Historical Overview The theory of comparative advantage is perhaps the most important concept in international trade theory. It is also one of the most commonly misunderstood principles. First, the principle of comparative advantage is clearly counter-intuitive.
Many results from the formal model are contrary to simple logic. Secondly, the theory is easy to confuse with another notion about advantageous trade, known in trade theory as the theory of absolute advantage.
The logic behind absolute advantage is quite intuitive. This confusion between these two concepts leads many people to think that they understand comparative advantage when in fact, what they understand is absolute advantage.
Finally, the theory of comparative advantage is all too often presented only in its mathematical form. Using numerical examples or diagrammatic representations are extremely useful in demonstrating the basic results and the deeper implications of the theory. However, it is also easy to see the results mathematically, without ever understanding the basic intuition of the theory. The early logic that free trade could be advantageous for countries was based on the concept of absolute advantages in production.
Adam Smith wrote in The Wealth of Nations"If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage.
If our country can produce some set of goods at lower cost than a foreign country, and if the foreign country can produce some other set of goods at a lower cost than we can produce them, then clearly it would be best for us to trade our relatively cheaper goods for their relatively cheaper goods.
In this way both countries may gain from trade. The original idea of comparative advantage dates to the early part of the 19 th century. Although the model describing the theory is commonly referred to as the "Ricardian model", the original description of the idea can be found in an Essay on the External Corn Trade by Robert Torrens in David Ricardo formalized the idea using a compelling, yet simple, numerical theories of international trade by adam smith in his book titled, On the Principles of Political Economy and Taxation.
Finally, the concept became a key feature of international political economy upon the publication of Principles of Political Economy by John Stuart Mill in Indeed some variation of Ricardo's example lives on in most international trade textbooks today. See page in this text In his example Ricardo imagined two countries, England and Portugal, theories of international trade by adam smith two goods, cloth and wine, using labor as the sole input in production.
He assumed that the productivity of labor i. However, instead of assuming, as Adam Smith did, that England is more productive in producing one good and Portugal is more productive in the other; Ricardo assumed that Portugal was more productive in both goods. Based on Smith's intuition, then, it would seem that trade could not be advantageous, at least for England.
However, Ricardo demonstrated numerically that if England specialized in producing one of the two goods, and if Portugal produced the other, then total world output of both goods could rise! If an appropriate terms of trade i. This means that England may nevertheless benefit from free trade even though it is assumed to be technologically inferior to Portugal in the production of everything. As it turned out, specialization in any good would not suffice to guarantee the improvement in world output.
Only one of the goods would work. Ricardo showed that the specialization good in each country should be that good in which the country had a comparative advantage in production.
To identify a country's comparative advantage good requires a comparison of production costs across countries. However, one does not compare the monetary costs of production or even the resource costs labor needed per unit of theories of international trade by adam smith of production. Instead one must compare the opportunity costs of producing goods across countries.
A country is said to have a comparative advantage in the production of a good say cloth if it can produce cloth at a lower opportunity cost than another country. The opportunity cost of cloth production is defined as the amount of wine that must be given up in order to produce one more unit of cloth. Thus England would have the comparative advantage in cloth production relative to Portugal if it must give up less wine to produce another unit of cloth than the amount of wine that Portugal would have to give theories of international trade by adam smith to produce another unit of cloth.
All in all, this condition is rather confusing. Suffice it to say, that it is quite possible, indeed likely, that although England may be less productive in producing both goods relative to Portugal, it will nonetheless have a comparative advantage in the production of one of the two goods. Indeed there is only one circumstance in which England would not have a comparative advantage in either good, and in this case Portugal also would not have a comparative advantage in either good.
In other words, either each country has the comparative advantage in one of the two goods or neither country has a comparative advantage in anything. Another way to define comparative advantage is by comparing productivities across industries and countries. Thus suppose, as before, that Portugal is more productive than England in the production of both cloth and wine.
If Portugal is twice as productive in cloth production relative to England but three times as productive in wine, then Theories of international trade by adam smith comparative advantage is in wine, the good in which its productivity advantage is greatest.
Similarly, England's comparative advantage good is theories of international trade by adam smith, the good in which its productivity disadvantage is least. This implies that to benefit from specialization and free trade, Portugal should specialize and trade the good in which it is "most best" at producing, while England should specialize and trade the good in which it is "least worse" at producing. Note that trade based on comparative advantage does not contradict Adam Smith's notion of advantageous trade based theories of international trade by adam smith absolute advantage.
If as in Smith's example, England were more productive in cloth production and Portugal were more productive in wine, then we would say that England has an absolute advantage in cloth production while Portugal has an absolute advantage in wine. If we calculated comparative advantages, then England would also have the comparative advantage in cloth and Portugal would have the comparative advantage in wine.
