Theory of Comparative Advantage of International Trade: by David Ricardo

The classical theory of international trade is popularly known as the Theory of Comparative Costs or Advantage. It was formulated by David Ricardo in 1815. The classical approach, in terms of comparative cost advantage, as presented by Ricardo, basically seeks to explain how and why countries gain by trading. The idea of comparative costs advantage is drawn in view of deficiencies observed by Ricardo in Adam Smith’s principles of absolute cost advantage in explaining territorial specialisation as a basis for international trade. Being dissatisfied with the application of classical labour theory of value in the case of foreign trade,  Ricardo developed a theory of comparative cost advantage to explain the basis of international trade as under:

Before this theory, the publication of Adam Smith’s Wealth of Nations (1776) the prevalent theory of foreign trade was mercantilism. This doctrine suggested that a country should do all it could to increase exports, but should restrict imports and so build up ‘treasure’. This view was criticised by Adam Smith. He argued that restrictions on foreign trade limited the benefits which could be obtained from market forces.

In essence, the case for free trade is the one in favour of markets on a large scale. If complete free trade were introduced the market would consist of the whole world and consumers would benefit from a wide choice of goods. Moreover, international competition would force domestic firms to keep down prices. Innovations in production tech­niques and product design would spread more rapidly, so benefitting consumers.

Absolute Advantage:

Smith argued that trade should be based on absolute advantage. This term describes the position when one country is absolutely more efficient at producing good A, whilst another country is absolutely ‘better’ at producing good B. Both countries would benefit if they specialised in producing the goods at which they have the advantage and then exchanged their prod­ucts.

Thus, Britain has an absolute advantage compared to Jamaica in the production of cars whilst Jamaica has an absolute advantage in the produc­tion of tropical fruits. It will benefit both countries if they specialise and trade. Absolute advantage is a specific example of the advantages of special­isation and division of labour.

Comparative Advantage:

Smith’s argument about absolute advantage was refined and developed by David Ricardo in 1817. Ricardo, improving upon Adam Smith’s exposition, developed the theory of international trade based on what is known as the Principle of Comparative Advantage (Cost). International trade involves the extension of the principle of specialisation or division labour to the sphere of international exchange.

As a person specialises in the trade in which he has best advantages, a country also specialises in the production of the commodity in which it has the best natural advantages. A country may produce many things at a time, but it may have comparative advantages in the production of some commodities (say, tea or jute as in India) over others and it will specialise in those goods.

Similarly, another country would produce those goods (say, machineries and engineering goods as in Ger­many or Japan) in which it has comparative advantage. If these two coun­tries produce goods according to their respective areas of comparative advantage, each country would be able to produce the goods at the lowest cost; and both these countries will gain from trading with each other. This is the substance of the principle of comparative advantage (cost).

The principle of comparative cost states that

(a) international trade takes place between two countries when the ratios of comparative cost of produc­ing goods differ, and

(b) each country would specialise in producing that commodity in which it has a comparative advantage.

Ricardo’s Theorem:

Ricardo stated a theorem that, other things being equal, a country tends to specialise in and export those commodities in the production of which it has maximum comparative cost advantage or minimum comparative disadvantage. Similarly, the country’s imports will be of goods having relatively less comparative cost advantage or greater disadvantage.

The Ricardian Model:

To explain his theory of comparative cost advantage,

Ricardo constructed a two-country, two-commodity, but one-factor model with the following assumptions:

1. Labour is the only productive factor

2. Costs of production are measured in terms of the labour units involved.

3. Labour is perfectly mobile within a country but immobile internationally.

4. Labour is homogeneous.

5. There is unrestricted or free trade.

6. There are constant returns to scale.

7. There is full employment equilibrium.

8. There is perfect competition.

Under these assumptions, let us assume that there are two countries A and ? and two goods X and Y to be produced.

Absolute Cost Difference:

As Adam Smith pointed out, if there is an absolute cost difference, a country will specialise in the production of a commodity having an absolute advantage (see Table 1).

Table 1 Cost of Production in Labour Units.

It follows that country A has an absolute advantage over ? in the production of X while ? has an absolute advantage in producing Y. As such, when trade takes place, A specialises in X and exports its surplus to ? and ? specialises in ? and exports its surplus to A.

Equal Cost Difference:

Ricardo argues that if there is equal cost difference, it is not advantageous for trade and specialisation for any country in consideration (see Table 2).

Table 2 Cost of Production in Labour Units:

On account of equal cost difference, the comparative cost ratio is the same for both the countries, so there is no reason for undertaking specialisation. Hence, the trade between two countries will not take place.

Comparative Cost Difference:

Ricardo emphasised that under all conditions, it, is the comparative cost advantage which lies at the root of specialisation and trade (see Table 3).

Table 3 Cost of Production in Labour Units:

It will be seen that country A has an absolute cost advantage in both the commodities X and Y. However, A possesses a comparative cost advantage in producing X. For, comparatively, country A’s labour cost involved in producing 1 unit of X is only 66 per cent of B’s labour cost involved in producing X, as against that of 80 per cent in the case of Y.

On the other hand, country ? has least comparative disadvantage in production of Y, though she has absolute cost disadvantage in both X and Y.

