3. The Ricardian Trade Model

The intuition for the negative slope here comes from the fact that this ratio measures a trade-off of one good for the other. We will generally speak of “aLx/aLy” without the sign, for convenience, unless we are drawing graphs.

Since we are considering an entire industry within each country, we ignore the decreasing costs area of the average cost curve and assume that we start in the efficient range, which implies an increasing-costs model. The increasing-costs area is represented by all points on the curve to the right of “peak efficiency”. (Fig. 3.3)

That central planning is rare enough today to be relegated to a footnote is significant. Only 30 years prior to the publication of this volume, a significant portion of the world operated under strict central-planning regimes. While central planners have made something of a comeback in certain sectors of the advanced democracies in the wake of the recent global economic crisis, full-scale top-down planning is today limited to North Korea and a handful of others.

We relax all these seemingly simplistic assumptions, like that of a two-good, two-factor world in Chap.​ 5. We also introduce real-world complications such as transportation costs, labor skills, trade distortions, etc., in later chapters. Nevertheless, the fundamental results obtained by implementing the simplified model at this time will not be compromised by these later refinements.

Students of microeconomics will recognize this as the “non-satiation” assumption. For the formulation “(1) More is better, and (2) More is better at a declining rate” the authors are grateful to their dear friend Dr. Peter Parks (1960–2012).

The relationship need not be symmetrical (and rarely if ever is, in practice). Typically, units of one good are more or less valued relative to the other across the range of quantities. We use a symmetrical relationship here for simplicity.

We will explore national income accounting in detail in Chap.​ 7.

Presently, North Korea would perhaps be the singular poster-child for a country operating under autarky.

Students of microeconomics will recognize that at the tangency point, the rate at which consumers are “willing” to substitute X for Y (the slope of the indifference curve, also known as the rate of marginal substitution) is equal to the rate at which producers are “able and willing” to transform X to Y (also known as the marginal rate of transformation), given by the slope of the PPF at the tangency point.

To clarify any confusion on “convex” versus “concave” in our terminology: PPFs are concave to the origin, i.e., bulging upward from the origin; indifference curves are convex to the origin, i.e., bulging inward toward the origin, or, if you prefer, shaped like a slide running down and then increasingly to the right.

In the next section, we will relax the “constant-costs” assumption and move to an increasing costs model.

Currencies will enter into the analysis in the latter part of the book in the Global Macroeconomics section.

The “Global Terms of Trade” is also called the International Terms of Trade. We use “Global” throughout for consistency.

For any currency or common unit of exchange, as we are interested in the ratio of the two prices, not their absolute level. It may be convenient, however, to think of prices as being in local currency.

The assumption of one input (here, labor) is made to maintain simplicity at this stage of our discussion. Relaxing this assumption (which may alternatively be given as a fixed ratio of labor to capital across industries) brings us to the PPF with increasing costs, which we examine later in this chapter.

Again, any figure here for national income will serve the same purpose; we are interested in price ratios, not nominal prices.

Matthew 4:4. Source: The Holy Bible, New International Version 1984, Biblica, Inc

This is not always the final result, as sometimes consumers, given the opportunity, may reduce their consumption of one item to obtain more of another. The final point of consumption will depend on the shape of the indifference curve (consumer preferences) and the availability of the consumption bundle outside the domestic PPF, thanks to specialization and free trade.

The Global Terms of Trade line can also be thought of (and is, by mathematical identity) the global production possibilities frontier (global PPF).

Increasing external returns to scale occur when an entire industry’s average cost decreases with increased industry output. This happens as industries grow to attract pools of suppliers and labor with increasingly specialized skills. This effect is seen in the IT industry in Silicon Valley, California, or in Bangalore, India. Ricardian theory assumes that entire industries are already operating at their optimal cost-per-unit (at the trough of the average cost curve in Fig. 3.24), implying that all possible external economies of scale have already been achieved. This is the condition that creates the concave-shaped PPF for entire industries. Note that “economies of scale” is synonymous with and often used in place of “returns to scale” for both internal and external returns to scale.

Russell Roberts, The Choice: A Fable of Free Trade and Protectionism, Prentice Hall, 3rd Edition, 2006. Roberts brilliantly employs the device of a benevolent ghost – adapted from the Jimmy Stewart movie It’s a Wonderful Life – to explicate the advantages of free trade in this parable written for the lay reader.