The Theory of Comparative Advantage

By K.Vignesh

MFT 15078 (FEC)Department of fisheries economics

SYNOPSIS

Introduction

Assumption

Concept of theory

Ricardo’s numerical example

Limitations

Background of the Theory the original description of the idea can be found in an

Essay on the External Corn Trade by Robert Torrens in 1815.

David Ricardo formalized the idea using a compelling, yet simple, numerical example in his 1817 book titled, On the Principles of Political Economy and Taxation.

The idea appeared again in James Mill's Elements of Political Economy in 1821. Finally, the concept became a key feature of international political economy upon the publication of Principles of Political Economy by John Stuart Mill in 1848.

Ricardo’s Idea of Comparative Advantage Ricardo's Law of Comparative Advantage

improved upon the earlier Law of Absolute Advantage. How?

If A (Advancedland) is more productive than B (Backwardland) in every productive activity, would both countries benefit from trade?

The law of absolute advantage has no answer to this question.

Ricardo's law of comparative advantage showed that the answer is yes.

A country has a comparative advantage in the production of a good or service that it produces

The theory of comparative costs argues that, put simply, it is better for a country that is inefficient at producing a good or service to specialise in the production of that good it is least inefficient at, compared with producing other goods.

Ricardo’s Idea of Comparative Advantage

Ricardo explains his theory with the help of following assumptions:-There are two countries and two commodities.There is a perfect competition both in commodity and factor market.

Assumptions

Cost of production is expressed in terms of labour i.e. value of a commodity is measured in terms of labour hours/days required to produce it. Commodities are also exchanged on the basis of labour content of each good.

Labour is the only factor of production other than natural resources.

Labour is homogeneous i.e. identical in efficiency, in a particular country.

Labour is perfectly mobile within a country but perfectly immobile between countries.

There is free trade i.e. the movement of goods between countries is not hindered by any restrictions.

Production is subject to constant returns to scale.

There is no technological change. Trade between two countries takes place

on barter system. Full employment exists in both countries. There is no transport cost.

Table-1

Country Wine(bottles)

Cloth(yards)

Cost Per Unit In Man Hours

Cost Per Unit In Man Hours

Kenya 40 40

Ethiopia 20 10

Ricardo’s numerical example

This Table illustrates Ricardo's comparative advantage principle when one nation has an absolute advantage in the production of both goods.

Assume that in one hour's time, Kenya workers can produce 40 bottles of wine

or 40 yards of cloth, while Ethiopia workers can produce 20 bottles of wine or 10 yards of cloth.

According to Smith's principle of absolute advantage, there is no basis for mutually beneficial specialization and trade, because the Kenyan workers are more efficient in the production of both goods. Comparative advantage, however, recognizes that Kenyan workers are four times as efficient in cloth production (40/1 0 = 4) but only twice as efficient in wine production (40/ 20 = 2).

They thus has a greater absolute advantage in cloth than in wine, while the Ethiopia has a smaller absolute disadvantage in wine than in cloth. Each nation specializes in and exports that good in which it has a comparative advantage-the United States in cloth, the United Kingdom in wine.

The output gains from specialization will be distributed to the two nations through the process of trade. Like Smith, Ricardo asserted that both nations can gain from trade.

Interpreting the Theory of Comparative Advantage first, fully employ all resources worldwide; second, allocate those resources within

countries to each country's comparative advantage industries;

and third, allow the countries to trade freely thereafter.

Limitations

It is possible for a nation not to have an absolute advantage in anything

but it is not possible for one nation to have a comparative advantage in everything and the other nation to have a comparative advantage in nothing.

That's because comparative advantage depends on relative costs.

His theory, however, depended on the restrictive assumption of the labor theory of value, in which labor was assumed to be the only factor input.

In practice, however, labor is only one of several factor inputs.

We have used trading models in which only two goods are produced and consumed and in which trade is confined to two countries the real world of international trade involves more than two products and two countries; each country produces thousands of products and trades with many countries

When a large number of goods is produced by two countries, operation of comparative advantage requires that the goods be ranked by the degree of comparative cost

Each country exports the product(s) in which it has the greatest comparative advantage.

Conversely, each country imports the product(s) in which it has greatest comparative disadvantage.