International Trade Theory. The Theory

¶ … International Trade Theory. The theory was first put forward by Robert Torrens in an essay on corn trade in 1815. It is, however, generally attributed to David Ricardo who explained it in clearer detail in his book the Principles of Political Economy and Taxation published in 1817. Despite Ricardo's thorough explanation of the concept with the use of examples, comparative advantage is often misunderstood as it is usually confused with the simpler theory of Absolute Advantage.

In this paper, I shall explain what is meant by Comparative Advantage and underline its importance; discuss how the concept differs from the related concept of Absolute Advantage and describe with the help of an example why comparative advantage may prove beneficial for individuals as well as countries. In the end I shall briefly review how the Ricardian model of Comparative Advantage applies to the real world situation.

What is Comparative Advantage? Comparative advantage is an economics theory which explains why it can be beneficial for two individuals or countries to trade, despite the fact that one of them may be able to produce each item more cheaply than the other. In other words, what is of critical importance in the viability of trade is not the absolute cost of production, but rather the ratio between how easily the two individuals (or countries) can produce different kinds of things.

According to the theory of comparative advantage, the total output will be increased if people and nations engage in those activities for which their advantages over others are the largest or their disadvantages are the smallest.

The importance and complexity of comparative advantage is best reflected in the words of the famous American economist and Nobel Prize winner in economics, Paul Samuelson who, in response to a challenge by Stanislaw Ulam "to name one theory in all of the social sciences which is both true and nontrivial," named the theory of comparative advantage and observed: That it is logically true need not be argued before a mathematician; that it is not trivial is attested by the thousands of important and intelligent men who have never been able to grasp the doctrine for themselves or to believe it after it was explained to them.

How Comparative Advantage is different from Absolute Advantage? The theory of absolute advantage in economics, emanates from the works of Adam Smith who observed in his Wealth of Nations (1776) that "if a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage." Hence the concept of absolute advantage in trade is a simple, straight-forward idea that it would be mutually beneficial if all countries concentrate on producing goods which they can produce at a lower cost and trade it with the goods needed from other countries, which can produce those goods more cheaply.

This is the basic premise under which the proponents of laissez faire and free international trade such as the World Trade Organization (WTO) operate. It has also given rise to the trend of 'specialization.' problem, however, arises when some countries have an absolute advantage over other countries in producing all goods, i.e., a country may be able to produce a number of goods like textiles, machinery, wheat, television -- all at a lower per unit cost than another country.

In such a situation one country has an absolute advantage over another country and it would seem at first sight that the country with the absolute advantage would not benefit by importing anything from the country that produces all the tradable goods at a higher cost. The theory of comparative advantage states that even in such a situation trade could (and usually does) prove beneficial for both countries. The principle of comparative advantage is, therefore, a much more useful economic theory.

It gives a much more compelling reason for increased international trade between individuals as well as countries since in the real world situations, especially with marked differences between the development levels of the first and the third worlds, some of the developed countries often exhibit an absolute advantage vis-a-vis the underdeveloped countries. Without an understanding of the comparative advantage principle, economists would be unable to justify trade between such countries on the basis of being mutually beneficial.

Explaining Comparative Advantage with the Help of Examples The theory of comparative advantage is applicable to individuals as well as to countries as illustrated in the following Example Let us suppose that two individuals, a and B. live on a remote island. Both are capable of producing two products -- fish and coconuts for which there is a requirement too. A enjoys an 'absolute advantage' in the production of both goods over B, i.e., a is capable of producing more coconuts and more fish than B.

As summarized below: Coconuts Fish Person 'A' Person 'B' As depicted in the table above 'A' has the capability of producing a maximum of 10 Coconuts or 10 fish vs. 'B' who can produce a maximum of 4 coconuts or 8 fish. It may be noted that both persons cannot produce the number of coconuts and fish given above at the same time.

The figures shown in the table represent the production possibility frontiers for the individuals, which are assumed to be linear as shown in the graph below: Source: NetMBA.com This graph shows us that if the individuals did not trade and spent half their time on producing coconuts and fish, a would produce 5 coconuts and 5 fish, while B. would produce 2 coconuts and 4 fish. (Total production = 7 coconuts and 9 fish).

In this case, 'A' and 'B' have opportunity costs for producing coconuts and fish, e.g., Opportunity Cost of Coconuts Opportunity Cost of Fish Person 'A' Fish per Coconut Coconut per Fish Person 'B' Fish per Coconut 0.5 Coconut per Fish As the opportunity cost of coconuts is lower for 'A' than 'B' it can be concluded that individual 'A' has a comparative advantage in producing coconuts and since the opportunity cost of fish is lower for 'B' than 'A' it can be concluded that individual 'B' has a comparative advantage in producing fish.

Hence if a produces coconuts and B. produces fish, the combined total of the island for coconuts would be 10 coconuts and 8 fish (vs. 7 coconuts and 9 fish). This would mean a net gain of 3 coconuts and a net loss of 1 fish. It can be argued that such a result does not convey a definite benefit for both individuals (and the island) because of the loss of one fish. However, if a chooses to produce 9 coconuts and 1 fish, the total production of the island would be 9 coconuts and 9 fish.

Such an eventuality means a definite gain of 2 coconuts and no loss of fish. Hence, this example proves that both individuals (and the island) gains through the application of the principle of comparative advantage. Does the Ricardian Model Apply to the Real World? The Ricardian Model of Comparative Advantage very conveniently 'proves' that free trade between countries is a truly win-win situation for both individuals as well as the countries, regardless of their level of development.

But is the real-world application of comparative advantage really so straight forward? In order to examine the question, we have to look at the assumptions made in the Ricardian Model. The Ricardian model assumes that only two countries are producing two goods using just one factor of production. The real world is much more complex: it consists of many countries producing many goods using several factors of production.

Other assumptions made in the model such as perfectly competitive markets, fixed labor productivity and full employment are also far removed from the real-world situation. In the real world, most markets are far from fully competitive, labor-productivity within a country varies over time.