Home > Uncategorized > Ricardo’s trade paradigm — a formerly true theory

Ricardo’s trade paradigm — a formerly true theory

from Lars Syll

Two hundred years ago, on 19 April 1817, David Ricardo’s Principles was published. In it he presented a theory that was meant to explain why countries trade and, based on the concept of opportunity cost, how the pattern of export and import is ruled by countries exporting goods in which they have comparative advantage and importing goods in which they have a comparative disadvantage.

Heckscher-Ohlin-HO-Modern-Theory-of-International-TradeAlthough a great accomplishment per se, Ricardo’s theory of comparative advantage, however, didn’t explain why the comparative advantage was the way it was. In the beginning of the 20th century, two Swedish economists — Eli Heckscher and Bertil Ohlin — presented a theory/model/theorem according to which the comparative advantages arose from differences in factor endowments between countries. Countries have a comparative advantages in producing goods that use up production factors that are most abundant in the different countries. Countries would mostly export goods that used the abundant factors of production and import goods that mostly used factors of productions that were scarce.

The Heckscher-Ohlin theorem — as do the elaborations on in it by e.g. Vanek, Stolper and Samuelson — builds on a series of restrictive and unrealistic assumptions. The most critically important — beside the standard market clearing equilibrium assumptions — are  

(1) Countries use identical production technologies.

(2) Production takes place with a constant returns to scale technology.

(3) Within countries the factor substitutability is more or less infinite.

(4) Factor-prices are equalised (the Stolper-Samuelson extension of the theorem).

These assumptions are, as almost all empirical testing of the theorem has shown, totally unrealistic. That is, they are empirically false. 

That said, one could indeed wonder why on earth anyone should be interested in applying this theorem to real world situations. As so many other mainstream mathematical models taught to economics students today, this theorem has very little to do  with the real world.

Using false assumptions, mainstream modelers can derive whatever conclusions they want. Wanting to show that ‘free trade is great’ just e.g. assume ‘all economists from Chicago are right’ and ‘all economists from Chicago consider free trade to be great’  The conclusions follows by deduction — but is of course factually totally wrong. Models and theories building on that kind of reasoning is nothing but a pointless waste of time.

What mainstream economics took over from Ricardo was not only the theory of comparative advantage. The whole deductive-axiomatic approach to economics that is still at the core of mainstream methodology was taken over from Ricardo. Nothing has been more detrimental to the development of economics than going down that barren path.

Ricardo shunted the car of economic science on to the wrong track. Mainstream economics is still on that track. It’s high time to get on the right track and make economics a realist and relevant science.

This having been said, I think the most powerful argument against the Ricardian paradigm is that what counts to day is not comparative advantage, but absolute advantage.

David_RicardoWhat has changed since Ricardo’s days is that the assumption of internationally immobile factors of production has been made totally untenable in our globalised world. When our modern corporations maximize their profits they do it by moving capital and technologies to where it is cheapest to produce. So we’re actually in a situation today where absolute — not comparative — advantages rules the roost when it comes to free trade.

And in that world, what is good for corporations is not nec

  1. July 26, 2017 at 10:54 am

    Until Syll comes just before the two lines at the middle of his post:

    “These assumptions are, as almost all empirical testing of the theorem has shown, totally unrealistic. That is, they are empirically false,”

    what he described is an exact description of the present popular understanding of the (mainstream) international trade theory.

    However, his opinion on Ricardo is full of misunderstandings. I totally agree with him when he put it:

    “It’s high time to get on the right track and make economics a realist and relevant science.”

    But, I have to question what he stated before this:

    “Ricardo shunted the car of economic science on to the wrong track. Mainstream economics is still on that track.

    I believe Lars is completely wrong.

    As the first half of his post shows, he does not know or understand that Heckscher-Ohlin-Samuelson theory is a trade theory completely in the neoclassical tradition and has few common points with Ricardian trade theory. He dare to criticize Ricardo and his trade theory by the present state of neoclassical economics. I wonder if he know that classical economics (Ricardo in particular) is very different from neoclassical economics.

