In the end of the 18th century, classical economists embraced the concept that wealth was determined by natural resources and their productivity (ppt). Trade was no longer considered as competition between the participants since the economic theory of international trade and comparative advantage overthrew the old paradigm.
David Ricardo built upon Adam Smith’s theory of absolute advantage by introducing the concept of comparative advantage. Ricardo argued that instead of trying to provide for its domestic needs on its own, a country can gain more by specialising in a certain sector, using its unique possession of natural resources, and then trade at lesser costs with others producing other goods. Ricardo’s theory of comparative advantage indicates that two countries, one absolutely more efficient than the other, can benefit from trading together.
Production of maximum units of textiles
Production of maximum units of beef
United States
45
90
China
25
30
An example representing this theory is illustrated through the graph above, using the data from the table. It is shown that the US has absolute advantage in both producing textiles and beef. However, it has comparative advantage in producing beef since it could produce maximum of 90 units of beef. From the data, it could be concluded that for every unit of textile the USA gives up two units of beef, thus, making the domestic cost ratio 1:2.
In contrast, China has absolute disadvantage in both industries, but comparative advantage in textiles of which it can produce a maximum of 25 units. For every unit of textile China produces, it gives up on units of beef, so the domestic cost ratio is 5:6 (McKenzie and Lee, 2016).
Both countries benefit from trading together because they have different consumption functions. At the resulting exchange ratio, the US could give up all of its units of beef and trade it for 75 units of textiles, which is with 30 units more than it can produce by itself. On the contrary, China can trade all of its 25 units of textiles in exchange for 50 units of US beef. Thus, a country gains from international trade by producing the good in which it has a ‘comparative opportunity cost advantage’ (McKenzie and Lee, 2016).
International trade price on the graph is given by the tangent lines, a and b, while the consumption points are c and d, which are outside their respective production possibilities as this could essentially lead to growth of real incomes. Any production outside the frontier on the graph is unattainable because the nation does not have the resources (Suranovic, 2015).
In order to adopt this model as adequate, some assumptions are taken into consideration. There are two countries producing two different goods with labour, land, capital and enterprise being the factors of production, as one of the countries is absolutely more efficient. The goods are homogeneous across countries. There is full employment of the workforce and the constant opportunity cost for the two countries is equal. Perfect mobility of factors of production within countries is a necessary factor to allow production to be switched, while factors are internationally immobile. Firms are perfectly competitive in the free market and companies strive to profit, while consumers seek utility maximisation. There are no transport costs (Suranovic, 2015).
The law of comparative advantage indicates that “free trade enables specialization, increased production and thus higher standards of living for all participants” (Cleaver, 2012). Comparative advantage is a dynamic concept concerned with globalisation and people’s choice. In a free market society, consumers exercise their choice, resources can be easily transported, and prices are flexible, depending on the demand and supply of the good. As new technologies are introduced and the market place alters, jobs change accordingly (Cleaver, 2012).
In the dynamics of international trade, there will be winners as well as losers, so the established long-term benefits would be at the price of short-term costs. Free trade suggests that market barriers between the participating countries are reduced, so that eventually the different markets adapt to become one. On a single international market, it is expected that each country adjusts its pre-trade price ratio to an equilibrium international price, depending on the global demand and supply. Therefore, an international price is formed predominantly by the more influential economy and an example for that would be the case of the USA and China. Both nations will gain at the international price, but China’s exports of textiles will sell for higher US prices as shown on the graph by the tangent lines, since the consumption point c is farther away from the curve of China’s production than consumption point d from the US’s production. Thus, there will be reallocation of production and employment, as there will be greater alternations for the country with the smaller economy. This concept is regarded as ‘the importance of being unimportant’, which means that China will gain more from trading with the US (Tony Cleaver, 2012).
Heckscher-Ohlin model expands on Ricardo’s theory by predicting how the gains from trade will be distributed within each country, but unlike the law of comparative advantage it does not demand perfect competition and initial equilibrium (Chenery, 1961).
A significant implication is the Stolper-Samuelson theorem, which demonstrates the returns to factors will be dependent on their utilization in trade. As a result, in labour-intensive export industries wages of workers will rise, while in capital-intensive export industries the investor’s returns will increase. Hence, the principle of factor-price equalization states that as free market prices have adjusted to the international demand and supply, then the prices of the respective factors will accordingly equalize. Following the changing pattern of international demand and subject to the occupational mobility of the resource, there will be reallocation of resources within each country until factor prices equalize and there is no further incentive for land, labour and capital to redeploy. In real life, however, the evidence shows that there is no equalization, but only narrowing of differences in factor incomes between trading partners. Therefore, the smaller economy country will usually have a greater degree of redeployment of its resources.
Ricardo’s law of comparative advantage is one of the most complex concepts to comprehend in economics due to the multiples of linked ideas behind it (Krugman, 1998). It gives a model of how to maximize the world’s total output by specilisation and free trade, but it cannot predict if the results from it would re-create in real life (Suranovic, 2015). Therefore, in order the principle of comparative advantage to provide greatest gains in trade, market economies need to be flexible enough to respond to the international changes.