2.2 Comparing Absolute Advantage with Comparative Advantage

In this section, we discuss two conventional theories of trade – Adam Smith’s absolute advantage and Ricardo’s comparative advantage. After defining these two theories, we set out their analytical approaches with the help of economic models and simple calculations. Because the real world is complex, we will use a model that assumes two goods, two countries, and one factor of production, namely, labour. To simplify our analysis, we will ignore all other goods produced by the two economies, all other countries in the world, and all other factors of production.

Adam Smith and Absolute Advantage

Absolute advantage is a notion with Adam Smith who contended that a country should export a product in which it has an absolute cost advantage and import a product in which it has an absolute cost disadvantage. Absolute advantage arises from the ability of a country to make a product at lower input cost (i.e., using a smaller quantity of labour) than another country. More broadly, a country has an absolute advantage in the production of a good if it can make that good with less resources than another country (Carbaugh, 2015; Pugel, 2020). Shifting a resource into an industry where it is more productive boosts overall productivity and raises global production efficiency because each country can exploit its absolute cost advantage. When each country has a product that other countries want, and can make it using fewer resources than other countries, we can see that there would be benefits from trade. Smith concluded that at least one country would be better off from trade and that, generally, both countries would be better off.

David Ricardo and Comparative Advantage

David Ricardo showed that there was a basis for trade even if a country did not have an absolute advantage with respect to the production of any good. In essence, Ricardo argued that if a country had to devote labour to making a product that it was not good at making, then its overall production would not be as large as it could be because labour would not have been put to its best use. Ricardo’s theory of comparative advantage was based on the notion of opportunity cost, which is the largest amount of some good that must be given up in order to produce a particular amount of another good. The implication is that a country will export goods that it can produce at lower opportunity cost and import goods that it can only produce at higher opportunity cost. Each country can benefit from international trade by exporting products in which it has the greatest relative advantage in production and importing products in which it has the least relative advantage.

Bringing Smith and Ricardo Together

Based on Smith’s measure of productivity, we can calculate Ricardo’s measure of comparative advantage as the ratio of labour productivity with regard to the two products. Figure 2.2 illustrates how Ricardo’s theory of comparative advantage is related to Smith’s theory of absolute advantage. Based on the labour productivity of the United States and the Rest of the World for the two products, the latter has an absolute advantage in the production of both textiles and grains. Based on absolute advantage, the Rest of the World should export both products as its productivity is higher for both products (Carbaugh, 2015; Pugel, 2020).

Ricardo’s comparative advantage argues that what should matter is not the productivity with respect to individual products but rather the relative productivity. The comparative advantage of one good is measured in terms of the quantity of the other good that must be given up to produce a unit of the good. The country with the lower productivity ratio for a particular product has a comparative advantage and should export that product and import the product for which the productivity ratio is higher. In Figure 2.2, the opportunity cost of producing textiles is lower for the Rest of the World, while the opportunity cost for producing grains is lower for the United States. Based on comparative advantage, therefore, the Rest of the World should export textiles while the United States exports grains. Both countries, therefore, benefit from trade (Carbaugh, 2015; Pugel, 2020).

Since Ricardo thought that product prices reflected labour costs, we consider the productivity ratio to be a relative price, i.e., the price of one good in terms of the price of the other good. As long as there are differences in relative prices between countries, there will be an opportunity for arbitrage, and international trade will emerge. Arbitrage involves buying a product where its price is low and selling it where its price is high with the aim of making a profit. With arbitrage, international trade eventually leads to relative prices in both countries being equal. The international equilibrium price will ultimately depend on the relative strength of demand for the two products. Both countries will benefit from trade due to increases in production efficiency, allowing overall production to increase and product prices to fall. Given higher income and lower average prices, overall consumption will also increase.

Overall, Ricardo’s theory of comparative advantage represents an improvement upon Smith’s explanation of trade. Ricardo established that a country can benefit from trade even when it does not have an absolute advantage in the production of any product. Since technology differences are assumed to be responsible for differences in labour productivity, even poor countries with relatively low levels of technology can benefit from trade. Also, the theory of comparative advantage suggests that low wages are not sufficient to give any country a competitive edge in international trade. This is because productivity levels are also important in influencing costs, prices, and trade. Although Ricardo’s comparative advantage encompasses and builds on Smith’s theory of absolute advantage, Smith nonetheless provides an explanation as to why living standards differ across countries. Countries with higher productivity tend to have higher incomes (Carbaugh, 2015; Pugel, 2020).

References

Carbaugh, R.J. (2015). International economics, (15th ed.). Cengage Learning.

Pugel, T. A. (2020). International economics, (17th ed.). McGraw-Hill.

Attributions

“Did You Know? Adam Smith” is adapted from “Adam Smith” in Unit 1: Industrialization and Theories of Economic Change, HIST363: Global Perspectives on Industrialization published by Saylor Academy under a CC BY 3.0 Unported license.

“Did You Know? David Ricardo” is adapted “33.1 Absolute and Comparative Advantage” in Principles of Economics 3e by OpenStax – Rice University and is licensed under a Creative Commons Attribution 4.0 International License, except where otherwise noted.