Theory of Comparative Advantage

The central message of this theory is that incentives to trade arise

from relative price differences.

That is, a country has a comparative advantage in producing a

commodity if the opportunity cost of producing that good in terms of
the other good is lower in that country compared to the other country.

The Ricardian Model

The Ricardian model implies that international trade is solely due to

international differences in productivity of labour.

Assumptions:

• Two countries, Home and Foreign

• One factor of production – labour (L)
• Two commodities – Y1 and Y2
• Full employment of the factor of production
• Zero profit
• Constant returns to scale

Assume that: ai = labour requirement to produce one unit of each

good in Home country, and ai* = labour requirement to produce one
unit of each good in Foreign country.

L  The Total Labour Force in Home country

L*  The Total Labour Force in Foreign country

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Given full employment then,

For Home country

L = a1 Y1 + a2 Y2 (1)

And for Foreign country

L* = a1* Y1 + a2* Y2 (2)

Equation (1) and (2) are the Production Possibilities Curves (PPC)

From equation (1): for Home country

L  a1 
Y2 = −   Y1
a2  a2 

From equation (2): for Foreign country

L  a1* 
Y2 = * −  *  Y1
a2  a2 

Zero profit assumption would mean:

w a1 = P1 Where:
P1 => unit price of Y1
w a2 = P2 P2 => unit price of Y2
w => wage rate

2
When there is only one factor of production, PPC will be a straight
line and the limits of production can be specified as:

For Home country For Foreign country

a1 Y1 + a2 Y2  L a1* Y1 + a2* Y2  L*

Y2 Y2*
p
B*
L*/a2*
L/a2 C

C*
A
A*

B p
pa pa*
Y1 Y1*
L/a1 L*/a1*

a1
pa =
a2

a1*
p a* =
a2*

In the absence of trade, supply of Y1 and Y2 will depend on the

movement of labour to the sector that pays higher wage.

If there is no profit the wage rate in Y1 and Y2 will be:

P1 P2
w1 = and w2 =
a1 a2

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Now if
w1  w2

P1 P2
Then 
a1 a2

P1 a1
Or 
P2 a2

P1 a1
That is: if  = wages in Y1 is higher
P2 a2

P1 a1
Conversely, if  = wages in Y2 is higher
P2 a2

Since everyone will want to work in the sector that pays the higher
wage, the equilibrium will be set at:

P1 a1
=
P2 a2

P1 a1 P P
That is: = = 1 = 2 = w1 = w2
P2 a2 a1 a2

In the absence of international trade the country will produce both the
goods for itself and as a result the relative prices of goods are equal to
their relative unit labour requirements.

Thus the autarky equilibrium at Home and Abroad might occur at

point A and A*.

4
Under Trade:

The slopes of Home and Foreign countries PPCs are given by:
a1 a1*
and
a2 a2*

The opportunity cost of Y1 in terms of Y2 is

a1 a*
If,  1* => greater in Home than Abroad. Hence Home
a2 a2 should produce Y2 and Foreign country
should produce Y1

The labour requirement ratio shows Home

a1 a* has comparative advantage in the production
That is:  1* =>
a2 a2 of Y2

The opportunity cost of Y1 in terms of Y2 is

*
a1 a lower in Home than Foreign. Hence Home
If,  1
=>
a2 a *
2
should produce Y1 and Foreign should
produce Y2

The labour requirement ratio shows Home

a1 a1*
That is:  * => has comparative advantage in the production
a2 a2 of Y1

Y2

 a1* 
PPC of Foreign Slope : −  * 
 a2 

PPC of Home a 
Slope : −  1 
 a2 

Y1

Slope of Foreign country’s PPC > Slope of Home country’s PPC

{absolutely}
Therefore, Home has comparative advantage in Y1.

5
Relative Price after Trade
Relative Price P1/P2

a1*
RS
a2*
e1

a1 e2 RD
a2
RD1
L Relative quantity Y1/Y2
a1
L*
a2*

Note that Home has comparative advantage in the Production of Y1.

• RS is the relative supply curve, which shows that there is no

supply of Y1 if the world price drops below a1 . Both countries
a2
fully specialize in Y2

P1 a1 workers in Home are indifferent between Y1 and Y2. So

• If = => Home will be willing to produce any relative amount of
P2 a2
two goods thus giving the flat segment of the RS curve.

P1 a1* workers in Foreign will produce only Y2.

• If  =>
P2 a2*

a1*
• For any relative price between a1
and , the relative supply of
a2 a2*

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 L
a1
Y1 is: *
Home will be specialised in producing Y1 and Foreign
L will be specialised in producing Y2.
a2*

P1 a*1 workers in Foreign are indifferent between Y1 and Y2. So

• If = => Foreign will be willing to produce any relative amount of
P2 a*2
two goods thus giving the flat segment of the RS curve.
On the other hand, Home will be producing only Y1.

P1 a*1 both Home and Foreign will specialise in Y1. No Y2

• Finally for 
P2 a*2 production will take place. And hence relative supply
of Y1 will be infinite.

RD is the World Relative Demand. For simplicity, we assume that

tastes are identical and homothetic across the countries.

Homothetic taste means that the proportion of income spent on either

good does not change regardless of an individual's level of income.
Therefore, the shape of social/community indifference curve(s) at
every level of utility is the same as the individual indifference curves.

Then demand will be independent of the distribution of income across

the countries.

Demand being homothetic means that relative demand d1 / d 2 in

either country is a downward-sloping function of the relative price p.

• RD reflects that as relative price of Y1 increases, consumers will

tend to decrease consumption of Y1 and increase that of Y2

• Equilibrium is at e1 => the relative price of Y1 is between the

two countries’ pre-trade prices. In this case, each will specialize
according to its comparative advantage.

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 • If the demand curve is RD1, the equilibrium is at e2 – where
P1 a1
= . This implies that Home must produce both of some Y1
P2 a2
P1 a*1
and Y2. At this point since  (i.e., price ratio is lower than
P2 a*2
the ratio of opportunity cost of Y1), Foreign will specialize in the
production of Y2.

Thus if two countries completely specializes, the price of a traded

good relative to that of another good ends up somewhere in
between its pre-trade levels in the two countries.

Production, Consumption and Trade after Free Trade

Home country exports Y1, which is due to the comparative advantage

a1 a1*
in the production of that good: as  .
a2 a2*

Thus trade patterns are determined by comparative advantage, which

is a deep insight from the Ricardian model.

For Home country, the consumption point is at C, and for the foreign
country the consumption point is at C*.

Clearly, both countries are better off under free trade than they were
in autarky: trade has allowed them to obtain a consumption point that
is above the PPF.