Comparative Advantage
by Matt Stark

The ecomomic theory of comparative advantage originated in David Ricardo's Principles of Political Economy and Taxation in 1817 in an effort to explain patterns of international trade. Ricardo's theory argues that so long as trade is unrestricted, total world output of goods will increase if countries tend to specialize in producing the good for which they have the greatest relative advantage over potential trading partners. In other words comparative advantage was designed to prove that if Country A were to focus on specializing in the production of the good for which it has the largest absolute advantage over Country B, then trade with Country B for the good for which it has the least absolute advantage, both countries will find that their domestic consumption possibilities frontier will exceed their domestic production possibilities frontier (Dietz & Cypher, 1998). Ricardo argues that this is possible because specialization allows a nation to limit their opportunity costs, or costs associated with the decision to produce one good over another (see example below). In order for the theory of comparative advantage to hold true, certain economic conditions must exist in both Country A and Country B for all sides to benefit. Perfect competition must exist in both countries, as well as producers with profit motives and consumers seeking the greatest possible value. Another factor that must be present for comparative advantage to be true is the lack of trade defict, where a country is importing more than it is exporting (Deardorff, 2005). The theory also assumes that if each country were to have a closed economy where there is no trade, then all commodity goods would still be consumed and there would be no shortage (Kemp and Okawa, 2006).

The following is an example of how Ricardo's comparative advantage prooves world output would increase by utilizing specialization:

In one labor hour, U.S. farmers can produce 10 bushels of corn and 15 busels of soybeans. In one labor hour, Mexican famrers can produce 8 bushels of corn and 4 bushels of soybeans. If the two countries do not specialize the North American output of corn is 18 bushels of corn and 21 bushels of soybeans per hour for a total of 39 bushels of commodity goods. However the theory of comparative advantage tells us (assuming there are no tariffs/quotas on imports/exports that if American farmers specialize in soybeans and Mexican farmers specialize in corn, then the North American output would be 16 bushels of corn and 30 bushels of soybeans per hour for a total of 46 bushels of commodity goods per hour.


Without Specialization





U.S
Mexico
Total
Corn
10
8
18
Soybeans
15
6
21
Total Output


39









With Specialization





U.S
Mexico
Total
Corn
0
16
16
Soybeans
30
0
30
Total Output


46

Many critics rendered Ricardo's comparative advantage theory as outdated and not able to accurately depict gains from trade in modern economic times because it only calculated relative advantage using one factor, labor. Economists argued that both fixed and marginal costs needed to be factored into the calculation of opportunity costs, not solely labor which is a constant cost that incrementally increases with every unit produced. Because of this Gottfried Haberler "modernized" the theory of comparative advantage in 1930 by determining opportunity costs (the cost of producing one good rather than another) by using fixed and marginal costs. Fixed costs are costs incurred no matter which type and what quantity is produced. Marginal costs include labor, materials, and overhead costs. In other words, Haberler's concept measured the value of a good x by calculating the fixed and marginal costs of producing good y and comparing that to the fixed and margina costs of producing good x (Bernhofen, 2005).

The following example demonstrates how Haberler's extension of comparative advantage more accurately depicts overall output increase due to specialization:

American and Mexican ethanol plants produce both corn ethanol and feed for livestock from soybeans. Both American and Mexican plants can produce 1 gallon of ethanol and 1 lbs. of feed per hour. The fixed costs at the American plants are $1.00 per hour while fixed costs at the Mexican plant are $1.25 per hour. Mexican plants marginal costs (labor, material, overheard) comes to $2.00 per hour for ethanol and $2.50 per hour for feed. Marginal costs for American plants run at $1.25 for ethanol and $2.25 for feed. Marginal costs are included in order more accurately calculate modern opportunity costs. Assume that set-up costs associated with each product are immaterial.

The total cost per hour to produce two units of each commodities comes to $11.00 [(1.00+1.00+1.25+2.25)x2] for American plants and $14.00 [(1.25+1.25+2.00+2.50)x2] for Mexican plants. However if the American plants were to specialize in ethanol and the Mexican plants in feed, the total cost to produce two units of each commodity would be $4.50 [(1.00+1.25)x2] for ethanol and $7.50 [(1.25+2.50)x2] for feed.


Multiple Choice Questions

1. Who developed the theory of comparative advantage in the article Principles in Political Economy and Taxation?
a. Gottfried Haberler
b. David Ricardo
c. Daniel Bernhofen
d. Alan Deardorff
Answer: b

2. Who extended the theory of comparative advantage in 1930?
a. Gottfried Haberler
b. David Ricardo
c. Daniel Bernhofen
d. Alan Deardorff
Answer: a

3. Comparative advantage allowed domestic consumption possibilities to exceed production possibilities by limiting what type of costs?
a. marginal costs
b. opportunity costs
c. fixed costs
d. set-up costs
Answer: b

4. Whose version of competitive advantage calculated opportunity costs based on modern costing systems using fixed and marginal costs?
a. Gottfried Haberler
b. David Ricardo
c. Daniel Bernhofen
d. Alan Deardorff
Answer: a

5. What factors must exist when applying the theory of competitive advantage to explain gains from international trade?
a. perfect competition
b. profit-motivated producers
c. commodity goods are consumed without surplus
d. all of the above
Answer: d

REFERENCES

Bernhofen, Daniel M. "Gottfried Haberler's 1930 Reformulation of Comparative Advantage in Retrospect." Review International
Economics. 13(5) (2005): 997-1000

Cypher, James H. and Dietz, James L. "Static & Dynamic Comparative Advantage: A Multi-Period Analysis with Declining Terms of
Trade." Journal of Economic Issues. Vol. XXXII No. 2 (1998): 306

Deardorff, Alan V. "How Robust is Comparative Advantage?" Review of International Economics. 13(5) (2005): 1004-1016

Kemp, Murray, C. and Okawa, Masayuki. " The Torrens-Ricardo Principle of Comparative Advantage: an Extension." Review of
International Economics. 14(3) (2006): 466-477