In the Ricardian model, countries are assumed to differ only in their productive capacities. It was in this model that David Ricardo first formally demonstrated the principle of comparative advantage. When defined in terms of productivity differences, comparative advantage is regularly confused with a simpler concept that economists call absolute advantage. It is worth taking a few moments to illustrate the differences.
If the US has higher productivity in corn production compared to Switzerland, while Switzerland has higher productivity in watch production compared to the US, economists would say the US has an absolute advantage in corn production and Switzerland has an absolute advantage in watch production. In this case it is intuitive that if the US concentrates on corn production and Switzerland on watch production, then resources could be shifted from relatively lower productivity industries to higher productivity industries and the total combined output of corn and watches would rise. With greater output, and after an appropriate trading pattern is introduced, both countries could end up with more of both goods than before, meaning that both countries can gain from trade. For most who have studied economics this is what they remember as comparative advantage. However, they are only partially right.
It is correct that this example of trade is consistent with comparative advantage; however, CA also covers cases that are less obviously advantageous for countries. For example, one might ask what happens if the US had higher productivity in both corn and watches compared to Switzerland? This is the question that Ricardo tackled when he formalized CA. His answer to the question also substantially expanded the number of situations in which technology differences could result in advantageous trade.
Ricardo’s simple analysis demonstrated that even when one country is technologically superior in both goods, it could still be advantageous for countries to trade. In this circumstance, a comparative advantage is present for those products that the country can produce most-best in comparison to other countries, even if the most best product is produced less productively than in the other country. For example, suppose the US is 10X more productive in corn and only 2X more productive in watches compared to Switzerland. In this case the US is clearly most-best at producing corn (10x > 2x). At the same time though, Switzerland is ½X as productive in watches and (1/10)X as productive in corn. Thus, Switzerland’s most-best product and hence its comparative advantage is watches (since ½ > 1/10) even though it can’t produce them as effectively as the US.
The reason both countries can benefit in this case is because productivity is not the only determinant of industry advantage; instead it is the combination of productivity and average wages. In countries with lower productivity in all industries, they will also have lower average wages. However, average wages for similar workers will lie somewhere in the middle of the range of the country’s industry productivities. In the example above, wage differences between the US and Switzerland in the absence of trade will fall in the range between 10X and 2X; perhaps wages will be 5X higher in the US in this example (which implies they are 1/5 as high in Switzerland). This means that for the relatively highest productivity industry in Switzerland (watches), productivity (1/2 as productive) will sufficiently exceed the average wage (1/5 as high) to make production in watches profitable in comparison to the US.
Observers of this situation may well note that Switzerland’s advantage is due to low wages since wages are only 1/5 as high as in the US. However, it is a mistake to think that low wages gives an advantage in all industries. That’s because, as Ricardo showed, in the low wage country’s least productive industry (in this case corn), Switzerland’s wage advantage (1/5 as high) will be overwhelmed by its productivity disadvantage (1/10 as productive). This means that corn production will be unprofitable in Switzerland despite having lower wages.
Looking at this same situation from the US perspective, the US is most-best at producing corn (10X as productive) but its wages are only 5X higher. That implies it will be profitable for the US to produce corn and sell it in Switzerland. At the same time though, the US productivity advantage in watches is only 2X higher, which is not enough to compensate for its 5X higher wages. That’s why the US will find cheaper watches in Switzerland.
The most important conclusion from the Ricardian model is that advantages from trade do not disappear just because another country has lower wages; nor do they disappear just because another country is more productive in everything. Ricardo demonstrated that by specializing in producing the products that one has a comparative advantage (which MAY NOT be ones in which the country has an absolute advantage) the world can expand total world output with the same quantity of resources. The expansion of output is the realization of increased economic efficiency that economists always talk about. Finally, given the expanded output, international trade can assure that all countries in the model gain from the surplus that’s created. In other words, without raising the quantity of resources, the world economy would be able to produce greater output and generate higher living standards for everyone. Economic efficiency will rise both internationally and nationally. This is how all nations can benefit from free trade.
It is important to note at this stage that the Ricardian model does not say that countries WILL gain from international trade; only that countries CAN benefit from increased output and trade if production is reorganized between countries appropriately while all resources are kept fully employed. The model is a gross simplification compared to the real world though, and thus it clearly does not incorporate everything that might happen with trade. Nevertheless the model does provide an insight that quite likely carries over to more complex situations. For example, the model results should cause observers of international trade situations to hesitate when fears grow that low wage countries may soon take over production of the world’s output, or when developing countries protect their markets because of fears that they cannot compete with the more developed countries in the world. These commonly expressed fears about international trade are shown, by virtue of the Ricardian model, to be based on a misperception.
http://www.thomaspalley.com/?p=87This fella (who formerly worked for the AFL-CIO) posts a critique of trade based on comparative advantage. He claims that capital mobility diminishes the benefits from comparative advantage. Among the other arguments: “downward wage equalization” & “the corporation versus country divide”.
