Why free markets create wealth

I’m not an economist, but I recently came across a simple law of economics, first thought of by David Ricardo in 1817. It’s called Ricardo’s Law of Comparative Advantage and it really should be required reading for any citizen.

Suppose that in Britain it takes 100 units of labour to produce one unit of cloth and it takes 110 units of labour to produce one unit of wine.

In Portugal it takes 90 units of labour to produce one unit of cloth and 80 units of labour to produce one unit of wine.

Britain: cloth costs 100 units, wine costs 110 units

Portugal: cloth costs 90 units, wine costs 80 units

Now, if both countries produce 1 unit of cloth and wine, it will cost Britain 210 units of labour and Portugal 170 units.

But what if Britain produces only cloth and Portugal produces only wine and then they trade? Now it costs Britain just 200 units and Portugal just 160 units.

Specialisation and trade results in an efficiency gain for both trading partners.

That’s cool, but it gets even cooler. Portugal benefits from selling wine to Britain and importing cloth even though it can produce cloth cheaper itself.

Now suppose that the British government decides it wants to protect its wine industry. It taxes the cloth industry by 5 units and gives this to the wine industry as a subsidy. There is no longer any advantage for Britain to import wine from Portugal and so trade ceases. Both countries lose out.

Or suppose that Portugal wants to protect its cloth industry. It places an import tax on British cloth of 10 units. Now it costs Britain 110 units to produce cloth, and there is no trade advantage. Again, trade ceases and both countries lose out.

Ricardo framed his law in terms of countries, but you can equally think about how companies trade globally. In both cases, free trade creates wealth; taxes and subsidies destroy wealth.

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4 responses to “Why free markets create wealth

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  3. From the capitalist’s viewpoint, yes, there is an advantage to save on labor units. But there are several other implications. Saving on labor units also means that workers work less and are paid less or being laid off. So, while the capitalists profit from the trade, the workers may lose or have to learn another skill. Brittish wine makers must now make clothes or stay unemployed, and Portugese cloth makers must now make wine or stay unemployed. Trade creates new jobs, however, associated with the trade and logistics.

    Also, apparently, not any trade is beneficial. This only works if clothes cost less than wine in Brittain, and wine costs less than clothes in Protugal. Each country benefits from making the cheaper product and importing the more expensive one. If wine costs less than clothes in both countries, the trade does not make sense. Then switching to the less expensive wine in one country will mean switching to the more expensive clothes in the other country – there is no win/win any more.

    • “From the capitalist’s viewpoint, yes, there is an advantage to save on labor units”
      The advantage is for everyone if the saving (or part of it) is passed to consumers. Hence the need for a competitive and efficient market.

      “workers work less and are paid less”
      Actually, high productivity is strongly correlated with high wages, so workers are likely to be paid more.

      “the workers may lose or have to learn another skill”
      Agreed. But as you say, other jobs will be created as a result. There is clearly a need for society to help workers who have lost their jobs and are seeking new employment. Those new jobs will be more secure than the old ones, which depended on artificial scarcity and inefficiency.

      “If wine costs less than clothes in both countries, the trade does not make sense”
      Correct. But no trade will ever be non-beneficial. The worst case scenario is that there is no gain or loss. And in reality, there is always something that one country (or company) can do better than another.

      Thank you for engaging with this ancient blog post, agrudzinsky!

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