In economics, David Ricardo is 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. Face-to-face trading interactions on the New York Stock Exchange trading floor. ... David Ricardo (18th April, 1772–11th September, 1823), a political economist, is often credited with systematizing economics, and was one of the most influential of the classical economists, along with Thomas Malthus and Adam Smith. ... For other uses, see Country (disambiguation). ... It has been suggested that Commerce be merged into this article or section. ... In economics, opportunity cost, or economic cost, is the cost of something in terms of an opportunity forgone (and the benefits which could be received from that opportunity), or the most valuable forgone alternative (or highest-valued option forgone), i. ...

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, even if one country has an absolute advantage in every type of output, the disadvantaged country can benefit from specializing in and exporting the product(s) with the largest opportunity cost for the other country.^[1] A country has an absolute advantage economically over another, in a particular good, when it can produce that good more efficiently. ... For other persons named Adam Smith, see Adam Smith (disambiguation). ...

Origins of the theory

Comparative advantage was first described by Robert Torrens in 1815 in an essay on the Corn Laws. He concluded it was England's advantage to trade with Poland in return for grain, even though it might be possible to produce that grain more cheaply in England than Poland. Colonel Robert Torrens (1780 – 1864) was a British army officer and owner of the influential Globe newspaper. ... April 5-12: Mount Tambora explodes, changing climate. ... The Corn Laws, in force between 1815 and 1846, were import tariffs ostensibly designed to protect British farmers and landowners against competition from cheap foreign grain imports. ... For other uses, see England (disambiguation). ...

However it is usually attributed to David Ricardo who explained it clearly in his 1817 book On the Principles of Political Economy and Taxation in 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. And conversely England benefits from this trade because its cost for producing cloth has not changed but it can now get wine at closer to the cost of cloth. David Ricardo (18th April, 1772–11th September, 1823), a political economist, is often credited with systematizing economics, and was one of the most influential of the classical economists, along with Thomas Malthus and Adam Smith. ... 1817 was a common year starting on Wednesday (see link for calendar). ... On the Principles of Political Economy and Taxation (1817) is the title of a book by David Ricardo on economics. ... For other uses, see Wine (disambiguation). ... It has been suggested that Textile be merged into this article or section. ...

The conclusion drawn from this is that a country should 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 2 all assumptions are italicized for easy reference, and some are explained at the end of the example.

Example 1

Two men live 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

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

If all the resources of the countries were allocated to the production of clothes, output would be:

• Northland: 100 tonnes
• Southland: 100 tonnes

Assuming each has constant opportunity costs of production between the two products and both economies have full employment at all times. All factors of production are mobile within the countries between clothing and food industries, but are immobile between the countries. The price mechanism must be working to provide perfect competition. In economics, opportunity cost, or economic cost, is the cost of something in terms of an opportunity forgone (and the benefits which could be received from that opportunity), or the most valuable forgone alternative (or highest-valued option forgone), i. ... In economics, full employment has more than one meaning. ... In economics, factors of production are resources used in the production of goods and services, including land, labor, and capital. ... A price mechanism or market-based method is any of a wide variety of ways to match up offers and requests that market players bid and ask: a bid is an offer to pay a fixed amount that is held open for a period of time an ask is an... Perfect competition is an economic model that describes a hypothetical market form in which no producer or consumer has the market power to influence prices. ...

Southland has an absolute advantage over Northland in the production of Food. Both countries are equally efficient in the production of clothes. There seems to be no mutual benefit in trade between the economies. The opportunity costs shows otherwise. Northland's opportunity cost of producing one tonne of Food is one tonne of Clothes and vice versa. Southland's opportunity cost of one tonne of Food is 0.5 tonne of Clothes. The opportunity cost of one tonne of Clothes is 2 tonnes of Food. Southland has a comparative advantage in food production, because of its lower opportunity cost of production with respect to Northland. Northland 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. A country has an absolute advantage economically over another, in a particular good, when it can produce that good more efficiently. ...

To show these different opportunity costs lead to mutual benefit if the countries specialize production and trade, consider the countries produce and consume only domestically. The volumes are:

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. 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. The 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 specialize in the goods in which they have comparative advantage, their outputs will be:

World production of food increased. Clothing production 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:

Northland traded 50 tonnes of Clothing for 75 tonnes of Food. Both benefited, and now consume at points outside their production possibility frontiers. In economics, the production possibility frontier (the PPF, also called the production possibilities curve (PPC) or the “transformation curve”) is a graph that depicts the trade-off between any two items produced. ...

Assumptions in Example 2

• 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? The modern version of comparative advantage (developed in the early twentieth century by the Swedish economists Eli Heckscher and Bertil Ohlin) attributes these differences to differences in nations' factor endowments. A nation will have comparative advantage in producing the good that uses intensively the factor it produces abundantly. For example: suppose the US has a relative abundance of capital and India has a relative abundance of labor. Suppose further that cars are capital intensive to produce, while cloth is labor intensive. Then the US will have a comparative advantage in making cars, and India will have a comparative advantage in making cloth. If there is international factor mobility this can change nations' relative factor abundance. The principle of comparative advantage still applies, but who has the advantage in what can change.

• Perfect competition - this is a standard assumption that allows perfectly efficient allocation of productive resources in an idealized free market.

Attorney example

There is an 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. Economics is a textbook by American economists Paul Samuelson and William Nordhaus. ... Paul Anthony Samuelson (born May 15, 1915, in Gary, Indiana) is an American neoclassical economist known for his contributions to many fields of economics, beginning with his general statement of the comparative statics method in his 1947 book Foundations of Economic Analysis. ...

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.

Ricardo's principle relies on a variety of implicit assumptions that may not apply in any given situation, such as that there is no (or a low) cost for transportation.

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. Free trade is an economic concept referring to the selling of products between countries without tariffs or other trade barriers. ... Communication is a process that allows organisms to exchange information by several methods. ... Free trade is one of the most debated topics of the 20th and 21st century. ...

Notes

References

• Ronald Findlay (1987). "comparative advantage," The New Palgrave: A Dictionary of Economics, 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