Theory of Comparative Advantage
Trade is carried out primarily for the exchange of goods and services. It takes place within the different regions of a country as well as between different countries. The trade within a nation’s confines is known as domestic trade. The trade conducted with other countries is foreign trade. It has been practiced for eons. It is a necessary economic activity, as every country is not endowed with all the resources to produce all the goods and services that it needs. It obtains its needs from other countries through exchange of goods and services that it produces with those it requires but which are produced by others.

Trade, whether taking place at an intra-country or inter-country level, is an economic instrument through which a province or country acquires specialization in the production of a commodity. Theories promoting trade have evolved over time. The theory of comparative advantage is a widely popular and accepted trade theory. However, it had its predecessors. The theory came into being as a result of the shortcomings of mercantilist and absolute advantage theories. Modern trade between countries is based on the principle of comparative advantage. The principle of comparative advantage is based on a comparison of relative prices of two commodities at home and a foreign country. It underscores specialization. Models of free trade are based on this principle. It determines the commodity composition of free trade.

The English economist David Ricardo gave the principle of comparative advantage in the nineteenth century. It is inversely stated as comparative cost. The principle of comparative advantage investigates the relative cost-price positions of two countries in two commodities. It utilizes the medium of exchange rate to compare the relative prices in two countries. The exchange rate is itself determined by the relative cost-price positions in the two countries.

The theory is a highly simplified model in economics. It advocates the promotion of trade. The theory is grounded in many assumptions. In this model there are only two countries. There are only two goods produced by both the countries. There is only one factor of production (input) namely labor. The value of the good is created solely by labor. Labor is perfectly mobile between the two goods industries domestically but on the other hand is perfectly immobile internationally between the two countries. The two goods produced by the two countries can move freely between countries and there are no trade restrictions. There is absence of transport costs and absence of other barriers to trade. Technology is assumed to remain constant in both countries.

The theory’s rationale is that in a two-country world where one common international factor of production in homogeneous labor is used to produce two identical goods in both countries, even if one country has absolute advantage in production of both goods, trade between the two countries must take place. This is based on the underpinning that for the wheels of trade to take place advantages have to be comparative or relative and not absolute.

Let us illustrate the theory lucidly through the medium of a tabular scheme. :

Scheme 1

1 man-day of labor
Wheat
Textiles
United States
60 bushels
20 yards
United Kingdom
20 bushels
10 yards

In this example United States has an absolute advantage over United Kingdom in production of both goods, wheat and textiles. However the degree of advantage differs in the two industries. In the wheat industry United States has a 3: 1 advantage over United Kingdom whereas in the textile industry United States has only a 2: 1 advantage over United Kingdom. Clearly United States has a greater degree of advantage or comparative (relative) advantage in the wheat industry. On the other hand United States has a less degree of advantage or comparative (relative) disadvantage in the textile industry.

The United Kingdom on the other hand has an absolute disadvantage in both the industries. However, the degree of disadvantage it has in the wheat industry is 3:1 whereas in the textile industry is 2:1. Clearly the degree of disadvantage is less in the textile industry. The United Kingdom has therefore a less degree of disadvantage or comparative (relative) advantage in the textile industry. On the other hand in the wheat industry it has a greater degree of disadvantage or comparative (relative) disadvantage.

Therefore United States, having comparative advantage in wheat should produce and export only wheat. On the other hand the United Kingdom having comparative advantage in textiles should only produce and export textiles. In this way the United States specializes in wheat while the United Kingdom specializes in textiles.

Specialization also increases the producer surplus in wheat but reduces it in textiles. Previously in autarky 2 man-days of labor resulted in 80 bushels of wheat and 30 yards of textiles combined in both countries. After trade 2 man-days of labor resulted in 120 bushels of wheat and 20 yards of textiles. Thus there is an increase in 40 bushels of wheat and a reduction in 10 yards of textiles.

Another way to state the principle of comparative advantage is through opportunity cost principle. One unit of textiles costs three units of wheat in the United States and two units of wheat in the United Kingdom. Therefore textiles are cheaper to produce in terms of wheat in the United Kingdom and United Kingdom consequently has a comparative advantage in textile production because production of textiles has a lower opportunity cost in United Kingdom than United States.

One unit of wheat costs one-third unit of textiles in the United States and one-half unit of textiles in the United Kingdom. Therefore wheat is cheaper to produce in terms of textiles in the United States and United States consequently has a comparative advantage in wheat production because production of wheat has a lower opportunity cost in United States than United Kingdom.

Each country specializes in the commodity that it can produce more cheaply (in terms of less sacrifice of production of other commodity) relative to the other country. It obtains the other commodity through trade.

The appropriate comparison for each country is between the opportunity cost of the commodity produced at home and the opportunity cost of the commodity when it is produced abroad. The country, which has a less opportunity cost in producing the commodity has a comparative advantage in the commodity and specializes in the production of the commodity. It obtains the other commodity through trade.