: http://internationalecon.com/Trade/Tch40/T40-0.php The Conference Board of Canada. (2013). Canadas trade strengths come from natural resources and related industries. Retrieved from The Conference Board of Canada: http://www.conferenceboard.ca/press/newsrelease/12-06-19/canada_s_trade_strengths_come_from_natural_resources_and_related_industries.aspx Figures Figure 1. Top Export Destinations. An overview of total exports from Canada to other countries. Figure 2. Top Import Sources. An overview of total imports to Canada from other countries. Figure 3. Exports, Imports and Trade Balance. A comparison of exports, imports, and the trade balance (deficit) from 2004-2013.