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.

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. The key question is - should they trade?

Comparative advantage

In comparative terms, country B has a clear 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 when countries specialise and trade, and: $2.3m with self-sufficiency.


SPECIALISING AND THEN TRADING - SUMMARY [Millions]

 

SUGAR (Tonnes)

MILK (Litres)

TOTAL

COUNTRY A 10 0  
COUNTRY B 0 8  
TOTAL UNITS 10 8 18
VALUE OF OUTPUT [1m litre of milk and 2 tonnes of sugar each equal $200,000] 10 tonnes x $100,000 = $1.0m 8 million litres x $200,000 = $1.6m $2.6m


SELF SUFFICIENCY - NO TRADE - SUMMARY [Millions]

Dividing resources evenly [midpoint of the PPF for both A and B].

SUGAR (Tonnes)

MILK (Litres)

TOTAL

COUNTRY A 5 2  
COUNTRY B 6 4  
TOTAL UNITS 11 6 17
VALUE OF OUTPUT [1m litre of milk and 2 tonnes of sugar each equal $200,000] 11 tonnes x $100,000 = $1.1m 6 million litres x $200,000 = $1.2m $2.3m

Different opportunity cost

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.

In the diagram below, country A has two different PPFs for milk and sugar. For PPF 'K', the opportunity cost of increasing output of sugar by 1 million tonnes is 0.5 million litres of milk, whereas for PPF 'L', the same gain in sugar production results in an opportunity cost of 2 million litres of milk - the steeper the gradient the greater the opportunity cost.

The implication of this is that, where countries have a comparative cost advantage, they should look to allocate scarce resources towards the production of these goods and services, and away from those where they have a comparative disadvantage.

Comparative advantage

It is clear that, while the principle of comparative advantage underpins world trade, and shapes the pattern of world trade, it is not the only determinant of trade.

Video on comparative advantage

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’.
Trade agreements

How comparative advantage affects trade aggreements.

Trade agreements
Fiscal policy

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Fiscal policy
Monetary policy

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