Question

Discuss in detail why Ricardo’s cost comparative theory explains better than Smith’s Absolute Advantage the current trade pattern between the developing and developed countries.

Answer 1

Smith's Absolute Advantage Theory: Country A has absolute advantage in production of good X than country B if A can simply produce more units of X than country B, given same technology.

Ricardo's Comparative Advantage Theory: Country A has comparative advantage in good X than country B if A can produce good X with a lower opportunity cost.

Ricardian theory considers the limitations of the factors used to produce the good which Smith's Absolute Advantage theory does not consider..

In Smith's theory , developed country will produce all goods in the world simple because they are more skilled at doing that. Since they have absolute advantage, they have lower absolute cost also. Hence they spend less factors in making one unit of that product. But this is really unrealistic because they have labour and capital constraints and cannot manufacture every single item. If they did, the demand for labour and capital will rise, wage and interest rates will rise too and the goods will be too expensive and the system will fail. It is not realistic.

Ricardo on the other hand focuses on the relative costs of production. Its focal point of discussion is not the amount of resources spent per unit but rather the opportunity cost i.e. how much potential goods were sacrificed for that extra unit. Developed countries will outperform everyone in a particular good but they have to choose which one to sacrifice, in the Ricardian theory. This allows the developing countries to produce and trade too.

Hence Ricardo's comparative theory explains trade pattern between developed and developing countries better than Smith's absolute advantage.