Ricardo Lies: 2 Big Problems With Comparative Advantage & Global Free Trade

David Ricardo’s Theory of Comparative Advantage

Everybody and their dog’s heard of Adam Smith, John Maynard Keynes, and Milton Friedman.  They’re household names.

But unless you’re an economist or a dabbling dilettante, you’ve probably never heard of David Ricardo.

You should have—he’s the most important economic thinker of them all.

His big idea, the theory of comparative advantage, underpins economic globalization and international free trade.  It shaped, and built, the modern world’s economic structure.

David Ricardo, inventor of the theory of comparative advantage
David Ricardo (d. 1823) is best remembered for his theory of comparative advantage.

It’s also (wrongly) been used to justify every bad trade deal from NAFTA to KORUS.  In fact, its misapplication is mostly to blame for America’s economic problems.

What Is It?  Comparative Advantage Defined.

Comparative advantage is pretty straightforward.

Basically, it’s the idea that countries should trade stuff they’re relatively good at making for stuff they’re relatively bad at making.  This improves economic efficiency, since everyone makes what they’re best at.

Ricardo’s Classic Example:

Pretend it takes England 100 man-hours to make a roll of cloth, and 120 hours to make a barrel of wine.

Next, pretend it takes Portugal only 90 hours to make the cloth, and 80 hours to make the wine.

In this example, Portugal’s absolutely better at making both products (meaning they can do both faster).  But, they are comparatively better at making wine (since it takes them less time to make wine than cloth), and England is comparatively better at making cloth.

Ricardo used Portuguese wine as an example to explain his theory of comparative advantage

Ricardo then argues that both countries would be better off if they specialized their production (Portugal only makes wine, England only makes cloth), and traded with each other. They will make a surplus, because their labor is used more efficiently.

Here’s the math.

If both countries worked alone, and each made 1 of each products, then 2 wine and 2 cloth would be made.

But, if they specialized and traded, they’d have more (together they’d make 2.125 barrels of wine and 2.2 rolls of cloth).

Of course, this overstates the case a little, since the hours they worked wasn’t equivalent (220 in England, 170 in Portugal), but even so, the theory holds up.

That’s it.

It’s an elegant theory.  Sadly, it’s been hijacked by people with ideological agendas and applied on a global scale—to America’s detriment.

People, like Milton Friedman or Henry Kissinger, argue that if every region on earth specialized, and maximized their comparative advantage, then the global economy would be as efficient as possible, and the world would be richer.

It’s a nice theory, but it’s wrong.  The reality is that global free trade has winners and losers.

America is one of the losers.

Why Doesn’t It Work?

I have written previously on America’s economic decline, and documented it all with hard data.  I won’t cover that here.

Instead, I’ll limit my discussion to debunking the theory (and thus everything that depends upon it).  It has two faulty premises.

Faulty Premise One: People Aren’t Greedy

The greatest critique of comparative advantage comes from David Ricardo himself.  It contains the seeds of its own destruction.

He writes that his theory implies that:

it would undoubtedly be advantageous to the capitalists [and consumers] of England… [that] the wine and cloth should both be made in Portugal [and that] the capital and labour of England employed in making cloth should be removed to Portugal for that purpose.

Ricardo explicitly states that, under his theory, it makes sense for England to import both cloth and wine from Portugal (since Portugal’s better at making both), and that England’s cloth-making industry should be offshored to Portugal.

Ricardo’s not a stupid man, and knows full well that this would be a losing strategy for England (if they imported everything and made nothing, they would have no economy).

Therefore, Ricardo adds an intellectual buttress to ensure that the temple of trade will not collapse.  He argues that:

most men of property [will be] satisfied with a low rate of profits in their own country, rather than seek[ing] a more advantageous employment for their wealth in foreign nations

And  there you have it.  Ricardo’s entire argument—the theory of comparative advantage, global free trade itself—is premised on the belief that most people love their country more than money, and will invest domestically out of the goodness of their hearts.

Sadly, Gordon Gekko won, and “greed is good” became the name of the game.

Faulty Premise Two: Capital’s Immobile

Ricardo also used a more technical defense to defend comparative advantage from this obvious flaw.

He argued that capital was functionally immobile (England’s cloth-making factories could not be moved to Portugal, regardless of cost differences).

In Ricardo’s time, this was largely true because transportation was so expensive, it was illegal to export machinery from Britain, Britain had 50% import tariffs, and endemic warfare prevented import dependency.  Therefore this hypothetical problem remained purely hypothetical for Ricardo.

