Comparative advantages Theory
Comparative advantage is an economic term that refers to an economy’s ability to produce goods and services at a lower opportunity cost than that of trade partners. A comparative advantage gives a company the ability to sell goods and services at a lower price than its competitors and realize stronger sales margins. The law of comparative advantage is popularly attributed to English political economist David Ricardo and his book “Principles of Political Economy and Taxation” in 1817, although it is likely that Ricardo’s mentor James Mill originated the analysis.
Theory of Comparative Advantage
Eighteenth-century economist David Ricardo created the theory of comparative advantage. He argued that a country boosts its economic growth the most by focusing on the industry in which it has the most substantial comparative advantage.
For example, England was able to manufacture cheap cloth. Portugal had the right conditions to make cheap wine. Ricardo predicted that England would stop making wine and Portugal stop making cloth. He was right. England made more money by trading its cloth for Portugal’s wine, and vice versa. It would have cost England a lot to make all the wine it needed because it lacked the climate. Portugal didn’t have the manufacturing ability to make cheap cloth. Therefore, they both benefited by trading what they produced the most efficiently.
Ricardo developed his approach to combat trade restrictions on imported wheat in England. He argued that it made no sense to restrict low-cost and high-quality wheat from countries with the right climate and soil conditions. England would receive more value by exporting products that required skilled labor and machinery. It could acquire more wheat in trade than it could grow on its own.
The theory of comparative advantage explains why trade protectionism doesn’t work in the long run. Political leaders are always under pressure from their local constituents to protect jobs from international competition by raising tariffs. But that’s only a temporary fix. In the long run, it hurts the nation’s competitiveness. It allows the country to waste resources on unsuccessful industries. It also forces consumers to pay higher prices to buy domestic goods.
David Ricardo started out as a successful stockbroker, making $100 million in today’s dollars. After reading Adam Smith’s “The Wealth of Nations,” he became an economist. He was the first person to point out that significant increases in the money supply create inflation. This theory is known as monetarism.
He also developed the law of diminishing marginal returns. That’s one of the essential concepts in microeconomics. It states that there is a point in production where the increased output is no longer worth the additional input in raw materials.
One of America’s comparative advantages is its vast land mass bordered by two oceans. It also has lots of fresh water, arable land, and available oil. U.S. businesses benefit from cheap natural resources and protection from land invasion.
Most important, it has a diverse population with a common language and national laws. The diverse population provides an extensive test market for new products. It helped the United States excel at producing consumer products
Diversity also helped the United States became a global leader in banking, aerospace, defense equipment, and technology. Silicon Valley harnessed the power of diversityto become a leader in innovative thinking. Those combined advantages created the power of the U.S. economy.
Comparative Advantage Versus Absolute Advantage
Absolute advantage is anything a country does more efficiently than other countries. Nations that are blessed with an abundance of farmland, fresh water, and oil reserves have an absolute advantage in agriculture, gasoline, and petrochemicals.
Just because a country has an absolute advantage in an industry doesn’t mean that it will be its comparative advantage. That depends on what the trading opportunity costs are. Say its neighbor has no oil but lots of farmland and fresh water. The neighbor is willing to trade a lot of food in exchange for oil. Now the first country has a comparative advantage in oil. It can get more food from its neighbor by trading it for oil than it could produce on its own.
Comparative Advantage Versus Competitive Advantage
Competitive advantage is what a country, business, or individual does that provide a better value to consumers than its competitors. There are three strategies companies use to gain a competitive advantage. First, they could be the low-cost provider. Second, they could offer a better product or service. Third, they could focus on one type of customer.
How It Affects You
Comparative advantage is what you do best while also giving up the least. For example, if you’re a great plumber and a great babysitter, your comparative advantage is plumbing. That’s because you’ll make more money as a plumber. You can hire an hour of babysitting services for less than you would make doing an hour of plumbing. Your opportunity cost of babysitting is high. Every hour you spend babysitting is an hour’s worth of lost revenue you could have gotten on a plumbing job.
Absolute advantage is anything you do more efficiently than anyone else. You’re better than everyone else in the neighborhood at both plumbing and babysitting. But plumbing is your comparative advantage. That’s because you only give up low-cost babysitting jobs to pursue your well-paid plumbing career.
Competitive advantage is what makes you more attractive to consumers than your competitors. For example, you are in demand to provide both plumbing and babysitting services. But it’s not necessarily because you do them better (absolute advantage). It’s because you charge less.
