The Principle of Comparative Advantage

 

 

Comparative advantage occurs when one country can produce a good or service at a lower opportunity cost than another. This means a country can produce a good relatively cheaper than other countries

The theory of comparative advantage states that if countries specialise in producing goods where they have a lower opportunity cost – then there will be an increase in economic welfare.

Note this is different to absolute advantage which looks at the monetary cost of producing a good.

Even if one country is more efficient in the production of all goods (absolute advantage) than the other, both countries will still gain by trading with each other, as long as they have different relative efficiencies.

Theory of Comparative Advantage

Comparative advantage was first described by David Ricardo who explained it in his 1817 book “On the Principles of Political Economy and Taxation” in an example involving England and Portugal.

Ricardo noted Portugal could produce both wine and cloth with less labour than England.

However, England was relatively better at producing cloth. Therefore, it made sense for England to export cloth and import wine from Portugal.

Example of Comparative Advantage

  • Assume two countries, UK and India
  • They both produce textiles and books.
  • Their relative production levels are shown in the table below.

Output  without trade

Textiles

Books

UK

1

4

India

2

3

Total

3

7

 

 

 

 

 

  • For the UK to produce 1 unit of textiles it has an opportunity cost of 4 books.
  • However for India to produce 1 unit of textiles it has an opportunity cost of 1.5 books
  • Therefore India has a comparative advantage in producing textiles because it has a lower opportunity cost
  • The UK has a comparative advantage in producing books. This is because it has a lower opportunity cost of 0.25 (1/4) compared to India’s 0.66 (2/3)
  • If each country now specializes in one good then assuming constant returns to scale output will double

Output after trade

Textiles

Books

UK

0

8

India

4

0

TOTAL

4

8

 

  • Therefore total output of both goods has increased illustrating the gains from comparative advantage.
  • By trading the surplus books and textiles, India and UK can enjoy higher quantities of the goods.

There are many examples of comparative advantage in the real world e.g. Saudi Arabia and oil, New Zealand and butter, USA and Soya beans, Japan and cars e.t.c.

http://www.economicshelp.org/blog/glossary/comparative-advantage/

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