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• Preface
• Studies In the Theory of International Trade
• Chapter I: English Theories of Foreign Trade, Before Adam Smith: I
• I. Introduction
• II. “ Mercantilism” and “bullionism”
• III. the Balance-of-trade Doctrine
• IV. Reasons For Wanting More Bullion
• V. Employment and the Balance of Trade
• Chapter II: English Theories of Foreign Trade, Before Adam Smith: Ii
• I. Legislative Proposals of Mercantilists
• II. the Collapse of Mercantilist Doctrine
• III. Some Modern Interpretations of English Mercantilism
• Chapter III: The Bullionist Controversies: I. The Inflation Phase
• I. the Participants In the Controversy
• II. the Factual Background
• III. Premium On Bullion As Evidence of Excess Issue: the Bullionist Position
• IV. Qualifications Conceded By the Bullionists
• V. Possible Objections to the Bullionist Position
• VI. the Anti-bullionist Position
• VII. the Balance of Payments Argument
• VIII. the Possibility of Excess Issue By Banks
• IX. Responsibility For the Excess Issue: Bank of England Vs. Country Banks
• X. Responsibility For Excess Issue: the Credit Policy of the Bank of England
• Chapter IV: The Bullionist Controversies: II. The Deflation Phase
• I. the Resumption of Cash Payments
• II. Responsibility of Resumption For the Fall In Prices
• III. the Economic Effect of Changing Price Levels
• IV. Ricardo's Position On the Gold Standard
• V. Reform Without Departure From the Metallic Standard
• VI. Paper Standard Currencies
• Chapter V: English Currency Controversies, 1825–1865
• I. Introduction
• II. the “currency School” -“banking School” Controversy
• III. the “palmer Rule ”
• IV. the Bank Act of 1844
• V. the Possibility of Overissue of Convertible Bank Notes
• VI. the Role of Deposits, Bills of Exchange, and “credit” In the Currency System
• VII. the Technique of Credit Control
• VIII. the Relation Between Bank of England Operations and Specie Movements
• IX. Currency Reform Proposals
• Chapter VI: The International Mechanism Under a Simple Specie Currency
• I. Introductory
• II. the Mechanism According to Hume
• III. an Omitted Factor? Relative Changes In Demand As an Equilibrating Force
• IV. Prices In the Mechanism: the Concept of “price Levels ”
• V. the “terms-of-trade” Concept
• VI. the Prices of “domestic” Commodities
• VII. the Mechanism of Transfer of Unilateral Payments In Some Recent Literature
• VIII. a Graphical Examination of Pigou's Analysis 1
• IX. Some Elaborations On the Basis of Pigou's Analysis
• X. an Alternative Solution
• XI. Types of Disturbance In International Equilibrium
• XII. Specie Movements and Velocity of Money
• XIII. Commodity Flows and Relative Price Levels
• XIV. Exchange Rates
• XV. A Criticism of the Purchasing-power Parity Theory 1
• Chapter VII: The International Mechanism In Relation to Modern Banking Processes
• I. Automatic Vs. Managed Currencies
• II. Primary and Secondary Expansion of Means of Payments
• III. Short-term Loans In the International Mechanism
• IV. Primary and Secondary Expansion In Canada , 1900–13
• V. the International Mechanism and Business Cycles
• Chapter VIII: Gains From Trade: the Doctrine of Comparative Costs
• I. the Nature and Origin of the Doctrine
• II. the Division of the Gain From Trade
• III. Trade In More Than Two Commodities
• IV. Trade Between More Than Two Countries
• V. Transportation Costs
• VI. Increasing and Decreasing Costs
• VII. Prices, Money Costs, and Real Costs
• VIII. Dependence of Comparative Cost Doctrine On a Real-cost Theory of Value
• IX. Differences In Wage Rates In Different Occupations
• X. Variable Proportions of the Factors and International Specialization
• XI. Variable Proportions of the Factor and Comparative Real Costs
• XII. “ Opportunity Cost” Analysis As a Substitute For Real Cost Analysis
• Chapter IX: Gains From Trade: the Maximization of Real Income
• I. “ Mass of Commodities” and “sum of Enjoyments”: Ricardo and Malthus
• II. Reciprocal Demand and the Terms of Trade
• III. Terms of Trade and the Amount of Gain From Trade
• IV. “ Net Benefit” In International Trade: Marshall
• V. Total Net Utility Derived From International Trade: Edgeworth
• VI. the Gain From Trade Measured In Money
• Appendix: a Note On the Scope and Method of the Theory of International Trade

II. The Division of the Gain from Trade

An Alleged Error in Ricardo. —Ricardo has been charged with claiming, on the one hand, that all the gain from trade goes to one of the countries1 and, on the other hand, that all the gain goes to each country,2 instead of finding it to be divided between the two countries.

