Comparative Advantage Theory of International Trade

Introduction

In 1817, an English Political Economist, David Ricardo gave the theory of Comparative Advantage in his book "Principles of Political Economy and Taxation". This theory is also known as comparative cost theory. It explains how countries can stand to benefit by involving in international trade. His theory is regarded as the Classical Theory of International Trade.

Background of Theory

Adam Smith in his book "The Wealth of Nations" explained that countries can benefit by engaging in international trade if they specialize and export in producing the commodity for which they have an absolute cost advantage.

He explained this phenomenon with the help of the example that Country I can produce 20 units of X commodity or 10 units of Y commodity with 1-day labor; and, country II can produce 10 units of X commodity or 2o units of Y commodity with 1-day labor. Here, country I has an internal exchange rate (2x:1y) which means forgoing 1 unit of X, it will get 0.5 unit of Y. Country II, on the other hand, is (1x:2y) getting 0.5 unit of X for giving 1 unit of Y.

If these countries enter into international trade, both will have the chance to trade at the exchange rate of 1: 1. More explicitly, Country I, for 1 unit of X can get 1 unit of Y, instead of 0.5; and also Country II can get 1 unit of X, instead of 0.5 units, for 1 unit of Y.

Both countries will have an absolute cost advantage from which they can be benefitted by engaging in trade. However, if they have equal cost differences -the internal exchange rate is the same in both countries- then no trade could be possible.

David Ricardo agreed with the idea of Adam Smith's absolute cost advantage. He went further, to argue that countries can still benefit from international trade even if one country has an absolute cost advantage in the production of both commodities and gave the theory of comparative advantage.

Comparative Advantage Theory

According to David Ricardo,

"The countries will produce and export those commodities in which they have greater comparative advantage and will import those commodities in which they have less comparative advantage. However, the other country will specialize in that commodity in which it has less comparative disadvantage."

Simply, a country will specialize in that commodity that will suit it more. It will produce the same in excess and then exchange the surplus with the imports from another country.

Assumptions of Comparative Advantage Theory

1. The model is based on two countries and two commodities.
2. There will be perfect competition in factor and commodity markets.
3. The Cost of Production will be calculated in terms of labor.
4. Labor is the only factor of production.
5. All the labor is homogenous, i.e., they have the same efficiency level.
6. The labor will be perfectly mobile within the country but immobile between the two countries.
7. Free trade exists between the two countries.
8. There will be no transportation cost.
9. No technological change.
10. There will be constant returns to scale.
11. Full employment in the economy.
12. The exchange will take place on the barter system.

Ricardo Theory Explanation with Example

Assume that there are two countries Portugal and England producing two commodities wine and cloth.

Portugal has the labor capacity to produce 1 unit of wine in 80 hours and England needs 120 hours for the same. To produce one unit of cloth Portugal needs 90 hours and England needs 100 hours.

• Portugal: 1 unit wine/80hrs; 1 unit cloth/90hrs
• England: 1 unit wine/120hrs; 1 unit cloth/100hrs

It is quite clear that Portugal is more efficient than England in the production of both commodities. Based on David Ricardo's Comparative Advantage theory it can still be benefitted if it trades with England.

Here in this example, Portugal has a greater comparative advantage in the production of wine which it produces in 40 fewer hours than England. Whereas it has less comparative advantage in the production of Cloth in which it is just 10 hours faster than England.

Moreover, England has greater comparative disadvantage in the production of wine and less comparative disadvantage in the production of cloth.

Therefore, if Portugal specializes in the production of wine and England specializes in the production of cloth and both countries enter into international trade with the exchange rate (i.e. terms of trade) of 1:1; trade will benefit each of them.

England can get 1 unit of wine for 1 unit of cloth whereas internally it has to give 1.2 units of cloth for 1 unit of wine. On the other side, Portugal will get 1 unit of cloth for giving 1 unit of wine whereas internally it was getting only 0.89 units of cloth for 1 unit of wine.

This shows that both countries can gain from trade with a comparative advantage.

Criticisms

The model is based on highly unrealistic assumptions:

1. The assumption that 'there are only two countries and two commodities' is too narrow. Every country trades with all other countries and in many commodities that come in its reach and benefit.
2. Perfect competition is idealistic and does not exist in the real world so neither factor nor commodity market can operate with perfect competition principles.
3. Production of commodities requires different factors of production, such as land, labor, and capital. All these factors are to be paid for their contribution. Hence, taking only labor as the sole factor of production is incorrect. Moreover, labor cannot be homogenous even in one country. They all differ in their efficiency and skills.
4. Ricardo assumed labor was perfectly mobile within one country and immobile between countries. However, in countries with large geographical areas and many divisions, it is impossible to move labor from one market to another.
5. Highly unrealistic assumptions were the absence of transportation costs technological change, and full employment. There is always some cost that occurs in the movement of material, logistics are not naturally endowed, and technological change occurs rapidly it cannot be considered static. Full employment is not possible in any economy because some level of seasonal or other types of employment always exists.