Comparative advantage

The principle of comparative advantage explains why countries obtain gains from international trade. This term was first mentioned by Adam Smith when talking about specialization, and later by David Ricardo, who developed the concept as we know it nowadays in his trade theory explained in his book “On the Principles of Political Economy and Taxation”, 1817.

When comparing two countries, even if one of them has absolute advantage in producing two goods compared to the other, it may be possible for both to obtain benefits from the trade of these two goods. The key is that each country should produce the good with the lowest opportunity cost. When a country specializes in the good for which it has a comparative advantage, total production rises.

Following the example by Ricardo, Portugal can produce cloth and wine with fewer inputs than England. However, for Portugal the opportunity cost of producing wine is lower than that of producing cloth, whereas, in the case of England the opportunity cost of producing cloth is lower than of wine. If Portugal specializes in producing wine and import cloth, and England specializes in producing cloth and import wine, both countries could make the most of its comparative advantage.

Comparative advantageLet’s see a numerical example, following Ricardo’s hypothesis. If England requires 10 men for one year for the production of cloth (let’s say, one unit), and 12 men for the production of wine (also one unit), while Portugal requires 7 men for the production of one unit of cloth and 8 men for the production of one unit of wine, Portugal has an absolute advantage on the production of both cloth and wine, as seen in the adjacent figure.

However, we must consider the opportunity cost of producing each commodity. Comparative costs are 10/12=0.83 in England and 7/8=0.875 in Portugal; these are called the terms of trade.

We can easily see that Portugal produces at lower costs than England: for cloth, (10-7)/10=30% cheaper; and for wine, (12-8)/12=33.3%. Since it can produce both products at a lower cost, we know that Portugal has an absolute advantage in the production of both commodities. However, we can also see that Portugal has a comparative advantage in the production of wine, since it’s comparatively cheaper than cloth (33.3% for wine instead of 30% for cloth).

We obtain the same results with the opposite reasoning. England produces at higher costs: for cloth, (10-7)/7=42.8% more expensive; for wine, (12-8)/8=50% more expensive. Therefore, England has a comparative advantage in the production of cloth, since it’s comparatively less expensive than wine (42.8% for cloth instead of 50% for wine).

In this case, trade will benefit both countries as long as the terms of trade stay between 0.83 and 0.875 units of cloth per unit of wine. As a conclusion, trade can benefit every country because it allows each to specialize in the production of goods and services in which they have a comparative advantage.