The data given in Ricardo's arithmetical illustration are as follows:

In order that all the benefit from trade should go to England, English cloth must exchange for Portuguese wine in the ratio of I unit cloth for 9/8 unit wine. In order that all the benefit should go to Portugal, English cloth must exchange for Portuguese wine in the ratio of i unit cloth for 5/6 unit wine. But Ricardo states that English cloth will exchange for Portuguese wine in the ratio of I cloth for I wine: “Thus England would give the produce of the labor of 100 men [= 1 cloth] for the produce of the labor of 80 [= 1 wine].” 3 At this ratio, the gain would be divided approximately evenly between the two countries. Ricardo, therefore, was guilty of neither error attributed to him.

James Mill, in the first edition of his Elements of political economy, did commit the error of attributing all the gain to each of the countries, but he corrected it in the third edition, 1826.4 Einaudi at one time attributed the error to Ricardo as well as to James Mill, and on the strength of a suggestion of Torrens's raised the question whether it was not James Pennington who first perceived and corrected the error.5 Sraffa,6 in reply, pointed out that Ricardo had not been guilty of the error, and that J. S. Mill, in his Autobiography,7 had stated that his father made the corrections in the 1826 edition of his Elements as the result of criticisms made by himself and by George Graham in 1825.

Another co-worker of J. S. Mill's, William Ellis,8 early in the same year, 1825, had presented an arithmetical illlustration similar to those used by James Mill, and had concluded therefrom that the gain would be equally divided between the two countries. It seems, therefore, that the error was detected about the same time by several members of the group associated with James Mill.

Relation of Comparative Costs to the Terms of Trade.—In Ricardo's illustration, the two commodities exchange for each other under trade in a ratio almost exactly halfway between their comparative cost ratios in the two countries.9 Ricardo does not indicate whether he regards this precise ratio as required by the conditions of the problem as he had stated them, or how the actual ratio would in practice be determined. Ellis in 1825 and James Mill in 1826 also stated that the gains from trade would be equally divided between the two countries. McCulloch presented the doctrine of comparative costs in terms of an arithmetical illustration under which the ratio of gain was equal for both countries.10 It is doubtful whether these writers attached any special significance to these arbitrary11 terms of trade, since in the early writings of the classical school, and especially in the works of Longfield and Torrens, recognition can be found of the fact that the location of the equilibrium terms of trade was variable and depended on the relative strength of the demand of the two countries for each other's products. Pennington, however, seems to have been the first explicitly to point out in print that the comparative costs set maximum and minimum rates for the terms of trade, and that within these limits the operation of reciprocal demand could fix the terms of trade at any point.12

Torrens had long been insisting vigorously that the terms of trade were determined by reciprocal demand, and his emphasis on this in connection with the tariff controversy in the 1840's13 had aroused considerable opposition on the part of economists who found Torrens's application of it as an argument against unilateral reduction of tariffs distasteful. The interest aroused by Torrens's discussion led J. S. Mill to publish in 1844 some essays written in 1829 and 1830, of which one dealt with the same problem. It was from his exposition in the Essays,14 repeated and developed later in the Principles,15 and not from Longfield, Torrens, or Pennington, that later economists took over the doctrine. No country would give in exchange for a unit of a foreign commodity A more units of a commodity B than it could produce at a real cost equal to that at which a unit of A could be produced at home. The comparative costs set the limits, therefore, within which the two commodities could exchange for each other, but the actual ratio is set by the reciprocal demand of the two countries for each other's products. The greater the demand for B in terms of A in the country with a comparative advantage in the production of A, the closer, other things being equal, would the rate of exchange of A for B approach to their relative costs of production in that country. The greater the demand for A in terms of B in the country with a comparative advantage in the production of B, the closer, other things being equal, would the rate of exchange of A for B approach to their relative costs of production in this other country. Under equilibrium conditions, however, the value of the exports must equal the value of the imports. Of the possible ratios of exchange between A and B, that one would be the actual ratio which made it possible to meet this condition, i.e., that ratio at which the quantity of A offered by one country would equal the quantity of A which the other country would be willing to take.

