Comparative advantage is the ability to produce goods with lower costs compared to the production of goods in other industries of the country (with lower costs of substitution).
R. Torrens was the first one to reveal the idea of comparative advantage. D. Ricardo scientifically proved this idea and presented it conceptually. That is why the approach is named after both of its’ authors — the Ricardo-Torrens theory.
In this theory, a proposition of the profitability of international trade was proved. It shows that even under certain circumstances, without certain absolute advantages, there are grounds for it from the position of comparing costs in the domestic market of different countries.
Comparative advantages occur where different amounts of labor are needed to produce two goods. In other words, when production can be characterized by different labor inputs. This means that the internal opportunity cost of the two goods are different in different countries, as a consequence of these internal price ratios to the establishment of trade relations and different, therefore, there are grounds for the emergence of opportunity cost.
According to this theory, it is necessary to compare the costs of production, not only of the same type of goods from different countries, but also of heterogeneous goods within the country. There may be a situation in which the products of a certain area of a single country have lower costs than in other countries, but higher than the products of the domestic most developed industry. Therefore it is necessary to abandon the relatively less efficient production, and the resources freed up directed to a more efficient production. This means that the export industry should be more highly productive in comparison with other branches of the country. Then an increase in the share of this type of production will allow the country to increase its national income.
Criteria for choosing export and import direction to maximize the benefits of foreign trade, according to D. Ricardo are the following. Firstly, exporting a good that has comparative advantages over other goods in the domestic market, and importing one that has not achieved such advantages. Secondly, exporting a good can become imported for another country if its comparative national cost is lower than the relative cost of its counterpart in another country.
D. Ricardo's conclusions are based on measuring relative prices in hours of labor. Nowadays, the same conclusions can be reached by comparing prices (costs) in dollar equivalent or in euros, because all types of currencies function in the exchange rate regime.
Practical application of the theory of Comparative Advantage
The theory of absolute advantage was based on the assumption of a kind of monopolization of the world market by individual countries. However, this theory turned out to be untenable in practice. Relations between countries of different levels of development create economic ties of different degrees of maturity, so Smith's theory becomes unworkable.
David Ricardo's theory uses the concept of opportunity cost. It is made up of the labor time it takes to create one unit of output. And then it is compared to the corresponding figure in the creation of a similar product by another country. Therefore, the theory of relative advantage states that the favorable opportunity cost of producing a good allows a country to specialize in it even in the absence of absolute advantage.
If we compare the production of two goods for two countries, according to Smith's theory, only the one with the necessary number of factors of production would benefit. Ricardo showed that with a favorable price of production, the situation could change for both countries. Despite the absolute advantage of one of a pair of countries, the other could also specialize in the production of a similar good, provided the production costs are commensurate.
David Ricardo's model has the following limitations: Comparing two goods of two different countries. Provided one country has a comparative advantage in producing one good, the other country will have an advantage in producing the second good of the pair in question. Labor costs are the same for both countries. International trade is supported by a policy of free trade. Transportation costs are the same. The possibility of market monopolization is not taken into account, nor is the capacity of the countries' domestic markets.
Disadvantages of the theory of Comparative Advantage
The model of comparative advantage identifies optimal production parameters for a pair of countries. It works for countries with similar levels of economic development. If international trade is carried out between countries with different levels of income, the theory ceases to work. The model does not take into account the peculiarities of labor applied to the creation of a good, its quality and qualification. The criticism of Ricardo's model was that he invented the theory of a gradual decline in a country's standard of living and economic development.
Ricardo's model is capable of describing modern processes of the international division of labor. It ignores the following:
- fluctuating prices;
- changes in wages;
- the migration of workers;
- the movement of capital.
It can be said that it does not take into account the dynamics of changes in the basic factors of production and economic processes. In addition, the theory is designed to compare the two countries. It does not take into account transportation costs, and considers production costs constant. It does not capture the impact of scientific and technological progress, resources are considered interchangeable.
The theory of comparative advantage for the first time provided an insight into aggregate supply and demand. It showed that a country's participation in international trade could not harm other countries. The theory of comparative advantage became the basis for the creation and development of other theories.
The Heckscher-Ohlin model, which shows the benefit of exporting those goods for the production of which a country has relatively surplus factors of production, is considered more modern. Imports of goods and services are justified in the case of a lack of necessary factors of production.