Theory of Comparative Advantage

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