Question

How does the Generalized Comparative Advantage (Modern Theory of International Trade) differ from David Ricardo’s classical Principle of Comparative Advantage? 

Answer 1

Generalized Comparative Advantage (Modern Theory of International Trade) :

• Comparative advantage is an economy's ability to produce a particular good or service at a lower opportunity cost than its trading partners.
• The theory of comparative advantage introduces opportunity cost as a factor for analysis in choosing between different options for production.
• Comparative advantage suggests that countries will engage in trade with one another, exporting the goods that they have a relative advantage in.
• Absolute advantage refers to the uncontested superiority of a country to produce a particular good better.

Comparative advantage is one of the most important concepts in economic theory and a fundamental tenet of the argument that all actors, at all times, can mutually benefit from cooperation and voluntary trade. It is also a foundational principle in the theory of international trade. The key to understanding comparative advantage is a solid grasp of opportunity cost. Put simply, an opportunity cost is a potential benefit that someone loses out on when selecting a particular option over another. In the case of comparative advantage, the opportunity cost (that is to say, the potential benefit which has been forfeited) for one company is lower than that of another. The company with the lower opportunity cost, and thus the smallest potential benefit which was lost, holds this type of advantage. Another way to think of comparative advantage is as the best option given a trade-off. If you're comparing two different options, each of which has a trade-off (some benefits as well as some disadvantages), the one with the best overall package is the one with the comparative advantage.

Diversity of Skills

People learn their comparative advantages through wages. This drives people into those jobs that they are comparatively best at. If a skilled mathematician earns more money as an engineer than as a teacher, they and everyone they trade with are better off when they practice engineering. Wider gaps in opportunity costs allow for higher levels of value production by organizing labor more efficiently. The greater the diversity in people and their skills, the greater the opportunity for beneficial trade through comparative advantage.

As an example, consider a famous athlete like Michael Jordan. As a renowned basketball and baseball star, Michael Jordan is an exceptional athlete whose physical abilities surpass those of most other individuals. Michael Jordan would likely be able to, say, paint his house quickly, owing to his abilities as well as his impressive height. Hypothetically, say that Michael Jordan could paint his house in eight hours. In those same eight hours, though, he could also take part in the filming of a television commercial which would earn him $50,000. By contrast, Jordan's neighbor Joe could paint the house in 10 hours. In that same period of time, he could work at a fast food restaurant and earn $100. In this example, Joe has a comparative advantage, even though Michael Jordan could paint the house faster and better. The best trade would be for Michael Jordan to film a television commercial and pay Joe to paint his house. So long as Michael Jordan makes the expected $50,000 and Joe earns more than $100, the trade is a winner. Owing to their diversity of skills, Michael Jordan and Joe would likely find this to be the best arrangement for their mutual benefit.

David Ricardo’s classical Principle of Comparative Advantage :

• David Ricardo was a classical economist who developed several key theories that remain influential in economics.
• Ricardo was a successful investor and member of Parliament who took up writing about economics after retiring young on his fortunes.
• Ricardo is best known for his theories of comparative advantage, economic rents, and labor theory of value.

Comparative Advantage

Among the notable ideas that Ricardo introduced in Principles of Political Economy and Taxation was the theory of comparative advantage, which argued that countries can benefit from international trade by specializing in the production of goods for which they have a relatively lower opportunity cost in production even if they do not have an absolute advantage in the production of any particular good. For example, a mutual trade benefit would be realized between China and the United Kingdom from China specializing in the production of porcelain and tea and the United Kingdom concentrating on machine parts. Ricardo is prominently associated with the net benefits of free trade and the detriment of protectionist policies. Ricardo's theory of comparative advantage produced offshoots and critiques that are discussed to this day.

Labor Theory of Value

Another of Ricardo's best-known contributions to economics was the labor theory of value. The labor theory of value states that the value of a good could be measured by the labor that it took to produce it. The theory stated that the cost should not be based on the compensation paid for the labor, but on the total cost of production. One example of this theory is that if a table takes two hours to make, and a chair takes one hour to make, one table is worth two chairs, regardless of how much per hour the makers of the table and chairs were paid. The labor theory of value would later become one of the foundations of Marxism.

Theory of Rents

Ricardo was the first economist to discuss the idea of rents, or benefits that accrue to the owners of assets solely due to their ownership rather than their contribution to any actually productive activity. In its original application, agricultural economics, the theory of rents shows that the benefits of a rise in grain prices will tend to accrue to the owners of agricultural lands in the form of rents paid by tenant framers. Ricardo's idea was later also applied to political economy, in the idea of rent seeking, where the owners of assets who can benefit from public policies that direct increased rents toward them have, and act on, an incentive to influence public policy.

Ricardian Equivalence

In public finance, Ricardo wrote that whether a government chooses to finance its expenditures through immediate taxation or through borrowing and deficit spending, the results for the economy will be equivalent. If taxpayers are rational, then they will account for any expected increase in future taxation to finance current deficits by saving an amount equivalent to current deficit spending, so the net change to total spending will be zero. So if a government engages in deficit spending to boost the economy, then private spending will just fall by an equivalent amount as people save more, and the net effect on the aggregate economy will be a wash.