First, Adam Smith, in 1776, first suggested the concept of absolute advantage as the basis for international trade in his publication “An Inquiry into the Nature and Causes of the Wealth of Nations”. Absolute advantage, as a principle, refers to the ability of an entity (like an individual, a firm, or a country) to produce a greater quantity of a commodity (product or service) than its competitors, by using the same amount of resources. Adam Smith, pointed out that all countries would have gains simultaneously if they, all, practiced free trade and specialized according to their absolute advantage.
Second, Robert Torrens, in 1808, referred to the concept of comparative advantage as the loss from the closing of trade. In his words: “If I wish to know the extent of the advantage, which arises to England, from her giving France a hundred pounds of broad cloth, 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.”.
Later, in 1815, Robert Torrens stated the principle of comparative advantage and trade. He articulated it in an article titled “Essay on the External Corn Trade”. Torrens starts the passage by analysing the basic idea of absolute advantage as described by Adam Smith, but, he also moves on to suggest that the simple intuition is not correct. Robert Torrens wrote,
“… suppose that there are in England, unreclaimed districts, from which corn might be raised at as small an expense of labor and capital, as from the fertile plains of Poland. This being the case, and all other things the same, the person who should cultivate our unreclaimed districts, could afford to sell his produce at as cheap a rate as the cultivator of Poland: and it seems natural to conclude, that if industry were left to take its most profitable direction, capital would be employed in raising corn at home, rather than bringing it in from Poland at an equal prime cost, and at much greater expense of carriage. But this conclusion, however obvious and natural it may, at first sight, appear, might, on closer examination, be found entirely erroneous. If England should have acquired such a degree of skill in manufactures, that, with any given portion of her capital, she could prepare a quantity of cloth, for which the Polish cultivator would give a greater quantity of corn, then she could, with the same portion of capital, raise from her own soil, then, tracts of her territory, though they should be equal, nay, even though they should be superior, to the lands in Poland, will be neglected; and a part of her supply of corn will be imported from that country.”. This is the first detailed description of one of the major results occurring from the theory of comparative advantage. It makes apparent Torrens\’ understanding that countries might benefit from free trade while reducing or eliminating production of a good, in which it is superior, in terms of technology, at producing.
David Ricardo, in 1817, established the idea of comparative advantage by using a compelling and simple numerical example, which can be found in his book “On the Principles of Political Economy and Taxation”. He describes the theory of comparative advantage, the theory that free trade between two or more countries could be mutually beneficial, even if one country has absolute advantage over the other countries in every aspect of the production. Duo to the fact that the idea of comparative advantage is not immediately intuitive, the most appropriate method of explaining it appears to be with a detailed numerical example as provided by David Ricardo. His example will be analyzed in detail on a following chapter. It was so important, that variations of it still are used in most international trade textbooks.
Finally, the concept of comparative advantage became a crucial element of international political economy with the publication of Principles of Political Economy by John Stuart Mill in 1848. He described issues such as which countries tended to have greater benefits in a system of trade that is based on comparative advantage, which, according to Stuart Mill, is those with more elastic demands for other countries\’ goods.
Definition of Comparative Advantage
The theory of comparative advantage states that even when a country is able to produce all its good at lower costs than another country can, trade still benefits both countries, based on comparative costs. Ricardo’s writings demonstrated what has become known as:
“… the principle of comparative advantage: a nation, like a person, gains from the trade by exporting the goods or services in which it has its greatest comparative advantage in productivity and importing those in which it has the least comparative advantage.”
Comparative Advantage can be defined as the ability of a firm or individual to produce commodities or services at a lower opportunity cost than other enterprises or individuals. A comparative advantage provides a firm the ability to sell goods and services cheaper than its competitors and formulate stronger sales margins.
It is important to note that a comparative advantage is not the same as an absolute advantage. Absolute advantage suggests that one is the best at something, while the comparative advantage relates more to the opportunity costs of the particular activity.
David Ricardo explains his theory of comparative advantage with the help of specific assumptions that be found below:
1. There are two countries and two commodities.
2. There is a perfect competition both in commodity and factor market.
3. The cost of production is expressed in terms of labour, meaning that the value of a commodity is measured in terms of labour required to produce it. Commodities are also exchanged on the basis of labour content of each good.
