To understand comparative advantage we first need to understand absolute advantage. Absolute advantage in the production of a good means that you can produce more of the good with a given amount of a production factor. The factor that we usually use in Ricardian trade theory is labour.
|Country||Widgets per hour||Number of workers|
From the table above we can see that country C has an absolute advantage in widget production.
It might seem that in a situation of free trade a country with an absolute advantage in the production of a good will export production to the country without absolute advantage. Furthermore, if one country had an absolute advantage in all traded goods then there would only be one-way trade. However, if we look at the production possibilities we can see that countries can benefit from trade even if they have no absolute advantage in the production of the traded goods.
Two countries of identical size, Happy Land and Love Land, make and consume 2 products: wheat and steel.
If both countries put all their resources into wheat production the result would be:
Happy Land 100 tonnes
Love Land 400 tonnes
If both countries put all their resources into steel production the result would be:
Happy Land 100 tonnes
Love Land 200 tonnes
Clearly Love Land has an absolute advantage in production of both wheat and steel. Why then might Love Land be prepared to import one or both of these products from Happy Land? To answer the question we need to look at the opportunity costs of producing each good.
If Happy Land were to switch production from wheat to steel there would be no difference in cost. In other words, one extra tonne of steel production would cost the sacrifice of one tonne of wheat production.
BUT in Love Land the opportunity cost of producing one extra tone of steel would be 2 tonnes of wheat. In other words to produce one extra tonne of steel they would have to sacrifice 2 tonnes of wheat production. The situation for wheat is the reversed; the opportunity cost of producing one tonne of wheat is ½ tonne of steel.
This means that Love Land has a comparative advantage in wheat production because the opportunity costs of wheat production are lower than Happy Land’s (1/2 vs 1). On the other hand Happy Land has a comparative advantage in steel production (1 vs 2).
Let’s look at the production and consumption situation before trade if both countries devote half of their resources to each good.
Now look at production after trade if they specialize in their comparative advantage.
As you can see there has been a gain in total wheat production of 50 tonnes.
Now let’s look at consumption. Assume that both countries will want to consume at least as much of each good as before trade. Also assume the to make trade worth while Love Land needs to have a minimum exchange rate of 1 tonne of steel for 2 tonnes of wheat. In our example below the countries settle on an exchange rate of 1 tonne of wheat to 2/3 tonne of steel (although they could also have settled on 1 wheat to ½ steel).
Consumption after trade at an exchange rate of 1 tonne of wheat to 2/3 tonne of steel
In this situation we see that Happy Land trades 50 tonnes of steel for 75 tonnes of wheat. Happy Land can now consume 25 tonnes more wheat that before and Love Land can now consume 25 tonnes more steel.
Although Ricardian trade theory can be criticized for being too simplistic, it does still however demonstrate that there is a clear advantage for countries to trade. It also goes some way to explain the advantages of trade.