Comparative advantage theory

It states that a country should specialize in the goods or services it can produce at a lowest
opportunity cost and then trade with another country.

Opportunity cost, is the foregone benefits from choosing one alternative over others.

This theory is given by a political economists David Ricardo in 1817. Ricardo used the theory of
comparative advantage to argue against Great Britain protectionists corn law, which restricted
the import of wheat from 1815 to 1846. In arguing for free trade, the political economists stated
that countries were better off specializing in what they enjoy a comparative advantage and
importing the goods in which they lack a comparative advantage.

Comparative advantage is a type of classical international trade theory.

It is propounded to overcome the limitation of absolute advantage theory.

If a country has advantage in production of both commodities, then compare the efficiency of
both the goods.

The country can produce and export those goods which can be produced more efficiently.

Example of comparative advantage theory

Labor cost of production (in hours)

Countries 1 unit of good A 1 unit of good B

Country 1 10 12
Country 2 9 8

Country 2 has comparative advantage over good B and country 1 has comparative advantage
over good A.

Therefore, both countries will gain from trade.

Assumptions of the theory

1. Two countries (A and B), the theory assumes that there are only two countries involved
labeled A and B.
2. Two commodities (x and y), both countries produce the same two commodities donated
as x and y
3. There are similar tastes, the taste of consumers in both countries are assumed to be
similar in other words, people in both countries have comparable preferences for goods x
and y
4. Labor as the only factor of production, labor is the sole factor of production, other factors
such as capital, land or technology are not considered in this simplified model.
5. Homogeneous labor units, all labor units are assumed to be identical. This means that
there are no variations in skills, education or productivity among workers.
6. Constant costs or returns, the production of commodities occurs under the law of constant
costs or returns. This means that the cost of producing goods x and y remains the same
regardless of the quantity produced.
7. Barter system, the two countries engage in trade using a barter system where goods are
exchanged directly.

Criticism of the comparative advantage theory

The theory oversimplifies by considering only two countries, in reality, global international trade
involves many more nations with varying economic conditions making the model less applicable
to complex real-world scenarios.

The assumption of only two commodities limits the theory’s applicability. In practice, economies
produce a wide range of goods and services, each with unique characteristics and production
processes.

The theory assumes similar consumer tastes across countries which overlooks cultural
differences and evolving consumer behavior. Real world accounts for diverse tastes and
preferences.
The theory simplifies production by considering labor as the only factor of production and
excludes other factors like capital, land and technology. However modern economics rely on
multiple factors of production.

The theory assumes constant costs and ignores the dynamic nature of production yet real-world
costs fluctuate due to changes in technology, resource availability and market conditions.

The barter system assumes direct exchange of goods without currency. However, modern trade
relies on currencies, financial markets and intermediaries.

Benefits of comparative advantage

The following are the advantages of comparative advantage for companies dealing in
international trade.

Diversification of products and services, companies can diversify their products and services
which can reduce their dependence on one market or product and help to mitigate the risk of
economic downturns.

Improved quality of products and services, business may access new technologies, ideas and best
practices from other countries, which can improve the quality of their products and services,
making them more competitive.

Access to new markets, organizations may have access to new markets, which can help increase
their customer base and sales.

Stimulation of economic growth, corporations can stimulate economic growth by creating jobs,
promoting innovation and increasing the exchange of goods and services between countries.

Lower opportunity costs and higher profit margins, nations or companies with a comparative
advantage can focus their labor, capital and resources on production that requires a lower
opportunity cost and therefore achieve higher profit margins.

Increased efficiency, companies choose to specialize their production of goods or services they
can make more efficiently and then purchase what they can’t create from trading partners.
Challenges of comparative advantages.

For businesses that deal in international trade face the following challenges;

Cultural differences, companies may face cultural differences that can create challenges such as
communication, negotiation and business practices.

Political and economic instability, a business can have exposure to political and economic
instability in other countries which can create risks to their operations and investments when
participating in international trade.

Intellectual property rights, companies may experience challenges in protecting their intellectual
property rights such as patents, trademarks and copyrights, in other countries.