David Ricardo believed that the international trade is governed by the comparative cost advantage rather than the absolute cost advantage. A country will specialise in that line of production in which it has a greater relative or comparative advantage in costs than other countries and will depend upon imports from abroad of all such commodities in which it has relative cost disadvantage.
Suppose India produces computers and rice at a high cost while Japan produces both the commodities at a low cost. It does not mean that Japan will specialise in both rice and computers and India will have nothing to export. If Japan can produce rice at a relatively lesser cost than computers, it will decide to specialise in the production and export of computers and India, which has less comparative cost disadvantage in the production of rice than computers will decide to specialise in the production of rice and export it to Japan in exchange of computers.
The Ricardian comparative costs analysis is based upon the following assumptions:
(i) There is no intervention by the government in economic system.
(ii) Perfect competition exists both in the commodity and factor markets.
(iii) There are static conditions in the economy. It implies that factors supplies, techniques of production and tastes and preferences are given and constant.
(iv) Production function is homogeneous of the first degree. It implies that output changes exactly in the same ratio in which the factor inputs are varied. In other words, production is governed by constant returns to scale.
(v) Labour is the only factor of production and the cost of producing a commodity is expressed in labour units.
(vi) Labour is perfectly mobile within the country but perfectly immobile among different countries.
(vii) Transport costs are absent so that production cost, measured in terms of labour input alone, determines the cost of producing a given commodity.
(viii) There are only two commodities to be exchanged between the two countries.
(ix) Money is non-existent and prices of different goods are measured by their real cost of production.
(x) There is full employment of resources in both the countries.
(xi) Trade between two countries takes place on the basis of barter.
This two-country, two-commodity model can be analysed through the Table 2.3.
|Table 2.3 Labour Cost of Production|
|Country||Labour cost per unit of commodity in man-hours|
|Commodity X||Commodity Y|
The Table 2.3 indicates that country A has an absolute advantage in producing both the commodities through smaller inputs of labour than in country B. In relative terms, however, country A has comparative advantage in specialising in the production and export of commodity X while country B will specialise in the production and export of commodity Y.
In country A, domestic exchange ratio between X and Y is 12 : 10, i.e., 1 unit of X = 12/10 or 1.20 units of Y. Alternatively, 1 unit of Y= 10/12 or 0.83 units of X.
In country B, the domestic exchange ratio is 16 : 12, i.e., 1 unit of X = 16/12 or 1.33 units of Y. Alternatively, 1 unit of Y = 16/12 or 0.75 unit of X.
From the above cost ratios, it follows that country A has comparative cost advantage in the production of X and B has comparatively lesser cost disadvantage in the production of Y.
In algebraic terms, let labour cost of producing X-commodity in country A is a1 and in country B is a2. The labour cost of producing Y-commodity in countries A and B are respectively a3 and a4.
The absolute differences in costs can be measured as:
a1/a2 < 1 < a3/a4
It shows that country A has absolute advantage in producing X and country B has an absolute advantage in commodity Y.
The comparative differences in costs can be measured as:
a1/a2 < a3/a4 < 1
The Table 2.3 satisfies the condition specified for comparative difference in costs;
a1/a2 < 1 < a3/a4 < 1
12/16 < 10/12 < 1
In case a1/a2 = a3/a4, there are equal differences in costs and there is no possibility of trade between the two countries.
In Fig. 2.2, AA1 and BB1 are the production possibility curves pertaining to countries A and B. Given the same amount of productive resources, A can produce larger quantities of both the commodities than the country B. It means country A has absolute cost advantage over B in respect of both the commodities.
If the curve BC1 is drawn parallel to AA1; the curve BC1 can represent the production possibility curve of country A. If country A gives up OB quantity of Y and diverts resources to the production of X, it can produce OC1 quantity of X, which is more than OB1. It means the country A has comparative cost advantage in the production of X-commodity.
From the point of view of B, it can produce the same quantity OB of Y, if it gives up the production of smaller quantity OB1 of X. If signifies that country B has less comparative disadvantage in the production of Y commodity. Accordingly, country A will specialise in the production and export of X commodity, while country B will specialise in the production and export of Y-commodity.