Trade at One of the Limiting Ratios.—Nicholson later pointed out, with the aid of a series of arithmetical illustrations, that if there were only two countries and two commodities, and if the relative magnitudes of the two countries were not the same, the terms of trade would probably settle at or near the comparative costs of the larger country, i.e., the smaller country would get all or nearly all the gain from trade. He suggested that the omission of consideration of the relative size of the two countries had resulted in some measure of confusion in J. S. Mill's analysis.16 Graham has more recently repeated this argument, although without reference to Nicholson. Graham has carried the argument further by pointing out explicitly that approximate equality in importance of the commodities as well as of the countries was necessary if under the conditions stated each country was to get a substantial share of the benefits from trade.17 Graham asserts, on the basis of this argument, that the situation which to J. S. Mill was only an “extreme and barely conceivable case,” namely, that all the benefit should go to one of the countries, was, under the conditions of constant costs, only two countries, and only two commodities, rather the normal case. He agrees with J. S. Mill that division of the benefit is the normal case, but only because ordinarily more than two commodities enter into trade, so that when the terms of trade are moving against a country because of excessive export of one commodity, it begins to export other commodities in which its comparative advantage is less, and thus checks the adverse movement of its terms of trade. He concedes, however, that Bastable has recognized these probabilities in trade between a small and a large country, but criticizes his manner of dealing with the problem.18

Graham's reasoning is sound, but his criticism of J. S. Mill is only partially justified. The passages in Mill's Principles which he attacks are quotations, presented as such, from Mill's Essays written long before. In the same chapter of the Principles in which these quotations appear, in a section first added in the third edition (1852), Mill explicitly raises the same problem, and gives the same answer as does Graham. He asks why, in a particular illustration given by him, he should assume that trade would result in the benefit being divided instead of all of it going to one of the countries. He answers that in such a case the country which gets all the benefit from trade would probably find it to its advantage to import from the other country additional commodities in which that other country had a comparative advantage, although a lesser one than in its original export commodity, in exchange for additional quantities of its own export commodity, until a state was reached where the other country no longer produced any of the commodity which it imported and the terms of trade had become such as to divide the benefit between the two countries. “And so with every other case which can be supposed.” 19 Pennington had already, in 1840, pointed out that the entrance of more commodities and more countries into trade would tend to prevent the terms of trade from establishing themselves at a point at which all of the gain goes to one of the countries.20

The Possibility of Partial Specialization.—Graham21 cites as another error in Mill's analysis, the following passage:

Cost of carriage has one effect more. But for it, every commodity would (if trade be supposed free) be either regularly imported or regularly exported. A country would make nothing for itself which it did not also make for other countries.22

Graham shows that if trade is at one of the limiting ratios this is erroneous even on the assumption of constant costs, since a country which trades on terms corresponding to its own relative costs of production may be, and is likely to be, producing at home some portion of its consumption of the commodity which it imports. It seems clear, however, that while Mill at first held that complete specialization would necessarily follow from free trade in the absence of transportation costs, he later adhered to it only on the assumption that trade did not take place at one of the limiting ratios, when the proposition would be correct. In correcting, in the third edition of his Principles, his earlier doctrine that with trade in only two commodities the terms of trade would ordinarily be such as to divide the benefit between the two countries, he also corrected this error. In the case which he assumes of trade at one of the limiting ratios, he makes one of the countries specialize only partially in the commodity which it exports. If Germany had a comparative advantage in linen and England in cloth, and if at the ratio of exchange equal to their relative costs of production in Germany the latter was willing to take more cloth than England could supply, then if no third commodity entered into the trade “England would supply Germany with cloth up to the extent of a million” and “Germany would continue to supply herself with the remaining 200,000 by home production.” 23 Whewell had previously shown, on the basis of Mill's own illustrations, that on the assumptions of constant costs, only two commodities, and only two countries, one of the countries was likely to find itself in a position where it derived no gain from trade, and that such country might specialize only partially in the production of the commodity in which it had a comparative advantage.24

Graham points out that Bastable also asserted the impossibility of only partial specialization under conditions of constant costs, only two countries, and only two commodities.25 Here again, however, he has not read his author carefully enough. In dealing with what he calls the “special case” of trade between a small and a large country Bastable had clearly, although inconsistently with his general denial, asserted the possibility—as far as the context indicates, perhaps even the probability—that the larger country will only partially specialize in the production of the commodity in which it has a comparative advantage.26 In 1897, moreover, Edgeworth criticized Bastable's position, and showed that Mangoldt had long before demonstrated the possibility of partial specialization by one of the countries,27 and in an appendix added in the third edition Bastable conceded his error.28

Ricardo had supported his argument for the benefit of international specialization in accordance with comparative costs by the following analogy with trade between two persons:29

Two men can both make shoes and hats, and one is superior to the other in both employments; but in making hats, he can only exceed his competitor by one-fifth or 20 per cent—and in making shoes he can excel him by one-third or 33 per cent;—will it not be for the interest of both, that the superior man should employ himself exclusively in making shoes, and the inferior man in making hats?