Labor and environmental standards, companies might encounter challenges ensuring their
suppliers and trading partners adhere to labor and environmental standards

Exchange rate fluctuations, companies can have exposure to exchange rate fluctuations which
affect the profitability of their operations and investments.

Competition with domestic companies, organizations may experience competition from domestic
companies, which can make it more difficult to sell their goods and services in their home
market.
Gross Domestic Product

Gross domestic product (GDP) is the total monetary or market value of all the finished goods
and services produced within a country’s borders in a specific time period (usually a year). It
includes both produce of resident citizens as well as foreign nationals.

GDP= Gross Domestic Product

GDP= C+G+I+NX

Or GDP=C+I+G+(X-M)

C= Consumption

G= Government spending

I= investment

NX= Net export

X=Exports

M=Imports

Types of Gross Domestic Product

Real GDP

Real GDP, is an inflation-adjusted measure that reflects the number of goods and services
produced by an economy in a given year, with prices held constant from year to year to separate
out the impact of inflation or deflation from the trend in output over time. Since GDP is based
on the monetary value of goods and services, it is subject to inflation.

Nominal GDP

Nominal GDP, is an assessment of economic production in an economy that includes current

prices in its calculation. In other words, it doesn’t strip out inflation or the pace of rising prices,
which can inflate the growth figure.
GDP Per Capita
GDP per capita, is a measurement of the GDP per person in a country’s population. It indicates
that the amount of output or income per person in an economy can indicate average productivity
or average living standards.

GDP Formulas
GDP can be determined via three primary methods. All three methods should yield the same
figure when correctly calculated. These three approaches are often termed the expenditure
approach, the output (or production) approach, and the income approach.

The Expenditure Approach

The expenditure approach, also known as the spending approach, calculates spending by the
different groups that participate in the economy. The U.S. GDP is primarily measured based on
the expenditure approach. This approach can be calculated using the following formula:

GDP=C+G+I+NX

where: C=Consumption

G=Government spending

I=Investment

NX=Net exportsGDP=C+G+I+NX

where=Consumption

G=Government spending

I=Investment

NX=Net exports
All of these activities contribute to the GDP of a country. Consumption refers to private
consumption expenditures or consumer spending. Consumers spend money to acquire goods
and services, such as groceries and haircuts

The Production (Output) Approach

The production approach is essentially the reverse of the expenditure approach. Instead of
measuring the input costs that contribute to economic activity, the production approach
estimates the total value of economic output and deducts the cost of intermediate goods that are
consumed in the process (like those of materials and services). Whereas the expenditure
approach projects forward from costs, the production approach looks backward from the
vantage point of a state of completed economic activity.

The Income Approach

The income approach represents a kind of middle ground between the two other approaches to
calculating GDP. The income approach calculates the income earned by all the factors of
production in an economy, including the wages paid to labor, the rent earned by land, the return
on capital in the form of interest, and corporate profits.

The income approach factors in some adjustments for those items that are not considered
payments made to factors of production. For one, there are some taxes, such as sales
taxes and property taxes, that are classified as indirect business taxes.

Gross National Product

Refers to the total value of goods and services produced by the nationals of the country during a
given period of time usually a year.

Income of foreign nationals who reside within the country are excluded

GNP=GDP+(X-M)

X-M=Net factor income

X(Exports)=inward remittance of a country from nationals of the country a broad

M(imports)= Outward remittances of a country from foreign nationals inside the economy.
Net National Product

NNP= GNP-Depreciation

Depreciation means wear and tear of the goods produced.

Depreciation doesn’t add value to the current years produce and hence is deducted from GNP.

Components of GNP include;

 Personal consumption expenditure- involves spending by individuals on goods and

services
 Private domestic investment- investment by businesses within the country
 Government expenditure, public spending on goods and services
 Net exports, the difference between exports and imports
 Income earned by residents from overseas investments
 Balance of payments (BOP)

Balance of payments of a country can be defined as a systematic statement of all economic

transactions of a country with the rest of the world during a specific period usually one year.

According to Kindle Berger, the Balance of payments of a country is a systematic record of all
economic transactions between the residents of the reporting country and the residents of the
foreign countries during a given period of time.

The BOP is maintained in a standard double entry book keeping method.

