Comparative+advantage+and+trade

//By: Trevor J. Moore//
 * Comparative Advantage and Trade**

Many agree that the idea of comparative advantage was developed by Robert Torrens in his 1815 essay //An Essay on the External Corn Trade// (Suranovic, The Theory of Comparative Advantage - Overview, 2007). However, some (Ruffin, Debunking a myth: Torrens on comparative advantage, 2005) argue that Torrens was working on theories of absolute advantage during this time and was not a predecessor to the theory of comparative advantage. Regardless of this concept’s roots, the idea was formalized in David Ricardo’s 1817 book titled, //On the Principles of Political Economy and Taxation//.

The principle of **comparative advantage** is a principle that says “a country has a comparative advantage in the production of a good if it can produce that good at a lower opportunity cost relative to another country” (Suranovic, Definitions: Absolute and Comparative Advantage, 2006).

An **opportunity cost** is “the value of the next best opportunity” (Suranovic, Definitions: Absolute and Comparative Advantage, 2006). In the context of national production, the nation has opportunities to produce Good X and Good Y. If the nation wishes to produce more of Good X, then because labor resources are scarce and fully employed (assumptions of the Ricardian Model), it is necessary to move labor out of Good Y production in order to increase Good X production. The loss in Good Y production necessary to produce more of Good X represents the opportunity cost to the economy.

Many find that it is easy to confuse this principle with the principle of absolute advantage. To clarify, **absolute advantage** is a principle that says “a country has an absolute advantage in the production of a good relative to another country if it can produce the good at lower cost or with higher productivity” (Suranovic, Definitions: Absolute and Comparative Advantage, 2006). The two should not be confused because they provide vastly different principles that are each used independently of each other.

In order for the Ricardian Model of Comparative Advantage to be applicable, the following assumptions must be made: (Suranovic, The Theory of Comparative Advantage - Overview, 2007)
 * Two countries producing two goods use labor as the only factor of production.
 * Goods are homogeneous (identical) across firms and countries.
 * Labor is homogeneous within a country but heterogeneous (non-identical) across countries.
 * Goods can be transported costlessly between countries.
 * Labor can be reallocated costlessly between industries within a country but cannot move between countries.
 * Labor is always fully employed.
 * Production technology differences exist across industries and across countries and are reflected in labor productivity parameters.
 * The labor and goods markets are perfectly competitive in both countries.
 * Firms maximize profit while consumers maximize utility.

Let us suppose that the US and Canada each produce bread and milk. The following are the current levels of production without trade between the countries:
 * || Bread (loaves) || Milk (gallons) ||
 * US || 16 || 4 ||
 * Canada || 3 || 2 ||
 * World Total || 19 || 6 ||

If Canada had a comparative advantage in the production of milk, they would choose to only produce milk and the US would choose to only produce bread. The two countries would then trade the other good in order to meet consumer demand. The following shows possible production if each country specializes:


 * || Bread (loaves) || Milk (gallons) ||
 * US || 24 || 0 ||
 * Canada || 0 || 8 ||
 * World Total || 24 || 8 ||

As one can see, the overall world production has increased due to specialization and having a comparative advantage in one good. The use of this model does not allow one to predict the new levels of world production, but illustrates the point that if each country specializes, the overall world production will increase.

If one wants to maximize the total output in the world, they must: (Suranovic, The Theory of Comparative Advantage - Overview, 2007)
 * Fully employ all resources worldwide.
 * Allocate those resources within countries to each country’s comparative advantage industries.
 * Allow the countries to trade freely subsequently.

Using the concept of comparative advantage, the wellbeing of all individuals might be raised, despite differences in productivity. This model simplifies the world’s economic situation and likely will not translate into similar results in the complex real world. The model simply gives us the opportunity to look at how things would have to look in order to achieve maximum results. The model of comparative advantage does not tell us what //will// happen when two countries begin to trade; the theory tells us some things that //could// happen.

Multiple Choice Questions

1. Comparative advantage is: a. The ability to produce a good at a lower opportunity cost relative to another country. b. The value of the next best opportunity. c. The ability to produce a good at lower cost or with higher productivity. d. None of the above. The correct answer is A. Although the definitions of comparative advantage and absolute advantage are often confused, comparative advantage deals with opportunity costs.

2. If the United States can produce a baseball for $0.87 and the Dominican Republic can produce an equivalent product for $0.69, who has the competitive advantage? a. The United States b. The Dominican Republic c. Neither d. It is impossible to tell from the data provided The correct answer is D. One could only determine the absolute advantage with the given data. To find comparative advantage, one would need the opportunity cost.

3. If France can produce a bicycle frame with an opportunity cost of $32 and Australia can produce an equivalent product with an opportunity cost of $31, who has the comparative advantage? a. France b. Australia c. Neither d. It is impossible to tell from the data provided The correct answer is B. A country has a comparative advantage if it can produce the good at a lower opportunity cost.

4. Which of the following is NOT an ingredient of maximizing total world output? a. Fully employ all resources worldwide. b. Allocate resources within countries to each country’s comparative advantage industries. c. Focus production in the most technologically advanced country. d. Allow the countries to trade freely subsequently. The correct answer is C. All of the other options are things that should be done. Benefiting from comparative advantage does not require the use of advanced technology to increase production.

5. Who is most often credited with the concept of comparative advantage? a. David Ricardo b. Alan Greenspan c. John Stuart d. James Mill The correct answer is A. David Ricardo was the first to formalize the idea of comparative advantage in his 1817 book, //On the Principles of Political Economy and Taxation//.

= = =Works Cited=

Faulkner, D., & Segal-Horn, S. (2004). The economics of international comparative advantage in the modern world. //European Business Journal// //, 16// (1), 20-31.

Kemp, M. C., & Okawa, M. (2006). The Torrens–Ricardo principle of comparative advantage: an extension. //Review of International Economics// //, 14// (3), 466-477.

Krugman, P. (n.d.). //Ricardo's Difficult Idea//. Retrieved September 5, 2007, from http://web.mit.edu/krugman/www/ricardo.htm

Ruffin, R. J. (2002). David Ricardo's discovery of domparative advantage. //History of Political Economy// //, 34// (4), 727-784.

Ruffin, R. J. (2005). Debunking a myth: Torrens on comparative advantage. //History of Political Economy// //, 37// (4), 711-722.

Suranovic, S. M. (2006, July 18). //A Ricardian Numerical Example.// Retrieved September 5, 2007, from International Trade Theory and Policy: http://internationalecon.com/Trade/Tch40/T40-5.php

Suranovic, S. M. (2006, July 18). //Definitions: Absolute and Comparative Advantage.// Retrieved September 5, 2007, from International Trade Theory and Policy: http://internationalecon.com/Trade/Tch40/T40-4.php

Suranovic, S. M. (2007, March 8). //The Theory of Comparative Advantage - Overview.// Retrieved September 5, 2007, from International Trade Theory and Policy: http://internationalecon.com/Trade/Tch40/T40-0.php#