4. Labour and natural resources are the only production factors.
5. Labour is homogeneous in a particular country.
6. Labour is perfectly mobile within the same country, but perfectly immobile between countries.
7. There is free trade meaning that nothing restricts the movement of goods between countries.
8. Production is subject to constant returns to scale.
9. There is no technological change. The comparative cost theory is based on the assumptions of static theory.
10. Trade between two countries is based on a barter system.
11. Full employment exists in both countries.
12. There is no transport cost.
Ricardo considers a world economy consisting of two countries, Portugal and England, which both produce two commodities of the same quality. In Portugal, it is possible to produce wine and cloth with less labor than England would need to produce the same quantities. However, the relative costs of producing those two commodities is different between the countries.
Hours of work necessary to produce one unit
Country Cloth Wine
England 100 120
Portugal 90 80
England could commit 100 hours of labor to produce one unit of cloth, or produce 5/6 units of wine .Portugal could use 90 hours of labor in order to produce one unit of cloth, or produce 9/8 units of wine. Portugal possesses an absolute advantage in the production of cloth due to fewer labor hours, and England holds a comparative advantage due to the lower opportunity cost.
Without trade, England requires 220 hours of work to make and consume a unit of cloth and a unit of wine, while Portugal needs 170 hours of work to make and consume the same amounts. England is relatively more efficient at producing cloth than wine, and Portugal is more efficient at producing wine rather than cloth. That\’s why, if each country specializes in the commodity for which it has a comparative advantage, then the global production of both commodities increases, for England can spend 220 labor hours to produce 2.2 units of cloth while Portugal is able to spend 170 hours in order to produce 2.125 units of wine. Furthermore, if both countries specialize in the above way and England trades one unit of its cloth for 5/6 to 9/8 units of wine produced in Portugal, then both countries can consume leastwise one unit each of cloth and wine, with 0 to 0.2 units of cloth and 0 to 0.125 units of wine are remaining in each respective country that can be either consumed or exported.
So, if each country specializes in the good for which it holds comparative advantage, then the global production of both goods increases. Consequently, both England and Portugal are able to consume more wine and cloth, when they are under free trade rather than in autarky.
A Ricardian Numerical Example
The example analyze how both countries will benefit from trade if they specialize in the good they have a comparative advantage and trade some of it for the other good.
We set up an example so that one country (the US) can produce both goods cheaper, so it has an absolute advantage in both goods. Ricardo\’s interesting assumption was that a country can benefit from trade even if it is technologically inferior in producing every good.
We make the assumption that the exogenous variables in the two countries take their numerical values as sawn in the next table.
US aLC = 1 aLW = 2 L = 24
France aLC* = 6 aLW* = 3 L* = 24
We made the assumption that the U.S. has the absolute advantage in both cheese production and wine production because aLC(1) < aLC*(6) and aLW(2) < aLW*(3). The US has the comparative advantage in cheese production since: The production cost of cheese in the U.S. is ½ gallon per pound of cheese. In France, it is 2 gallon per pound. France holds the comparative advantage in wine production since The cost of producing wine in France is ½ pound of cheese for each gallon of wine while in the U.S., it is 2 pounds per gallon. The figure beyond depicts The Production Possibility Frontiers (PPFs) for each country. It is noticeable that the US PPF lies outside France\'s PPF. Because countries are both assumed to be the same size in the example, this indicates that the US has an absolute advantage in the production of both goods. The Production Possibility Frontiers (PPFs) for US and France. The absolute value of the slope of each PPF saws the opportunity cost of cheese production. Since, the US PPF is more flat than France\'s this saws that the opportunity cost of cheese production is lower in the US and this indicates that the US has the comparative advantage in producing cheese. Supposing full employment of labor, production will happen at some point on the PPF. To notice the effects of specialization and implementation of free trade we have to compare it to a situation of no trade, like as autarky. That’s why we must construct autarky equilibrium first. To calculate the autarky production point requires some data about the consumer demand for the goods. Producers will produce whatever consumers demand at the appropriate prices so as the supply of each good to be equal with the demand for it. In autarky this is meaning that the production and consumption point for a country are the same. For this example we will simply assume a plausible production and consumption point under autarky. In essence we assume that consumer demands are such as it to make the chosen production point. The following Table also shows the autarky production/consumption levels regarding the two countries. It also points out total world production for each of the goods. Autarky Production/Consumption Cheese (lbs) Wine (gals) US 16 4 France 3 2 World Total 19 6 Autarky Production/Consumption Points. Production/Consumption in Autarky The autarky production and consumption points for the US and France are the depicted in the above diagram. Each point is located on the interior area of the country\'s