Thanks for the reference. I had addressed some of Palley’s points in a previous post here: http://stevesuranovic.blogspot.com/2007/04/comparative-advantage-with-factor.html
Steve, do you think you will be placing the other International Trade Theories online. Your explanation of comparative advantage is very easy to follow. (International Business student)
Be sure to go to internationalecon.com if you haven’t already. Otherwise I will be regularly posting items here that may be of interest so check back occasionally.
Steve, thank you for making your knowledge available to others. I have been using some of your information to supplement a trade course I am taking and it has been very helpful.
Thank you for making your knowledge available on line. May I have your permission for me to use your site as a reference for my International Trade paper?Violetkh7mi@hotmail.com
There is not a single word about equilibrium of trade between the two countries. If trade is not balanced, what impact does that have on the analysis?
I too, want to know what happens to comparative advantage when trade is unequal. This is the big, important question that is ignored too often
HI Steve,thank you for sharing your ‘Lesson on Comparative Advantage’..I am very new to economics and would like to ask .. why is it important for management to know about comparative and absolute advantage? I still haven’t grasped the whole CA and AA concepts but your information has provided me with good data. Thanks.
Thank you for donating your time & knowledge.In your chapter 40 at ‘internationalecon ‘ you give the gardening example to explain CA. Can you please verify my understanding…If the father works alone, then the garden is completed in 3 hours, and costs 3 man-hour. When the father and son both work, the garden is completed in 2 hours, but costs 4 man-hours. So, why does this example not tell me that ‘gardening efficiency’ world wide would suffer, therefore result in fewer gardens produced, although employment would increase?If we assume that the son takes twice as long to roto-tiller, but the same to rake and seed, then the situation is even worse. Working alone, the world wide cost of gardens would be 3.5 man-hours, but together they would be 4 man-hours.Even though the father gets the garden in 1 hour less, he does not get the whole garden — that garden belongs to two people. So, I don’t know what the trade agreement is between them, but he would have to own more than 2/3 of the garden for that to be an advantage to him.Sorry I’m being dense, but in this example, I don’t see what the advantage to the father is. The benefit was employment of the son, which resulted in a more expensive garden and two employed people who could then compete for the same resources (making things more expensive).Not trying to be funny… but if the father didn’t let the kid work, he would have fewer gardens, but own a greater share of the gardens, and he would not have created a competitor for his gardens or other resources.Please, if you don’t mind, explain what I am not getting from the example.I feel I understand the England/Portugal example, but I just can’t see CA in the garden example.thanks…
Regarding a previous poster’s question on the importance of management knowing about CA…We often see this in a make-buy decision. We are good widget-makers, and it may only cost us $500 to make something that would cost us $800 to buy. However, by making it, we used up labor that could have been used to earn more than the $300 we would have saved by making it ourselves.We may have an absolute advantage in making both products, but our comparative advantage is in sticking to our core competency (what we’re “most best at”). By choosing to ‘buy’ in this make-buy decision, we are both benefiting from this trade.(If this is a misapplicaiton or misunderstanding of CA, then Steve, please correct me, and please delete this post as to not confuse people!)
“all resources fully occupied”. Does that mean all resource fully occupied in producing tradable goods? Most resources in the U.S. are occupied in producing non-tradable goods. When non-tradable goods pay a wage rate above the rate that would allow tradable goods to be produced at a price that will meet the international market, there may be no product that the rich nation can produce that will sell on the international market.resources fully utilitized produces a tradeable good that will sell on the international market when the countries wage rate is low enough.
JoeEco is correct. Comparative advantage assumes that labor has an alternative use that is more valuable (in terms of producing tradable goods) that in making everything ourselves.Of course, that is true is some situations for almost every economy.It is also possible that all those alternative uses has already been exploited and that, at the moment, no alternative use for labor is available that can produce something that will sell on the international market.That condition has been reached by the U.S. Unless it had been reached, the 30 year trade deficit suffered by the U.S. would be impossible.
