Comparative advantage
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In economics, the theory of comparative advantage explains why it can be beneficial for two countries to trade, even though one of them may be able to produce every kind of item more cheaply than the other. What matters is not the absolute cost of production, but rather the ratio between how easily the two countries can produce different kinds of things. It was first described by Robert Torrens in 1815 in an essay on the corn trade. He concluded that it was to England's advantage to trade various goods with Poland in return for corn, even though it might be possible to produce that corn more cheaply in England than Poland. However, it is usually attributed to David Ricardo who explained it clearly in his 1817 book The Principles of Political Economy and Taxation in an example involving England and Portugal. In Portugal it is possible to produce both wine and cloth with less work than it takes in England. However, the relative costs of producing those two goods are different in the two countries. In England it is very hard to produce wine, and only moderately difficult to produce cloth. In Portugal both are easy to produce. Therefore, while it is cheaper to produce cloth in Portugal than England, it is cheaper still for Portugal to produce excess wine, and trade that for English cloth. And conversely England benefits from this trade because its cost for producing cloth has not changed but it can now get wine at closer to the cost of cloth.
When one entity (be it a firm or a country) is able to produce more efficiently than another entity it has an absolute advantage; that is, assuming equal inputs, the entity with an absolute advantage will have a greater output.
Stanislaw Ulam once challenged Paul Samuelson to name one theory in all of the social sciences which is both true and nontrivial. Several years later, Samuelson responded with David Ricardo's theory of comparative advantage.
"That it is logically true need not be argued before a mathematician; that it is not trivial is attested by the thousands of important and intelligent men who have never been able to grasp the doctrine for themselves or to believe it after it was explained to them."—Paul Samuelson
Because the theory produces a counter-intuitive result, it may be useful to consider the following:
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Example 1
by Hari Politopoulos
Two men land alone in an isolated island. To survive they must undertake a few basic economic activities like water carrying, fishing, cooking and shelter construction and maintenance. The first man is young,strong and educated and is faster, better, more productive at everything. He has an absolute advantage in all activities. The second man is old, weak and uneducated. He has an absolute disadvantage in all economic activities. In some activities the difference between the two is great in others it is small.
Is it in the interest of either of them to work in isolation? Specialisation and exchange (trade) can benefit both of them.
How should they divide the work? According to comparative, NOT absolute advantage. The young man must spend more time on the tasks in which he is much better. The old man must concentrate in the tasks in which he is only a little worse. Such an arrangement will increase total production and/or reduce total labour. It will make both of them richer.
Specialisation and exchange will not be possible if there is an absolute resource constraint. If for example the amount of fresh water available on the island is enough for one man only. Then there will be war.
Example 2
Suppose there are two countries, Northland and Southland. Both have a wine-making industry and a clothing industry.
- In Northland, it takes a worker:
- 3 days to make a suit of clothes
- 5 days to make a bottle of wine.
- Southland is more efficient in both industries – a Southlander can make a suit of clothes in 1 day or a bottle of wine in 1 day.
Tabulated: Production capabilities each day
| Country | Clothes | Wine |
|---|---|---|
| Southland | 1 | 1 |
| Northland | 3 | 5 |
Absolute cost a day
| Country | Clothes | wine |
|---|---|---|
| Southland | 1 | 1 |
| Northland | 0,33 | 0,2 |
Southland has an "absolute advantage" in both industries – it is more productive at making both wine and clothes. However, it is 5 times more productive than Northland in wine making and only 3 times more productive than Northland in Clothes making. That is, it has a comparative advantage in wine making. While Northland is worse at making either kind of goods, it is least deficient at making clothes.
In a competitive market, the price of goods reflects the cost of making them, so it is likely that in Northland, a bottle of wine (taking 5 days for a Northlander to produce) costs more than a suit of clothes (made in 3 days). As the Southlanders can make either wine or clothes at the same production cost, it is rational to export wine to Northland, and take the higher profit. Ultimately, Northland must pay for this imported wine somehow, and since clothing can be produced relatively more easily, clothes will be exported back to Southland.
Wine will be a more profitable export than clothes for Southland as this comparative advantage in productivity is maintained, so it would be rational for Southlanders to deploy more resources into the wine industry at the expense of the clothes industry.
This can be illustrated as follow. Suppose Northland and Southland do not trade with each other. In a work week (let us say 5 working days) where 1 day is used to produce wine and 4 days is used to produce clothes. The total production will then be as follow:
| Country | Clothes | Wine |
|---|---|---|
| Northland | 4 (4*1) | 1 (1*1) |
| Southland | 12 (4*3) | 5 (1*5) |
| Sum: | 16 | 6 |
Suppose the Countries start using their Comparative advantage and do trade with each other. Southland produces wine in all 5 days and Northland produce clothes all 5 days.
| Country | Clothes | Wine |
|---|---|---|
| Northland | 5 (5*1) | 0 (0*1) |
| Southland | 0 (0*3) | 25(5*5) |
| Sum: | 5 | 25 |
When Northland and Southland do trade and specialize they produce 30 units instead of 22 units if each country tries to be self sufficient. A analogous example appears in the German version [Komparativer Kostenvorteil (http://de.wikipedia.org/wiki/Komparativer_Kostenvorteil)].
Suppose that the Southland clothes industry now collapses due to a labour (or capital) shortage caused by the boom in the wine industry. This might not worry the Southland Treasury – the Northlanders should be willing to pay more for wine than for clothes: until the price rises above 5:3, it will not be economic to reopen the Northland vineyards. Therefore a Southland worker can make wine, buy clothes and still be in profit. Provided the profit margin is enough, it is worth Southland trading wine for clothes with Northland, even though Southland imports goods that it could manufacture more efficiently itself. If Northland's clothes were to rise to more than the price fetched by wine, it would be time to re-open the Southland clothes factories.
This theoretical model omits several factors that sometimes apply in the real world: Workers and capital may not be painlessly transferable between industries. The clothing industry (in Southland) and wine-making industry (in Northland) may therefore exert political pressure (through industry associations and trades unions) to protect their industries. Governments also sometimes decide to provide subsidies or to erect import barriers to preserve domestic industries. Reasons other than political include national prestige, or the wish to avoid being dependent on imports in case trade is disrupted – for example by war.
See also
External links
- The Principles of Trade and Taxation (http://socserv2.socsci.mcmaster.ca/~econ/ugcm/3ll3/ricardo/prin/index.html)
- Ricardo's Difficult Idea (http://web.mit.edu/krugman/www/ricardo.htm)de:Komparativer Kostenvorteil