Timeless economics

Still makes sense.. and we’ll always have Paris..

Ricardo’s Hit [Comparative Advantage] and Miss [Labor Theory of Value]

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(1772 - 1823)

David Ricardo was born in 1772 and was the 3rd of 17 children. He belonged to a family of Dutch Jews that migrated to England. He entered his father’s business at 14 years old, but eventually left the Jewish faith to become a Unitarian at 21 years old and married a Quaker.  Because he was disowned by his family, he became a stock broker on his own and in a few years, became richer than his Father.

At 27 years old, he came across Smith’s Wealth of Nations and became more interested in economics. His first published work was a letter to a newspaper on currency problems. James Mill, a good friend of his, urged him to produce more works (he didn’t like writing that much). In 1817, he came out with Principles of Political Economy and Taxation, which became his most famous work.

The Bullion Controversy

Ricardo was first noticed by economists over the “bullion controversy.” In 1809, he wrote that England’s inflation was brought about by the Bank of England’s propensity to issue excess banknotes, because it was no longer a requirement to pay in gold on demand. The remedy Ricardo called for was to return to the gold standard. Then if the price of gold in the market rose, every over-issue of bank notes would be cancelled automatically by the flow of paper back to the Bank. The restoration of the gold standard would then curb inflation.

Ricardo’s plan was adopted by Parliament in 1819, and the gold standard worked for over a century thereafter, except during major wars and financial crises.

Production to Distribution

Ricardo changed the emphasis of economic analysis from production to distribution. Adam Smith stated that the well-being of a nation depends on the total production and the number of people who must share it. In contrast, Ricardo’s Principles of Political Economy and Taxation raised as the key problem the division of the produce of the earth among three classes: land owners, capitalists, and laborers. He emphasized the division of income rather than the growth of income because of his pessimism.

Labor Theory of Value

Ricardo was concerned with relative values, not with absolute value. Utility, he said, is not the measure of exchangeable value, although it is absolutely essential to it. Possessing utility, commodities derive their exchangeable value from two sources: from their scarcity, and from the quantity of labor required to obtain them. Ricardo was unconditionally committed to his labor theory value. The exchange value of a commodity depends on the labor time necessary to produce it.

The simple form of labor theory of value would be logical (although not necessarily correct) under two conditions: if all industries had the same ratios of capital to labor, and if the capital investments in all industries had the same durability. As these conditions are hard to obtain, if not, non-existent, if all commodities sold at their value as measured by labor time, the consequences would be unequal rates of return in different industries.

Examine this situation then. A sports apparel company hires 100 workers to cut and sew 1,000 basketball shorts in a day. A communications company hires 100 workers to assemble 1,000 mobile phones a day. Both companies give the workers 8 hours a day to work on these products. If we apply Ricardo’s labor theory of value, then a basketball shorts’ value would be equal to that of a mobile phone’s value, which means that the selling price of these two different products should be equal as well. And we all know that in reality, this cannot be true.

The problem with Ricardo’s theory is it does not take into consideration the capital of the industries, the costs of raw materials and other factors that influence the price of the commodities (competition, brand, etc.) Labor cannot alone determine the value of a product, especially in this age where technology actually lessens the needed physical input from laborers.

Theory of Comparative Advantage

According to Ricardo, if one country is more efficient than another in producing all commodities, trade between the two nevertheless would be of mutual advantage. The more efficient country should export those commodities in which her comparative cost is lowest, and she should import those whose comparative cost is highest. This is the basis for Ricardo’s free trade policy for manufactured goods.

The theory of comparative advantage, as he described it, seems to be that both those rich in ability and the poor alike concentrate each their own analytical powers on meeting the needs and abilities of the richer, more skillful party to an otherwise unequal exchange and thereby both benefit. Ideas often extrapolated are: that both benefit equally; and that somehow in such exchange each nation, or person, is enabled to focus on its own area of real specialization in a bi-directional equal trade — but we only start with an idea of purely comparative specialization in one direction.

A modern example would be an exchange of commodities between the United States and the Philippines. For the sake of example, let’s momentarily consider nurses as ‘commodities’ and somehow equate them with mobile phones. The US of course, produces more mobile phones than nurses. The Philippines, on the other hand, produces more nurses than mobile phones. So if we consider these two commodities in a trade, comparative advantage comes in when the US trades more of their mobile phones  and less of nurses and the Philippines trades more nurses than mobile phones. This is because US, of course, is one of the leading countries in telecommunications technology, with multi-national corporations continuously advancing and improving the industry. Meanwhile, the Philippines produces quite a number of trained and qualified nurses more than willing to work in the United States. And since the ‘Filipino care’ is world-renowned, there’s actually a demand for more nurses.

In this way, both countries — the Philippines and the US — benefit from each other by exporting more of their strong commodities, and importing those products that are scarce in their own country. And these two countries found exactly that in their trade of nurses and mobile phones. They make use of their strengths and weaknesses to benefit each other. Comparative advantage.

This theory by Ricardo became one of the foundations of global trade as we know it today.

Oh, and for those of you who would like to read the original text, Ricardo’s Principles of Political Economy and Taxation can be found online. =)

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Written by zequeenbee

May 15, 2010 at 4:00 PM

Posted in Uncategorized

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