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Lecture 2: Testing comparative advantage

x David Ricardo (1817) discovered the principle of comparative advantage.


x Gottfried Haberler (1930) reformulated the theory of comparative advantage and provided its modern
opportunity cost formulation.
x Alan Deardorff (1980) provided the modern general equilibrium formulation.

Revisiting Ricardo’s original formulation:

“The quantity of wine which she [Portugal] shall give in exchange for the cloth of England, is not determined by the
respective quantities of labour devoted to the production of each, as it would be, if both commodities were manufactured in
England, or both in Portugal.
England may be so circumstanced, that to produce the cloth may require the labour of 100 men 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.
To produce the wine in Portugal, might require only the labour of 80 men for one year, and to produce the cloth in the
same country, might require the labour of 90 men for the same time, It would therefore be advantageous for her to export
wine in exchange for cloth.”

Ricardo’s modelling framework:


- 2 commodities: cloth and wine,
- 1 factor of production: labour,
- fixed labour unit coefficients in each country: acE,awE,acP,awP
- cloth and wine are exchanged on an international market,
- but commodities are valued by the labour embodied in them.

Ricardo’s logic (following Ruffin (2002) and Maneschi (2004))

- Denoting with Tc the trade of cloth and Tw the trade of wine, Ricardo assumed that Tc units of cloth are
exchanged for Tw units of wine at the international market.
=> the terms of international trade is then given by Tc/Tw .

-Since commodities are valued by the labour embodied in them, England faces a ‘labour exchange rate’ of
acETc/awETw embodied in its commodity trade. This is the labour terms of trade line depicted in Figure 1.
England will only be willing to engage in trade if it obtains gains.

Similarly, Portugal faces a ‘labour exchange rate’ of acPTc/awPTw and will only trade if it gains from such
trade.

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- There are two possibilities about the direction of international trade
(i) Tc>0, Tw<0, import cloth and export wine (vector T2 in Figure 1) or
(ii) Tc<0, Tw>0, export cloth and import wine (vector T1 in Figure 2)
- Ricardo’s four numbers pertain to 100=TcacE, 120=TwawE, 80=TwawP, 90=TcacP.
(T1=(-100, 120) and T2=(100, -120) in Figure 1).

Figure 1: Ricardo’s labour content formulation for England (Bernhofen, 2009):


Lwimp
0
45 Labour
terms of
120 trade line
gain of 20 T1
100

100 120 Lcimp


Lcexp -100

loss of 20
T2
-120

Lwexp
- A country will incur gains from international trade if the labour it receives from its imports is larger than
the labour it has to give up through its exports (imports=benefits, exports=costs).

-If England imports cloth and exports wine, its net benefit is TcacE-TwawE=100-120<0;
-If it imports wine and exports cloth, its net benefit is TwawE-TcacE=120-100>0.
=> England will import wine and export cloth because this generates a gain of 20 labour units..

Similarly, Portugal will import cloth and export wine since TcacP-TwawP=90-80>0.

Ricardo established a direct link between the pattern of international trade and the gains from international
trade.

Modern 2-good formulation of comparative advantage

Assumptions:
- we assume there are two regimes: autarky and free international trade.
- 2 goods are produced under constant returns to scale.
- autarky: state of isolation, the economy can consume only what it produces.
- autarky prices: the country’s equilibrium prices in isolation are p1a,p2a.
- free international trade: the economy is part of an international trading system and
has the option to trade with other trading partners.
- small country assumption: the country has no effect on the international prices.
- terms of trade: equilibrium prices under free trade are p1f,p2f.

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- Budget constraint/Balanced trade condition: If the country decides to engage in international trade, it
must be at the terms dictated by the world market:

p1fT1+p2fT2=0 (1)

or p1f(C1-X1)+p2f(C2-X2)=0

Equation (1) is an implication of the small country assumption. If Ti>0, good i is imported (i.e. C1>X1) and
if Ti<0 (i.e.C1<X1), it is exported.

