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In [[economics]], the principle of comparative advantage (also known as comparative costs) explains how any country can benefit from [[free trade]], whether it has [[absolute advantage]]s or not. This principle was developed by [[Robert Torrens]] in 1815, and demonstrated in [[David Ricardo]]'s ''Principles of political economy and taxation'' in 1817.  Subsequent developments have not altered the basic intuition: if markets work perfectly, a country will always be better off under free trade, even though the gains from trade may be distributed unevenly.
The law of comparative advantage states that, even if one of two producers had an absolute advantage over the other in every type of activity, both will benefit if each concentrates upon what he does best and exchanges the product with the other . For example it would pay a writer of best-sellers who was better at plumbing than any of the available plumbers, to stick to his writing and hire a plumber. What is true of skill differences is true also of other advantages, such as the possession of better tools or access to more advanced technology. It was first formulated in terms of differences between countries, and [[John Stuart Mill]] illustrated it in terms of the trade in cloth and wine between Britain and Portugal.


[[Paul Samuelson]] once cited the principle of comparative advantage as the best example of an economic proposition that was both true and non-trivial.  In modern economics, it is used to explain why countries export what they do.  There are several model of comparative advantage, with differ in their assumptions and implications:
==Proof==


1. The Ricardian model, as developed by [[David Ricardo]]. In this model, each country produces the same goods, but with different technologies.  Ricardo's example was Britain and Portugal, which both produce wine and textiles (or at least they did in 1817).  It may be that Britain has an absolute cost advantage in both wine and textiles, but Portugal is better at producing wine in relative terms (that is, Portugal will have to give up fewer units of textiles to produce one more unit of wine).  In this case, each country should specialize completely: so Portugal should produce only wine, export the surplus to Britain and buy textiles with the proceeds.  Both countries will end up consuming more.
The logical basis of the law of comparative advantage can be demonstrated by a simple example.


2. The Heckscher-Ohlin model, also known as the factor endowments model. This model assumes that technology is identical across countries, whereas the endowments of factors of production (like land, labour and capital) differ. Heckscher and Ohlin were two Swedish economists trying to explain why Europe imported beef from Argentina and Australia in the 19th century. Their explanation was that Argentina and Australia were abundant in land, so they should concentrate in producing goods like beef that use land intensively, while Europe should produce manufactured goods that use capital intensively. In general terms, countries should export whatever products are intensive in the factors of production in which they are relatively abundant.
::Able needs 10 pairs of shoes and 20 shirts each year, either of which he can either make himself or obtain by trading with Ben. It takes Able 20  weeks to make 10 pairs of shoes and 10 weeks to make 20 shirts so, if he decides to make them both, he has to  spends a total of 30 weeks a year  to meet his  needs. If, on the other hand, he could get 10 pairs shoes from Ben in exchange for fewer than  20 shirts, he would have to work fewer hours to  get all the shoes and  shirts he needs.


Both of these theories assume perfect competition between firms and that perfect price information is available to all parties.  Relaxing these assumptions does not alter the mathematical truth of the models, but may change their predictions.   
::It would be to Ben’s advantage  to provide  Able with 10 pairs of shoes for fewer than 20  shirts provided that he is able  to make the 10 pairs of shoes  in less time than it would take him to make the 20 shirts.  That comparative advantage would  provide a motive that is independent of any differences in absolute advantage.  The exchange would be mutually beneficial  even if Ben needed both more time than Able’s 20 weeks to make 10 pairs of shoes and  more time than Able’s 10 weeks to make 20 shirts.


Measuring comparative advantage is harder than measuring absolute advantage, because it is a relative concept and cannot be expressed in dollars.  The most popular economic measure is 'revealed comparative advantage'. This assumes that if a country is a net exporter of a good, it must have comparative advantage in it.
::The logical conclusion is thus that even if Ben’s absolute costs were all higher than Able’s , the difference in comparative  costs would make the trade beneficial to both Able and Ben.
Economists disagree about the extent to which the theories above explain international trade, but most agree that a country should always chose free trade and specialize itself in the production for which it has a lower [[opportunity cost]] than its partners.


The  logic of the example would be  unchanged by substituting the names of companies  or countries for the names Able and Ben, or by substituting different commodities for shoes and shirts. It does not depend upon observation, and it  does not depend upon any postulate except rationality. In its international context, in particular, it does not depend, as is sometimes claimed, upon the assumption that there is  perfect competition.
==Factor endowments==




[[Category:CZ Live]]
[[Category:CZ Live]]
[[Category:Economics Workgroup]]
[[Category:Economics Workgroup]]

Revision as of 09:01, 21 December 2007

The law of comparative advantage states that, even if one of two producers had an absolute advantage over the other in every type of activity, both will benefit if each concentrates upon what he does best and exchanges the product with the other . For example it would pay a writer of best-sellers who was better at plumbing than any of the available plumbers, to stick to his writing and hire a plumber. What is true of skill differences is true also of other advantages, such as the possession of better tools or access to more advanced technology. It was first formulated in terms of differences between countries, and John Stuart Mill illustrated it in terms of the trade in cloth and wine between Britain and Portugal.

Proof

The logical basis of the law of comparative advantage can be demonstrated by a simple example.

Able needs 10 pairs of shoes and 20 shirts each year, either of which he can either make himself or obtain by trading with Ben. It takes Able 20 weeks to make 10 pairs of shoes and 10 weeks to make 20 shirts so, if he decides to make them both, he has to spends a total of 30 weeks a year to meet his needs. If, on the other hand, he could get 10 pairs shoes from Ben in exchange for fewer than 20 shirts, he would have to work fewer hours to get all the shoes and shirts he needs.
It would be to Ben’s advantage to provide Able with 10 pairs of shoes for fewer than 20 shirts provided that he is able to make the 10 pairs of shoes in less time than it would take him to make the 20 shirts. That comparative advantage would provide a motive that is independent of any differences in absolute advantage. The exchange would be mutually beneficial even if Ben needed both more time than Able’s 20 weeks to make 10 pairs of shoes and more time than Able’s 10 weeks to make 20 shirts.
The logical conclusion is thus that even if Ben’s absolute costs were all higher than Able’s , the difference in comparative costs would make the trade beneficial to both Able and Ben.

The logic of the example would be unchanged by substituting the names of companies or countries for the names Able and Ben, or by substituting different commodities for shoes and shirts. It does not depend upon observation, and it does not depend upon any postulate except rationality. In its international context, in particular, it does not depend, as is sometimes claimed, upon the assumption that there is perfect competition.

Factor endowments

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