Question

According to Ricardo, specialization and trade permits a country to consume beyond its production possibilities frontier. Prove this.

Answer 1

Ricardo's theory of comparative advantage explains the benefits of trade arising on account of comparative advantage. When two countries are specialized in the production of different goods, it is beneficial to both if they trade with each other rather than producing both the goods individually. This is because it becomes cheaper to import than to produce those goods. Thus both the countries can consume more than they would have produced. Or, they consume beyond their production possibility frontier.

For example, consider the following production of fruits and chocolate by two countries: Hawii and Belgium

	Fruits	Chocolate
Hawaii	5	3
Belgium	3	1
Hawaii OC	3/5	5/3
Belgium OC	1/3	3

As we see from opportunity cost (OC) of the two countries, Hawaii has a comparative advantage in the production of chocolate and Belgium in the production of fruit. As a result, Hawaii will specialize in the production of chocolate and Belgium in the production of fruit. They will then exchange for a term of trade and get to consume more than they can produce. It will happen thus:

Let us assume the above matrix gives us the units of fruit and chocolate each worker can produce in the two countries. There are 16 workers in all in each country.. Hawaii will employ 6 workers for the production of fruit and produce and 30 units of fruit. It will employ the remaining 10 workers to produce chocolate and produce 30 units of chocolate and consume it.

Similarly, Belgium will employ 4 workers to produce 12 units of fruit and consume it. It will employ the rest 12 workers to produce chocolate and produce 12 units of chocolate and consume it.

Now if they enter into a trade, it is beneficial for Hawaii to produce only chocolate and Belgium to produce only chocolate because of comparative advantage. So now, Hawaii will employ all workers for chocolate and produce (16*5) 80 units of chocolate. Belgium will employ all 16 workers to produce fruit and produce 48 units of fruit.

Suppose the terms of trade is that Hawaii will trade 16 chocolates for 32 units of fruit. Belgium will now get to consume 16 units of chocolates (as against 12 earlier) and Hawaii will get to consume 32 units of fruit (as against 30 earlier).

In the graph below, we see that before trade, both the countries consumed on the production possibility frontier. That is what they can produce. But, after trade, they consume beyond the PPF.

In this way both countries will benefit due to their comparative advantage.