    First of all, his understanding of Ricardo’s trade theory is not correct as an interpretation of Ricardo’s text (and four magic numbers in particular). A new interpretation is now widely known since a bit less than 20 years. As for the new interpretation of four magic numbers, please read the encyclopedic article by Gilbert Faccarello:

    Compartaive advantage
    https://www.researchgate.net/publication/290821134_Comparative_Advantage

    There are many other papers on this point but I omit all other references here.

    Second misunderstanding is the relation of comparative advantage and Ricardo. Lars Syll believes that Ricardo argued gains from trade by the the logic of comparative advantage. This is a complete error. The new interpretation points that Ricardo only argued that there are gains from trade for both countries (even if a country has inferior production techniques for all industries) when prices are suitably determined. This is simply a repetition of what Viner named the 18th century rule. If we understand comparative advantage theory as the one based on the comparison of two ratios of labor inputs, it is a pure fiction constructed after John Stuart Mill.

    What is more important is that a Ricardian theory of trade on the extension of Ricardo’s theory of domestic values is now constructed. See my paper:

    The New Theory of International Values: An Overview
    https://link.springer.com/chapter/10.1007/978-981-10-0191-8_1

    The new theory solved unsettled questions to determine the terms of trade (after the expression of John Stuart Mill) by showing how the international values (composed of country-wise wage rates and prices of products). When the wages (converted to a common currency) of all countries are given, we can calculate full cost of any product by any production techniques and compare those costs. The new theory shows that it is the firm (in a country) that can produce the same product at the minimal full cost.

    Syll’s argument that

    “the most powerful argument against the Ricardian paradigm is that what counts to day is not comparative advantage, but absolute advantage”

    is not only supported historically but also wrong in view of up-to-date knowledge of Ricardian trade theory.

    Syll had added

    “When our modern corporations maximize their profits they do it by moving capital and technologies to where it is cheapest to produce. So we’re actually in a situation today where absolute — not comparative — advantages rules the roost when it comes to free trade.”

    By pointing this, he thought to have criticized Ricardian theory. The reason was that the Ricardian theory is out-dated. But he is again wrong, because the new theory of international values is just the theory that treats modern corporations which moves capital and technologies. What is outdated is not the Ricardian theory but his knowledge on it.

    It is possible that all Syll’s arguments have no real relation to Ricardo and his trade theory. Syll only wanted to argue against the neoliberal policy thought by pointing that trade theory is not reliable. Even at this point, he is wrong. Probably he could not imagine that a theory can exist and we can analyze with that theory gains and losses from trade. In this point also, it is important to distinguish neoclassical and classical theories. As I have already argued this point in my comment (the 3rd comment at July 25, 2017 at 9:32 am) on David Ruccio’s post “Globalization—how did they get it so wrong?” I do not repeat it again. The point is that the neoclassical trade theory (including HOS theory) excludes unemployment, bankruptcy, and industrial decline by assumption. The new theory of international values can treat these questions (See section 4 of my paper).

    My conclusion of this discussion is three:

    (1) Identifying theory and policy is a bad habit. Lars Syll is denouncing a theory in order to denounce a policy. This is an error as grave as the custom to believe that a policy is derived from a theory. Right policy never comes without empirical studies and experiences combined with a theory.

    (2) It is extremely important to distinguish classical and neoclassical economics. Syll is a specialist in history of economic thoughts but seems to ignore intentionally this difference when he talks about Ricardo.

    (3) The last point is related to the attitude that we have to keep in mind when we want “to get on the right track and make economics a realist and relevant science.” I wonder if Syll has a right idea “to get on the right track.” As I have wrote in my comment at July 17, 2017 at 4:56 on Lars Syll’s post “A new perspective on microfoundations,” Lars Syll is always sharp in his critique of mainstream economics, but he does not present his own perspective on how to re-build or re-construct economics.

  2. July 26, 2017 at 11:28 am

    I have recently published a paper in the WEA Journal Economic Thought, titled Ricardo’s Numerical Example Versus Ricardian Trade Model: a Comparison of Two Distinct Notions of Comparative Advantage (http://et.worldeconomicsassociation.org/papers/ricardos-numerical-example-versus-ricardian-trade-model-a-comparison-of-two-distinct-notions-of-comparative-advantage/) which shows that:
    1) Ricardo’s original numerical example was reformulated in terms of opportunity costs by Austrian economist Gottfried von Haberler back in 1930 as a result of a misinterpretation of the role of the labor theory of value in the example;
    2) Ricardo did not make the unrealistic assumptions usually attributed to him; and
    3) the original propositions he proved with the numerical example are still valid today.

