Ricardian Comparative Advantage: Theory and Empirical Evidence

Introduction to the Ricardian Model

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

The Ricardian model also argues that a country performs better 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.

Unfortunately, as Golub and Hseih (2000) point out, the theory is almost entirely ignored in current applied usage, and given the difficulty of substantiating the Ricardian model empirically, few empirical studies exist to support it. This is also partly due to the fact that the model omits a great deal of detail. Nonetheless, its central ideas can be investigated, and some researchers have done precisely that.

Using an algorithmic formulation, the model argues that letting a_i represent unit labor requirements for sector b in country j:

Theoretical Framework and Labor Productivity

a_i = L_b / Q_jt

where Q = value added and L = labor employment.

The marginal products of labor — that is, the results of labor input — are assumed to be consistent with variations in labor and technology. All of these elements are closely intertwined.

The competitiveness of sector i in country j relative to another country also depends on that country's wage level and the bilateral exchange rate, which together determine the relative unit labor cost expressed in that country's specific currency.

Empirical Testing: Golub and Hseih (2000)

In 2000, Golub and Hseih used the OECD database to assess information about trade flows, unit productivity, and labor costs for approximately 40 manufacturing sectors from OECD regions — including Mexico and Korea — covering the years 1970 to 1992. In order to examine the 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 for a number of these countries vis-à-vis the United States.

As measures of trade flow, bilateral trade balances and export ratios were used as dependent variables. The independent variables were relative unit labor costs and relative productivity.

In order to deal with the problem of converting the output of all countries to a common currency, the researchers experimented with three alternative purchasing power parity (PPP) 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 correlated error terms across years — demonstrated that the Ricardian model could be applied to contemporary trading situations and still retained explanatory significance. This was particularly evident in the case of Japan, where relative productivity and unit labor costs were significantly associated with a strong proportion of bilateral U.S.–Japan trade.

The authors attributed the weaker effects observed in other countries to the inherent difficulty of converting the Ricardian model into an empirical study, as well as the likelihood of measurement error in the independent variables. Such measurement error may arise 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 short, the authors discovered "fairly strong [empirical] support" for the Ricardian model, despite the considerable difficulties in structuring international comparisons of productivity and labor compensation — though they found their PPP approach valuable. The authors concluded:

"In the vast majority of cases, relative productivity and unit labor cost help to explain U.S. bilateral trade patterns, 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 further concluded that "despite its extreme simplicity, the Ricardian model continues to perform surprisingly well empirically" (ibid.).

Conclusion

Although the Ricardian model is difficult to test and may be hampered by various limitations, a number of researchers have managed to provide empirical corroboration of the model. The Ricardian model argues that companies and countries achieve superior results and higher productivity levels through a combination of increased wages and greater technological and labor advantage. The model may be simplistic and classical in origin, but the evidence suggests it retains enduring explanatory power in the study of international trade.