With respect to anonymous’ post about the gardening story: (A very good question, sorry for such a lengthy delay!) You suggest that efficiency is falling when the boy’s labor is used because it takes 4 man-hours to produce the garden rather than 3 when the father works alone. What’s missing from this analysis is the value of the the extra hour of time spent between the father and son. In my story that time is leisure time which has value but is not measured as such in the marketplace. The two scenarios consist of the following, which is not clearly described in the notes. 1) The father works three hours to produce the garden alone. The son does no work but has three hours of leisure (playtime).2) The father and son together spend 2 hours each producing the garden and both get one hour of leisure time together. Now I have imagined that the son wants to help the father rather than playing by himself, so the son must get more utility from 2 hours of work than two hours of play. I also imagine that the father wants first and foremost to get the garden planted but derives extra utility from playing with his son. For these reasons, the second scenario with the father and son team generates more overall utility than the father working alone. Alternatively, one could eliminate the leisure part of the story and assume that all 3 hours for the father and son must be work hours producing some output. Under this assumption, there are to scenarios.1) The father works 3 hours alone planting the garden while the son works three hours producing, let’s say, a birdhouse. However, since the son has very few skills the birdhouse would most likely win the praise of his parents but would not likely be of any value to anyone else. 2) The father and son team up to produce the garden in two hours and then work together for another hour producing a birdhouse. In this case the birdhouse would have value and be sellable, since the father’s skills combined with the son’s enthusiasm would surely produce a better birdhouse. Thus, in terms of the total value of output of the combined 6 hours of work, scenario two, in which each individual specializes in his comparative advantage tasks, generates the more productive and more efficient outcome.
Thanks for this. I felt a sudden compulsion to find out what the theory of CA is (I should know, but that Economics A level was a long time ago by now), and came across your easily digestible explanation.
I am waiting for a response to my request to deal with the fact of unequal trade. The Richarian models ignore that possibility. CA does not deal with imports. How can we be assured that 30 years of unequal trade has, on balance, benefited the U.S.?And if it has not benefited the U.S., why is it tolerated?
Ray,Didn’t mean to ignore your question about trade imbalances … time is just sometimes too short. Also, the standard trade models assume trade is balanced and I’m not completely sure if there is a literature with a trade model allowing for unbalanced trade. I suspect there is, but I am not familiar with it. Nevertheless, just because the Ricardian model assumes trade is balanced does not mean the argument falls apart if trade is “unbalanced.” It might, … but one would have to show why unbalanced trade would prevent resources from finding their most productive occupation in a competitive marketplace.One thing to remember about trade imbalances, is that they represent situations where individuals are trading assets on top of their exchanges for goods and services. G&S trade is only part of international transactions. People also engage in international borrowing and lending or sales and purchases of equities. When they do this, trade imbalances arise. For a complete description of this read < HREF="http://internationalecon.com/Finance/Fch5/Fch5.php" REL="nofollow">Chapter 5<> and < HREF="http://internationalecon.com/Finance/Fch6/Fch6.php" REL="nofollow">Chapter 6<> in my Finance Text Maybe I’m wrong, but it seems that trade imbalances need not influence the allocation of resources on the basis of CA. For example, first assume no borrowing or lending and that countries trade on the basis of CA. Next, imagine that residents in one country decide to save some of their income and do so by lending it to residents in the other country. The saving corresponds to foregone consumption, meaning that an individual earned an income and could have bought G&S but decided instead not to consume. The resident in the other country, who borrows money, is able to consume more this period than he could have out of his own income alone. In other words, the borrowing and lending merely shifts who consumes more today and who consumes less, not whether resources are allocated to their best uses. In this instance a trade deficit appears for the borrowing country and a trade surplus in the lending country, but the borrowing and lending have no influence on what s produced.Of course, this is a very simple example. Perhaps you can suggest some process that I’m missing and suggest why borrowing and lending might invalidate CA. Oh, one other point. You had also mentioned the issue of non-tradable goods. I know there is a literature on this but I do not have the results at my fingertips. My recollection though is that the presence of non-tradables should not lead to a situation like you describe, namely where a country loses all of its CA goods. If anyone can find a reference on this, or a refutation, I’d be happy to hear.
