comparative advantage - Critical analysis of Ricardo's theory

The argument that trade depends on the relative and not the absolute levels of costs of production in different countries. It holds that countries both should and do tend to export goods which their resources make it possible for them to produce relatively cheaply, and to import goods where lack of resources means they can produce only at relatively high cost or not at all. A country with poor natural resources, and little physical and human capital, may well have high costs (ie low productivity) in all sectors, but with a suitable price level and exchange rate it can still export the goods for which its relative cost disadvantage is smallest. A country's comparative advantage can change over time, as geographical discoveries, investment, education, and technical progress alter both its resources and those of other countries.

In economics, the theory of comparative advantage (sometimes known as "Ricardo's Law") explains why it can be beneficial for two parties (countries, regions, individuals and so on) to trade, even though one of them may be able to produce every item more cheaply than the other.

Under "absolute advantage", each state in an unregulated international economy would find a productive niche based on absolute advantage, i.e. 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

Critical analysis of Ricardo's theory

Ricardo's principle relies on a variety of implicit assumptions that are debatable, such as that there is no (or a low) cost for transportation, and that the advantages of increased production outweigh externalities such as environmental contamination or social inequities.

Opponents of free trade often point out that globalized communications and transportation unavailable in Ricardo's time invalidate the assumption of capital immobility and cause capital to gravitate toward absolute advantage (though proponents would point out that modern low cost transportation only makes the assumption more sound).

Example 2

A Needs 100 P1 and 100 P2
B Needs 100 P1 and 100 P2

A: No trade

Product	Cost	Produced	Cost
P1	10	100	1000
P2	20	100	2000
Net	-	200	3000

B: No trade

Product	Cost	Produced	Cost
P1	15	100	1500
P2	25	100	2500
Net	-	200	4000

A with trade: 100P1 for 56 P2

Product	Cost	Produced	Cost
P1	10	200	2000
P2	20	44	880
Net	-	244	2880

B With trade: 56 P2 for 100 P1

Product	Cost	Produced	Cost
P1	15	0	0
P2	25	156	3900
Net	-	156	3900

So A saved 120 cost units or 4% and B saved 100 cost units or 2.5%. The productive capacities and efficiencies of the countries are such that if both countries devoted all their resources to Food production, output would be as follows:

Northland: 100 tonnes Southland: 200 tonnes

Conversely if all of the resources of the countries were allocated to the production of Clothes, output would be:

Northland: 100 tonnes Southland: 100 tonnes

We need to assume that each of the countries has constant opportunity costs of production between the two products, and that both economies have full employment at all times.

So Southland has an absolute advantage over Northland in the production of Food, and both countries are equally efficient in the production of Clothes. And Northland also has a comparative advantage over Southland in the production of Clothes, the opportunity cost of which is lower in Southland with respect to Food than in Northland.

To show that these different opportunity costs can lead to mutual benefit if the countries specialise production and trade, consider the following starting position. The volumes are:

Production and consumption before trade

	Food	Clothes
Northland	50	50
Southland	100	50
World total	150	100

We now examine the consequences of trade between the two countries.

If both countries specialise completely in the goods in which they have comparative advantage, their outputs will be:

Production after trade

	Food	Clothes
Northland	0	100
Southland	200	0
World total	200	100

Note that world production of Food had increased and Clothing production has remained the same. Using the exchange rate of one tonne of Food for 2/3 tonne of Clothes, Northland and Southland are able to trade to yield the following level of consumption:

Consumption after trade

	Food	Clothes
Northland	75	50
Southland	125	50
World total	200	100

Northland has traded 50 tonnes of Clothing for 75 tonnes of Food.

Assumptions in Example 3

Two countries, two goods - the theory is no different for larger numbers of countries and goods, but the principles are clearer and the argument easier to follow in this simpler case.