In this case, gains from trade could be realized if both countries specialized in their comparative, and absolute, advantage goods. Advantageous trade based on comparative advantage, then, covers a larger set of circumstances while still including the case of absolute advantage and hence is a more general theory.
The Ricardian Model - Assumptions and Results The modern version of the Ricardian model and its results are typically presented by constructing and analyzing an economic model of an international economy. In its most simple form, the model assumes two countries producing two goods using labor as the only factor of production. Goods are assumed homogeneous i. Labor is homogeneous within a country but heterogeneous non-identical across countries.
Goods can be transported costlessly between countries. Labor can be reallocated costlessly between industries within a country but cannot move between countries.
Labor is always fully employed. Production technology differences exist across industries and across countries and are reflected in labor productivity parameters.
The labor and goods markets are assumed to be perfectly competitive in both countries. Firms are assumed to maximize profit while consumers workers are assumed to maximize utility. See page for a more complete description The primary issue in the analysis of this model is what happens when each country moves from autarky no trade to free trade with the other country - in other words, what are the effects of trade?
The main things we care about are trade's effects on the prices of the goods in each country, the production levels of the goods, employment levels in each industry, the pattern of trade who exports and who theories of international trade by adam smith whatconsumption levels in each country, wages and incomes, and the welfare effects both nationally and individually.
Using the model one can show that, in autarky, each country will produce some of each good. Because of the technology differences, relative prices of the two goods will differ between countries.
The price of each country's comparative advantage good will be lower than the price of the same good in the other country. If one country has an absolute advantage in the production of both goods as assumed by Ricardo then real wages of workers i. In other words, workers in the technologically advanced country would enjoy a higher standard of living than in the technologically inferior country.
The reason for this is that wages are based on productivity, thus in the country that is more productive, workers get higher wages. The next step in the analysis is to assume that trade between countries is suddenly liberalized and made free. The initial differences in relative prices of the goods between countries in autarky will stimulate trade between the countries.
Since the differences in prices arise directly out of differences in technology between countries, it is the differences in technology that cause trade in the model. Profit-seeking firms in each country's comparative advantage industry would recognize that the price of their good is higher theories of international trade by adam smith the other country.
Since theories of international trade by adam smith costs are zero, more profit can be made through export than with sales domestically. Thus each country would export the good in which they have a comparative advantage. Trade flows would increase until the price of each good is equal across countries. In the end, the price of each country's export good its comparative advantage good theories of international trade by adam smith rise and the price of its import good its comparative disadvantage good will fall.
The higher price received for each country's comparative advantage good would lead each country to specialize theories of international trade by adam smith that good. To accomplish this, labor would have to move from the comparative disadvantaged industry into the comparative advantage industry. This means that one industry goes out of business in each country. However, because the model assumes full employment and costless mobility of labor, all of these workers are immediately gainfully employed in the other industry.
One striking result here is that even when one country is technologically superior to the other in both industries, one of these industries would go out of business when opening to free trade. Thus, technological superiority is not enough to guarantee continued production of a good in free trade.
A country must have a comparative advantage in production of a good, rather than an absolute advantage, to guarantee continued production in free trade. From the perspective of a less developed country, the developed countries' superior technology need not imply that LDC industries cannot compete in theories of international trade by adam smith markets.
Another striking result is that the technologically superior country's comparative advantage industry survives while the same industry disappears in the other country, even though the workers in the other country's industry has lower wages.
In other words, low wages in another country in a particular industry is not sufficient information to know which country's industry would perish under free trade. From the perspective of a developed country, freer trade may not result in a domestic industry's decline just because the foreign firms pay their workers lower wages. The movement to free trade generates an improvement in welfare in both countries both individually and nationally.
Specialization and trade theories of international trade by adam smith increase the set of consumption possibilities, compared with autarky, and will make possible an increase in consumption of both goods, nationally. These aggregate gains are often described as improvements in production and consumption efficiency. Free trade raises aggregate world production efficiency because more of both goods are likely to be produced with the same number of workers.
Free trade also improves aggregate consumption efficiency, which implies that consumers have a more pleasing set of choices and prices available to them. Real wages and incomes of individual workers are also shown to rise in both countries. Thus, every worker can consume more of both goods in free trade compared with autarky. In short, everybody benefits from free trade in both countries.
In the Ricardian model trade is truly a win-win situation. The True Meaning and Intuition of the Theory of Comparative Advantage Many people who learn about the theory of comparative advantage quickly convince themselves that its ability to describe the real world is extremely limited, if not non-existent. Although the results follow logically from the assumptions, the assumptions are easily assailed as unrealistic.
For example, the model assumes only two countries producing two goods using just one theories of international trade by adam smith of production.
There is no capital or land or other resources needed for production.
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