Academic journal article NBER Reporter

Old Idea, New Insights: The Ricardian Revival in International Trade

Academic journal article NBER Reporter

Old Idea, New Insights: The Ricardian Revival in International Trade

Article excerpt

Two centuries ago, David Ricardo wrote down a simple thought experiment that changed the way economists think about international trade. Suppose the residents of two nations, England and Portugal, differ in their ability to produce two goods, cloth and wine: Portugal is more efficient at both, but its relative advantage over England is weaker in cloth. If these countries are able to trade, what will happen? Who will trade what with whom? Who will gain from the trades? How large will the gains be?

Ricardo's famous example has been used to answer these fundamental questions of international trade in countless textbooks: England imports Portuguese wine and everyone's a winner, all the more so the worse the English are at making wine.

Until recently, however, Ricardo's logic has had surprisingly little impact on the way that economists use data from the world around them to answer questions about trade policy. Extending the logic to a realistic economy with many regions and products had seemed somewhere between impractical and impossible. But thanks to a number of recent innovations--most importantly in the seminal work of Jonathan Eaton and Samuel Kortum--this is rapidly changing. (1) In this research report, we describe some of our recent attempts to connect Ricardo's 200-year-old idea to the real world.

Ricardian Comparative Advantage and Empirical Patterns of Trade

We begin by asking the most basic of empirical questions: How well do the predictions of a Ricardian model line up with data on trade patterns? In a famous challenge, a mathematician, Stan Ulam, once asked Paul Samuelson to name one proposition in the social sciences that is both true and nontrivial. After much reflection, Samuelson's reply was: "Ricardo's theory of comparative advantage."

The practical content of Ricardo's theory has received surprisingly little attention due to the challenges of connecting Ricardo's ideas to data. Together with Ivana Komunjer, we have extended Eaton and Kortum's quantitative model to study inter-industry Ricardian comparative advantage in a way that is amenable to empirical scrutiny. (2)

The basic prediction of the Ricardian model is that countries should export relatively more in sectors in which they are relatively more productive. Our model captures this simple idea by providing closed-form solutions for relative bilateral trade flows as a function of relative observed productivity. Crucially, the model takes into account the fact that countries will not produce all varieties of every good. Rather, a country will only produce those varieties in which it is relatively more efficient. This implies that differences in observed productivity tend to be smaller than true differences in productivity as a result of a selection effect.

Combining standard data on industry-level trade flows and productivity, we find that countries do indeed tend to export goods where their relative productivity is higher, as this Ricardian model would predict. More precisely, a 1 percent change in relative productivity is associated with a 6.5 percent change in relative exports. There is also support for the notion that observed productivity differences are biased by Ricardian selection. We use our estimates to quantify the welfare impact of this Ricardian channel across sectors. Cross-industry differences in technologies generate only a small part of the gains from trade; comparative advantage operates mostly at the within-industry product level.

Ricardo's Difficult Identification Problem

"Ricardo's difficult idea," as Paul Krugman once referred to the theory of comparative advantage, contains at its core a fundamental barrier to empirical analysis. Ricardo's simple example involved a prediction about trade patterns as a function of four productivity numbers--England's and Portugal's productivity levels in cloth and wine. But how is an analyst to measure England's productivity in an activity, such as wine making, which it does not engage in because it can import wine from Portugal? …

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