production possibility frontier. Ricardo believed that gains from trade could occur if countries start with specializing in their comparative advantage good and then trade with the other country. Specialization in this example means that the US focuses its production entirely on cheese and produces no wine, while France produces only wine and zero units of cheese. These quantities can be found in the following matrix. Additionally, someone can see the world totals for each of the goods. Production with Specialization in the Comparative Advantage Good Cheese (lbs) Wine (gals) US 24 0 France 0 8 World Total 24 8 In order both countries to benefit from the increase in world production efficiency they have to be able trade with each other after specialization. Both production points could be achieved under autarky but the countries demanded some of each good. That’s why the countries will want some of each good after specialization and the only way to achieve this is via trade. Now if the world can produce more of both commodities through specialization, clearly there must be a method to divide the surplus between the two countries so that each country ends up with more of both commodities after the use of trade than they would have in autarky. The surplus in world production is calculated to 5 extra pounds of cheese and 2 extra gallons of wine. In order trade to be considered advantageous for both countries, each must have at least as much to consume of the one commodity and more to consume of the other commodity. Suppose we split the wine surplus in equal and give 3 additional pounds of cheese to France and 2 additional pounds to the US. Since the US consumed 16 cheese and 4 wine in autarky, they could have 18 cheese and 5 wine after countries specialize and trade. France, which began with 3 units of cheese and 2 of wine before trade, would now with the use of trade have 6 cheese and 3 wine. Consumption and production after both counties start to trade can be found in the Table below. Consumption and Production after Trade Cheese (lbs) Wine (gals) Consumption Production Consumption Production US 18 24 5 0 France 6 0 3 8 World Total 24 24 8 8 In order for the consumption of both goods to be higher in each country trade must be involved. In this example, the US is consuming 5 gallons of wine and producing zero so it have to get the 5 gallons from France through trade. France is consuming 6 pounds of cheese with zero cheese production so it must import the 6 pounds from the US. The Terms of Trade occurs as ToT = 5 gal/6 lbs or 5/6 gal/lb. In Conclusion, The Ricardian model numerical example makes the assumption that countries have different production technologies so as that one of the countries is absolutely better in terms of production than the other in terms of production of both goods. If both countries specialize their production in their comparative advantage product then world production would increase for both products. Increased production can happen even if there is no increase in the amount of labor used in the world. In this way this example points out that specialization is able to give raise world production efficiency. Duo to the increase in the surplus there is the possibility to construct a Terms of Trade (ToT) between the countries so as both countries consume more of each good with specialization and trade than it was possible without trade. Thus both countries benefit from the use of trade. The surprising result from this example is that a country which is inferior in terms of technology to another, in the production of all goods could still benefit from trade with that country. Sources of Comparative Advantage Comparative advantage is not a static concept, but it is occurring from a dynamic progress. This means that it can and does change over time. For countries, the following factors are important in order to determine the relative unit costs of production: 1. The quantity and quality of factors of production that are available. Abundance in supply of good quality land for agriculture, oil, gas and other basic factors of production in some nation can provide them with comparative advantage. Also, climate and geography are considered key factors in forming differences in comparative advantage. At more recent time the shale gas revolution is shifting the pattern of world energy production. In the future, limited water supply in the majority of the developing countries might have vastly important effects on their ability to export products. 2. Different proportions of factors of production. Some countries have abundant low-cost labour appropriate for the volume production of manufacturing products. 3. Increasing returns to scale and the division of labour. Increasing returns can occur when output grows more than in proportion to inputs. Rising demand in the markets where trade that occurs helps to encourage specialisation, higher productivity and internal and external economies of scale. These long-run scale economies provide regions and countries with a significant advantage. 4. Investment in Research and Development (R&D) which can lead to innovation and invention. 5. Fluctuations in the exchange rate, which can affect the relative prices of exports and imports and provoke changes in demand from domestic and overseas customers. 6. Import controls such as tariffs, export subsidies and quotas. Their use can develop an artificial comparative advantage for a nation\'s domestic producers. 7. The non-price competitiveness of producers. Covering factors such as the standard of product design and innovation, product reliability, quality of after-sales support. Many countries are now building comparative advantage in high-knowledge related industries and specializing in specific knowledge areas. One example is the division of knowledge in the medical industry. Some countries specialize in heart surgery, others in pharmaceuticals. 