THEORY OF COMPARATIVE ADVANTAGE
In his theory put forward in a book published in 1817, David Ricardo argued that what was needed for two countries to engage in international trade was comparative advantage. He believed that 2 countries can still gain, even if one country is more productive then the other in all lines of production. Using the Labour Theory Value, Ricardo's contribution was to show that a sufficient basis for trade was a difference, not in absolute costs. He illustrated his theory with 2 countries and two commodities, I and II and A and B respectively.
COUNTRY COST OF PRODUCING I UNIT
I 8 9
II 12 10
We can observe that country I has complete absolute advantage in the production of both commodities since it can produce them with a lower level of resources. Country I is more efficient than country II.
Ricardo believed that even then there could still be a basis for trade, so long as country II is not equally less productive, in all lines of production. It still pays both countries to trade. What is important is the Comparative Advantage. A country is said to have comparative advantage in the production of a commodity if it can produce at relatively lower opportunity costs than another country. (The Law of Comparative Advantage states that a nation should specialize in producing and exporting those commodities which it can produce at relatively lower costs, and that it should import those goods in which it is a relatively high cost producer). Ricardo demonstrated this by introducing the concept of Opportunity Cost.
The opportunity Cost of good A is the amount of other goods which have to be given up in order to produce one unit of the good. To produce a unit of good A in country I, you need 8 man hours and 9 man hours to produce good B in the same country. It is thus more expensive to produce good B then A. The opportunity costs of producing a unit of A is equivalent to 8/9 units of good B. One unit of B is equal to 9/8 units of A.
In country II, one unit of A is equal to 12/10 of B and one unit of B = 10/12 units of A. Therefore he felt that: -
Opportunity cost of producing one unit of:
I 9/8 (1.25) B 8/9 (0.89) A
II 10/12 (0.83) B 12/10 (1.2) A
B is cheaper to produce in country II in terms of resources as opposed to producing it in country I. The opportunity costs are thus lower in country II than in country I.
Consider commodity A valued in terms of B. A cheaper in country I than country II.
A country has comparative advantage in producing commodity if the opportunity cost of producing it is lower than in other counties. Country I has a lower opportunity cost in producing A than B and II has a lower opportunity cost in the production of B than A. In country I, they should specialize in the production of A and Import B.