The basic principle explaining the pattern of international specialization and the gains from trade.
If two countries each have an absolute advantage in producing a different good (i.e., each country can produce a particular good with smaller factor inputs per unit of output than any other country), then there are obvious gains from each country specializing in producing the commodity in which it has an absolute advantage, as Adam Smith explained in 1776. Comparative advantage, the basic insight of international trade theory, is far less obvious: all countries can benefit from specialization and exchange even if one country has an absolute advantage in producing all goods. Robert Torrens gave a verbal statement of comparative advantage in 1815 (which was made clearer in subsequent editions of his Essay on the External Corn Trade), but the widespread influence of the concept is because of David Ricardo’s famous numerical example in chapter 7 of his Principles of Political Economy (1817).
Ricardo assumed that two countries, Portugal and England, could produce two goods, cloth and wine, using a single factor of production: labor. Each country has a fixed amount of labor, which is mobile between occupations within a country, but not between countries. Ricardo assumed that England could produce 1 unit of cloth with 100 person-years of labor and 1 unit of wine with 120 person-years of labor. Portugal could produce 1 unit of cloth with 90 person-years of labor and 1 unit of wine with 80 person-years of labor, so that Portugal had an absolute advantage in producing each good. Suppose that, without trade, each country would produce and consume one unit of each good, so that total output would be two units of cloth and two of wine. If England devoted all of its 220 person-years of labor to producing cloth, it could produce 2.2 units of cloth. If Portugal devoted all of its 170 person-years of labor to producing wine, it could produce 2.125 units of wine.
By England specializing in cloth production and importing Portuguese wine, and Portugal specializing in wine production and importing English cloth, each country could consume strictly more of each good. Both countries would be better off because of the international division of labor and efficient allocation of resources. The crucial point is that the opportunity cost of a unit of cloth is five-sixths of a unit of wine in England and nine-eighths of a unit of wine of Portugal, so that England has a comparative advantage in producing wine (even though it is at an absolute disadvantage, measured by the labor input per unit of cloth). Similarly, the opportunity cost of a unit of wine is sixth-fifths of a unit of cloth in England and eight-ninths of a unit of cloth in Portugal, so the opportunity cost of producing wine is lower in Portugal.
Comparative advantage shows that two countries both benefit from specialization and exchange even if labor is more productive or better paid in one of the countries.
Robert W. Dimand
See also: Economics, Classical; Ricardo, David; Smith, Adam.
Krugman, Paul. “Ricardo’s Difficult Idea: Why Intellectuals Don’t Understand Comparative Advantage.” In The Economics and Politics of International Trade. Vol. 2, ed. G. Cook. New York: Routledge, 1998.
Maneschi, Andrea. Comparative Advantage in International Trade: A Historical Perspective. Aldershot, UK: Edward Elgar, 1998.
Ricardo, David. The Principles of Political Economy and Taxation. Intro. by D. Winch. New York: Dutton, Everyman’s Library, 1973.
Torrens, Robert. An Essay on the External Corn Trade. 5th ed. Fairfield, NJ: Augustus M. Kelley, 1972.