Comparative advantage

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In economics, the theory of comparative advantage explains why 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 is given up of one good to produce a unit of the other good. Comparative advantage is critical to understanding modern international trade theory.

Under absolute advantage, one country can produce more output per unit of productive input than another. With comparative advantage, even if one country has an absolute (dis)advantage in every type of output, it it can benefit from specializing in and exporting those products in which it has a relative advantage (i.e., a lower opportunity cost) and importing the good in which it has a relative disadvantage.[1]

Contents

[edit] Origins of the theory

Comparative advantage was first described by Robert Torrens in 1815 in an essay on the corn trade. He concluded that it was to England's advantage to trade various goods with Poland in return for corn, even though it might be possible to produce that corn more cheaply in England than Poland.

However, the theory is usually attributed to David Ricardo who created a systematic explanation in his 1817 book The Principles of Political Economy and Taxation using 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. Conversely, England benefits from this trade because its cost for producing cloth has not changed but it can now get the cheaper Portuguese wine.

Stanislaw Ulam once challenged Nobel laureate Paul Samuelson to name one theory in all of the social sciences which is both true and nontrivial. Several years later, Samuelson responded with David Ricardo's theory of comparative advantage:

That it is logically true need not be argued before a mathematician; that it is not trivial is attested by the thousands of important and intelligent men who have never been able to grasp the doctrine for themselves or to believe it after it was explained to them.

[edit] Examples

The following worked examples explain the reasoning behind the theory. In Example 3 all assumptions are italicized for easy reference, and some are explained at the end of the example.

[edit] Example 1

Two men land 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 labor. It will make both of them richer.

[edit] Example 2

A Needs 100 P1 and 100 P2
B Needs 100 P1 and 100 P2

A: No trade

Product Cost Produced Cost
P1 10 100 1000
P2 20 100 2000
Net - 200 3000

B: No trade

Product Cost Produced Cost
P1 15 100 1500
P2 25 100 2500
Net - 200 4000

A with trade: 100P1 for 56 P2

Product Cost Produced Cost
P1 10 200 2000
P2 20 44 880
Net - 244 2880

B With trade: 56 P2 for 100 P1

Product Cost Produced Cost
P1 15 0 0
P2 25 156 3900
Net - 156 3900

So A saved 120 cost units or 4% and B saved 100 cost units or 2.5%. Clearly A gained more from the trade, but both parties experienced growth. Now if B adds some taxes to protect the producers of P1 he can try to get a larger percentage of the trade but his savings goes down as do the overall savings.

[edit] Example 3

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

Conversely if all of the resources of the countries were allocated to the production of Clothes, output would be:

  • Northland: 100 tonnes
  • Southland: 100 tonnes

We need to assume that each of the countries has constant opportunity costs of production between the two products, and that both economies have full employment at all times. Also all factors of production are perfectly mobile within the countries between clothing and food industries, but are immobile between the countries. Finally the price mechanism must be working to provide perfect competition.

So Southland has an absolute advantage over Northland in the production of Food, and both countries are equally efficient in the production of Clothes. Intuitively it would seem that there is no mutual benefit in trade between the economies. But an examination of the opportunity costs shows something different. For Northland the opportunity cost of producing one tonne of Food is one tonne of Clothes and vice versa. But for Southland the opportunity cost of one tonne of Food is 0.5 tonne of Clothes; and the opportunity cost of one tonne of Clothes is 2 tonnes of Food. Looked at this way, Southland has a comparative advantage in Food production because of its lower opportunity cost of production with respect to Northland. And Northland also 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 that these different opportunity costs can lead to mutual benefit if the countries specialise production and trade, consider the following starting position. Both 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

We now examine the consequences of trade between the two countries. 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. But 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. It follows that the actual 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 countries specialise completely 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

Note that world production of Food had increased and Clothing production has 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 has traded 50 tonnes of Clothing for 75 tonnes of Food. Both countries have benefited. In fact, both countries are now consuming at points outside their production possibility frontiers.

Assumptions in Example 3

  • 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? Capital includes production technology and know-how. If it can be moved between countries then the production capabilities of the countries will change. Similarly the movement of labour will change that factor cost and productivity. Perfect transnational mobility of factors of production would invalidate comparative advantage. Imperfect transnational mobility reduces the mutual benefit of trade.
  • Perfect competition - this is a standard assumption that allows perfectly efficient allocation of productive resources in an idealized free market.

[edit] 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.

[edit] Criticisms

Few critisisms exist of the basic insight that rational division of labour depends on comparative and not absolute advantage. However there are many who question that this requires support for free trade.

[edit] Notes

  1. ^ Cohn, Theodore H. (2005 (third edition)). Global Poltical Economy Theory and Practice. Pearson Education, Inc.. ISBN 0-321-20949-4. 

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[edit] 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.

[edit] External links


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Definitions

Balance of payments · Current account (Balance of trade) · Capital account · Foreign exchange reserves · Comparative advantage · Absolute advantage · Import substitution · International trade

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World Trade Organization · International Monetary Fund · World Bank · International Trade Centre · Trade bloc · Free trade zone · Trade barrier · Import quota · Tariff

Schools of Thought

Free trade · Balanced trade · Mercantilism · Protectionism

Related Issues

Globalization · Outsourcing · Trade justice and fair trade

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