Friday, May 26, 2006

Ricardo on India and China

There have been interesting comments from John and Jay in response to my post on India and China. They got me thinking. The reason I believe that China’s growth is not an issue for India is, of course, Mr. David Ricardo’s theory of comparative advantage.

The theory itself is beautiful - a wonderfully subtle idea that requires no more than elementary arithmetic to understand. However, it is subtle. Most of the chatterati who comment on matters of international trade seem not have got it. Krugman calls it Ricardo’s difficult idea.

It appears to me that one problem with how the theory is usually presented is that it presents two static pictures- one snapshot taken “before trade”, the other taken “after trade”- and tries to show that both parties are better off with trade than they were before. The theory is hard to explain and hard to follow. I personally find it easier to follow theories when they are presented as stories.

I thought I would try and make a movie instead; show step-by-step how one scene plays out. Remember that this is a story- only one scenario, to show what may happen. A mathematical model, even one that uses only basic arithmetic, has the advantage that it captures a whole range of possibilities- it allows you to ask “what if”?

We begin with two countries: call them India and China. They are neighbors, separated by a high mountain range. There are no other countries in this world. They are perfectly ordinary countries, but the mountains make it difficult for them to trade with each other. They trade a few goods that can be produced only in one of them - Ivory from India, and Jade from China, and so on- but not much that matters to the man on the street.

The staple diet of both the Chinese and Indians is rice and vegetables. Assume that the same land can be used to grow either rice or vegetables. Some farmers in each country choose to specialize in cultivating rice, others specialize in growing vegetables.

What can we say about prices and costs in each country? Not much, but we can say this: in both countries, the expected returns to a farmer from growing rice on any given acre of land must equal the expected returns from growing vegetables on that land. If the returns from growing rice were greater, vegetable farmers would switch to cultivating rice: the supply of rice would rise, its price would fall; the supply of vegetables would fall, and its price would rise until returns are equal. If the returns from growing vegetables were greater, rice farmers would shift to growing vegetables, to similar effect.

Now imagine that an enterprising Chinese farmer discovers some technique that increases vegetable yields by 1/3, so that a given acre of land that could produce 3 tons of vegetables can now produce 4 tons, with no additional labor. Also assume that this technique can work only on Chinese land, so that it is unavailable to Indian farmers. What happens now?

Initially, only a few vegetable farmers in China adopt this technique, and they produce 1/3 more vegetables than they used to. As only a few farmers are using this technique, the supply of vegetables does not move up a whole lot. Prices stay about the same. The early adopters now earn 30% on each acre of land.

Seeing this, more and more vegetable farmers begin to adopt this new technique, and the prices of vegetables begin to fall. Assume that Chinese mums decide that since vegetables are now cheaper, their kids should eat more vegetables. That keeps prices, and returns, from falling too far. Also, farmers can grow 1/3 more vegetables on each acre. Revenues from any given acre of vegetables will fall only if prices fall by more than 25%. So, lets assume that the returns from growing vegetables on any given acre are still up even when all Chinese vegetable farmers have adopted this technique, and total vegetable production is up by 1/3.

Now, remember that returns from growing rice on a given acre of land must equal those from growing vegetables. As returns per acre of vegetable go up, returns per acre of rice must go up as well, or rice farmers will shift to growing vegetables. Rice output per acre is no more than before, so the only way returns from rice cultivation can increase is by an increase in the price of rice in China. Hence, the story so far: production of vegetables in China up, production of rice in China may even have fallen (as some Chinese rice farmers shift to producing vegetables), prices of vegetables in China down, prices of rice in China up. No change yet in India.

Isn’t this a beautiful story?

Now, enter India. As the price of vegetables in China fell, that in India remained unchanged. It is now worthwhile to haul vegetables from China to India. There is a flood of Chinese imports. Panic! Petitions to the Indian Government from Concerned Vegetable Farmers! The price of vegetables in India cannot rise above the price of vegetables imported from China.

However, note that the price of rice in China has now increased, and the production of rice has also fallen, while that in India is unchanged. Demand from India now actually increases the price of vegetables in China. That further increases the returns from growing vegetables in China, and even more Chinese rice farmers move into vegetables. That further increases the price of rice in China, and reduces the supply of rice.

The end is a bit of an anticlimax- you must have seen it coming for some time now: Indian vegetable farmers increasingly shift to producing rice. They export rice to China. The price of rice in China falls as Indian rice comes in. The prices of vegetables in India rise again as Indian vegetable farmers move into rice. Each country specializes in the production of the article that it has a comparative advantage in.

Note that we never even mentioned things like labor costs, and dumping, because all those are already captured in the returns.

The moral of the story is that firms compete not only with firms in the same business from other countries; they also compete with firms in different lines of business from their own country. As they grow, they need resources that those other firms also need. This pushes up resource prices for those other firms.

Firms’ growth depends not only on how efficiently they use resources (their productivity) , but on how efficiently they use those resources relative to how other firms from their country use them, and on how efficiently their direct competition in from other countries use their resources relative to other firms from their country. Its truly an emergent phenomenon.

That Ricardo was something else!


Jay said...

now when all the wonderful exchange is happening will price fall down for both products in both China and India

Rajeev Ramachandran said...

It should, but now you got to work through the math to see how