The model of comparative advantage is associated with 19th Century English economist David Ricardo, and provides the basic theory to understand how countries trade and why they trade.
Ricardo suggested that countries will specialise in producing goods and services for which they have a comparative cost advantage over other countries, rather than a simple 'absolute' advantage.
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. The key question is - should they trade?
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] |
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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 |
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 is faced with 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.
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.