Gain from Trade:
The comparative cost principle underlines the fact that two countries will stand to gain through trade so long as the cost ratios for two countries are not equal. On the basis of Table 2.3, country A specialises in the production of X commodity, while country B specialises in the production of Y commodity.
In the absence of international trade, the domestic exchange ratio between X and Y commodities in these two countries are:
Country A: 1 unit of X = 12/10 or 1-20 units of Y
Country B: 1 unit of Y = 12/16 or 0-75 unit of X
If trade takes place and two countries agree to exchange 1 unit of X for 1 unit of Y, the gain from trade for country A amounts to 0.20 units of Y for each unit of X. In case of country B, the gain from trade amounts to 0.25 unit of X for each unit of Y. Thus the comparative costs principle confers gain upon both the countries.
Doctrine of Comparative Advantage:
The doctrine of comparative advantage originated as an improvement and development of the 18th century criticism of mercantilist policy. It has continued to command attention mainly because of its use as the basic “scientific” argument of free trade economists in their attack on protective tariffs.
Rejecting Smith’s principle of absolute advantage, Ricardo asserted that international trade depends en a difference in the comparative, not in the absolute cost of producing goods.
The doctrine of comparative costs maintains that if trade is lot free, each country in the long-run tends to specialize in the product in of and to export those commodities in whose production it enjoys a comparative advantage in terms of real costs, and to obtain by importation those commodities which could be produced at home only at a comparative disadvantage in terms of real costs.
Such specialization will be to the mutual advantage of the countries participating in the foreign trade. In the explanation of the doctrine the “real “costs are expressed as a rule in terms of quantities of labour-time.
In the beginning, of the free trade doctrine in the 18th century the usual economic arguments for free trade were based on the advantage to the country in exchange for native products, those commodities which either could not be produced at home at all or could be produced at home only at costs absolutely greater than those at which they could be produced abroad. Thus under free trade, all products would be produced in those countries where their real costs were lowest. The case for free trade as presented by Adam Smith did not advance beyond this point.
|Comparative differences in production costs|
Ricardo in his Principles first published in 1817, presented the doctrine of comparative costs by means of what was to become a famous illustration. Suppose there are two countries Portugal and England and they are producing two commodities wine and cloth. In Portugal a unit of wine costs 80 and a unit of cloth 90 hours of labour; in England a unit of wine costs 120 hours and a unit of cloth 100 hours of labour. In the above example, Portugal has an absolute superiority in both branches of production.
This superiority, however, is greater in wine than in cloth. She has a comparative advantage in the production of wine, since here her cost-difference is relatively greater than in the case of cloth. For 80/120 is less than 90/100. We have to compare the ratios of the costs of production of one good in both countries, 80/120 with the ratios of the costs of production of the other good in both countries 90/100.
Expressed in words:
Portugal has a comparative advantage over England in wine relatively to cloth. Conversely, the disadvantage of England is greater in wine than in cloth. Stated in another way, England has an absolute disadvantage in cloth but at the same time she has a comparative advantage in cloth.
In the absence of trade, the domestic ratio of exchange in England will be; 1 unit of wine exchanged against 1.2 units of cloth and in Portugal, 1 unit of wine exchanged against 0.88 units of cloth. The main task of the labour-cost hypothesis was to determine these exchange-ratios or relative prices.
Let us now assume that trade takes place between the two countries. It is clearly advantageous for Portugal to send wine to England where a unit of it command 1.2 units of cloth. Now Portugal will take to producing wine instead of cloth. England, on the other hand can obtain wine at much less expense by specializing upon the manufacture of cloth and exchanging the cloth with Portugal against wine. For Portugal, there is sufficient inducement to participate in International trade if 1 unit of wine commands a little more than 0.88 units of cloth; for England, if a little less than 1.2 units of cloth must be given for 1 unit of wine.
Hence any exchange ratio between 0.88 and 1.2 units of cloth against 1 unit of wine represents a gain to both countries. Let us assume that the exchange ratio is established at 1 unit of wine exchanged for 1 unit of cloth. Then for every 100 labour-units which England sends to Portugal embodied in the form of cloth, she receives 1 unit of wine which in the absence of international division of labour, would have cost her 120 labour-units to produce for herself and Portugal obtains cloth at a cost of 80 per unit; whereas to produce in for herself would cost 90. Thus, each country specializes upon that branch of production in which it enjoys a comparative advantage, thereby obtaining a greater total product from its given factors of production.
