Theory of Comparative Advantage
The theory of comparative advantage is perhaps the most important concept in international trade theory. English political economist 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. Ricardo considered what goods and services countries should produce, and suggested that they should specialise by allocating their scarce resources to produce goods and services for which they have a comparative cost advantage.
There are two types of cost advantage – absolute, and comparative:
Countries have different absolute advantages in producing goods.
In 1776, Adam Smith first introduced 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 of 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.
(Book IV, Section ii, 12)
David Ricardo extended Smith’s vision of specialization within a given industry to specialization between industries and nations, and made the argument that two countries can benefit from free trade even if one country is absolutely less competitive in both industries than the other. In his hypothetical example, Portugal could produce both cloth and wine with less labor than England. If England specialized at the industry it was comparatively better at (cloth, obviously) and Portugal specialized in wine, then the total output of both industries would rise.
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”
If Portugal had no commercial connexion with other countries, instead of employing a great part of her capital and industry in the production of wines, with which she purchases for her own use the cloth and hardware of other countries, she would be obliged to devote a part of that capital to the manufacture of those commodities, which she would thus obtain probably inferior in quality as well as quantity. The quantity of wine which she shall give in exchange for the cloth of England, is not determined by the respective quantities of labour devoted to the production of each, as it would be, if both commodities were manufactured in England, or both in Portugal.(Section 7.13-7.16)
The most important conclusion from the Ricardian model is that advantages from trade do not disappear just because another country has lower wages; nor do they disappear just because another country is more productive in everything.