It should be noted that, to know the comparative advantage, we have to compare the ratio of the costs of production of one commodity in both countries (i.e., 10/15 in the case of X in our example) with the ratio of the cost of producing the other commodity in both countries (i.e., 20/25 in the case of ? in our example). To state in algebraic terms:

If in country A, the labour cost of commodity X is Xa and that of ? is Ya, and in B, it is Xb and Yb respectively, then absolute differences in cost can be expressed as:

Xa/Xb < 1 < Ya/Yb

(Which means that country A has an absolute advantage over country ? in commodity X and country ? has over A in commodity ?). And, comparative differences in costs are expressed as:

Xa/Xb < Ya/Yb < 1

(Which implies that country A possesses an absolute advantage over ? in both X and (Y, but it has more comparative advantage in X than in Y). If, however, there is an equal cost difference, i.e., Xa/Xb = Ya/Yb will be no international trade between the two countries.

In our illustration, since country A has comparative cost advantage in commodity X, as per Ricardo s theorem, this country should tend to specialise in X and export its surplus to country ? in exchange for ? (i.e., import of ? from B). Correspondingly, since country ? has least cost disadvantage in producing ?, she should specialise in ? and export its surplus to A and import X.

Gain Attributes of International Trade:

It further follows that when countries A and ? enter into trade, both will gain. In the absence of trade, domestically in country A, IX = 0.5?. Now, if after trade, assuming the terms of trade to be IX — 1Y, country A gains 0.5 unit more. Similarly, in country ?, IX = 0.6 ? domestically, after trade, its gain is 0.4Y.

In short, “each country can consume more by trading than in isolation with a given amount of resources. Indeed, the relative gains of the two countries will be conditioned by the terms of trade and one is likely to gain proportionately more than the other but it is definite that both will gain.

In fact, the principle of comparative costs shows that it is possible for both the countries to gain from trade, even if one of them is more efficient than the other in all lines of production.

The theory implies that comparative costs are different in different countries because the abundance of factors which may be necessary for the production of each commodity does not bear the same relation to the demand for each commodity in different countries.

Thus, specialisation based on comparative cost advantage clearly represents a gain to the trading countries in so far as it enables more of each variety of goods to be produced cheaply by utilising the abundant factors fully in the country concerned and to obtain relatively cheaper goods through mutual international exchange.

Ricardo’s theory pleads the case for free trade. He stresses that free-trade is the pre-requisite of gains and improvement of world’s welfare. Free trade “by increasing the general mass of production diffuses general benefit and binds together by one common tie of interest and intercourse, the universal society of nations throughout the civilised world.”

To sum up, what goods will be exchanged in international trade is the main question solved by Ricardo’s theory of comparative costs. The theory is lucidly summarised by Kindle-Berger as follows:

“The basis for trade, so far as supply is concerned, is found in differences in comparative costs. One country may be more efficient than another, as measured by factor inputs per unit of output, in the production of every possible commodity, but so long as it is not equally more efficient in every commodity, a basis for trade exists. It will pay the country to produce more of those goods in which it is relatively more efficient and to export these in return for goods in which its absolute advantage is least.”

Criticisms of the Theory:

As with many other economic ideas there are criticisms to be levelled at this theory:

(i) It is much more complicated in the real world in deciding in which goods countries have a comparative cost advantage. This is so because there are a large number of goods and many countries.

(ii) In reality we find changing pattern of comparative advantage. A country may gain comparative advantage by raising its factor (labour) productivity or by imposing restrictions on trade such as an import tariff. So, comparative advantage is dynamic concept, and not a static one, as Ricardo thought.

(iii) The theory ignores the effects of transport costs. England might specialise in cloth and Portugal in wine. However, once transport costs are added any comparative advantage may be lost.

(iv) The theory assumes that if Portugal wants to specialise introducing more wine it can do so easily by transferring factors of production into wine production. However, it may be difficult to easily transfer these factors from cloth to wine production. In addition, textile workers might not know how to produce wine.

(v) Modern theories, no longer based on Ricardo’s labour theory, have established that the only necessary condition for the possibility of gains from trade is that price ratios should differ between countries.

(vi) Ricardo ignored the role of demand completely and explained trade from supply side. The post-trade exchange rate between the commodities, whose determination Ricardo could not explain, is established by the Law of Reciprocal Demand, i.e., one country’s demand for another country’s product and vice versa.

(vii) Ricardo’s analysis is based on the labour theory of value as costs are expressed in terms of labour hours. However, the classical labour theory itself has lost its relevance.

(viii) Riocardo’s theory assumes the operation of the law of constant cost. Hence, it cannot be applied in the case of increasing or decreasing costs.

(ix) The classical writers have applied their principle in case of trade with two countries only and with two commodities only. So, the principle has a limited scope of application in practice. It cannot explain multi-lateral trade.

(x) Increasing returns or decreasing cost are a second great factor — in addition to differences in comparative costs — in explaining the basis of trade. Writes Paul Samuelson, “If economies of mass production are over­whelmingly important, costs may decrease as output expands. This would strengthen the case for international exchange of goods.”

(xi) Trade may also occur due to a third factor, viz., difference in tastes between countries. America produces motor cars. It also imports cars from Japan because it has a special liking for Japanese cars. Here, trade occurs due to consumption bias.

(xii) Finally, the theory assumes that costs remain constant at all levels of output. But, in reality, we find that costs rise after a certain stage due to the operation of the law of diminishing returns. Thus, at some point, after each country has expanded the production of its speciality far enough the cost ratios may become equal.

At this point the basis for trade — difference in opportunity costs between the two nations — will have been eliminated. Moreover, at that point it is quite likely that each country will try to produce some amount of both the goods. Hence, when there are increasing costs, specialisation will not be as complete, nor the volume of trade as large, as is the case when costs are constant.