Web MindTools.net

Comparative Advantage

We mentioned that the concept of absolute advantage seems to imply that entities (countries, corporations, people) ought to seek economic opportunities where they have absolute advantages over competitors (e.g., through obtaining a monopoly). The concept of absolute advantage tends to support a WINER-LOSER psychology of trade.

In contrast, the concept of comparative advantage, developed by economist David Ricardo in 1817, shows how a WIN-WIN psychology of trade can be supported. Ricardo's theory has the crucially important result that even when a nation does not have an absolute advantage in the production of particular goods or services with another nation, it can still be in the self-interest of that nation to engage in international trade.

Ricardo's theory is important for understanding Globalization because it provides a powerful theoretical basis for the idea that free trade among nations is to everyone's advantage. Ricardo's theory is also important because it encourages nations to specialize in specific areas, and developing countries need to have a reliable theory that will guide them in finding the appropriate areas of specialization.

Here is an example based on Ricardo's. Consider two countries, England and Portugal. Both countries produce wine and cloth, and both are currently trading these. Assume that Portugal is more efficient at producing both products; i.e., it can produce more with less input. Portugal therefore has an absolute advantage over England in these areas. Does it pay for England to continue to trade with Portugal in these commodities? Since England does not have absolute advantage, and presumably, cannot hope to obtain absolute advantage, should it just give up trying to produce these commodities and import them from Portugal? Or should it try to stop trading with Portugal altogether -- or perhaps just erect severe traiffs against Portugal -- since it cannot "win" in trading?

Ricardo shows how both sides can benefit, or "win," by adjusting the efforts of their labor forces. We have to make some assumptions to simplify the model, but the fundamental points Ricardo makes are still valid today.

Assume the labor costs for these commodities are as follows:

                      Hours Required to Produce
               1 Gallon of Wine       1 Yard of Cloth
Portugal             80                     90
England              120                    100

Also assume that the current exchange prices for these commodities are equal. That is, one gallon of wine will buy one yard of cloth.

Observe that if Portugal diverts relatively more of its labor to wine production, it can, in effect, obtain cloth more cheaply. The reason is as follows: if Portugal spends 90 hours producing wine (instead of cloth), it produces 1 and 1/8 (1.125) gallons of wine with that labor. If the wine is exported to England, it purchases 1.125 yards of cloth. It is a more efficient for Portugal to export wine and trade it for cloth than to produce cloth domestically. Stated another way, if you are a laborer in Portugal, 90 hours of labor allows you to produce 1 yard of cloth domestically, or purchase 1.125 yards of cloth through international trade.

What about England? England can gain by producing relatively less wine and diverting its resources to cloth production. It takes 120 hours to produce 1 gallon of wine, but in those same 120 hours England can produce 1.20 yards of cloth, and this can be exchanged for 1.20 gallons of wine.

In regard to contemporary Globalization, it is important to note the following about Ricardo's model:

• Both countries have to be willing to trade; they must be willing to accept foreign goods
• The model assumes no tariffs
• The model encourages specialization
• The model applies to trade between individuals, corporations, nations, or regions
• The model assumes differences in labor hours; all that is actually necessary is that price ratios differ between the two entities engaged in trade
• The model assumes a captive labor pool; Portuguese labor cannot migrate freely to England. (This raises important issues for the model in a global society where people can move more freely than in Ricardo's time. See our discussion the disappearance of the Mexico/USA border.)
• The model assumes that labor is completely fluid: workers can freely move from wine production to cloth production. In the real world, workers cannot move from one profession to another without at least temporary unemployment or time for retraining. Trade may cause temporary unemployment in specific industries when products produced by domestic work are replaced by imported products. We call it "outsourcing" today. However, contemporary economists have shown that despite potential job displacement, international free trade is a WIN-WIN game, and has overall benefits to a national economy, just as Ricardo claimed.

Created on ... February 16, 2004. Revised on 18:58 2/13/2005