Ricardo gave an example of trade between Britain and Portugal, and we will follow his example in general but not in numerical detail. Both countries consume two goods: wine and wool. They rely on just one resource: labor. In Britain, with its cold, damp climate, labor is generally less productive. A barrel of wine requires 5 man-days of labor, while a bale of wool requires 10 man-days of labor. Thus, if Britain is isolated from trade, and prices in Britain depend on British costs, a bale of wool will fetch a price high enough to purchase two barrels of wine.

• By producing wool for export rather than domestic wine, the British can get their wine for 3.33 man-days of labor per barrel, while domestic wine would cost them 5 man-days per barrel. By importing wine they are getting it at a lower cost.
• Suppose that Portugal exports wine to Britain in return for British Wool. At British prices, two barrels of wine will fetch a bale of wool. But if the Portuguese produce wool at home, they give up three barrels of wine. The Portuguese get their wool cheaper by producing wine to trade for it than by producing wool at home .
• Suppose the price in international trade is two-and-one-half barrels of wine per bale of wool. Then the British gain an advantage by exporting wool -- they get 2 1/2 barrels of wine when they give up a bale of wool, instead of 2 barrels in domestic production. But the Portuguese also gain an advantage: they give up only 2 1/2 barrels of wine for a bale of wool, whereas by domestic production they would give up three.

Trade Between Britain and Portugal

Trade is beneficial to both countries. And this happens despite the fact that both industries are more productive in Portugal. For neoclassical economics, the key point is that Britain has a comparative advantage in wool, even though Portugal has the absolute advantage in both goods. According to the neoclassical theory, every country has a comparative advantage in some goods. When a country trades according to its comparative advantage, it is making the best advantage of its own resources in production for export and for domestic production.

With no trade, in America, a bulldozer will sell for twice as much as a car. In Japan, three times as much.

Therefore, if Japan exports cars to America and sells them at American prices, Japan can get a bulldozer for two cars. At Japanese prices, a bulldozer would cost three cars.

If America sells bulldozers in Japan at Japanese prices, we get 3 cars for a bulldozer.

Although the US has the absolute advantage in both products, each country has a comparative advantage in one product.

• Labor is not really the only productive resource
• The theory doesn't really tell us what the prices will be in international trade
• Countries produce many more than two goods
• Countries may import and export the same goods
• The theory ignores monopoly
• The theory ignores unemployment
• Even if the theory is correct, international trade is not really symmetrical

The international monetary system that David Ricardo designed for nineteenth century Britain worked like this:

• If Britain imported more than it exported, pound notes would be turned in for gold at the Bank of England, and gold would flow out of the country.
• With less gold reserves, the bank of England would be forced to cut the number of Pounds in circulation.
• This would reduce the British price level, making exports cheaper and imports more costly in Britain.
• This would reduce British imports and increase their exports, restoring balance.

The exchange rate between two currencies is the price of one currency in terms of the other.

For example: the number of Dollars per Pound is the price of a Pound in dollars -- the number of Dollars you have to pay to buy a British Pound.

Many economists (especially conservative, free-market oriented economists) say it should be determined by supply and demand.

From this point of view, trying the currency to gold is a kind of price fixing. If the U. S. and Britain both tie their currencies to gold, the result is to fix the price of Dollars in terms of Pounds. The price-specie-flow mechanism has to wait for thousands of prices to change, when really only one price needs to change: the price of Pounds in terms of Dollars.

Devaluation

When the number of Dollars per Pound rises, the number of Pounds per Dollar falls, so the Dollar has less value measured in pounds. This is called "devaluation."

Why would the citizens of one country demand the currency of another country, in return for their own? To trade in real goods and services. Devaluing the dollar in terms of the pound raises the price of pounds in terms of dollars -- thus raises the price of British exports to the US -- thus cuts the quantities demanded for imports from Britain.

Imports and Exports of Cheshire Cheese

All prices are in British Pounds.

Figure 1. The Trade in Cheese

In this example, as the diagrams show, the United States has an excess demand for cheese, amounting to Q₄- Q₃, while Britain has an excess supply, amounting to Q₂- Q₁.

Devaluation

Every dollar price is now equivalent to a higher Pound price than before, so, from the British point of view, American demand has been reduced and American supply increased.

Figure 2. The Trade in Cheese: Devaluation

This is no longer an equilibrium. Americans are importing less cheese than the British export. There is a world-wide excess supply of cheese, and that means the would price will fall somewhat.

Result of Devaluation

The decrease in the world price is shown in Figure 3. The world price of cheese drops from p to p'.

Figure 3. The Trade in Cheese: After Devaluation

This is the new equilibrium.

Globalization

In a world in which nations grow closer together thanks to progress in communications and transportation, international trade grows more important to all countries. This "globalization" of the market economy seems from some points of view to be new, but economists have envisioned the market economy as a global system from the beginnings of our science. Monetary systems will change, but the fundamentals of supply, demand, and comparative advantage only grow more important.

We have seen two viewpoints on international trade:

flows of real goods and services.

Why do nations trade? Most economists have answered this question with the concept of comparative advantage.

monetary flows and national currencies

Early economists relied on the "price-specie-flow" mechanism to regulate monetary systems.

Twentieth century economists have preferred to rely on the supply and demand in markets for international currencies to do that.