THEORY OF COMPARATIVE ADVANTAGE

The Theory of Comparative Advantage

David Ricardo developed the classical theory of comparative advantage in his book ‘Principles of Political Economy and Taxation’ published in 1817. The law of comparative advantage states that even if one nation is less efficient than (has an absolute disadvantage with respect to) the other nation in the production of all commodities, there is still scope for mutually beneficial trade. The first nation should specialize in the production and export of the commodity in which its absolute disadvantage is smaller (this is the commodity of its comparative advantage) and import the commodity in which its absolute disadvantage is greater (this is the commodity of its comparative disadvantage). Comparative advantage differences between nations are explained by exogenous factors which could be due to the differences in national characteristics. Labour differs in its productivity internationally and different goods have different labour requirements, so comparative labor productivity advantage was Ricardo’s predictor of trade.

The theory can be explained with a simple example

                                              Output per Hour of Labour

Commodity                       Country A                        Country B
Wheat (bushels/hour)	6	1
Cloth (yards/hour)	4	2

•  In this example, country B can produce only two yards of cloth per hour of labour. Country B has now absolute disadvantage in the production of both wheat and cloth. However, since B’s labour is only half as productive in cloth but six times less productive in wheat compared to country A, country B has a comparative advantage in cloth.
•  On the other hand, country A has an absolute advantage in both wheat and cloth with respect to the country B, but since its absolute advantage is greater in wheat (6:1) than in cloth (4:2), country A has a comparative advantage in production and exporting wheat. In a two-nation, two-commodity world, once it is established that one nation has a comparative advantage in one commodity, then the other nation must necessarily have a comparative advantage in the other commodity. 
• Put in other words, country A’s absolute advantage is greater in wheat, and so country A has a comparative advantage in producing and exporting wheat. Country B’s absolute disadvantage is smaller in cloth, so its comparative advantage lies in cloth production. According to the law of comparative advantage, both nations can gain if country A specialises in the production of wheat and exports some of it in exchange for country B’s cloth. Simultaneously, country B should specialise in the production of cloth and export some of it in exchange for country A’s wheat.

How do these two countries gain from trade by each country specializing in the production and export of the commodity of its comparative advantage? We need to show that both nations can gain from trade even if one of them (in this case country B) is less efficient than the other in the production of both commodities.

• Assume that country A could exchange 6W for 6C with country B. Then, country A would gain 2C (or save half an hour of labour time) since the country A could only exchange 6W for 4C domestically. We need to show now that country B would also gain from trade. We can observe that the 6W that the country B receives from the country A would require six hours of labour time to produce in country B. 
•  With trade, country B can instead use these six hours to produce 12C and give up only 6C for 6W from the country A. Thus, the country B would gain 6C or save three hours of labour time and country A would gain 2C. However, the gains of both countries are not likely to be equal. 
• However, we need to recognize that this is not the only rate of exchange at which mutually beneficial trade can take place. Country A would gain if it could exchange 6W for more than 4C from country B; because 6W for 4 C is what it can exchange domestically (both require the same one hour labour time). The more C it gets, the greater would be the gain from trade. Conversely, in country B, 6W = 12C (in the sense that both require 6 hours to produce). Anything less than 12C that country B must give up to obtain 6W from country A represents a gain from trade for country B. 
• To summarize, country A gains to the extent that it can exchange 6W for more than 4C from the country B. country B gains to the extent that it can give up less than 12C for 6W from country A. Thus, the range for mutually advantageous trade is 4C < 6W < 12C.
• The spread between 12C and 4C (i.e., 8C) represents the total gains from trade available to be shared by the two nations by trading 6W for 6C. The closer the rate of exchange is to 4C = 6W (the domestic, or internal rate in country A), the smaller is the share of the gain going to country A and the larger is the share of the gain going to country B. 
• Alternatively, the closer the rate of exchange is to 6W = 12C (the domestic or internal rate in country B), the greater is the gain of country A relative to that of country B. However, if the absolute disadvantage that one nation has with respect to another nation is the same in both commodities, there will be no comparative advantage and no trade. 
• Ricardo based his law of comparative advantage on the ‘labour theory of value’, which assumes that the value or price of a commodity depends exclusively on the amount of labour going into its production. This is quite unrealistic because labour is not the only factor of production, nor is it used in the same fixed proportion in the production of all commodities. 
• In 1936, Haberler resolved this issue when he introduced the opportunity cost concept from Microeconomic theory to explain the theory of comparative advantage in which no assumption is made in respect of labour as the source of value. Opportunity cost is basically the value of the forgone option. It is the ’real’ cost in microeconomic terms, as opposed to cost given in monetary units.
•  According to the opportunity cost theory, the cost of a commodity is the amount of a second commodity that must be given up to release just enough resources to produce one extra unit of the first commodity. The opportunity cost of producing one unit of good X in terms of good Y may be computed as the amount of labour required to produce one unit of good X divided by the amount of labour required to produce one unit of good Y. 
• That is, how much Y do we have to give up in order to produce one more unit of good X. Logically, the nation with a lower opportunity cost in the production of a commodity has a comparative advantage in that commodity (and a comparative disadvantage in the second commodity). 
• In the above example, we find that country A must give up two-thirds of a unit of cloth to release just enough resources to produce one additional unit of wheat domestically. Therefore, the opportunity cost of wheat is two-thirds of a unit of cloth (i.e., 1W = 2/3C in country A). 
• Similarly, in country B, we find that 1W = 2C, and therefore, the opportunity cost of wheat (in terms of the amount of cloth that must be given up) is lower in country A than in country B, and country A would have a comparative (cost) advantage over country B in wheat. In a two-nation, two- commodity world, if country A has a comparative advantage in wheat, then country B will have a comparative advantage in cloth.
•  Therefore, country A should consider specializing in producing wheat and export some of it in exchange for cloth produced in country B. By such specialization and trade, both nations will be able to consume more of both commodities than what would have been possible without trade.
• In summary, international differences in relative factor-productivity are the cause of comparative advantage and a country exports goods that it produces relatively efficiently. This points to a tendency towards complete specialization in production. Ricardo demonstrated that for two nations without input factor mobility, specialization and trade could result in increased total output and lower costs than if each nation tried to produce in isolation. Trade generates welfare gains and both countries can potentially gain from trade. 
• Therefore, international trade need not be a zero-sum game. 
• However, the Ricardian theory of comparative advantage suffers from many limitations. Its emphasis is on supply conditions and excludes demand patterns. Moreover, the theory does not examine why countries have different costs. 
• The theory of comparative advantage also does not answer the important question: Why does a nation have comparative advantage in the production of a commodity and comparative disadvantage in the production of another? The answer to this question is provided by the Heckscher-Ohlin theory.