Absolute advantage theory

The Theory of
Comparative Advantage
By
K.Vignesh
MFT 15078 (FEC)
Department of fisheries economics

SYNOPSIS
 Introduction
 Assumption
 Concept of theory
 Ricardo’s numerical example
 Limitations

Background of the Theory
 the original description of the idea can be found in an
Essay on the External Corn Trade by Robert Torrens
in 1815.
 David Ricardo formalized the idea using a
compelling, yet simple, numerical example in his
1817 book titled,
On the Principles of Political Economy and Taxation.
 The idea appeared again in James Mill's
Elements of Political Economy in 1821. Finally, the
concept became a key feature of international
political economy upon the publication of Principles
of Political Economy by John Stuart Mill in 1848.

Ricardo’s Idea of
 Ricardo's Law of Comparative Advantage
improved upon the earlier Law of Absolute
Advantage. How?
 If A (Advancedland) is more productive than B
(Backwardland) in every productive activity,
would both countries benefit from trade?
 The law of absolute advantage has no answer to
this question.
 Ricardo's law of comparative advantage showed
that the answer is yes.

 A country has a comparative advantage in the
production of a good or service that it produces
 The theory of comparative costs argues that, put
simply, it is better for a country that is inefficient
at producing a good or service to specialise in
the production of that good it is least inefficient
at, compared with producing other goods.
Ricardo’s Idea of Comparative Advantage

Ricardo explains his theory with the help
of following assumptions:-
There are two countries and two
commodities.
There is a perfect competition both in
commodity and factor market.
Assumptions

 Cost of production is expressed in
terms of labour i.e. value of a
commodity is measured in terms of
labour hours/days required to produce
it. Commodities are also exchanged on
the basis of labour content of each
good.
 Labour is the only factor of
production other than natural
resources.

 Labour is homogeneous i.e. identical in
efficiency, in a particular country.
 Labour is perfectly mobile within a
country but perfectly immobile between
countries.
 There is free trade i.e. the movement of
goods between countries is not
hindered by any restrictions.

 Production is subject to constant
returns to scale.
 There is no technological change.
 Trade between two countries takes
place on barter system.
 Full employment exists in both
countries.
 There is no transport cost.

Table-1
Country Wine
(bottles)
Cloth
(yards)
Cost Per Unit
In Man Hours
Cost Per Unit
In Man Hours
Kenya 40 40
Ethiopia 20 10

Ricardo’s numerical example
 This Table illustrates Ricardo's
comparative advantage principle when
one nation has an absolute advantage in
the production of both goods.
Assume that in one hour's time,
 Kenya workers can produce 40 bottles of
wine or 40 yards of cloth, while Ethiopia
workers can produce 20 bottles of wine or
10 yards of cloth.

 According to Smith's principle of absolute
advantage, there is no basis for mutually
beneficial specialization and trade,
because the Kenyan workers are more
efficient in the production of both goods.
Comparative advantage, however,
recognizes that Kenyan workers are four
times as efficient in cloth production (40/1
0 = 4) but only twice as efficient in wine
production (40/ 20 = 2).

 They thus has a greater absolute
advantage in cloth than in wine, while the
Ethiopia has a smaller absolute
disadvantage in wine than in cloth. Each
nation specializes in and exports that good
in which it has a comparative advantage-
the United States in cloth, the United
Kingdom in wine.

 The output gains from specialization will
be distributed to the two nations through
the process of trade. Like Smith, Ricardo
asserted that both nations can gain from
trade.

Interpreting the Theory of
 first, fully employ all resources worldwide;
 second, allocate those resources within
countries to each country's comparative
advantage industries;
 and third, allow the countries to trade
freely thereafter.

Limitations
 It is possible for a nation not to have an
absolute advantage in anything
 but it is not possible for one nation to have
a comparative advantage in everything
and the other nation to have a
comparative advantage in nothing.
 That's because comparative advantage
depends on relative costs.

 His theory, however, depended on the
restrictive assumption of the labor theory
of value, in which labor was assumed to
be the only factor input.
 In practice, however, labor is only one of
several factor inputs.

 We have used trading models in which
only two goods are produced and
consumed and in which trade is confined
to two countries the real world of
international trade involves more than two
products and two countries; each country
produces thousands of products and
trades with many countries

 When a large number of goods is
produced by two countries, operation of
comparative advantage requires that the
goods be ranked by the degree of
comparative cost

 Each country exports the product(s) in
which it has the greatest comparative
advantage.
 Conversely, each country imports the
product(s) in which it has greatest
comparative disadvantage.

Absolute advantage theory

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Absolute advantage theory