Theories of International Trade - Theory of Comparative Advantage

David Ricardo

In the last post, we discussed the theory of Absolute Advantage advanced by Adam Smith. It was observed that the theory of Absolute Advantage was not able to answer all the problems of International Trade. As trade started increasing between the nations, it became more complex too. Also, there were countries that did not have Absolute Advantage in any kind of goods. Absolute Advantage was no solution for them.

In 1817, famous Economist, David Ricardo introduced his theory of Comparative Advantage. As per this theory if a country had absolute advantage in two or more products or in no product, specialization and trade could still occur between the countries.

As per this theory, Comparative Advantage exists when a country is able to produce a commodity better and more efficiently than it does other commodities. This theory focuses on the relative productivity difference, whereas Absolute Advantage theory focused only on absolute productivity.

A simple example could be that of a farmer who could produce either wheat or rice on his 1 hectare of farmland. Wheat gives him $100 per hectare and Rice gives him $150 hectare. It turns out that this farmer is able to yield better and more efficiently than other farmers in his area in both wheat and rice. We see that even though the farmer has absolute advantage in both the crops, should he produce both the crops? The answer is in negative as for every hectare of wheat produced in his farmland, he would be giving up $50 ($150 - $100) in income. The productivity of his farmland will be highest if he specializes only in producing rice. In a similar manner, a country will specialize in doing what it does relatively better. There could be other factors but this is what the crux of the theory of comparative advantage is.

Merits of this Theory

1. This theory demonstrates that trade between two countries is possible even when a country is able to produce all its goods at a cheaper cost than other countries. This is possible when the cost advantage is comparatively more in some goods than in the others. The country is compensated more by focusing its skill and knowledge on producing those goods in which it has a better cost advantage.

2. This theory also has the potential to incorporate costs other than labour. Thus it can take more complex situations into account than the absolute advantage theory.

3. It also takes into account the ‘Opportunity Cost’ of producing the goods. A lower opportunity cost than another country would signify comparative advantage available to a particular country.

Demerits and criticisms of Comparative Advantage Theory

1. This theory assumes that the internal economies of countries are competitive. However, this is not true. Most of the countries have industries that are monopolistic in nature.

2. This theory also assumes the existence of constant returns. This is quite utopian as change in availability of resources and other such dimensions directly affect the economic structure of a country.

3. This theory like Absolute Advantage again assumes existence of free trade between the countries. It fails to take into account factors like quantitative restrictions, public policy, protectionist measures, export subsidies etc.

4. Another important criticism is that comparative advantage though relative in nature measures only static advantage and fails to take into dynamic advantage. It does not provide answers as to how a country could gain comparative advantage by making the necessary investments.

In the next post, we shall discuss the theory propounded by Hecksher and Ohlin.

Theories of International Trade:

1. Mercantilism
2. Theory of Absolute Advantage
3. Theory of Comparative Advantage
4. Hecksher-Ohlin Model

International Trade Law Notes