world of economics
1027 views

Introduction

  • comparative advantage, economic theory, first developed by 19th-century British economist David Ricardo, that attributed the cause and benefits of international trade to the differences in the relative opportunity costs (costs in terms of other goods given up) of producing the same commodities among countries.
  • In Ricardo’s theory, which was based on the labour theory of value (in effect, making labour the only factor of production), the fact that one country could produce everything more efficiently than another was not an argument against international trade.
  • In 1817, Ricardo published his “Principles of Political Economy and Taxation”, in which he presented the law of comparative advantage.
  • According to law of Comparative advantage, even if one nation is less efficient than (has an absolute disadvantage with respect to) the other nation in the production of both commodities, there is still a basis for mutually beneficial trade.
  • The first nation should specialize in the production and expert of the commodity in which its absolute disadvantage is smaller (this is the commodity of its comparative advantage) and import the commodity in which it’s absolute disadvantage is greater (this is the commodity of its comparative disadvantage).

Example of Comparative Advantage

  • A real-world example could be one of the economic relationship and differences between a doctor in a hospital and the orderly who assist the doctors by helping set up operating rooms and cleaning up after operations.
  • A doctor likely might have been an orderly in the past, and could perform the orderly’s duties more efficiently and faster than the orderly.
  • The doctor has an absolute advantage in both performing the tasks of a doctor and in doing those of an orderly.
  • However, they both benefit due to comparative advantage. Neither of them suffers opportunity cost. The orderly makes less money than the doctor, so there is no opportunity cost to the doctor to focus on her tasks and let the orderly do his work.

Assumptions

  1. Every country has a fixed endowment of resources and all units of each particular resource are identical.
  2. The factors of production are perfectly mobile between alternative productions within a country.
  3. Factors of production are completely immobile between countries.
  4. Labour is the only primary input to production
  5. The relative ratios of labour at which the production of one good can be traded off for another differ between countries
  6. Countries use fixed technology
  7. Production is under constant cost conditions regardless of the quantity produced. Hence the supply curve for any goods is horizontal.
  8. There is full employment in the macro-economy.
  9. The economy is characterized by perfect competition in the product and market.
  10. There is no governmental intervention in the form of restriction to free trade.
  11. Transport costs are zero.
  12. It is a two-country, two-commodity model.(2X2 model)

Illustration

 USUK
Wheat(bushels/hour)61
Cloth(Yards/hours)42

Description

  • In this schedule there are two countries U.K and U.S and both are producing two commodities Wheat and Cloth.
  • UK has an absolute disadvantage in production of both wheat and cloth with the respect to U.S.
  • U.K labour is half as productive in cloth but 6 times less productive in wheat with the respect to U.S, the U.K has a Comparative Advantage in cloth.
  • On the other hand, the US has an absolute advantage in both wheat and cloth with respect to U.K, but since its absolute advantage is greater in wheat (6:1) than in cloth (4:2), the Unites States has a Comparative Advantage in Wheat.
  • Both Nations can gain if the U.S specializes in the production of Wheat and export some of it in exchange for British cloth and the UK specializes in the production and export of Cloth.

The Gains from Trade

  • The U.S would be indifferent to trade if it received only 4C from the U.K in exchange of 6W, since the U.S can produce exactly 4C domestically by utilizing the resources released in giving up 6W and U.S would not trade if it received less than 4C from 6W.
  • Similarly, the U.K would be indifferent to trade if it had to give up 2C for each 1W it received from the U.S, and it certainly would not trade if it had to give up more than 2C for 1W.
  • To show that both nations can gain, suppose the United States could exchange 6W for 6C with the United Kingdom. The United States would then gain 2C (or save 1/ 2 hour of labor time) since the United States could only exchange 6W for 4C domestically. To see that the United Kingdom would also gain, note that the 6W that the United Kingdom receives from the United States would require six hours to produce in the United Kingdom. The United Kingdom could instead use these six hours to produce 12C and give up only 6C for 6W from the United States. Thus, the United Kingdom would gain 6C or save three hours of labor time.
  • Once again, the fact that the United Kingdom gains more from trade than the United States is not important at this point. What is important is that both nations can gain from trade even if one of them (in this case the United Kingdom) is less efficient than the other in the production of both commodities.
  • The both nations would gain by exchanging 6W for 6C. However, this is not the only rate of exchange at which mutually beneficial trade can take place. Since the United States could exchange 6W for 4C domestically (in the sense that both require 1 hour to produce), the United States would gain if it could exchange 6W for more than 4C from the United Kingdom. On the other hand, in the United Kingdom 6W = 12C (in the sense that both require 6 hours to produce). Anything less than 12C that the United Kingdom must give up to obtain 6W from the United States represents a gain from trade for the United Kingdom.
  • To summarize, the United States gains to the extent that it can exchange 6W for more than 4C from the United Kingdom. The United Kingdom gains to the extent that it can give up less than 12C for 6W from the United States. Thus, the range for mutually advantageous trade is :

4C < 6W < 12C

  •  The spread between 12C and 4C (i.e., 8C) represents the total gains from trade available to be shared by the two nations by trading 6W. For example, we have seen that when 6W are exchanged for 6C, the United States gains 2C and the United Kingdom 6C, making a total of 8C. The closer the rate of exchange is to 4C = 6W, the smaller is the share of the gain going to the United States and the larger is the share of the gain going to the United Kingdom.
  • On the other hand, the closer the rate of exchange is to 6W = 12C, the greater is the gain of the United States relative to that of the United Kingdom.

Criticisms of Comparative Advantage

  1. The theory only considers labour costs and neglects all non-labour costs involved in the production of the commodities.
  2. The theory considers all labour to be homogenous. However, in reality, labour is heterogeneous due to different grades and kinds.
  3. The theory assumes similar tastes for all. However, the tastes differ with the growth of economies and income brackets.
  4. The theory assumes that a fixed proportion of labour is used in the production of all commodities. However, in reality, utilization of the proportion of labour depends on the type of commodity being produced.
  5. The theory has an unrealistic assumption of constant costs. However, large-scale productions lead to cost reduction and thereby increase the comparative advantage.
  6. Transport costs play an essential role in determining the pattern of trade. But the Ricardo theory neglects this independent factor of production.
  7. The assumption of the factors of production being mobile internally is unrealistic. The factors do not move freely from one region to another or one industry to another. The greater the degree of specializations in an industry, the more immobile the factor will be.
  8. The assumption of the theory of having only two countries and two commodities is unrealistic as international trade takes place among countries trading numerous commodities.
  9. Every country implements restrictions on the movement of goods to and from the countries. Thus, tariffs and trade restrictions play a role in world imports and exports. However, the theory assumes free and perfect world trade.
  10. The theory assumes full employment. However, every economy has an existence of underemployment. 
  11. A country may or may not want to trade a commodity due to military, strategic or development considerations. Therefore, self-interest stands in the operation of the comparative advantage theory.
  12. The Ricardian theory considers only the supply side of world trade and neglects the demand side.
  13. The theory only explains how two countries gain from international trade. But the theory fails to explain how the gains from the trade are distributed between the two countries.

0 Comments

Leave a comment

Your email address will not be published.