This is no longer true.

capital is mobile in today's global economy

Capital is incredibly mobile today.  A factory can be relocated from America to China in the blink of an eye, and transportation for bulk goods is incredibly (almost hilariously) cheap.

In fact, in the decades after Ricardo’s death (1823) capital grew ever more mobile, and his hypothetical problem soon became very real.

Throughout the 1800s, there was a steady increase of capital outflows from Great Britain (British investors built projects abroad seeking higher returns).  In 1815, £10 million were invested abroad.  In 1825 this climbed to £100 million, and by 1870 it was £700 million.

By 1914 (the peak) over 35% of Britain’s national wealth was held abroad—Britain suffered a severe, decades long shortfall in domestic investment.

The same thing is happening to America: between 2000 and 2015 we invested almost $4 trillion abroad (in terms of FDI), and accumulated $10 trillion in trade deficits.

These two facts, that (i) people are greedy and (ii) capital is mobile, completely destroy comparative advantage by invalidating its underlying premises.

Let Ricardo’s Theory Rest In Peace

David Ricardo was a smart man who recognized his theory’s limits, and it is unfortunate that his ideas have been bastardized to justify global free trade in a world where his theory was never meant to apply.

Select Sources:

Chambers, J.D. The Workshop of the World: British Economic history from 1820-1880. London, Oxford University Press, 1961.

Lance, Davis E. and Robert E. Gallman. Evolving Financial Markets and International Capital Flows: Britain, the Americas, and Australia 1865-1914. Cambridge: Cambridge University press, 2001.

Ricardo, David. On the Principles of Political Economy and Taxation. London: John Murray, 1821.

Reinert, Eric. How Rich Countries got Rich and Why Poor Countries Stay Poor. New York: Carroll & Graf, 2007.

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About Spencer P Morrison 40 Articles
JD candidate, writer, and independent intellectual with a focus on applied philosophy, empirical history, and practical economics.Author of "America Betrayed" and Editor-In-Chief of the National Economics Editorial.

7 Comments

  1. So in addition to a tarriff on trade from off-shore factories, Trump would need to implement a tarriff on the outflow of capital since a company that has off-shored its production can still make a lot of money from exporting its products to other countries beside the United States.

    • Thanks for reading. That’s a good question.

      I think for the present time a simple tariff on imports would be enough, given how large America’s market share truly is.

      The issue is really a question of balancing America’s deficits: it harms America to send a factory abroad, only to sell the goods back home. However, if an American company built a factory in Vietnam and sold the products to China (while taking the capitalist’s cut), that would benefit America (albeit less than if we exported the products themselves).

      It’s a balancing act.

  2. Dear Mr. Morrison,

    I’m sorry to tell you that you have also been a victim of those who have misinterpreted Ricardo’s numerical example.
    Here is a short list of the misinterpretations:

    1. The numbers in Ricardo’s original numerical example are not unitary labor-time costs but the number of men working for a year necessary to produce unspecified amounts of cloth and wine traded between Portugal and England; 
http://etdiscussion.worldeconomicsassociation.org/?wea_paper=ricardos-numerical-example-versus-ricardian-trade-model-a-comparison-of-two-distinct-notions-of-comparative-advantage;

    2. the purpose of the numerical example was not to offer an argument for free trade but to illustrate that his labour theory of value is not valid in international exchanges;

    3. Ricardo’s case for free trade is very much based on Smith’s insight on the positive effect of an extension of the market on the division of labor – and not on comparative advantage. 
http://et.worldeconomicsassociation.org/files/WEA-ET-3-2-MoralesMeoqui.pdf

    4. The classical case for free trade is not affected by the international mobility of capital, nor by the creation of winners and losers; after all, any technological change creates winner and losers, but very few argue in favour of banning technical progress.
http://epub.wu.ac.at/2952/


    But I agree with you that the political support for free trade is very much affected by greed. The greedy ones are those who want to protect their investments from foreign competition, and also those who deny the funds to provide assistance to displaced workers who are in desperate need of retraining.

    You can be sure that Ricardo’s insight will continue to attract the attention of scholars for many more years.

  3. Dear Mr. Morrison,

    I’m sorry to tell you that you have also been a victim of those who have misinterpreted Ricardo’s numerical example.

