Ricardian Theory of Comparative Advantage

Ricardian theory of comparative advantage states that relative labor productivity determines trade advantage. In other words that the international difference in comparative advantage is due to relative labor productivity, and mostly technological differences between nations with some nations able to produce more than others due to their technological advantage. All other factors are assumed to be similar across the countries.

The Ricardian model also argues that a country shows better profit in trade in those sectors where its productivity advantage is greater than its wage disadvantage or where its wage advantage is greater than its productivity disadvantage.

Using algorithmic features, the model, in other words, argues that letting ai represent unit labor requirements, for sector b in country j:

ai = Lb/Qjt

where Q = the added value

L = labor employment.

The marginal products of labor, therefore results of labor, are supposed to be consistent with variations in labor / technology. All are intertwined and conjoined.

The competitiveness of the sector I in country j compared with another country also depends on the pitch of its wages as well as the bilateral exchange rate which determines the relative labor unit cost that is determined by that country's specific currency.

Unfortunately, as Golub and Hseih (2000) point out, not only is the theory almost totally ignored in current usage but, given the difficulty with which the Ricardian model can be substantiated empirically, little empirical studies exist to support it. This is also due to the fact that the model also leaves out a lot of details. Nonetheless, its central ideas may be investigated and some researchers have done as much.

The following figure adapted from Ashenfelter and Jurajda (2001, p.43), provides cross-sectional evidence of the hourly wage of countries and productivity vis-a-vis the U.S. Mexico, India, China, and Korea are at the bottom range of the scale, whilst the more technologically equipped countries of Germany, Japan, and France are in the top-right hand corner, Japan being uppermost.

The figure shows that not only do higher wages signal higher productivity, but technological finesse seems to follow a similar positive association:

In 2000, Golub and Hseih used the OECD database to assess information about the trade flows, unit productivity, and labor costs of about 40 manufacturing companies from OECD regions including Mexico and Korea in the years 1970 to 1972. In order to examine association between trade patterns and relative labor costs, the authors ran cross-sectional regressions of sectoral trade flows on sectoral relative labor productivity and unit labor costs on a number of these countries ivis-a-vis the Untied States. As measures of trade flow, bilateral trade balances and export ratios were used. These were the dependent variables.

The independent variables were relative unit labor costs and relative productivity.

In order to deal with the problem of converting output of all countries to a common currency, the researchers experimented with three alternative Purchasing Power Parity exchange rates.

They then ran cross-sectional regressions testing for comparative rather than absolute advantage.

The results of their "seemingly unrelated regression" model (used to correct for possible error terms during the years) demonstrated that the Ricardian model could be applied to contemporary trqadign situations and still contained significance. This was particularly so in the case of Japan where relative productivity and unit labor costs associated significantly with a strong proportion of bilateral U.S.-Japan trade.

The authors attributed the low effects in other areas to the difficulty of converting the Ricardian model into an empirical study and the other likelihood of measurement error that intrudes in the independent variable. The measurement error may come from any number of omitted variables.

Researchers also found that when the dependent variable is relative exports, productivity shows slightly better results than unit labor costs, but the reverse is the case when the dependent variable is bilateral trade balances.

In other words, the authors discovered 'fairly strong [empirical] support" for the Ricardian model despite the intense difficulties in structuring international comparisons between productivity and labor compensation (although the authors found their PPP approach valuable). The authors concluded that:

in the vast majority of cases, relative productivity and unit labor cost help to explain U.S. bilateral trade pattern, particularly when sector-specific purchasing-power-parity exchange rates are used. In most cases, only a small part of the variation of trade patterns is explained by the model, but this is common in cross-sectional analysis (Golub & Hseih (2000), p.231).

They concluded that "despite its extreme simplicity, the Ricardian model continues to perform surprisingly well empirically." (ibid.)

Golub and Hseih (2001) were not the only ones who provided empirical support for the Ricardian theory. The Hungarian economist, Bela Balassa, provides further evidence of the confirmation of the Ricardian model. Comparing the ratio of U.S. To British labor productivity, in 1951, for 26 manufacturing industries, he discovered that a positive correlation existed between labor productivity and exports (Choi, & Kwan, 2002 )