The Law of Comparative Advantage (B)

Shortcomings of the theory of absolute advantage:

 The theory focuses on the supply side and ignore the demand side.
 The theory considered the labour as the only relevant factor of production.
However,
o Labour is only one factor combined with other factors of production to produce
the commodity.
o Labour does not enter the production of the two commodities with a constant
ratio
o Labour units are not considered standardised.
 The theory failed to explain the situation in which one country has an absolute
advantage over the two commodities.

Trade based on Comparative Advantage: David Ricardo

Assumptions:
 There are only two countries and two commodities
 Free trade prevail between the two countries
 There is perfect mobility of labor within each country but is immobile between the
two countries
 There is no transaction cost
 There is no technical change
 There is constant return to scale
 The theory depends on the labor theory of value (i.e., factor is the only factor of
production or is used in the same proportion in the production of all commodities,
and labor units are homogenous.
 Perfect competition.
Comparative advantage
 A person or a nation has a comparative advantage in the production of a product
when it can produce the product at a lower domestic opportunity cost than can a
trading partner.
 Comparative advantage is the basis for all trade between individuals, regions, and
nations.
 The theory states that even if one country has absolute advantage in producing
two commodities, specialization can occur as the first country specialize in
producing the commodity in which it has comparative advantage and leaves the
second commodity to be produced by the other country.

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Example:
Cost of production (labour hours)
Country USA UK
Wheat 6 1
Cloth 4 2
 The UK has an absolute disadvantage in the production of both commodities with
respect to the USA
However, since the UK is half as productive in cloth but 6 times less productive in
wheat, it has a comparative advantage in cloth.
 The USA has an absolute advantage in the production of both commodities with
respect to UK.
Since the US absolute advantage is greater in wheat (6:1) than in cloth (4:2), it has
a comparative advantage in wheat.
The Gains from Trade
For USA
 In USA they domestically exchange 6W = 4C
 The USA is indifferent to trade if it received only 4C from the UK in exchange for
6W, since the USA can produce exactly 4C domestically using resources released
in giving up 6W. And would not trade if it received less than 4C for 6W.
For UK
 In UK they domestically exchange 1W = 2C
 The UK is indifferent to trade if it had to give up 2C for each 1W it received from
the USA. And would not trade it had to give up more than 2C for 1W.
Suppose the USA exchanges 6W for 6C with the UK.
 The USA gains 2C (or saves ½ hour) since it could only exchange 6W for 4C
domestically.
 For the UK, the 6W it received would require 6 hours to produce domestically.
These 6 hours can be used to produce 12C and give up only 6C for 6W from US
Thus, the UK gains 6W or save 3hours of labor time.
 The USA gains from trade as long as it receives more than 4C for 6W.
 The UK gains from trade as long as it gives up less than 12C for 6W.
 The range for mutually advantageous trade is:
4C > 6W > 12C
 The spread between 12C and 4C (i.e. 8C) represents total gains from trade
available to be shared by the two nations by trading 6W.

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