Economists do it with models International Trade Debate II


Honda model, Malaysia, 2008: Photo by Nguyễn Thành Lam

I hope readers liked my story in the blog post - International Trade Debate I. The story of castaways Eva and Ricardo illustrated the point made by an economist, David Ricardo, over 200 years ago. Ricardo argued that trade among nations lifts the well being of all the nations involved in the trading. The argument is really an extension of Adam Smith's idea (Adam Smith of Invisible hand fame) propounded almost 40 years before Ricardo, that when we don't try to do everything for ourselves but instead specialize, and trade with others for things they specialize in, then both sides of the trade are usually better off. It doesn't mean that trade will change the relative income position of the two sides in the trade. For example, note that in my story, Eva was always more productive and therefore better off than was her fellow castaway Ricardo. She was "richer" shall we say than Ricardo, both before and after the trade. But Eva, and Ricardo were both better off after the trade as compared to before the trade.

That idea of Ricardo's, which economists now call comparative advantage, - some even call it the law of comparative advantage - is at the core of why a large majority of professional economists support and favor free trade among nations. That's not the end of the story, of course. Economists have developed more knowledge, propositions and insights into International trade theory since David Ricardo was doing his economics.

I will try to cover some of these modern developments in subsequent blog posts. My view is that the modern developments in trade theory provide texture and realism and better understanding of trade among nations, but they don't wipe out David Ricardo's insight, nor do they overturn the general argument that international trade is a good thing in the world economy, and for each of the nations engaged in that trade.

But in this blog post I want to use my made up story of the castaways Eva and Ricardo as an illustration of what it is that professional economists are trained to do. Think of how I used that story. I used it as a way of taking a complicated real world question. That question simply stated is " Is it better for a nation to close its borders to foreign products and produce everything it consumes within its own country, especially when it is more productive than any of its neighbor countries? Remember in my story, Eva was more productive in both fishing and baking than was her fellow castaway, Ricardo.

The answer to the question is not intuitively obvious. In fact, at first blush, many would answer with something like, "Well if one country is so productive that it can produce everything more efficiently than another, then there is no advantage to it in trading with other countries." A country that can produce everything more efficiently than another (probably a rare case indeed) is said to have an absolute advantage in all production. In fact, Adam Smith, the economist of 1776 fame, answered it that way. Well Ricardo, the economist, not the castaway, showed with his comparative advantage idea that even when a country has an absolute advantage in everything, it still profits from trade in products for which it does not have a comparative advantage.

If one were to delve into Ricardo the economist's idea a little further one would see that while it is possible that a country can have an absolute advantage in producing everything, it cannot have a comparative advantage in producing everything. So trade between countries is most always beneficial. And if you are really curious and you want to think about it further, you will note that it is possible, though unlikely, that two countries could have identical comparative advantages in everything. In that rare hypothetical case there would be no possible way that either could gain by trading with the other.

But I'm getting off track here. What I want to note is how Ricardo the economist went about his reasoning. He took a complicated real world situation (the world was complicated even in 1817) and developed a simpler scenario - two goods and two countries that faced different trade offs between the two goods within their own country when producing a little more of one of the goods in order to get a little more of the other (He used England and Portugal and wine and cloth in his scenario). Then he worked through this hypothetical scenario with some arithmetic to come to his conclusion that even when one country can produce both goods at less costs than another it can still make itself better off by specializing in the production of the good in which it has a comparative advantage, and trading with the less productive country. That is what economist call model building, or modeling. The real world is complicated and complex. To see through this complexity Ricardo hypothesized a simpler scenario, a model, and worked with that to come to some conclusions.

A lot has happened in the development of economics since 1817. Indeed there has been much progress. Economists know a lot more about how the economy works and mathematics has increasingly infused the profession, so many of the models that economists work with are expressed in mathematical equations. But the way economists work to find answers to difficult issues is basically the same as David Ricardo worked in the 1817. They use models to simplify, and that include basic assumptions and leave out complications, and then work with, and within, those models to come to some conclusions and hypotheses about the real world.

Some of the models used by modern economists have themselves become very complicated and highly mathematical, but hopefully less complicated than the highly complicated and complex real world economies and markets that they are trying to analyze. In fact, as you might expect, Ricardo's simple two country, two good model has been extended to include multi-goods and multi- countries using mathematics. Trust me, you wouldn't want to go through the mathematics, unless of course you have taken a lot of math courses, and have the time and patience and curiosity.

Whenever there is a significant model developed in the economics profession it is followed by dialogue among economists about the model, it's conclusions and hypotheses. And when possible there is testing of hypotheses with real world data to see if there is evidence that supports the hypotheses. There is often, very often, real arguments and debate among economists, real give and take, usually in the professional economic journals, but often in the media as well. Sometimes it gets very heated. It can be fun for us economists. Confusing perhaps for non-economists.

Many of the things you hear about in economics - perfect competition, monopoly, demand and supply, aggregate demand and deficient aggregate demand, the advantages of markets over government in certain market, but where government may have an advantage in some, public goods versus private goods, effects of government spending in recessions, and at full employment - are concepts developed from models. What economists have to guard against is to not confuse their models with the real world. Not to invest ideological fervor into the models, but to use them solely as the tools of analysis that they are. It is real world evidence that matters, and that is often difficult to come by.

So economists do it with models. There is even a blogging website called economistsdoitwithmodels.com (wish I had thought of that first). Jodi Beggs is the professional economist and creator of the site. I love her logo. She sells T-shirts imprinted with the logo. I think I'll buy a couple.

References:

Economists do it with models http://www.economistsdoitwithmodels.com/

On the possibility that two countries can have identical comparative advantages leading to trade not being advantageous. This reference also includes a list of criticisms or caveats

http://www.economicsonline.co.uk/Global_economics/Comparative_advantage.html

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