In economics, David Ricardo is credited for the
principle of comparative advantage to explain how it can be beneficial for two parties (countries, regions, individuals and so on) to trade if one has a lower relative
cost of producing some good. What matters is not the absolute cost of production but the opportunity cost, which measures how much production of one good is reduced to produce one more unit of
the other good. Comparative advantage is a key economic concept in the study of free trade.
Under the principle of absolute advantage, developed by Adam Smith, one country can produce more output per unit of productive input than another. With comparative
advantage, even if one country has an absolute advantage in every type of output, the disadvantaged country can benefit from
specializing in and exporting the product(s) with the largest opportunity cost for the other country.[1]
Origins of the theory
Comparative advantage was first described by Robert Torrens in
1815 in an essay on the Corn Laws. He concluded it was
England's advantage to trade with Poland in return for grain,
even though it might be possible to produce that grain more cheaply in England than Poland.
However it is usually attributed to David Ricardo who explained it clearly in his
1817 book On the
Principles of Political Economy and Taxation in an example involving England and Portugal. In Portugal it is possible
to produce both wine and cloth with less work than it takes in
England. However the relative costs of producing those two goods are different in the two countries. In England it is very
hard to produce wine, and only moderately difficult to produce cloth. In Portugal both are easy to produce. Therefore while it is
cheaper to produce cloth in Portugal than England, it is cheaper still for Portugal to produce excess wine, and trade that for
English cloth. And conversely England benefits from this trade because its cost for producing cloth has not changed but it can
now get wine at closer to the cost of cloth.
The conclusion drawn from this is that a country should specialize in products and services in which they have a
comparative advantage. They should then trade with another country that has products in which that country has a
comparative advantage. In this way both countries become better off.
Examples
The following hypothetical examples explain the reasoning behind the theory. In Example 2 all assumptions are italicized for
easy reference, and some are explained at the end of the example.
Example 1
Two men live alone in an isolated island. To survive they must undertake a few basic economic activities like water carrying,
fishing, cooking and shelter construction and maintenance. The first man is young, strong, and educated and is faster, better,
more productive at everything. He has an absolute advantage in all activities. The second man is old, weak, and uneducated. He
has an absolute disadvantage in all economic activities. In some activities the difference between the two is great; in others it
is small.
Is it in the interest of either of them to work in isolation? No, specialization and exchange (trade) can benefit both of
them.
How should they divide the work? According to comparative, not absolute advantage: the young man must spend more time on the
tasks in which he is much better and the old man must concentrate on the tasks in which he is only a little worse. Such an
arrangement will increase total production and/or reduce total labour. It will make both of them richer.
Example 2
Suppose for example we have two countries of equal size, Northland and Southland, that both produce and
consume two goods, Food and Clothes. The productive capacities and efficiencies of the countries are such that if
both countries devoted all their resources to Food production, output would be as follows:
- Northland: 100 tonnes
- Southland: 200 tonnes
If all the resources of the countries were allocated to the production of clothes, output would be:
- Northland: 100 tonnes
- Southland: 100 tonnes
Assuming each has constant opportunity costs of production between the two
products and both economies have full employment at all times. All
factors of production are mobile within the countries between clothing and
food industries, but are immobile between the countries. The price mechanism must
be working to provide perfect competition.
Southland has an absolute advantage over Northland in the production of Food. Both
countries are equally efficient in the production of clothes. There seems to be no mutual benefit in trade between the economies.
The opportunity costs shows otherwise. Northland's opportunity cost of producing one tonne of Food is one tonne of Clothes
and vice versa. Southland's opportunity cost of one tonne of Food is 0.5 tonne of Clothes. The opportunity cost of one tonne of
Clothes is 2 tonnes of Food. Southland has a comparative advantage in food production, because of its lower opportunity cost of
production with respect to Northland. Northland has a comparative advantage over Southland in the production of clothes, the
opportunity cost of which is lower in Southland with respect to Food than in Northland.
To show these different opportunity costs lead to mutual benefit if the countries specialize production and trade, consider
the countries produce and consume only domestically. The volumes are:
Production and consumption before trade
|
Food |
Clothes |
| Northland |
50 |
50 |
| Southland |
100 |
50 |
| World total |
150 |
100 |
This example includes no formulation of the preferences of consumers in the two economies which would allow the determination
of the international exchange rate of Clothes and Food. Given the production capabilities of each country, in order for trade to
be worthwhile Northland requires a price of at least one tonne of Food in exchange for one tonne of Clothes; and Southland
requires at least one tonne of Clothes for two tonnes of Food. The exchange price will be somewhere between the two. The
remainder of the example works with an international trading price of one tonne of Food for 2/3 tonne of Clothes.