Pareto, citing this passage from Ricardo, argued that it was erroneous in its implication that complete specialization would necessarily be advantageous, as compared to no specialization at all. He showed by means of arithmetical illustrations that complete specialization would under some circumstances result in more of one commodity but less of the other, as compared to no specialization, and that, depending on the relative demands for these commodities, the increase in one commodity might not be sufficient to offset in value the deficit in the other commodity.30 This has occasionally been interpreted as a partial rejection of the principle of comparative costs as an argument for free trade.31 If it were so intended, it could, of course, easily be refuted by showing that specialization in accordance with comparative costs, to the extent that such specialization would tend to be carried under free trade, would not, under the conditions stated, result in a loss. But it seems an injustice to Pareto to interpret him in this way. His criticism appears to be directed only against the proposition that complete specialization is necessarily profitable as compared to no specialization. Pareto himself shows that where complete specialization would not be profitable it would not take place even under free trade.32

Ricardo's statement that it would be to the interest of two individuals to specialize completely if each had a comparative advantage in the production of one of the commodities seems an inadequate basis, moreover, upon which to convict him of the belief that complete specialization would necessarily be profitable to each of two countries if they had comparative differences in costs of production. It so happens that the sentence cited by Pareto to show that Ricardo held this belief follows immediately in Ricardo's text an express stipulation that partial specialization by one of the countries is a possibility:

It will appear, then, that a country possessing very considerable advantages in machinery and skill, and which may therefore be enabled to manufacture commodities with much less labor than her neighbors, may, in return for such commodities, import a portion of the corn required for its consumption, even if its land were more fertile, and corn could be grown with less labor than in the country from which it was imported.33

Another writer, A. F. Burns, later repeated Pareto's demonstration that complete specialization may be unprofitable.34 This writer goes further, however, than did Pareto, for he definitely argues as if specialization along the lines of comparative advantage necessarily involves complete specialization, and then claims that whenever such specialization results in more of one commodity but less of another it is impossible to show that free trade has been profitable. He overlooks the fact that if the specialization is voluntary it will not be carried to the point where the marginal unit exported is worth less on the market than what is obtained in exchange for it, and, therefore, that while there may be no profit from trade for one of the countries under the conditions stated, there must be profit for at least one of the countries, and there can be loss to neither, if in each country the prices of its own products are proportional to their real costs.

[1]“In the view of the question presented by Mr. Ricardo, the advantages derived from foreign trade were confined to only one of these countries.” (Torrens, The principles and practical operation of Sir Robert Peel's Act, 3d ed., 1858, preface to 2d ed., pp. xiii–xiv.) This same charge is repeated by J. W. Angell, The theory of international prices, 1926, pp. 54, note; 67.

[2]“Mr. Ricardo ... unguardedly expressed himself as if each of the two countries making the exchange separately gained the whole of the difference between the comparative costs of the two commodities in one country and in the other” (J. S. Mill, Essays on some unsettled questions of political economy, 1844, pp. 5–6.)

[3]Ricardo, Principles, Works, pp. 76–77.

[4]James Mill, Elements of political economy, 1st ed., 1821, pp. 86–87; 3d ed., 1826, p. 122.

[5]L. Einaudi, “James Pennington or James Mill: an early correction of Ricardo,” Quarterly journal of economics, XLIV (1929–30), 164–71.

[6]Cf. P. Sraffa, “An alleged correction of Ricardo,” ibid., 539–44, and Einaudi's acceptance of Sraffa's account, ibid., 544–45. Cf. also my review of Angell's Theory of international prices in the Journal of political economy, XXXIV (1926), 609, where I had previously shows that Ricardo was not guilty of this error.

[7]J. S. Mill, Autobiography, 1873, pp. 121–22.

[8]“Exportation of machinery,” Westminister review, III (1825), 388–89.

[9]Ricardo states that cloth and wine will exchange for each other in the ratio of I cloth for I wine. The ratio exactly halfway between the ratios of comparative costs of the two commodities in the two countries would be I cloth for wine.

[10]Principles of political economy, 4th ed., 1849, p. 147 (also in earlier editions).

