Question

What benefits are to be gained from countries producing according to the law of comparative advantage? What if a country is absolutely more productive in all goods?

Answer 1

Comparative advantage is a theory of international trade devloped by David Ricardo. According to Ricardo it is comparative difference in costs that determine trade relations between two countries. When a country enters into trade with some other country, it will export those commodities in which its comparative production costs are less, and will import those commodities in which comparative production costs are high. This is basis of international trade according to Ricardo.It follows that each country will specialise in the production of those commodities in which it has the greatest advantage or the least comparative disadvantage.Each and every country will reallocate the factors accordingly and exports that commodity in which its benefit is more . Both countries will benefit by comparative advantage principle. Comparative advantage is an economic term that refers to an economy's ability to produce goods and services at lower opportunity cost than that of trade partners. A comparative advantage gives a company the ability to sell goods and services at a lower price than its competitors and realize stronger sales margins.

Comparative advantage is a powerful tool for understanding how we choose jobs in which to specialize, as well as which goods a whole country produces for export. Can one country produce everything so cheaply that other countries have no production options and no work opportunities for their citizens? Do large countries which can produce more of everything take unfair advantage of small countries when they trade? The benefits from comparative advantage could be better understand with this example of Ricardo.Comparative Advantage and its Benefits in Free Trade:-

How does identifying each country’s comparative advantage aid in understanding its benefits in free trade?

First, let’s assume that the maximum amount of labor hours is 100 hours.

In France: If all labor hours went into wine, 1,000 barrels of wine could be produced.

If all labor hours went into cloth, 500 pieces of cloth could be produced.

In the United States:-If all labor hours went into wine, 2,000 barrels of wine could be produced.

If all labor hours went into cloth, 2,000 pieces of cloth could be produced.

Following Ricardo’s theory of comparative advantage in free trade, if each country specializes in what they enjoy a comparative advantage in and imports the other good, they will be better off. Recall that:France enjoys a comparative advantage in wine. The United States enjoys a comparative advantage in cloth. In France, the country specializes in wine and produces 1,000 barrels. Recall that the opportunity cost of 1 barrel of wine in the United States is 1 piece of cloth. Therefore, the United States would be open to accepting a trade of 1 wine for up to 1 piece of cloth.

From the above mentioned discussion, its clear that when a country has a comparative advanatge in the production of both goods the terms of trade will be favourable for that country. A country will earn lot of foreign market for its products. A country will gain lot of foreign currency by exporting to other countries.Even when a country has high levels of productivity in all goods or have comparative advantage, it can still benefit from trade. If other countries specialize in the area of their comparative advantage as well and trade, the highly productive country is able to benefit from a lower opportunity cost of production in other countries