8. Institutions. These are important for comparative advantage and important for growth as well. Banking systems are essential in order to provide capital for investment and export credits, legal systems help to enforce contracts, political institutions and the stability of democracy is a basic factor behind decisions about international capital flows. The list above is just a part of the elements which can cause one country to have a comparative advantage. Whatever could cause one enterprise to have a different relative cost of production than another enterprise gives rise to a comparative advantage. Comparative advantage is often a self-reinforcing process. Enterprises in a country form a new comparative advantage in a product either because they find ways of producing it more efficiently or they create a genuinely new product that finds a growing demand in home and international markets. Rising demand and output encourages the exploitation of economies of scale. Higher profits can be reinvested in the business to fund further product development, marketing and a wider distribution network. Skilled labour is attracted into the industry and so on. The expansion of an industry is leading to external economies of scale. Comparative Advantage and Strategy The design of international strategies is structured on the interplay between the comparative advantages of countries and the competitive advantages of firms. These two advantages determine the answer to the two principal questions in international strategy. One is: Where should the value-added chain be broken across borders? And the other is: In what functional activities should a firm focus its resources? Answers to both of these questions are affected by comparative and competitive advantage. Comparative advantage, usually, is referred to as location-specific advantage, because it influences the decision of where to source and market. Comparative advantage is based on the lower cost of a factor, for example labor, in one country relative to another. Thus, that is favouring industries that use this factor in higher intense. Competitive and comparative advantages are not totally independent of each other. Each one can be affected by the other and via versa. Firms could differ in location of sourcing of their production and they could acquire a competitive edge with better usage of the comparative advantages among countries. That’s why differences along firms regarding the location of their sourcing could raise significant strategic advantages. So, it is useful to make a distinction between strategies based on competitive advantage and those based on comparative advantage. The value-added chain can be used for purposes of structuring the strategic allocation decision. Comparative advantage can affect an international production chain for countries and it is derived from differences in factor costs. Consequently, the interaction between comparative and competitive advantage can affect how international strategy is developed. There is a significant difference between competing on the initial transfer of an advantage, through exporting a product from a plant favored by the place that is located or a firm advantage by investing overseas, and competing on the basis of the subsequent advantages gained by being global. As an example, the Japanese entry into the United States frequently supposes a historical pattern of competition based upon an initial transfer of a comparative advantage in exports coming from from low wages, and a later transfer of a competitive advantage in the form of exporting by or investing overseas in production which is intensive in terms of capital at minimum efficient scale. As comparative and competitive advantages between American and Japanese enterprises evolve more similar, competition in the large North American market is characterized by an increasingly domestic character, even if the names of some of the players are not local. That\'s why, the initial global advantage of Japanese firms is not always sustainable. New competitive advantages, such as brand labeling, must therefore be developed, but these advantages are not global as they are not entirely acquired by participating in world markets. The creation of a global network offers the benefit of profiting from the uncertainty of the world market. A critical element of forming an international strategy is creating the organizational flexibility and incentives that respond to changes in economies between countries. So, the international enterprise can be viewed as representing investments in flexibility that allow the exploitation of profit opportunities created by environmental instability. That\'s why, the crucial operating dimensions in a global strategy are to recognize the potential profit opportunities and to create the organizational flexibility that responds to changes in the environment. Limitations of Comparative Advantage The theory of comparative cost advantages formulated by David Ricardo was the most acceptable explanation of the International trade. The most common argument for free trade, among mainstream economists, is comparative advantages. However, Ricardo\'s theory was a number of limitations that was criticized about. In more detail some of the basic points that the theory of comparative advantage took critic are: Restrictive Model: Ricardo\'s Theory is based on just two countries and only two commodities. But international trade is among many countries with many commodities. Labour Theory of Value: Value of goods is expressed in terms of labour content. Labour Theory of value developed by classical economists has too many limitations and thus is not applicable to the reality. Full employment: The assumption of full employment aids the