[11]Cf., however, Angell, Theory of international prices, p. 305:

He [i.e., Achille Loria] seems to hold that international values will be fixed midway between the two points of maximum and minimum gain, for the one country and the other. This can perhaps be regarded, however, as a legitimate deduction from the principle of comparative costs. J. S. Mill held that the gains would be divided equally more often than in any other specific ratio. Cf. supra, p. 325, note 7.

[12]James Pennington, A letter ... on the importation of foreign corn, 1840, pp. 32–41. Cf. also J. S. Mill, Essays on some unsettled questions (written 1829–30), 1844, p. 12.

[13]Especially in The budget, 1841–44, passim.

[14]Essays on some unsettled questions, 1844, Essay I. Mill claims for himself not “the original conception, but only the elaboration” of the part played by reciprocal demand. (Ibid., preface, p. v.) He says that this question was not dealt with by Ricardo, “who, having a science to create, had not time, or room, to occupy himself with much more than the leading principles.” (Ibid., p. 5.)

[15]Principles of political economy, 1848, bk. iii, chap. xviii. Repeated in all editions.

[16]J. S. Nicholson, Principles of political economy, II (1897), 302.

[17]F. D. Graham, “The theory of international values re-examined,” Quarterly journal of economics, XXXVIII (1923), 55–59, 79.

[18]Ibid., pp. 63–65.

[19]Principles, Ashley ed., p. 601, note.

[20]A letter ... on the importation of foreign corn, 1840, p. 41.

[21]Graham, “The theory of international values re-examined,” loc. cit., pp. 67 ff.

[22]Mill, Principles, Ashley ed., p. 589.

[23]Mill, Principles, Ashley ed., p. 601, note.

[24]William Whewell, “Mathematical exposition of some doctrines of political economy. Second memoir,” Transactions of the Cambridge Philosophical Society, IX, part I (1856), 141. This memoir was read in 1850, and printed in the same year for private circulation. Since it was primarily a criticism of Mill's doctrines, Mill may have been acquainted with it.

[25]Graham, “The theory of international values re-examined,” loc. cit., p. 60; Bastable, The theory of international trade, 4th ed., 1903, pp. 29, 35, 177, 178.

[26]Bastable, ibid., p. 43: “It therefore follows that the production of both x and y will continue to be carried on in B, while A will give its entire efforts to the production of y, and will therefore obtain almost the entire gain of the trade.” (The same passage appears in the 2d ed., 1897, p. 43.) Bastable says “almost the entire” instead of the entire gain, because he is assuming that y is produced in B at different costs of production, and that it is therefore “probable that B will receive some advantage, since the production of the most costly part of y will be abandoned by it.”

[27]Edgeworth, review of 2d ed. of Bastable, Economic journal, VII (1897), 398-400. Nicholson had also pointed out the possibility of partial specialization in the same year. (Principles, II (1897), 302.)

[28]Cf. Bastable, Theory of international trade, 4th ed., 1903, p. 179, note.

[29]Principles, Works, p. 77, note.

[30]V. Pareto, Manuel d'économie politique, 2d ed., 1927, pp. 507-14.

[31]Cf., e.g., Angell, Theory of international prices, p. 256, who says that Pareto shows that specialization does not lead to a total output which is necessarily greater in value than that secured under non-specialization, and that the principle of comparative costs is therefore “not universal in its application, and may involve a non sequitur.“

[32]Manuel, p. 513.

[33]Principles, Works, p. 77, note. (Italics not in original text.) It may reasonably be objected that Ricardo was not adhering to the constant cost assumption in his reference to the possibility of partial specialization in the production of corn, but the passage, given its location in Ricardo's text, serves at least to show that he was not placing any emphasis on complete specialization as a necessary result of specialization in accordance with comparative advantage.

Wicksell, in a review of Pareto, agreed that if the commodities were not of equal importance there would be only partial specialization, but he characterized Pareto's criticism of Ricardo as captious, and commented that Ricardo was not writing fairy tales for children.—Knut Wicksell, “Vilfredo Paretos Manuel d'économie politique,” Zeitschrift für Volkswirthschaft, XXII (1913), 148-49. (I am indebted to G. J. Stigler for this reference.)

[34]A. F. Burns, “A note on comparative costs,” Quarterly journal of economics, XLII (1928), 495-500. Cf. the criticisms of his argument by G. Haberler, “The theory of comparative cost once more,” ibid., XLIII (1929), 380-81, and by the present writer, “Comparative costs: a rejoinder,” ibid., XLII (1928), 699.