Generally, the credit for the first publication of the principle of comparative costs is given to David Ricardo. Leser, however, in 1881 assigned to Torrens the credit of discovery of the doctrine. In 1815, Torrens published his “An Essay on the External Corn Trade” giving a satisfactory formulation of the doctrine and first using the term “comparative cost”. Leser’s comment attracted no notice, but some year later credit for priority in formulating the doctrine of comparative cost was again claimed for Torrens by Professor Seligman. Professor Hollander has replied in defense of Ricardo’s claims that much of the evidence in support of Torrens presented by Seligman was of questionable weight. Even after the appearance of Ricardo’s Principles, Torrens never realized the full significance of the comparative cost doctrine and never made explicit use to it.
That Ricardo’s claim to priority could never be overcome merely by the fact that Torrens in a single paragraph had correctly stated the doctrine “in outline” before Ricardo had published his Principles. It is unquestionable, however, that Ricardo is entitled to the credit for the first giving due emphasis to the doctrine, for first placing it in an appropriate setting and for obtaining general acceptance of it by economists.
Ricardo based his analysis on the following assumptions:
(i) Ample time for long-run adjustments;
(ii) Free competition;
(iii) Only two countries and only two commodities;
(iv) Constant labour costs as output is varied; and
(v) Proportionality of both aggregate real costs and supply prices within each country to labour time costs within that country.
Ricardo’s emphasis on comparative advantage as opposed to absolute advantage marks his great advance over Adam Smith. Ricardo was the true author of comparative advantage doctrine. As Alfred Marshall wrote: “Professor Hollander has shown that nearly every part of Ricardo’s doctrine was anticipated by some of his predecessors; but his masterly genius, like that of Adam Smith, was largely occupied with the supreme task of building up a number of fragmentary truths into coherent doctrine such a doctrine; has constructive force because it is an organic whole.”
The doctrine of comparative advantage is no doubt a brilliant and Intellectual discovery in the realm of international trade and an explanation for international specialization. The doctrine remained supreme in the realm of international trade for more than a century (1817-1933). It served as a tool of analysis of international specialization. But later on it was vehemently criticized.
Critics of the doctrine of comparative advantage point out that it is valid only under the simple assumptions upon which it was originally formulated. But Haberler and Viner have asserted that this is not so and that the simplifications merely help the exposition without affecting the essentials of the matter. Both the economists have demonstrated that even if we give up some of these assumptions still the doctrine holds true but the scope of the trade may be narrowed down.
Another criticism leveled against the theory is that it failed to explain the basis of international specialization. Bertil Ohlin, the most outstanding and vigorous of the critics of the doctrine of comparative costs, bases his criticism on the interpretation of the doctrine as representing the attempt of the classical school to explain the forces which determine the specific nature of the course of trade and of international specialization.
Ricardo assumed the differences in the comparative costs and then went on analyzing how trade would be mutually advantageous to participating countries. He did not explain as to why Portugal has comparative advantage in the production of wine and England in cloth. Ricardo started from the hypothesis that nations differ in their productive performance and has expressed rather than explained the differing labour time used in the production of different commodities.
The doctrine is primarily concerned with the gains from trade and the critics hold that the theory is simply a demonstration of gains from trade. G.H. Williams had vehemently criticized the doctrine. His criticism is based on an article. “The Theory of International Trade Reconsidered.” His Criticism is directed against the assumptions which are claimed to be highly unrealistic, lay also points out the illogicality of the doctrine as the conclusion of the theory does not follow from its premises.
To quote Williams, “Logically followed though the classical doctrine contradicts itself its conclusions contradict its premises. It is a theory of benefit from the territorial division of labour. If before trade England and Portugal produced both cloth and wine, after trade is opened England will produce cloth for both and Portugal wine. This means national specialization for world market. But such specialization is antithesis of mobility, in this case of domestic movement of productive factors.”
Again, the doctrine was built up in a static analytical framework. The theory was based on an outdated and antiquated labour cost theory of value. “Despite all these difficulties, the supporters of real-cost doctrine have often argued that the deficiency of the theory of value employed in stating the comparative positions of various countries does not detract from its importance and usefulness as an instrument of welfare analysis which is what the theory intended to be. But if the analytic value of the theory is limited in the sense that it holds goods only under very heroic assumptions, then the same limitation applies to the welfare conclusions derived from the heroics.”