  3. patrick newman
    July 26, 2017 at 11:57 am

    So what! It’s globalization and its effects we need to understand and that involves attaining escape velocity from the comfort zone of classical and neo-classical economics. The function of comparitive advantage was to justify the status quo of imperialism at the time.

    • July 26, 2017 at 2:09 pm

      @ Patrick: I doubt that one can really understand the process of globalization and its effects without grasping the underlying theories and concepts. How can you infer the purpose or function of a concept like comparative advantage without knowing what it actually means?

  4. July 26, 2017 at 2:20 pm

    Yes, Patrick. I wonder whether Jorge has read Chapter 10 of Polanyi’s “The Great Transformation” to get a feel for the economic realities of Ricardo’s time. In Cobbett’s “Rural Rides” one can find an account by a first-hand observer. This from Reigate, July, 1823:

    “The hop affair is a pretty good illustration of the doctrine of “relief” from “diminished production”. Mr Ricardo may now call upon any of the hop-planters for proof of the correctness of his notions. They are ruined, for the most part, if their all be embarked in hops. How are they to pay their rent? … Thus the Quaker gets rich, and the poor devil of a farmer is squeezed into a gaol. The Quakers carry on the far greater part of this work. They are, as to the products of the earth, what the Jews are as to gold and silver. How they profit, or rather, the degree to which they profit, at the expense of those who own, and those who till the lad, may be guessed at if we look at their immense worth, and if we, at the same time, reflect that they never work”.

    And this from Ryall, in September, 1826:

    “While we were petitioning for reform [of a Parliament that had denied representation] in 1817, my Lord Somers [then busy building himself Eastnor Castle] wrote and published a pamphlet under his own name, condemning our conduct and our principles, and insisting that we, if let alone, should produce “a revolution [this in the aftermath of the French Revoluton] and endanger all property!” [Ironically] The Barings are adding field to field and tract to tract in Herefordshire; and as to the Ricardos, they seem to be animated with the same laudable spirit. This Osmond Ricardo has a park at one of his estates called Broomsborough, and that park has a new porter’s lodge, upon which there is a span new cross as large as life. I had never seen such an one before; and I know not what sort of thought it was siezed me at that moment; but, though my horse is but a clumsy goer, I very believe I got away from it at the rate of ten or twelve miles an hour. ”

    On to Hayden, commenting on the state of once-rich Withington, near Cheltenham:

    “A part, and perhaps a considerable part, of the decay and misery of this place is owing to the use of machinery, and to the monopolising, in the manufacture of blankets, of which fabric the town of Witney (above mentioned) was the centre, and from which town the wool used to be sent round to, and the yarn, or warp, came back from, all these Cotswold villages, and quite into a part of Witshire. This work is all now gone, and so the women and girls are a “surplus popalashon [sic], mon”, and are, of course, to be dealt with by the “Emigration Committee” of the “Collective Wisdom”! There were, only a few years ago, above thirty blanket manufacturers at Witney: twenty-five of these have been swallowed up by the five that now have all the manufacture in their hands. And all this has been done by that system of gambling and fictitious money, which has conveyed property from the hands of the many into the hands of the few. But wise Burdett LIKES this! He wants the land to be cultivated by a few hands, and he wants machinery and all those things which draw money into large masses; that make a nation consist of a few of very rich and of millions of very poor! Burdett must look sharp or this system will play him a trick before it comes to an end. [If only …].

    And on to Burghclere, amusing himself with those from whom he asked the road:

    ” saying more to them than I should have said by daylight, and a great deal less than is should have said had my horse been in a condition to carry me away as swiftly as he did from Osmond Ricardo’s terrific cross! “There!” exclaims Mrs Scrip, the stock-jobber’s young wife to her old hobbling wittol of a spouse, “You see, my man, that this mischievous man could not let even these poor peasants alone”. ‘Peasants’, you dirty-necked devil, and where got you that word? You who, but a few years ago, came perhaps up from the country in a wagon; who made the bed you now sleep in; and who got the husband by helping him to get his wife out of the world, as some young parti-coloured blade is to get you and the old rogue’s money by a similar process!” [A wry comment on the reality of “marrying well”].