theory to explain trade on the basis of comparative advantage. The reality is far from full employment. Cost of production, even in terms of labour, may change as the countries, at different levels of employment are moving towards full employment. Ignore transport cost: Another serious defect is that the transport costs are not consider in determining comparative cost differences. Transport costs may outweigh any comparative advantage. Demand is ignored: The comparative advantage theory focuses on the supply of goods. Each country specializes in the production of the commodity based on its comparative advantage. The theory explains international trade in terms of supply and takes demand for granted. Mobility of factor of production: As against the assumptions of perfect immobility between the countries, we witness difficulties in the mobility of labour and capital within a country itself. Also, their mobility between nations is not impossible. No Free Trade: The theory of comparative advantage takes into assumption that trade is free. This is meaning no restriction on the movement of goods between the countries. It is unrealistic to assume not to have any restriction. Governments actually may restrict trade. In reality a lot tariff and non-tariff barriers may be enforced by governments on international trade. Complete Specialization: The comparative advantage theory comes into the conclusion of complete specialization. In Ricardo’s example, England is specializing fully on cloth and Portugal on wine. Such complete specialization is unrealistic even in two countries and two commodities model. Static Theory: The modern economy is dynamic, but the comparative cost theory is based on the assumptions of static theory. It assumes fixed quantity of resources. It does not take into account the effect of growth. Not applicable to developing countries: Theory of comparative advantage is not applicable to developing countries as these countries are nowhere near to full employment. Additionally, developing countries exhibit characteristics of dynamic economy. Constant Returns to Scale: Another drawback of the principle of comparative costs is that assumes constant returns to scale and thus constant cost of production in both the countries. In actual practice a country produces a particular commodity and also imports a part of it, which theory of comparative costs fails to explain. Real Life Examples of Comparative Advantage A real life example involves India and Philippines operating call centers and IT (Information Technology) services. India has an absolute advantage in call centers industry compared to the Philippines due to its low cost of labor and abundant labor force. But, when u take trade into consideration, comparative advantage is considered more important than absolute advantage. Comparative advantage takes into account the opportunity cost of specializing in one activity over another. Even if it is cheaper for India to operate call centers in comparison with the Philippines, the potential gains from another activity, such as IT services, could be much greater. India has seen immense growth in its IT services industry, with revenue growing double since 2010. It has a comparative advantage in specializing in IT relative to other nations. This fact may be why India\'s contribution to the call center operations has been declining over time. Additionally, the Philippines has experienced boom, meaning rapid growth, in its call center industry because it has a comparative advantage in relating to American customers. In the real world, specialization and trade is not quite this simple. Other elements that influence trade decisions are barriers (for example tariffs and quotas), the cost and economies of scale in production, and the mixture of goods and services that local population is demanding. While a country may hold an absolute and even comparative advantage in a specific good or service, it often produces items for which it doesn\'t necessarily have an advantage. Another real life example involves Korea steel mill industry development and how government helped in order a comparative advantage to be formed. A study by the World Bank in the 1960s ‘expressed the view that an integrated steel mill in Korea was a premature proposition without economic feasibility’ (Pohang Iron and Steel Co. Ltd, 1984), p.23, cited in Amsden, 1989). Multitude of factors, including Korea’s deficiency in the required raw materials and its small domestic market for such a scale-intensive industry, suggested that steel making was an industry in which Korea was not likely to have a comparative advantage. Besides that in 1973, the Korean government founded the Pohang Iron and Steel Company Ltd (POSCO) with an starting investment of $3.6bn. Government assistance in a wide variety of forms, including subsidization of the cost of capital and investments in infrastructure, that had been important to POSCO’s development. The company quite soon emerged to one of the lowest cost steel related producers globally. In 1985, Korea unit costs of production were less than those of Japan and around two thirds of those in the United States (Amsden, 1989), Table 12.2). By 1988, POSCO had become the eleventh largest steel company in the world, operating 80 individual plants (Enos and Park, 1988). Besides the fact that at the time POSCO was founded Korea did not appear to have a comparative advantage in the iron and steel industry, it seems incontrovertible that it now does and that the Korean government has played a important role in acquiring one. We see how Korea has entered sectors in which they used to lack a comparative advantage, but acquired such an advantage in the future as a result of the potential for productivity growth. Consequently, Korea manage to form comparative advantage to steel mill industry.