Equality (1) implies that there are two possible trade configurations:
(i) good 1 is exported (T1<0) and good 2 is imported (T2>0)
(ii) good 1 is imported (T1>0) and good 2 is exported (T2<0),

Opportunity cost formulation of comparative advantage: The country will export the good in which it has a
lower opportunity cost

x If p1a/p2a < p1f/p2f, then T1<0 and T2>0, (2)


x If p1a/p2a > p1f/p2f, then T1>0 and T2<0,

Figure 2: (p1a/p2a < p1f/p2f => good 1 is exported (T1<0) and good 2 is imported (T2>0)

Ca is the economy’s consumption point in autarky, which will coincide with its production point Xa.
Through international trade, the economy can obtain a consumption point Cf that differs from its production
point Xf.
p1f/p2f
good 2
C2 Cf
a a
p1 /p2
Ca=Xa

T2

T1 Xf
X2

good 1
C2 X1

The comparative advantage slope prediction (2) can be captured more compactly in a single inequality:

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p1aT1+p2aT2>0 (3)

Proof:
The equivalence between (2) and (3) follows directly from rewriting the balance of trade condition (1) such
that -(T2/T1)= p1f/p2f.

The general formulation of the law of comparative advantage (Deardorff, 1980)

The 2-good formulation of the comparative advantage prediction can be generalized to n goods under very
general conditions.

Notation:

pi : n-vector of commodity prices.


pa denotes the economy’s equilibrium price vector in autarky
pf denotes the economy’s equilibrium price under trade
i
X : n-vector of production
Xa denotes the economy’s equilibrium production vector in autarky
Xf denotes the economy’s equilibrium production vector under trade
i
C : n-vector of consumption
Cf denotes the economy’s equilibrium consumption point under trade

(in autarky Xa=Ca).


T: n-vector of net imports
T=Cf-Xf; T is also called the economy’s net import vector.
If Ti>0, good i is imported; if Ti<0 it is exported.

Key behavioural assumptions of the model:

1) Competitive producers maximize the value of production on a convex technology set F:


piXi  piX for all production points X in F. (A1)

2) Aggregate consumption conforms to the weak axiom of revealed preference:

p1C1 p1C2 => p2C1>p2C2. (A2)

(Note: C1 and C2 are the revealed choices under the price regimes p1,p2, respectively).

The weak axiom of revealed preference says: if C1 was chosen over C2, although C2 was affordable at p1 (i.e.
C1 is revealed preferred to C2), then C1 must have been more expensive than C2 at p1.

3) Balanced trade condition: pfT=0. (A3)

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Theorem of comparative advantage (Deardorff, 1980, 1994)

If (A1)-(A3) => paT>0. (4)

Proof: (A1) and (A3) => pfCf=pfXf pfXa=pfCa. From (A2), we get paCf>paCa=paXa. Since (A1)
implies paXa paXf , we finally obtain paCf>paXf ,or paT>0.

Figure 3: The general n-good prediction of comparative advantage


f imports
p T=0
of good 2
paT=0
paT>0 T1
advantage relative to autarky

imports
A of good 1
exports
of good 1 disadvantage relative to autarky

T2

paT<0
exports
of good 2

Comments:

(i) The balanced of trade condition requires the economy’s trading vector T to lie on the ‘terms of trade hyperplane’ pfT=0. As in the 2-
good case, the pattern of international trade is dictated by the gains from trade. The comparative advantage prediction paT>0, can be
interpreted as cutting the terms of trade hyperplane into half. The theory predicts that one should not observe trading vectors that lie
in the shaded area, i.e. paT<0.
(ii) A comparison between Figure 1 and Figure 3 reveals the amazing similarities behind Ricardo’s analytical framework and the modern
general equilibrium formulation. The similarities are two-fold. First, both rely on the gains from trade criteria to impose a restriction
(or prohibition) on the set of observable outcomes. Second, both are similar in a Popperian predictive sense. Consider Popper’s
famous predictability statement: “Every good scientific theory is a prohibition; it forbids certain things to happen. The more a theory
forbids, the better it is”. Since both formulations predict that half of the permissible trading configurations violate the gains from
trade criteria both theories “forbid the same amount”.
(iii) The above “non-traditional” discussion was developed to prepare the ground for the empirical testing of the theory. Deardorff’s
(1980) original formulation was much richer and was building on the long theoretical literature on comparative advantage which was
aiming to extend the law to the case of more than two sectors.
(iv) Deardorff’s (1980) inequality paT>0 is often called the correlation version of comparative advantage. The inequality is often
interpreted to say that a country will, on average, exports the goods with low autarky price and imports the goods with high autarky
prices. This stems from the fact that (after some normalization), paT>0 can be shown to imply cor(pa-pf, T)>0 (Deardorff, 1980, p.
951), i.e. there is a positive correlation between autarky-free trade price differences and net imports.
(v) In his classical article Deardorff (1980) has shown that the law is robust to the incorporation of trade costs or government imposed
barriers to international trade, as long as export subsidies are ruled out (where the latter must only be ruled out in an average sense).
In an extension Deardorff (1994) shows that this law does also hold under unbalanced trade (if one assumes homothetic preferences),
production distortions and regional differences within a country (i.e. “lumpiness” within a country).
(vi) A key lesson of the theory of comparative advantage is that if n>2, it is not possible to pinpoint in which specific sector a country has
a comparative advantage or disadvantage. This has important implications for the policy making community since policy makers
often ask economists where they think the country has a comparative advantage. The theory implies that if there are more than two
sectors, the fact that a specific good is exported/imported can not be linked to underlying comparative advantage fundamentals. The
appropriate answer is that the market will figure it out, if we allow the market to reign.

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(vii) The autarky price formulation of comparative advantage is the most general way to state the law of comparative advantage. The key
point to recognize is that in a market economy autarky prices embody all the relevant information about economic fundamentals like
technologies, endowments or tastes. In contrast, the Ricardian and the Heckscher-Ohlin models focus on specific fundamentals like
technological differences (Ricardian framework) or endowment differences (Heckscher-Ohlin framework) that are thought of
“driving” international specialization.

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A formal characterization of the comparative advantage gains from trade

The inner product paT embodies information about the gains from trade. More formally, the gains from
international trade can be captured by the Slutsky compensation measure of a welfare change. The Slutsky
compensation measure asks the following question: What income is necessary to move from the autarky
consumption point Ca to the free trade consumption point Cf, assuming that prices remain at the autarky
level pa? Formally, this can be written as

WSlutsky = paCf-paCa. (5)

The first part of the proof of the law of comparative advantage has already established that paCf>paCa.
Positive gains from trade are a sufficient condition for the pattern of trade prediction. But we can also show
that paT provides an upper bound for the gains from trade:
WSlutsky= paCf-paCa = pa(Cf-Xf)+pa(Xf-Ca)
= paT-pa(Xa-Xf)
 paT. (6)

The latter inequality results from (A1), since paXa paXf. The inner product paT will be an exact measure of
the gains from trade for constant opportunity costs of production (i.e. paXa=paXf). Figure 4 illustrates the
relationship (6) in the two good case.

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Measuring real income in terms of units of good 1, WSlutsky is given by the line segment ST. Also
measured in units of good 1, the CA index is T1+(p2/p1)T2, which corresponds to XfT=OT-OXf in the graph.
But XfT exceeds ST by XfS. In the case of a linear production possibility frontier, Xf will coincide with S.

Figure 4: (Bernhofen & Brown (2005), Figure 1) Note Xa=Ca

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Testing the theory of comparative advantage: the natural experiment of Japan

Recall from Samuelson’s foundations (1947, p.5):

“...under ideal circumstances an experiment could be devised whereby one could refute the
hypothesis”.