    Here is a short list of the misinterpretations:
    1. the numbers in Ricardo’s original numerical example are not unitary labor-time costs but the number of men working for a year necessary to produce unspecified amounts of cloth and wine traded between Portugal and England; 
http://etdiscussion.worldeconomicsassociation.org/?wea_paper=ricardos-numerical-example-versus-ricardian-trade-model-a-comparison-of-two-distinct-notions-of-comparative-advantage

    2. the purpose of the numerical example was not to offer an argument for free trade but to illustrate that his labour theory of value is not valid in international exchanges;

    3. Ricardo’s case for free trade is very much based on Smith’s insight on the positive effect of an extension of the market on the division of labor – and not on comparative advantage. 
http://et.worldeconomicsassociation.org/files/WEA-ET-3-2-MoralesMeoqui.pdf

    4. The classical case for free trade is not affected by the international mobility of capital, nor by the creation of winners and losers; after all, any technological change creates winner and losers, but very few argue in favour of banning technical progress.
http://epub.wu.ac.at/2952/


    But I agree with you that the political support for free trade is very much affected by greed. The greedy ones are those who want to protect their investments from foreign competition, and also those who deny the funds to provide assistance to displaced workers who are in desperate need of retraining.

    I can assure you that Ricardo’s insight will continue to attract the attention of scholars for many more years.

    • Thanks for the detailed and insightful comment. I really appreciate it. A few things I’d like to mention:

      1. You’re right on that one, as per Ricardo 7.15:
      England may be so circumstanced, that to produce the cloth may require the labour of 100 men for one year; and if she attempted to make the wine, it might require the labour of 120 men for the same time. England would therefore find it her interest to import wine, and to purchase it by the exportation of cloth.

      2. That’s a highly controversial statement that I don’t think most modern economics would buy (least of all most free trade pundits), nor necessarily care about if it were true. There’s just no question that modern free trade is justified in light of comparative advantage, and the example in particular, whether or not that’s what Ricardo intended. So it’s a little besides the point to argue semantics.
      http://www.dailywire.com/news/7901/7-facts-about-free-trade-you-need-know-aaron-bandler
      http://www.dailywire.com/news/3999/note-trump-and-sanders-supporters-4-reasons-ben-shapiro
      Don’t get me wrong, I largely agree with what you’re arguing, I just don’t think it matters in light of our political reality. The argument’s bigger than Ricardo at this point.

      3. I’m not convinced about that, although there’s a decent enough case to be made (as per the paper you sited). I think that comparative advantage is basically the argument for division of labor, with the caveat that the most efficient maker should make the product. Although, again, I think it’s a distinction without a difference in practice.

      4. Long-term economic growth can only happen with technology grows, so of course it would be stupid to be against technological growth. But that’s one of my points entirely: when free trade leads to the offshoring of advanced industries (because it’s cheaper to build a research lab in India than America), it can lead to diminishing long term growth in the affected country, since they lose out on the technological advance. Given the profit curve is steeply weighted towards the temporal beginning, this greatly undercuts potential growth.
      The classical case for free trade is a Platonic model, devoid and divorced from reality, which is basically my point. It’s useless in the real world. It lacks any sort of empirical backing.
      Agreed on greed. It’s one of mankind’s (unfortunate) driving factors.

      • I’m pleased to read that we agree on the correct interpretation of the four numbers. My other claims just follow logically from the correct interpretation of the numerical example. They are quite easy to grasp if one reads Ricardo’s Principles without prejudice.

        The problem with the current political debate on free trade is that both sides are getting essential things wrong. Those in favour of free trade are making a flawed case based on crucial errors and misunderstandings regarding comparative advantage. Those who are against free trade criticise these obvious flaws, but erroneously believe that they are refuting Ricardo’s original theory.

        Whether Ricardo’s original thoughts matter or not in the actual political debate on free trade, I certainly think they do. If not, then why so many claim to have refuted his theory?

        Here (http://epub.wu-wien.ac.at/2952/1/PhD-Tesis-JMM.pdf) you can read about a classical case for free trade completely devoid of Platonic models and unrealistic assumptions.

        • I agree, comparative advantage is usually applied incorrectly, & this leads to imperfect refutations.

          However, if a strictly incorrect understanding of the theory is used to justify an outcome, it should still be refuted, regardless of its inherent correctness.

          That being said, I am still quite convinced that the theory is predicated upon capital immobility, as per Ricardo’s own words. If it’s not, let me know why.

          But theory aside, I think the data is the determinative factor in this (and any) debate.

          I will take a detailed look through the paper you linked for me over the coming days, it looks interesting.

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