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Theory of Comparative Advantage

Theory of Comparative Advantage. The theory of comparative advantage was first proposed by Ricardo countries should specialize in producing those goods of which they are relatively more efficient producers these countries should then trade with the rest of the world to obtain needed commodities

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Theory of Comparative Advantage

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  1. Theory of Comparative Advantage • The theory of comparative advantage was first proposed by Ricardo • countries should specialize in producing those goods of which they are relatively more efficient producers • these countries should then trade with the rest of the world to obtain needed commodities • if countries do specialize this way, total world production will be greater

  2. Theory of Comparative Advantage • Suppose that this is the marginal cost data for England and Portugal for the production of wine and cloth

  3. Theory of Comparative Advantage • In Ricardo’s analysis, marginal costs were assumed to be constant • If we let total resource costs be fixed for each country at 100, the production possibility frontier for England is 8W + 4C = 100 and for Portugal it is 2W + 2C = 100

  4. Theory of Comparative Advantage • The RPTs differ between these countries:

  5. Theory of Comparative Advantage • Although Portugal has an absolute advantage in the production of both goods, both countries could benefit from trade • wine is relatively less costly in Portugal • Portugal has a comparative advantage in wine • cloth is relatively less costly in England • England has a comparative advantage in cloth

  6. Theory of Comparative Advantage • Suppose that, prior to trade, each country devotes half its resources to each good • For England: W = 50/8 = 6.25 C = 50/4 = 12.5 • For Portugal: W = 50/2 = 25 C = 50/2 = 25

  7. Theory of Comparative Advantage • World output can be increased if England was to produce less wine and more cloth and Portugal was to produce more wine and less cloth • Suppose that England decided to devote all of its resources to the production of cloth W = 0/8 = 0 C = 100/4 = 25

  8. Theory of Comparative Advantage • Suppose that Portugal decided to devote 70% of its resources to the production of wine, with the remaining 30% used to produce cloth W = 70/2 = 35 C = 30/2 = 15 • World output of wine has increased from 31.25 to 35, and cloth output has risen from 37.5 to 40

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