Theory of Comparative Advantage of

International Trade: by David Ricardo

Comparative advantage is an economic term that refers to an economy's

ability to produce goods and services at a lower opportunity cost than that
of trade partners. A comparative advantage gives a company the ability to
sell goods and services at a lower price than its competitors and realize
stronger sales margins.

The law or principle of comparative advantage holds that under free

trade, an agent will produce more of and consume less of a good for which
they have a comparative advantage.[1] Comparative advantage is the
economic reality describing the work gains from trade for individuals, firms,
or nations, which arise from differences in their factor
endowments or technological progress In an economic model, agents have
a comparative advantage over others in producing a particular good if they
can produce that good at a lower relative opportunity cost or autarky price,
i.e. at a lower relative marginal cost prior to trade. One shouldn't compare
the monetary costs of production or even the resource costs (labor needed
per unit of output) of production. Instead, one must compare
the opportunity costs of producing goods across countries.
David Ricardo developed the classical theory of comparative advantage in
1817 to explain why countries engage in international trade even when one
country's workers are more efficient at producing every single good than
workers in other countries. He demonstrated that if two countries capable
of producing two commodities engage in the free market, then each country
will increase its overall consumption by exporting the good for which it has
a comparative advantage while importing the other good, provided that
there exist differences in labor productivity between both countries.Widely
regarded as one of the most powerful yet counter-intuitive] insights in
economics, Ricardo's theory implies that comparative advantage rather
than absolute advantage is responsible for much of international trade
Classical theory and David Ricardo.
Adam Smith first alluded to the concept of absolute advantage as the basis for
international trade in The Wealth of Nations:
If a foreign country can supply us with a commodity cheaper than we ourselves can
make it, better buy it off them with some part of the produce of our own industry
employed in a way in which we have some advantage. The general industry of the
country, being always in proportion to the capital which employs it, will not thereby be
diminished [...] but only left to find out the way in which it can be employed with the
greatest advantage.
Writing several decades after Smith in 1808, Robert Torrens articulated a preliminary
definition of comparative advantage as the loss from the closing of trade:
[I]f I wish to know the extent of the advantage, which arises to England, from her giving
France a hundred pounds of broadcloth, in exchange for a hundred pounds of lace, I
take the quantity of lace which she has acquired by this transaction, and compare it with
the quantity which she might, at the same expense of labour and capital, have acquired
by manufacturing it at home. The lace that remains, beyond what the labour and capital
employed on the cloth, might have fabricated at home, is the amount of the advantage
which England derives from the exchange.
In 1817, David Ricardo published what has since become known as the theory of
comparative advantage in his book On the Principles of Political Economy and Taxation
Ricardo's example
Graph illustrating Ricardo's example:
In case I each country spends 3600 hours to produce a mixture of cloth and wine.
In case II each country specializes in its comparative advantage, resulting in greater
total output.
In a famous example, Ricardo considers a world economy consisting of two
countries, Portugal and England, which produce two goods of identical quality. In
Portugal, the a priori more efficient country, it is possible to produce wine and cloth with
less labor than it would take to produce the same quantities in England. However, the
relative costs of producing those two goods differ between the countries.
Hours of work necessary to produce one unit

Produce
Cloth Wine
Country

England 100 120

Portugal 90 80
In this illustration, England could commit 100 hours of labor to produce one unit of cloth, or
produce 5/6 units of wine. Meanwhile, in comparison, Portugal could commit 90 hours of labor
to produce one unit of cloth, or produce 9/8 units of wine. So, Portugal possesses an absolute
advantage in producing cloth due to fewer labor hours, and England has a comparative
advantage due to lower opportunity cost.
In the absence of trade, England requires 220 hours of work to both produce and consume one
unit each of cloth and wine while Portugal requires 170 hours of work to produce and consume
the same quantities. England is more efficient at producing cloth than wine, and Portugal is
more efficient at producing wine than cloth. So, if each country specializes in the good for which
it has a comparative advantage, then the global production of both goods increases, for England
can spend 220 labor hours to produce 2.2 units of cloth while Portugal can spend 170 hours to
produce 2.125 units of wine. Moreover, if both countries specialize in the above manner and
England trades a unit of its cloth for 5/6 to 9/8 units of Portugal's wine, then both countries can
consume at least a unit each of cloth and wine, with 0 to 0.2 units of cloth and 0 to 0.125 units of
wine remaining in each respective country to be consumed or exported. Consequently, both
England and Portugal can consume more wine and cloth under free trade.

Assumptions of the Theory:

The Ricardian doctrine of comparative advantage is based on the following
assumptions:

(1) There are only two countries, say A and B.

