Adam Smith had advocated the theory of Absolute Advantage, where he argued that a country should produce a good if it can produce more of the good with the same or fewer resources than another country. This theory is different from Comparative Advantage.
David Ricardo, another Economist, suggested that a country only needs to have Comparative Advantage when deciding if it should produce a good. He published this theory in 1817 in his book titled, “On the Principles of Political Economy and Taxation.”
The definition of Comparative Advantage is when a country may produce goods at a lower opportunity cost, but not necessarily have an absolute advantage in producing that good. This simply means that a country can produce a good at a lower cost than another country.
Factors Affecting Comparative Advantage
1. Factors of Production
A major factor that affects comparative advantage is the country’s quality and quantity of the factors of production. For example, the natural availability of mineral resources like iron, gold, and copper is not something a country can change.
2. Exchange Rate
Movements in exchange rates affect the prices of imported and exported goods. For example, if your home currency depreciates which means foreign currency can buy more of your home currency, then your exports will increase as your goods are cheaper relative to others.
An increase in the rate of inflation would make exported goods more expensive and imported goods cheaper.
4. Trade Barriers
Subsidies and taxes are examples of trade barriers that can be implemented by the government to create an artificial comparative advantage. A subsidy would make exports more competitive and a tax would discourage imports.
Assumptions in Comparative Advantage
1. Constant Returns to Scale
The theory of Comparative Advantage assumes that the costs remain constant for producing any number of goods. This means that if you require 2 hours to make one shirt, then you will spend 10 hours to make five shirts, 20 hours to make ten shirts, etc. In reality, costs will go down because of economies of scale.
There is perfect mobility of the factors of production. This means that we assume that we can move any factor of production to any part of the country at any time. In reality, we cannot move factors of production easily.
There are no transportation costs, i.e. it does not cost anything to move goods from one place to another. This assumption is also not rooted in reality.
4. Free Trade
Free trade exists between the two countries. This means there are no barriers to trade.
Example of Comparative Advantage
In the diagram below, we have two countries: Red and Black country that can produce two goods: Good X and Good Y.
Red Country has an Absolute Advantage over Black Country in producing both goods, but since their production possibility curves don’t meet, their costs are different, and there is room for specialization. Red should specialize in Good Y, and Black should specialize in Good X.
For Red, 1 unit of Good X ‘costs’ 5/7 or 0.71 units of Good Y, while for Black, 1 unit of X ‘costs’ 0.67 units of Good Y. Consequently, it’s cheaper for Black to produce Good Y than it is for Red. Likewise, we can calculate that Red has a comparative advantage in creating Good Y.
Criticisms of Comparative Advantage
The model assumes constant returns to scale, where as in the real world firms often see increasing returns to scale and economies of scale.
It’s not possible to move factors of productions so easily from one location to the other (when countries have to specialize in a particular good).
There are transportation costs that the model does not consider.
4. Perfect Competition
5. Trade Barriers
The Heckscher-Ohlin Model
The Heckscher-Ohlin Model describes the interaction of relative abundance of factors and relative intensity of their use in different production processes.
The model builds on David Ricardo’s theory of comparative advantage by predicting patterns of commerce and production based on the factor endowments of a trading region. The model essentially says that countries will export products that use their abundant and cheap factor(s) of production and import products that use the countries’ scarce factor(s).
Assumptions of the Heckscher-Ohlin Model
- There are only two factors of production – Land and Labor
- The amount of labor and land is fixed but it is allowed to vary across countries
- Countries can only produce two goods
- Production uses constant returns to scale technology and diminishing Marginal Product
- Technology for producing one product is more land intensive than the other
- There are only two countries
- All markets are competitive
- Producers take prices and wages/rents as given
- Workers get competitive wages
- Landowners get competitive rent
Conclusions of the Heckscher-Ohlin Model
The exports of a capital-abundant country will be from capital-intensive industries, and labor-abundant countries will import such goods, exporting labor-intensive goods in return. Competitive pressures within the H–O model produce this prediction fairly straightforwardly. Conveniently, this is an easily testable hypothesis.