Comparative advantage

Comparative advantage is associated with 19th Century English economist David Ricardo. Ricardo suggested that countries should specialise in producing goods and services for which they have a comparative advantage. While an ‘absolute’ advantage means one country is more cost-efficient than another, comparative advantage relates to the extent to which one country is more efficient. Let’s look at a simple example.

Consider two countries producing only two goods – milk or sugar. Using all its resources, country A can produce 4m litres of milk or 10 tonnes of sugar. Country B can produce 8m litres of milk or 12 tonnes of sugar. We will assume that 1 million litres of milk is equal to 2 tonnes of sugar in terms of value – let’s say each is worth $200,000. Clearly, B is better at both and has an absolute advantage over A. So, should they trade?

Well, in comparative terms B has an advantage in terms of milk – it is 100% more productive in milk, but only 20% better at sugar production, so, in terms of the principle of comparative advantage, they should trade - with B specialising in milk leaving A to produce sugar. Lets look at this.

If they specialise and then trade, world output will be 18 units (Milk = 8, sugar = 10): However, if they divide up their resources to produce both, then they can produce half of the maximum for both products - and total output will be 17 units. (Milk 2 + 4, and sugar, 5 + 6).

The relative value of world output is: $2.6m with specialisation and trade, and: $2.3m without self-sufficiency.

Graphically, the gradient of the PPF reflects the opportunity cost of production - different gradients mean different opportunity costs ratios, and hence specialisation and trade will be beneficial.

Criticisms

1. However, the principle of comparative advantage ignores the costs of trade, including transport and any external costs such as air and sea pollution.
2. It also assumes perfect mobility of factors and no diminishing returns - unlikely in practice as there may be barriers to entry for labour and producers.
3. Information failure is also a significant criticism - how, at the microeconomic level, do producers individually know which of their goods, if any, have a comparative advantage?
4. Trade barriers in the real world can also limit the extent to which the principle of comparative advantage can be applied.
5. It is also possible that, even if comparative advantage is understood, country's can develop new comparative advantages, and lose others such that what was once an advantage may no longer be one.
6. Specialisation might create structural unemployment as some workers cannot transfer between sectors.
7. Finally, modern trade theories, such as ‘gravity theory', explain trade patterns more in terms of similarities between countries rather than differences, with countries trading most with those they are ‘attracted to’ in terms of similar size, levels of development, and cultural and economic ‘proximity’.