Ö Japan’s 19th century opening up provided us with the ideal circumstances of a natural experiment.
POWER POINT SLIDES ON JAPAN

Motivation: Japan’s opening up to world commerce in 1853 after over 200 years of self-imposed autarky
provides an unusual opportunity to empirically investigate the theory of comparative advantage. Japan’s
trade liberalization experience is unique in several ways:

(i) Japan’s domestic production environment before and shortly after its trade liberalization was similar (i.e.
its production possibility set remained relatively unchanged).
(ii) While operating under autarky, the Japanese economy was predominantly a market economy. By
contrast, virtually all other countries that opened up to international trade in the past (i.e. Latin America in

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the 1980s, Eastern Europe in the 1990s), were not market oriented before opening up. Hence, domestic
market reform often coincided with external trade liberalization, which makes it difficult to disentangle their
relative effects (i.e. what is caused by domestic market reform and what by trade liberalization). Japan is a
notable exception since it didn’t experience significant domestic reforms in the early trade liberalization
period, i.e. during 1868-1875.
(iii) Given that Japan produced relatively homogeneous products in small scale production units, other
explanations for international trade –like increasing returns to scale and imperfect competition- can be ruled
out as accounting for Japan’s pattern of trade.

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A test of the pattern of trade prediction of comparative advantage:

The attractiveness of the comparative advantage prediction (4) stems from its refutability. The null and
the alternative hypothesis can then be stated as follows:

H0: Pr(paT>0)=1; H1: paT is random and Pr(paT>0)=1/2 (7)

where Pr(.) denotes the probability measure. A great virtue of the opportunity cost formulation of
comparative advantage is not only that it leaves us with an alternative hypothesis, CHANCE (i.e. paT is just
random), but also with a probability statement about that randomness. If all outcomes are equally likely, the
likelihood of getting a positive sign is exactly 0.5.

Figure 6. (Figure 1 in Bernhofen (2005)) Counterfactual interpretation of the pattern of trade prediction)

Empirical challenge: How can we apply a static theory to a dynamic world?

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good 2
Cf1870s
pa1870
Ca1870s

pa1850s
T2
Ca1850s

Pf1870s
T1
pf1870s

good 1
PPF1850s PPF1870s

Theory requires information about pa1870s, which is not observable. Under what conditions can we substitute
the observed pa1850s for the unobserved pa1870s?

Identification condition: (pa1850s- pa1870s )T0, (8)

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(8) requires that the slope of pa1870s has not become larger than pa1850s. Assuming unchanging preferences,
this condition can be interpreted that the economy’s growth path from PPF1850s to PPF1870s was either
balanced or biased towards its exportable.
In the n-good case (8) says that the economy experienced, on average, a growth path which was either
balanced or biased towards the export goods.

The Composition of Japanese Trade, 1868-1875 (Table 1 in Bernhofen & Brown (2004))

Product Percent of Imports Percent of Exports


Agricultural: Non-Food
Silk 35.9
Silkworm Eggs 15.7
Other (Vegetable Wax and Cotton) 2.2 2.7
Agricultural: Food
Tea 28.2
Rice 10.8
Sugar 9.9

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Other Foods 4.2 8.2
Other Raw Materials
Fuel (Coal and Charcoal) 1.9
Other 3.1 2.9

Textiles 0.2
Cotton Yarn 15.1
Cotton Cloth 18.4
Woollens 19.2
Other textiles 1.8
Other manufactures 4.3
Weapons and ammunition 2.7
Machinery and instruments 1.4
Miscellaneous manufactures 11.2
Notes: The trade shares of each commodity group are based upon total imports and exports for the period 1868-1875.

