About the Theory

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The theory of Comparative Advantage was derived by an English economist named David Ricardo in the early 1800s. David Ricardo studied Adam Smith¶s theory of Absolute Advantage and he explored what could happen when a country has an absolute advantage in the production of all goods. A country can have an absolute advantage in the production of a good without having a comparative advantage which determines whether it pays to produce a good or import it.

Main Things about Comparative Advantage:

1. The theory of Comparative Advantage was developed by David Ricardo, who took Adam Smith¶s theory of Absolute Advantage a step further. Ricardo¶s theory explores what might happen when one country has an Absolute Advantage in the production of all goods. 2. Ricardo¶s theory is contrary to Smith¶s theory as Smith implies that a country might not derive any benefits from international trade if they have absolute a dvantage in the production of some goods. Ricardo looks at the absolute advantage in the production by a single country of all goods; not just some goods. 3. Ricardo showed that a country could derive benefits from international trade even if it meant buying goods that it could produce more efficiently than the country it might buy from. 4. Ricardo concluded that free trade is beneficial to all countries that operated under the theory of comparative advantage. The problem with Ricar do¶s theory noted by many economists is that he used a simple model of two countries where in the real world there are many countries and many goods, and this leaves room for doubt of the theory¶s real world application because there are too many assumptio ns that need to be made. 5. Although the Ricardian model has its short comings there is much research suggesting that the basic idea that countries will export the goods that they are most efficient at producing. One economist goes so far as to say that in ³certain circumstances the theory of comparative advantage predicts that a rich country might actually be worse off by switching to a free trade regime with a poor nation´. 6. A country operating under the theory of comparative adv antage may face anger and grief from its work force as the theory implies that free trade is taking place and that certain members of the labor force maybe come unemployed or be forced to take inferior jobs. This is as a result of the fact that resources cannot always be moved easily from one economic activity to another. 7. Historical research has shown that when there is political opposition to adopting free trade, this opposition usually comes from those whose jobs are most at risk. Typically industries that unionized have the most to lose from free trade and government intervention

and capital. the theory of comparative advantage and free trade society yield positive gains that are both significant and long lasting. Obviously both countries are better off when Americans produce wheat and exchange a portion of it for some of the coffee that Brazilians produce. But does this mean that a country with an absolute advantage in the production of a good should always produce that good rather than impor t it? No. A study as recent as the late 1990s indicated that a country with an open economy and applying free trade is rewarde d with higher economic growth rates and that this higher growth raised both income levels and living standards. Rich countries find it difficult to treat less fortunate countries with equal opportunities to trade. labor.000 computers requires three units of PR in the United States and four in Brazil. and one productive resource which is some composite of land. Everyone has an opinion about the positive and negative effects from international trade. etc to reach a consensus and move in the direction of free trade. A country can have an absolute advantage in the production of a good without having a comparative advantage.S. 10. Assume also tha t producing 100 cars requires two units of the productive resource (PR) in the United States and four units in Brazil. and Brazil is better at producing coffee than the United States. It is difficult if not impossible for governments. workers. cars and computers. 8. The theory of comparative advantage also loses strength in the real world due to the fact that countries when producing or specializing in. and producing 1. Absolute versus Comparative Advantage: The most straightforward case for free trade is that countries have differ ent absolute advantages in producing goods. In the long run however. Diminishing return happens when it takes more and more units of certain resources to produce each additional unit. certain production face the dilemma of diminishing returns. U. Assume that there are only two goods. Brazil 100 cars 1. economist.becomes necessary to assist those union workers that lose their jobs as a result. What seems to be stopping us from expl oring the application of theories such as comparative advantage is the fact that international trade is such a complex issue to tackle in the political arena. 9. Comparative advantage is what determines whether it pays to produce a good or import it. because of differences in soil and climate.000 computers 2 3 4 4 . the United States is better at producing wheat than Brazil. There are numerous economic studies that suggest countries that participate in international trade have higher economic growth rates than countries that do not participate in such trade. as the David Ricardo first explained in the early 1800s. For example.

000 cars and Brazil can produce 20. It is important to understand the opportunity cost one country gives up to produce one good over another. Brazil produces computers for only two-thirds as much as it costs in the United States. yielding 1. Using the three units of PR required to produce 1. Clearly the United States benefits from specializing in cars.400 cars and 6. yielding 3.000 computers.550) and 2. while producing 100 cars in Brazil costs 1. Compared to what has to be sacrificed.500 more computers (7. the United States produced both cars and computers it might devote 70 units of PR to car production and 30 units to computer production. On the other hand. The United States could trade 1.000 additional computers. by specializing in their comparative advantages. All costs are opportunity costs. Producing 1 00 cars here costs 666 computers. it migh t devote 56 units of PR to car production and 24 to computer production.450) and 1. . If.000 com puters. Trade is productive since it generates more output of both products. If Brazil produced both products. while Brazil would have 50 more cars (1.Americans have an absolute advantage in producing both cars and computers.000 computers. Managers and employees don¶t typically get to discuss an issue such as international free trade and its effects since it¶s not a topic stockholders and owners of companies care to share or help their workers understand. has a comparative advantage over Brazil in the production of cars. So even though Americans have an absolute advantage in producing computers.500 more computers (12. and trading with Brazil for some of the computers it prod uces more cheaply. the United States can produce 5.000 computers. of course.450 cars to Brazil for 12. This concept greatly affects the means in which countries trade over internationa l borders. for example. Societies would be positively affected.500). Why not produce both cars and computers here? Because it costs more to produce computers in the United States than in Brazil. The cost of producing computers is the cars that could have been produced. Comparative Advantage is extremely important in today¶s society. which it produces more cheaply than Brazil. The United States.000 computers in Brazil requires sacrificing only 100 cars. Using the four units of PR required to produce 1. Brazilians have a comparative advantage.. Juglary.500).500 cars and 10. It may seem that Americans can realize no gain by trading with Brazilians.500 computers and have 50 additional cars (3.000 computers in the United States requires sacrificing the production of 150 cars. or a total of 100 additional cars and 4.

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