If both specialize in the goods in which they have comparative advantage, their outputs will be:
Production after trade
|
Food |
Clothes |
| Northland |
0 |
100 |
| Southland |
200 |
0 |
| World total |
200 |
100 |
World production of food increased. Clothing production remained the same. Using the exchange rate of one tonne of Food for
2/3 tonne of Clothes, Northland and Southland are able to trade to yield the following level of consumption:
Consumption after trade
|
Food |
Clothes |
| Northland |
75 |
50 |
| Southland |
125 |
50 |
| World total |
200 |
100 |
Northland traded 50 tonnes of Clothing for 75 tonnes of Food. Both benefited, and now consume at points outside their
production possibility frontiers.
Assumptions in Example 2
- Two countries, two goods - the theory is no different for larger numbers of countries and goods, but the principles
are clearer and the argument easier to follow in this simpler case.
- Equal size economies - again, this is a simplification to produce a clearer example.
- Full employment - if one or other of the economies has less than full employment of factors of production, then this
excess capacity must usually be used up before the comparative advantage reasoning can be applied.
- Constant opportunity costs - a more realistic treatment of opportunity costs the reasoning is broadly the same, but
specialization of production can only be taken to the point at which the opportunity costs in the two countries become equal.
This does not invalidate the principles of comparative advantage, but it does limit the magnitude of the benefit.
- Perfect mobility of factors of production within countries - this is necessary to allow production to be switched
without cost. In real economies this cost will be incurred: capital will be tied up in plant (sewing machines are not
sowing machines) and labour will need to be retrained and relocated. This is why it is sometimes argued that 'nascent industries'
should be protected from fully liberalised international trade during the period in which a high cost of entry into the market
(capital equipment, training) is being paid for.
- Immobility of factors of production between countries - why are there different rates of productivity? The modern
version of comparative advantage (developed in the early twentieth century by the Swedish economists Eli Heckscher and Bertil
Ohlin) attributes these differences to differences in nations' factor endowments. A nation will have comparative advantage in
producing the good that uses intensively the factor it produces abundantly. For example: suppose the US has a relative abundance
of capital and India has a relative abundance of labor. Suppose further that cars are capital intensive to produce, while cloth
is labor intensive. Then the US will have a comparative advantage in making cars, and India will have a comparative advantage in
making cloth. If there is international factor mobility this can change nations' relative factor abundance. The principle of
comparative advantage still applies, but who has the advantage in what can change.
- Perfect competition - this is a standard assumption that allows perfectly efficient allocation of productive resources
in an idealized free market.
Attorney example
There is an illuminating example illustrated in the well known book Economics by
Paul Samuelson. Imagine a city where the best lawyer happens also to be the best
secretary, that is he would be the most productive lawyer and he would also be the best secretary in town. However it is quite
clear that this lawyer would focus on the task of being an attorney by employing a secretary instead of doing all the paperwork
by himself. This can easily be explained with the concept of comparative advantage: He is the best secretary AND the best lawyer,
however by comparing what he can earn as a secretary with the income he could earn by running a law firm AND employing a
secretary one can clearly see that the latter option is the better one.
More complexities
While the Ricardian model has only one input, we could extend the model both increasing the number of goods from two goods to
n goods and by allowing the productivity coefficient to vary.
Criticism
Optimizing trade equations for maximum total GDP may not necessarily optimize
other factors, such as equality, stability, military technology, trade secrets, human-rights, pollution, cultural identity,
etc.
Ricardo's principle relies on a variety of implicit assumptions that may not apply in any given situation, such as that there
is no (or a low) cost for transportation.
Opponents of free trade often point out that globalized communications and transportation unavailable in Ricardo's time invalidate the assumption of capital
immobility and cause capital to gravitate toward absolute advantage (though proponents would point out that modern low cost
transportation only makes the assumption more sound). It has also been argued that
comparative advantage may reduce economic diversity to risky levels.
Notes
- ^ Cohn, Theodore H. (2005 (third edition)). Global Poltical Economy Theory and
Practice. Pearson Education, Inc.. ISBN 0-321-20949-4.
References
- Ronald Findlay (1987). "comparative advantage," The New
Palgrave: A Dictionary of Economics, v. 1, pp. 514-17.
- Hardwick, Khan and Langmead (1990). An Introduction to Modern Economics - 3rd Edn
- A. O'Sullivan & S.M. Sheffrin (2003). Economics. Principles & Tools.
External links
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