(2) They produce the same two commodities, X and Y.

(3) Tastes are similar in both countries.

(4) Labour is the only factor of production.

(5) All labour units are homogeneous.

(6) The supply of labour is unchanged.

(7) Prices of the two commodities are determined by labour cost, i.e.. the number of
labour-units employed to produce each.

(8) Commodities are produced under the law of constant costs or returns.
(9) Trade between the two countries takes place on the basis of the barter system.

(10) Technological knowledge is unchanged.

(11) Factors of production are perfectly mobile within each country but are perfectly
immobile between the two countries.

(12) There is free trade between the two countries, there being no trade barriers or
restrictions in the movement of commodities.

(13) No transport costs are involved in carrying trade between the two countries.

(14) All factors of production are fully employed in both the countries.

(15) The international market is perfect so that the exchange ratio for the two
commodities is the same.

Cost Differences:
Given these assumptions, the theory of comparative costs is explained by taking
three types of differences in costs: absolute, equal and comparative.

(1) Absolute Differences in Costs:

There may be absolute differences in costs when one country produces a
commodity at an absolute lower cost of production than the other.
Country Commodity-X Commodity- Y

A 10 5

B 5 10

The table reveals that country A can produce 10 X or 5F with one unit of labour and
country В can produce 5X or 10К with one unit of labour.In this case, country A has
an absolute advantage in the production of X (for 10 X is greater than 5 X), and
country В has an absolute advantage in the production of Y (for 10 Y is greater than
5 Y).This can be expressed as 10X of A/5X of B > 1 > 5 Y of A/10Y of B.

Trade between the two countries will benefit both, as shown in Table
Country Production Production after Gains from
before Trade Trade Trade

Commodity (1) (2) (2-1)

XY XY XY

A 10 5 20 — + 10 -5

В 5 10 — 20 -5 +10

Total Production 15 15 20 20 +5 +5

It reveals that before trade both countries produce only 15 units arch of the two
commodities by applying one labour-unit on each commodity. If A were to specialise
in producing commodity X and use both units of labour on it, its total production will
be 20 units of X. Similarly, if В were to specialise in the production of Y alone, its
total production will be 20 units of Y. The combined gain to both countries from trade
will be 5 units of X and Y. Adam Smith based his theory of international trade on
absolute differences in costs between two countries. But this basis of trade is not
realistic because we find that there are many underdeveloped countries which do
not possess absolute advantage in the production of commodities, and yet they
have trade relations with other countries. Ricardo, therefore, emphasised
comparative differences in costs.
(2) Equal Differences in Costs:
Equal differences in cost arise when two commodities are produced in both
countries at the same cost difference. Suppose country A can produce 10 X or 5 Y
and country В can produce 8 X or 4 Y.

In this case, with one unit of labour country A can produce either 10 X or 5 Y, and
the cost ratio between A” and Y is 2:1. In country B, one unit of labour can produce
either 8X or 4Y, and the cost ratio between the two commodities is 2: 1.

3) Comparative Differences in Costs:

Comparative differences in cost occur when one country has an absolute advantage
in the production of both commodities, but a comparative advantage in the
production of one commodity than in the other.
Country Commodity – X Commodity – Y

A 10 10

B 6 8

The table reveals that country A can produce 10X or 10Y, and country В can
produce 6X or 8X.

In this case, country A has an absolute advantage in the production of both X and Y,
but a comparative advantage in the production of X. Country В is at an absolute
disadvantage in the production of both commodities but its least comparative
disadvantage is in the production of Y. This can be seen from the fact that before
trade the domestic cost ratio of X and Y in country A is 10: 10 (or 1:1), while in
country B, it is 6:8 (or 3:4). If they were to enter into trade, country A’s advantage
over country В in the production of commodity X is 10X of A / 6X of B or 5/3, and in
the production of Y, it is 10Y of A/8Y of B or 5/4. Since 5/3 is greater than 5/4, A’s
advantage is greater in the production of commodity X, A will find cheaper to import
commodity Y from country В in exchange for its X.Similarly, we can know the
comparative disadvantage of country В in the production of both commodities. In the
case of commodity X, country В’s position is 6X of B/10X of A or 3/5. In the case of
commodity Y, it is 8Y of B/10Y of A or 4/5 Since 4/5 is greater than 3/5, B has least
comparative disadvantage in the production of Y. It will trade its Y for X of country
A.In other words, country A has a comparative advantage in the production of
commodity A’, and В has least comparative disadvantage in the production of Y.
Thus, trade is beneficial for both countries.