BOP is the method countries use to monitor all international monetary transactions at a specific
period of time.

It is calculated every quarter and every calendar year.

It shows the receipts and payments from trade

Purpose of BOP

To know the strength and weaknesses of the economy in international relations.

To know the overall gains and losses from international trade
BOP statements give warning signals for future policy formulation.
Types of Balance of Payment

The balance of payment is divided into three types:

Current account: This account scans all the incoming and outgoing of goods and services
between countries. All the payments made for raw materials and constructed goods are covered
under this account. Few other deliveries that are included in this category are from tourism,
engineering, stocks, business services, transportation, and royalties from licenses and copyrights.
All these combine together to make a BOP of a country.

This is a record of all payments for trade in goods and services plus income flow it is divided
into four parts.

 Balance of trade in goods (visible)

 Balance of trade in services (invisibles) e.g., tourism, insurance.
  Net income flows. Primary income flows (wages and investment income)
 Net current transfers. Secondary income flows (e.g., government transfers to UN,
EU)
Capital account: This refers to the transfer of funds associated with buying fixed assets such as
land.

Capital transactions like purchase and sale of assets (non-financial) like lands and properties are
monitored under this account. This account also records the flow of taxes, acquisition, and sale
of fixed assets by immigrants moving into the different country. The shortage or excess in the
current account is governed by the finance from the capital account and vice versa. It involves
inflows and outflows

The capital account balance measures the difference between U.S. sales of assets to foreigners
and U.S. purchases of foreign assets. U.S. sales (or exports) of assets are recorded as credits, as
they result in capital inflow. On the other hand, U.S. purchases (imports) of foreign assets are
recorded as debits, as they lead to capital outflow. Unlike trades in goods and services, trades in
financial assets affect future payments and receipts of factor income

Finance account: The funds that flow to and from the other countries through investments like
real estate, foreign direct investments, business enterprises, etc., is recorded in this account. This
account calculates the foreign proprietor of domestic assets and domestic proprietor of foreign
assets, and analyses if it is acquiring or selling more assets like stocks, gold, equity, etc.

This is a record of all transactions for financial investment. It includes:

 Direct investment. This is net investment from abroad. For example, if a UK firm
built a factory in Japan, it would be a debit item on UK financial account)
 Portfolio investment. These are financial flows, such as the purchase of bonds,
gilts or saving in banks. They include
 Short-term monetary flows known as “hot money flows” to take advantage of
exchange rate changes, e.g., foreign investor saving money in a UK bank to take
advantage of better interest rates – will be a credit item on financial account.
 Importance of balance of payments.

 It examines the transaction of all the exports and imports of goods and services for a
given period.

 It helps the government to analyses the potential of a particular industry export growth
and formulate policy to support that growth.

 It gives the government a broad perspective on a different range of import and export
tariffs. The government then takes measures to increase and decrease the tax to
discourage import and encourage export, respectively, and be self-sufficient.

 If the economy urges support in the mode of import, the government plans according
to the BOP, and divert the cash flow and technology to the unfavorable sector of the
economy, and seek future growth.

 The balance of payment also indicates the government to detect the state of the
economy, and plan expansion. Monetary and fiscal policy are established on the basis of
balance of payment status of the country.

The Balance-of-Payments Identity

When the balance-of-payments accounts are recorded correctly, the combined balance of the
current account, the capital account, and the reserves account must be zero, that is,
BCA+ BKA +BRA= 0
where: BCA balance on the current account
BKA= balance on the capital account
BRA= balance on the reserves account
The balance on the reserves account, BRA, represents the change in the official reserves.

Under the fixed exchange rate regime, the combined balance on the current and capital accounts
will be equal in size, but opposite in sign, to the change in the official reserves:
BCA+ BKA= -BRA

References
 1. Ruffin, R. (2002). David Ricardo's discovery of comparative advantage. History of
political economy, 34(4), 727-748
2. Rahmawati, F., & Intan, M. N. (2020). Government Spending, Gross Domestic Product,
Human Development Index (Evidence from East Java Province). KnE Social Sciences,
774-786.
3. Eun, C. S., Resnick, B. G., & Chuluun, T. (2021). International financial management.
McGraw-Hill.