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In economics, David Ricardo is most often credited for the principle of 'comparative advantage' to explain how 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 production of one good is reduced to produce one more unit of the other good. Comparative advantage is a key economic concept in the study of free trade.
Under the principle of absolute advantage, developed by Adam Smith, one country can produce more output per unit of productive input than another. With comparative advantage, if one country has an absolute (dis)advantage in every type of output, the other might benefit from specializing in and exporting those products, if any exist. Global Poltical Economy Theory and Practice, , Theodore H., Cohn, Pearson Education, Inc., 2005 (third edition), ISBN 0-321-20949-4

Contents

Origins of the theory

Examples

Example 1

Example 2

Example 3

Attorney example

More complexities

Criticism

Notes

References

External links

Origins of the theory

Comparative advantage was first described by Robert Torrens in 1815 in an essay on the Corn Laws. He concluded that it was to England's advantage to trade various goods with Poland in return for grain, even though it might be possible to produce that grain more cheaply in England than Poland.
However, the theory is usually attributed to David Ricardo who created a systematic explanation in his 1817 book ''On 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.
Ricardo's theory requires the explicit assumption that capitalists were restricted to investing money only in their own region. He noted for example that within England, a comparative advantage for London would not help if Manchester had an absolute advantage. London capitalists would invest in Manchester, and all the goods would be produced there. In a global economy where investments can easily move from one part of the world to another, ''comparative advantage'' is irrelevant and ''absolute advantage'' determines investment. However some economists still invoke comparative advantage without theoretical justification when promoting trade.
The conclusion drawn from this is that a country should restrict capital mobility and specialize in products and services in which they have a ''comparative advantage.'' They should then trade with another country that has products in which that country has a ''comparative advantage''. In this way both countries become better off.

Examples

The following hypothetical 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.

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 labour. It will make both of them richer.

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.

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.

Attorney example

There is also a very illuminating example illustrated in the well known book Economics by Paul Samuelson. Imagine a city where the best lawyer happens also to be the best secretary, that is he would be the most productive lawyer and he would also be the best secretary in town. However it is quite clear that this lawyer would focus on the task of being an attorney by employing a secretary instead of doing all the paperwork by himself.
This can easily be explained with the concept of comparative advantage: He is the best secretary AND the best lawyer, however by comparing what he can earn as a secretary with the income he could earn by running a law firm AND employing a secretary one can clearly see that the latter option is the better one.

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.

Criticism

Optimizing trade equations for maximum total GDP may not necessarily optimize other factors, such as equality, stability, military technology trade secrets, human-rights, pollution, cultural identity, etc. Economists sometimes call these factors "Externalities". Ricardo's principle relies on a variety of implicit assumptions that are debatable, such as that there is no (or a low) cost for transportation, and that the advantages of increased production outweigh externalities such as environmental contamination or social inequities.
Opponents of free trade often point out that globalized communications and transportation unavailable in Ricardo's time invalidate the assumption of capital immobility and cause capital to gravitate toward absolute advantage (though proponents would point out that modern low cost transportation only makes the assumption more sound). It has also been argued that comparative advantage may reduce economic diversity to risky levels.

Notes

References

★ Ronald Findlay (1987). "comparative advantage," ''The '', 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''.

External links

★ David Ricardo's The Principles of Trade and Taxation (original source text)

★ Ricardo's Difficult Idea, an economist's exploration of why non-economists don't understand and won't take seriously the idea of comparative advantage

★ The Ricardian Model of Comparative Advantage

★ J.G. Hülsmann's Capital Exports and Free Trade explanation of why the immobility of capital is not an essential condition