Comparative Advantage Assignment Help
Absolute Advantage refers to a situation when an economy can produce larger quantity of goods with a constant or same level of various factors of production. Hence, for example one worker can produce units as follows (in two different economies on an annual basis):
Hence, USA has an absolute advantage in producing cars (1000:400) while France has an absolute advantage in producing wine (800:100)
So, it is possible for an economy to have absolute advantage in producing more than one commodity or maybe, even all commodities. That is to say, that it can produce more units of all (or more than one) commodities given the same level of factors of production.
Ricardo’s Theory of Comparative Advantage
David Ricardo contributed this theory in 1817. The theory has tremendous implications for international trade and distinguishes the same from domestic trade.
According to the Ricardian theory of comparative advantage, every country will specialise in production of a particular commodity. Hence, it will produce this commodity in maximum quantity available and once the needs of the country are satisfied, it will export the remaining quantity to other countries. Similarly, other commodities that are required by the country will be imported from a nation that has the respective comparative advantage in production of required commodity.
Further, even if a country has comparative advantage in production of two commodities, it will only produce the commodity where it has greater advantage and import the other commodity.
Absolute Advantage versus Comparative Advantage
The difference between Absolute Advantage and Comparative Advantage is that while in case of Absolute Advantage, focus is on producing more units of a commodity at a lower level of factors of production (or cost); in case of Comparative Advantage, focus is on producing more units of a commodity at a lower level of opportunity cost.
According to the theory of comparative advantage, an economy should not try and produce everything even if it has an absolute advantage in same.
Hence, to continue with above example, if USA produces wine, the opportunity cost is 1000/100 = 100 cars foregone. Similarly, if France produces cars, the opportunity cost is 800/400 = 2 wines foregone. Therefore, USA should produce cars while France should produce wine.
Now, let us see another hypothetical example where one economy has absolute advantage in producing both commodities:
Now, if USA produces wine, the opportunity cost is 1000/900 = 1.1 cars foregone. Similarly, if France produces cars, the opportunity cost is 800/100 = 8 wines foregone. Therefore, USA should produce cars while France should produce wine. This is irrespective of the fact that USA has absolute advantage in both commodities (cars and wine).
We can analyse it further through total units produced per unit of labour. In above case, the total units are 1000+100 cars and 900+800 wines which lead to a total of 2800 units of commodities.
However, as per theory of comparative advantage, if USA produces only cars and France produces only wine, considering that twice the labour will be employed, the production will be as follows:
This leads to a production of 3600 units which is much more than earlier output of 2800 units. This is beneficial for both the economies.
The theory of opportunity cost has a direct implication for any economy. An economy that is able to lower the opportunity cost for producing a commodity will have an advantage, known as comparative advantage.
Assumptions of the Theory of Comparative Advantage
Ricardo’s theory is based on a number of assumptions which can be listed as follows:
- There are only two economies (say, A and B) which produce same commodities (say, X and Y)
- Labour is the only factor of production and its supply remains unchanged. Further, all units of labour are homogenous and perfectly mobile within the economy. Also, they are not mobile to the other economy.
- The labour cost determines the price of the two commodities
- The two countries trade on the barter system. Further, the barter does not involve any transportation cost.
- Free trade is undertaken between the two countries. Trade barriers and restrictions in the movement of commodities are absent.
- Technological knowledge is unchanged.
- The exchange ratio for the two commodities is the same.
Criticism of the Theory of Comparative Advantage
Considering the above assumptions, many obvious criticisms may come to mind instantly, such as:
- The assumption that there are only two economies that produce same two commodities is not feasible in real world. In reality, there are multiple economies in the world that produce many goods.
- All labour units available can never be homogenous; rather, they will be heterogeneous in terms of skill set and quality. Also, in reality, the labour will not be perfectly mobile. Alternatively, it may move to the other economy in question.
- The theory assumes that same unit of labour can produce any good at the same rate. However, in reality, different grade and different quantity of labour will be required for different commodities.
- Again, labour is not the only factor of production. There are other important factors as well that play a pivotal role. The theory also ignores non-labour costs required for production.
- The theory assumes that there is no transportation cost and there is no barrier to trade across economies. In reality, there are trade restrictions, barriers to entry, tariffs, economy’s trade policies, etc. that play a pivotal role in determining trade partners for various commodities.
- The theory assumes that factors of production are fully employed and are constant.
- The theory considers only the supply side of world trade and neglects the demand side.
Despite the limitations and criticism, Ricardo’s theory of Comparative Advantage is a breakthrough theory that has implications for international trade. The theory cannot be totally written off due to the assumptions and can be used in various situations to arrive at optimal solutions.