There is no body of economic theory that has achieved greater professional acceptance than David Ricardo's theory of comparative advantage and the modern emendations of Ricardo's "law." Criticisms of comparative advantage and its extensions from a theoretical perspective have not resulted in any substantial weakening of the overall strength of this body of theory nor of its corollary, a free trade regime.
Certain special-case exceptions to the law of comparative advantage have been demonstrated. Jagdish Bhagwati showed that under unrestricted free trade "immiserizing growth" could occur [Bhagwati 1958]. More recently, the "new" trade theorists have focused on the policy implications of trade under conditions of increasing returns and imperfect competition, arguing that under such conditions violations of free trade policy could be optimal.(1)
Our purpose is not to revisit these issues. Rather, we intend to reconsider the theory of comparative advantage from a more dynamic perspective than is found in the literature. We believe it is possible to demonstrate that the basic Ricardian theory of comparative advantage, including its extensions, is too static a theory on which to rest a first-best argument in favor of free trade in quite a number of realistic scenarios. Especially for poor, less-developed nations, we show that the generalized argument in favor of free trade policy derived from trade theory cannot be sustained once one takes the long-term historical trend of the terms of trade into consideration. When comparative advantage is understood as a dynamic concept and process, violations of free trade may be desirable, necessary, and, perhaps most controversially, first-best for some nations.(2)
The Traditional Theory of Comparative Advantage
The theory of comparative advantage, of course, argues that unrestricted exchange between countries will increase the total amount of world output if each country tends to specialize in those goods that it can produce at a relatively lower cost compared to potential trading partners. Each country then will trade some of those lower-cost goods with other nations for goods that can be produced elsewhere more cheaply than at home. At the end of the day, with free trade among nations, all countries will find that their consumption possibilities lie outside their domestic production possibilities.
The basic theory assumes that all the factors of production are immobile and that both (all) countries have the capacity to produce both (or all) goods. Any imports are perfectly balanced by an equivalent-valued export flow; thus, neither country incurs a trade deficit, which must he financed. Further, it is assumed that perfect competition, and not monopoly production, prevails and that all resources in each country are fully employed. The last is an especially important assumption, particularly for less-developed nations, since with less-than-fully employed resources, tariffs or other forms of protection (including subsidies) to block imports and to increase domestic employment could well be the preferred policy. With less-than-fully employed resources, the key allocative issue becomes an internal mobilization of domestic resources to their full use, rather than a reallocation among alternative uses. To be reasonably confident in applying the basic Ricardian analysis and its conclusions to any country or situation, it seems sensible, in practice, to inquire to what degree the assumptions of the theory conform to the reality of the economy under investigation.(3)
While these are important considerations having to do with the validity of assumptions in practice, there are other concerns about a blanket endorsement of the comparative advantage argument and free trade recommendations for less-developed nations. Joan Robinson's comment on the real-time effect of following free trade and specialization, at least as far as Portugal was concerned in Ricardo's original example, remains provocative and presages our reformulation.
. . the imposition of free trade on Portugal killed off a promising textile industry and left her with a slow-growing export market for wine, while for England, exports of cotton cloth led to accumulation, mechanisation and the whole spiraling growth of the industrial revolution [Robinson 1978, 103].
This passage provides us with a valuable historical and dynamic hint about the impact of pursuing comparative advantage. It may not be specialization per se that is so important for a country's future as is the choice of what to specialize in. The production of some goods may be more likely to have expanding world demand in the future, as England did with cloth production at the time Ricardo formulated his example. Some types of production may be more likely to benefit from the application of science and technology over time. And, what is the impact of the trend of the terms of trade for a country on the gains from specialization? It is this more dynamic approach to the theory of comparative advantage and to the nature of the ensuing path dependence that accompanies decisions to produce particular goods or services for the world market that forms the basis of our argument.
Multi-Period Comparative Advantage and Declining Terms of Trade
Our argument can be summarized...