Comparative Advantage

It is also possible for two nations to trade to mututal benefit where one nation has no absolute advantage over the other in the production of any good, so long as a comparative advantage exists. David Ricardo showed that a poor country without any absolute industrial advantage can still trade to mutual benefit with a rich country.

Given the following assumptions:

(a)     Both the United States and India produce only two goods, wheat (food) and burlap (clothing).

(b)     Labor is the only variable factor of production, but its productivity differs in each country.

(c)     In each country, the productivity of labor is constant respective to the scale of production.

(d)     Labor in each country is fully employed.

(e)     There is no migration of labor between the two nations.

(f)      Although output per man-hour is greater in the United States than in India for both products, the productivity gap in wheat is not proportional to the productivity gap in burlap.

Also suppose the following schedule:

Product	Hours of labor in United States	Hours of labor in India
1 Bushel of Wheat	1	10
1 Meter of Burlap	2	10

The United States is absolutely more efficient in both products. However, it takes 10 times as much effort to produce wheat in India than in the U.S., but only 5 times as much effort to produce burlap. India has a comparative advantage in burlap and the U.S. has a comparative advantage in wheat.

If I live in the U.S. and I want a meter of burlap, I can pay the value of 2 hours of labor and buy one locally. Alternately, I can pay the value of 1½ hours of labor for 1½ bushels of wheat, which I trade to India for a meter of burlap. This is to India’s benefit since wheat and burlap cost the same on Indian market. I now have my meter of burlap for less than it would have cost to produce locally, so I have benefited.

If two countries engage in mutual trade where a comparative advantage exists, the actions of independent traders will tend to establish a market price for different goods. In the example above, we start out with a bushel of wheat worth 1 meter of burlap in India, and 2 meters in the U.S. As trading occurs, the U.S. will specialize in wheat and India will specialize in burlap, and eventually the relative prices will be equal in both markets. Without knowing more about the preferences of consumers, all that can be said is that the price ratio will be somewhere between 1 and 2. As long as the ratio is different in the two countries, there will be an incentive for trading and specialization to occur that will tend to move the ratio closer to equal.

Each country has a production possibility frontier that shows the efficient combinations of wheat and burlap that can be produced in that country. It is also possible to draw a production possibility frontier that shows the efficient production possibilities across both countries. This frontier will show that specialization allows greater total production between the two countries than they would have been able to achieve acting independently.