Before we proceed to uncover what is comparative advantage, let's take a brief tour of the foundation of international trade. International trade - all of this import and export affair - is founded upon the economic principles of scarcity and choice. To elaborate, it is not possible for every individual to be self-sufficient and produce all those things he needs, wants or desires in his life himself. Neither does he have access to all available resources nor is he equally talented in each and every skill necessary for making the objects that are suitable for the satisfaction of his wants.
This is where the entire concept of specialization, exchange and trade takes root. Now, magnifying this phenomenon to a macroeconomic scale, the situation is same in case of individual nations as well. Not all countries are equally equipped to produce a particular commodity and each has to depend on others for fulfilling the requirements of those commodities which it is ill-disposed to produce on its own. This is where the theories of absolute followed by comparative advantage in economics make a grand entrance.
Meaning of Comparative Advantage in Economics?
The theory of comparative advantage stems from its predecessor, the theory of absolute advantage. Propounded by Adam Smith in the year 1776 in his legendary economic treatise An Inquiry into the Nature and Causes of the Wealth of Nations (most popularly known as Wealth of Nations), the theory of absolute advantage argues that each nation can benefit by entering into trade with other nations as not all countries are equally endowed for the production of all economic utilities.
He argued that gold reserves alone do not suffice to measure the wealth of a nation and taking the economic utilities available to its citizens is a better way to judge how rich a country is. For this purpose, a country would benefit most if it imports those goods for the production of which it is not well disposed (in terms of resources or opportunity cost) and it should export all those commodities which it has the ability to produce in surplus.
For instance, if Country A can produce 500 units of a commodity in a day using 300 units of labor and Country B can produce 1000 units of the same commodity in a day using 300 units of labor, then the latter is identified as having an absolute advantage over the former and A would be better off importing the commodity from B, assuming each unit of the factors of production cost the same in both countries.
Although profitable, this method may not be mutually beneficial for both countries entering into a commercial relation with each other. The theory of comparative advantage builds up from hereon. Propounded by David Ricardo in the year 1817 in his famous work On the Principles of Political Economics and Taxation, this theory argues that both parties of an international trade can reap mutual benefits and that it is not necessary for such a relation to be a one-way affair (one country only importing and the other only exporting). There are certain assumptions that are necessary for better explaining this theory.
These assumptions are:
- Suppose there are two countries.
- Each country produces two commodities, such that all the resources of the country are allocated towards the production of just these two commodities.
- One of the countries produces both commodities more than the other
- The cost of the factors of production are the same in both countries
- .....and of course, Ceteris Paribus
Utopia devotes all its resources towards the production of 200 tons of cloth or 200 tons of wine. Narnia devotes all its resources towards the production of 300 tons of cloth or 500 tons of wine. The opportunity cost of Utopia in producing 200 tons of cloth is 200 tons of wine and vice versa. However, the opportunity cost of Narnia in producing 300 tons of cloth is 500 tons of wine and its opportunity cost in producing 500 tons of wine is 300 tons of cloth, making it a 3:5 ratio. Therefore, in order to produce 1 ton of cloth, Narnia must give up on the opportunity to produce 0.6 tons of wine and for producing 1 ton of wine, Narnia must give up on the opportunity of producing 1.7 tons of cloth.
Here, if we see in terms of just the numbers, Narnia seems to have an absolute advantage over Utopia in producing both commodities. Hence, no mutual benefits are to be derived from a trade between the two. However, judging by opportunity cost, Narnia would benefit if it goes for cloth production and Utopia would benefit from producing wine (Utopia's opportunity cost for producing wine is lower than Narnia's in terms of cloth) and then export each of their surplus produce to the other.
I hope that helped you understand the concept of comparative advantage. The key differentiating factor between Smith's and Ricardo's theories is the absence and presence of the concept of opportunity cost, respectively, from the entire national product equation. While absolute advantage paves the way for economic dominance by the country wielding the exporting power over the importing country, the theory of comparative advantage extends a solution by which both countries can mutually exist and be interdependent on each other for a symbiotic economic relationship.