The Theory of Comparative Advantage

- Given by David Ricardo

. On the Principles of Political Economy and Taxation.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. Finally. numerical example in his 1817 book titled. David Ricardo formalized the idea using a compelling. the concept became a key feature of international political economy upon the publication of Principles of Political Economy by John Stuart Mill in 1848. yet simple. The idea appeared again in James Mill's Elements of Political Economy in 1821.

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.Ricardo’s Idea of Comparative Advantage     Ricardo's Law of Comparative Advantage improved upon the earlier Law of Absolute Advantage. .

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   A country has a comparative advantage in the production of a good or service that it produces The theory of comparative costs argues that.

 Complete mobility of labor in the country and complete immobility of labor across the country  No transportation costs  Full employment  .Assumptions 2*2*1 model  Homogeneous goods  Labor is homogeneous within a country but heterogeneous across countries.

Assumptions    Production technology differences exist across industries and across countries and are reflected in labor productivity parameters. Firms are assumed to maximize profit while consumers (workers) are assumed to maximize utility. . The labor and goods markets are assumed to be perfectly competitive in both countries.

producing two goods.  .  Ricardo assumed that Portugal was more productive in both goods. using labor as the sole input in production. cloth and wine. England and Portugal.  He assumed that the productivity of labor varied between industries and across countries.Ricardo’s numerical example In his example Ricardo imagined two countries.

Table-1 Country Wheat Cost Per Unit In Man Hours England Portugal 15 10 Wine Cost Per Unit In Man Hours 30 15 .

England is relatively better at producing wheat than wine: so England is said to have a comparative advantage in the production of wheat. .Ricardo’s numerical example  Portugal is relatively better at producing wine than wheat: so Portugal is said to have a COMPARATIVE ADVANTAGE in the production of wine.

Ricardo’s numerical example  Table 2 shows how trade might be advantageous. England is assumed to have 270 man hours available for production. Total production between the two economies is 17 units of wheat and 11 units of wine . Portugal has fewer labour resources with 180 man hours of labour available for production. Before trade takes place it produces and consumes 9 units of wheat and 6 units of wine. Costs of production are as set out in Table 1. Before trade takes place it produces and consumes 8 units of wheat and 5 units of wine.

Table-2 Country Production Before Trade Wheat Wine After Trade Wheat Wine England Portugal Total 8 5 18 0 9 17 6 11 0 18 12 12 .

Specialisation has enabled the world economy to increase production by 1 unit of wheat and 1 unit of wine. total production is 18 units of wheat and 12 units of wine.Ricardo’s numerical example  If both countries now specialise. . Portugal producing only wine and England producing only wheat.

A better way to state the results is as follows. Stated this way it is easy to imagine how it would not hold true in the complex real world. The Ricardian model shows that if we want to maximize total output in the world then. The usual way of stating the Ricardian model results is to say that countries will specialize in their comparative advantage good and trade them to the other country such that everyone in both countries benefit. .Interpreting the Theory of Comparative Advantage   The garden story offers an intuitive explanation for the theory of comparative advantage and also provides a useful way of interpreting the model results.

allocate those resources within countries to each country's comparative advantage industries.  and third. fully employ all resources worldwide.Interpreting the Theory of Comparative Advantage first.  second. allow the countries to trade freely thereafter.  .

instead we should say that the theory tells us some things that can happen. In this description. we do not predict that a result will carry over to the complex real world.Interpreting the Theory of Comparative Advantage  In this way we might raise the wellbeing of all individuals despite differences in relative productivities. Instead we carry the logic of comparative advantage to the real world and ask how things would have to look to achieve a certain result (maximum output and benefits). In the end we should not say that the model of comparative advantage tells us anything about what will happen when two countries begin to trade. .

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