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Empirical evidence: Table 2 from Bernhofen and Brown (2004)

The Approximate Inner Product in Various Test Years


(in million Ry)

Components Year of Net Import Vector


1868 1869 1870 1871 1872 1873 1874 1875
(1) Imports with
observed 2.24 4.12 8.44 7.00 5.75 5.88 7.15 7.98
autarky prices
(2) Imports of
0.98 0.82 1.29 1.56 2.16 2.50 1.56 2.33
woollen goods
(3) Imports with
approximated
1.10 0.95 0.70 0.85 1.51 2.08 1.60 2.65
autarky prices
(Shinbo index)
(4) Exports with
observed -4.07 -3.40 -4.04 -5.16 -4.99 -4.08 -5.08 -4.80
autarky prices
(5) Exports with
approximated
-0.09 -0.03 -0.07 -0.07 -0.15 -0.07 -0.11 -0.10
autarky prices
(Shinbo index)
Total inner
product (sum 0.18 2.47 6.31 4.17 4.28 6.31 5.11 8.06
of ((1)-(5))

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Notes: All values are expressed in terms of millions of ry. The ry equaled about $1 in 1873 and was equivalent to the yen when it was
~
introduced in 1871. The estimates are of the approximation of the inner product ( ~
p1aT ) valued at autarky prices prevailing in 1851-1853. For an
explanation of the assumptions underlying the approximation, please see the text.
Source: For sources of price data, see footnotes 18 and 21. For numbers (3) and (5), current silver yen values are converted to values of 1851-
1853 by deflating them with the price indices for exports and imports found in Shinbo (1978, Table 5-10).

Summary:

The fact that each of the 8 inner products had a positive sign provides a strong empirical case for the
prediction of the theory. The alternative CHANCE, i.e. H1:Pr(paT>0)=1/2, can be rejected with the
likelihood of 99.6%.

An empirical assessment of the comparative advantage gains from trade

We consider now the empirical implementation of (6), which leads to the following counterfactual:

“By how much would real income have had to increase in Japan during its final autarky years of 1851-1853
to afford the consumption bundle the economy could have obtained if it were engaged in international trade
during that period?

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Figure 7: (Figure 2 in Bernhofen (2005)): The counterfactual gains from trade)

good 2

Cf1870s

Cf1850s
pa1850s

Ca1850s
WSlutsky
Pf1870s
Pa1850s

good 1
PPF1850s PPF1870s

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Alternative Estimates of the Gains from Trade for the Autarky Years of 1851- 1853 as a Percentage of
GDP (Table 4 in Bernhofen and Brown (2005))

Assumed annual growth rate of GDP per


Method and Period capita
0.15% 0.4% 1.5% 2.0%
Using the “backcast”
5.4 5.8 7.8 9.0
estimates of GDP
Using the “forecast”
9.1 8.9 7.8 7.3
estimates of GDP
Summary: The counterfactual gains from trade were between 6 and 9% of Japan’s GDP at the time.

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References:

Bernhofen, D.M. and J.C. Brown, 2004. “A direct test of the theory of comparative advantage: the case of
Japan”. Journal of Political Economy 112(1), 48-67.
Bernhofen, D.M., Brown J.C., 2005. “An empirical assessment of the comparative advantage gains from
trade: evidence from Japan”. American Economic Review 95(1), 208-225.
Bernhofen, D. M. 2005, “The empirics of comparative advantage: overcoming the tyranny of
nonrefutability”, Review of International Economics 13(5), 1017-1023,
Bernhofen, D. M. 2009. “On predictability in the neoclassical trade model: a synthesis”, forthcoming in
Economic Theory.
Deardorff, A.V, 1980. “The general validity of the law of comparative advantage”. Journal of Political
Economy 88, 941-57.
Deardorff, Alan, 1994, "Exploring the Limits of Comparative Advantage", Weltwirtschaftliches Archiv
130:1-19.
Maneschi, Andrea, 2004. The true meaning of David Ricardo’s four numbers. Journal of International
Economics 62, 433-443.
Ruffin, R.J., 2002. David Ricardo’s discovery of comparative advantage. History of Political Economy 34,
727-748.

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