Comparative Advantage

The theory of comparative advantage in economics states that trade between two countries can benefit both countries if each country exports the goods in which it has a relative comparative advantage. David Ricardo coined the term. The principle explains the benefits of free trade.

The example on which the principle was based is very simple. Let us assume that, given the endowment of factors of production (labor, land, climate, capital, etc.), a worker in a foreign land is able to produce one unit of cloth or one unit of wine per day, whereas in the homeland a worker is able to produce four units of [Page 382]cloth or two units of wine per day. On the face of it, the foreign land seems likely to be excluded from trade, as the homeland has an absolute comparative advantage in both products.

However, the inhabitants of both countries will be better-off if the workers of the homeland specialize in producing the cloth and export a part of their output to the foreign land, while the workers of the foreign land concentrate on producing wine and sell a part to the homeland. In the foreign land, the opportunity cost of wine in terms of cloth is 1 (to produce one unit of wine the foreign land has to forgo one unit of cloth, which is what one worker produces in 1 day), whereas in the homeland the opportunity cost is 2 (four units of cloth for two units of wine). It is more profitable for the homeland workers to produce only cloth, in which they are relatively more productive, even though they are also more productive than the foreign land workers in producing wine.

Trade between two countries benefits both if each specializes in the products in which it has a “relative comparative advantage”—the ones it can produce with a relatively lower cost. This argument can be generalized to many countries, factors, and products; the main conclusion remains the same, though the details get more complicated. For example, the existence of more than one factor of production reduces the tendency toward specialization; and transportation costs may interfere with the direction of trade and with specialization.

A good deal of the theory of international trade derives from the theory of comparative advantage. Examples include the following three. The HeckscherOhlin theorem establishes that, under certain conditions, an economy will tend to be relatively effective at producing goods that are intensive in the factors with which the country is relatively well-endowed. The Stolper-Samuelson effect says that trade benefits the scarcest factor. The Lerner-Samuelson factor price equalization theorem establishes that, under fairly restrictive conditions, trade leads to the equalization of factor prices internationally, even if factors are not mobile.