    • July 26, 2017 at 2:37 pm

      @ Dave: No, I haven’t read it yet. But I am not sure what relevance does it have for the topic we are discussing here.

      • July 26, 2017 at 2:56 pm

        As I tried to indicate, “to get a feel for the economic realities of Ricardo’s time”. It is about Townsend’s rejoinder to Adam Smith on economics being about controlling the working population, and the mechanism Ricardo theorises, i.e. global monopolisation of money, which Cobbett sees Burdett as liking.

    • July 26, 2017 at 2:41 pm

      PS. Osmond Ricardo perhaps reflects David’s marriage or refers to his son,apparently but it was David who lived at Broomsborough (now Bromsberrow):

      https://link.springer.com/chapter/10.1007/978-94-010-1401-4_20.

      I don’t agree with Yoshinori’s first conclusion:

      “(1) Identifying theory and policy is a bad habit. Lars Syll is denouncing a theory in order to denounce a policy. This is an error as grave as the custom to believe that a policy is derived from a theory. Right policy never comes without empirical studies and experiences combined with a theory.”

      This is missing the point. Wrong policy can come from evil theory based on empirical studies. What Ricardo saw was how to make and keep money, not how to run an economy.

      • July 26, 2017 at 5:16 pm

        Dear Dave Taylor,

        I do not claim that theory is always policy neutral. Theories of international trade were long received as backing trade liberalization and by consequence as promoters of globalization. But, as I have explained in my comment to David Ruccio’s post “Globalization—how did they get it so wrong?”, most of the traditional theories of international trade are based on general equilibrium framework and could not analyze the losses and bads that the sudden liberalization produces. By consequence, those theories all backed liberalization and globalization. In this case, I willingly admit that theories are often biased toward a specific policy.

        The point I want to argue is this. Even if Ricardian trade theory (wrongly interpreted through the looking glasses of neoclassical economics or not) played the role of free trade promoters, this theory (that stands on the different tradition from neoclassical economics) has the possibility that it can be developed as a theory that can fully analyze the gains and losses of trade and how they affects people. Lars Syll and many others claim that Ricardian theory is doomed to be propagandist of free trade ideology. I object this rough and inexact contention.

        Globalization is proceeding by various reasons. It is not only a result of neoliberal political thought but also a consequence of strong economic forces that propel the world economy to globalization. If it is the fact of the present state, we need a theory (or theories) by which to analyze what is happening. If not, we will not be able to make a right diagnosis and create good prescriptions. This must be the reason why Jorge Morales Meoqui mentioned the necessity of “grasping the underlying theories and concepts.” The new theory of international values which stands on (the extension of) the Ricardo’s value theory is, I believe, such a theory.

  5. July 26, 2017 at 5:38 pm

    Lars Syll,
    “These assumptions are, as almost all empirical testing of the theorem has shown, totally unrealistic. That is, they are empirically false,”
    “It’s high time to get on the right track and make economics a realist and relevant science.”
    ( https://rwer.wordpress.com/2017/07/26/ricardos-trade-paradigm-a-formerly-true-theory/ )
    Please, any profound answer;
    Why isn’t there any “due examination of Frederic Soddy’s Theory of ‘What is Money’ and
    ‘What is the Role Of Money’ now that it is being proven to be “empirically true” ?
    ******Excerpt from http://en.wikipedia.org/wiki/Frederick_Soddy
    “In four books written from 1921 to 1934, Soddy carried on a “quixotic campaign for a radical restructuring of global monetary relationships”[this quote needs a citation], offering a perspective on economics rooted in physics—the laws of thermodynamics, in particular—and was “roundly dismissed as a crank”[this quote needs a citation]. While most of his proposals – “to abandon the gold standard, let international exchange rates float, use federal surpluses and deficits as macroeconomic policy tools that could counter cyclical trends, and establish bureaus of economic statistics (including a consumer price index) in order to facilitate this effort” – are now conventional practice, his critique of fractional-reserve banking still “remains outside the bounds of conventional wisdom”[this quote needs a citation]. Soddy wrote that financial debts grew exponentially at compound interest…”
    Free download-
    http://archive.org/stream/roleofmoney032861mbp/roleofmoney032861mbp_djvu.txt

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