Comparative Advantage: Concept and Benefits of Outcome

Topics: Economics, International trade, Comparative advantage Pages: 9 (2839 words) Published: December 20, 2010
Comparative advantage
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In economics, the law of comparative advantage refers to the ability of a party (an individual, a firm, or a country) to produce a particular good or service at a lower opportunity cost than another party. It is the ability to produce a product with the highest relative efficiency given all the other products that could be produced.[1][2] It can be contrasted with absolute advantage which refers to the ability of a party to produce a particular good at a lower absolute cost than another. Comparative advantage explains how trade can create value for both parties even when one can produce all goods with fewer resources than the other. The net benefits of such an outcome are called gains from trade. It is the main concept of the pure theory of international trade.

|Contents | |[hide] | |1 Origins of the theory | |2 Examples | |2.1 Example 1 | |2.2 Example 2 | |2.3 Example 3 | |3 Effect of trade costs | |4 Effects on the economy | |5 Considerations | |5.1 Development economics | |5.2 Free mobility of capital in a globalized world | |6 See also | |7 Notes | |8 References | |9 External links |

[pic][edit] Origins of the theory

Comparative advantage was first described by Robert Torrens in 1815 in an essay on the Corn Laws. He concluded it was to England's advantage to trade with Portugal in return for grain, even though it might be possible to produce that grain more cheaply in England than Portugal. However, the concept is usually attributed to David Ricardo who explained it in his 1817 book On the Principles of Political Economy and Taxation in an example involving England and Portugal.[3] In Portugal it is possible to produce both wine and cloth with less labor than it would take to produce the same quantities in England. However the relative costs of producing those two goods are different in the two countries. In England it is very hard to produce wine, and only moderately difficult to produce cloth. In Portugal both are easy to produce. Therefore while it is cheaper to produce cloth in Portugal than England, it is cheaper still for Portugal to produce excess wine, and trade that for English cloth. Conversely England benefits from this trade because its cost for producing cloth has not changed but it can now get wine at a lower price, closer to the cost of cloth. The conclusion drawn is that each country can gain by specializing in the good where it has comparative advantage, and trading that good for the other.

[edit] Examples

The following hypothetical examples explain the reasoning behind the theory. In Example 2 all assumptions are italicized for easy reference, and some are explained at the end of the example.

[edit] Example 1

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