Steve –My favorite economic textbook is the 1993, fourth edition of International Economics by Krugman and Obstfeld. It is my favorite because it was under $60 as a used book. It says,(page 3) “Since 1980, the gap between exports and imports has been one of the most heated issues of U.S. economic controversy”.Yet his book provides no models for dealing with unbalanced trade. You say you are not familiar with such models. I agree. I will go further. I will assert that there are no “standard models” (accepted by most economists) for dealing with unequal trade.The profession has been dealing with this important issue by developing ad hoc models, assumptions about causal relationships that seem helpful in this instance, without proper testing as to their validity.It may be the case that this is the only way to deal with an isue derived from data rather than theory.I am trying to find people who have the time to talk with me about causal assumptions that fall outside the widely accepted models.Ben Bernanke wrote an article before he became head of the Federal Reserve Board in which he argued that trade deficits arise due to international borrowing and lending or sales and purchase of equities. I assume that viewpoint is widely accepted. You repeated it. But the evidence is strongly on the side of an opposite view of causation. Trade imbalances arise because of the purchasing decisions of millions of consumers and purchasing agents. The financial consequences, such as The Current Account and The Capital Account (to use an oldfashioned term) are derived rather that causal. This is a substantial claim, which deserves serious treatment, with arguments and counter arguments. So far, I have been unable to get anyone familiar with the literature to discuss this issue with me.Th is is only one example. Another issue is how to measure the costs and benefits of unequal trade. But I should leave you alone. Going outside accepted models is not the path to advancement in Economics, unless you revolutionize the field.
hi steve ,this theory is also known as “classical theory of comparitive advantage” and the matter proving by u is definately helpfull to understand the theory.thanks for work.ur truely.
Steve thanks for sharing your knowledges. I’m studying economics in Iran and I found this post really useful.I’d translated it and used it for my paper about Comparative Advantage(certainly by notifying my source!)
Steve, thanks for sharing your knowledge. honestly steve, past 5 hrs i was browsing to find an easy definition and understanding of CA. and the moment i started read your post, i felt like i wrote it, lol. i meant to say it was really easy to understand. will you consider to post more economic theories.Muhammad Shydul IslamStudentLondon School of CommerceLONDON
I can find lots papers and opinions dismissing the idea of wage convergence, but I’m starting to believe they are wrong. Real wages per occupation in developed countries have fallen as trade with less developed nations grows. Is the new economic crisis a price level adjustment– particularly is the market forcing those most biasly regulated aspects of the price level into agreement with the lower compensation paid to the same occupations over time?
Thank you Steve, for this, I have an exam, and one of the topic is on CA, and I was complelty lost unil now!thank!!!
Hello Steve,great site, great initiative.Regarding the comparative advantage, I was wondering whether the law was ever expressed in a mathematical equation, in order to determine the optimum specialization.ThanksRobert
Robert,A mathematical description of the theory of comparative advantage is available on my website at http://internationalecon.com/Trade/Tch40/Tch40.php The idea can’t be condensed to just one formula, except perhaps to the opportunity cost comparison formula which defines CA in a simple two good model. Take a look and see what you think.
Hi Steve I am an international student; I want to see that idea for this site is great. I am a sophomore student and in one of my economics book one of the authors says that “The Public Debt= Total accumulation of deficit (minus) total accumulation of surplus”.Professor Steve is this formula completely correct or something is missing here. Because the other book that I read, is not completely the same. I want to know you opinion what do you think about this formula.YOUR opinion is of my INTERESTThank YOU
Dear Steve,
How can one justify this thought, ” In countries with lower productivity in all industries, they will also have lower average wages” ??
and what assumptions are made in the process of justification?
Thank you
the formula “The Public Debt= Total accumulation of deficit (minus) total accumulation of surplus” is true. It dont need a professor to find it.
Thank you for your valuable time and knowledge sharing. I understand the concept of the CA from your help. Again I thank you.
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Hello Steve ,this is Victor k. Mutai from Maseno University, am glad and satisfied of your work.Undoubtedly, it has simplified my assignment.I had rough time with it but now I am excellently sought and have completed my work.Thanks a lot.
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Hi Steve, can you assist I’ve never done economics in my life until now. now I’m to discuss the CA and AA in an assignment seeing your praises from the other comments can you clarify the theories for me?
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Thank You for making this theory easy to understand …
before i read this i was confuse with understanding …and now i m interested more in this than before ~ Thank You !!
not enough to understand this topic without diagrams
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Great writing! Thank you for taking the time to share your knowledge.This is the best explanation I have read so far. It helped me a lot
can someone be my e-tutor please. 2nd i wish to download such post if possible.
Absolute advantage and comparative advantage are two important concepts in international trade that largely influence how and why nations devote limited resources to the production of particular goods. They describe the basic economic benefits that countries get from trading with one another.Absolute advantage is a condition in which a country can produce particular goods at a lower cost in comparison to another country. On the other hand, comparative advantage is a condition in which a country produces particular goods at a lower opportunity cost in comparison to other countries.
Comparative Vs Absolute Advantage
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