What is ‘comparative advantage’? Give an example. How has the concept evolved since it was first propounded by David Ricardo?
Guell (2015), in their book Issues in Economics Today, comparative advantage is the ability to produce a good at a lower opportunity cost of the resources used. It gives an ability to sell goods and services at a cheaper price than its competitors and earn a great profit margin. It also explains how trade can create value for both parties even when one can produce all goods with fewer resources than the other.
For instance, moreover a country has a comparative advantage if it can produce a good at a lower opportunity cost than another country. Let’s assume two nation which produce coffee and tea using one of labor. In the table1we assume Nepal can produce 1kg of tea and 4kg of coffee using one labor. Likewise India can produce 2 kg tea and 3 kg coffee using one labor.
Table 1: Comparative advantage
In case of absolute advantage for Nepal is Tea whereas for India also absolute advantage is tea. Whereas in case of opportunity cost, Nepal can produce 1kg of Tea and 4 kg of Coffee and India can produce 2kg of Tea and 3kg of coffee. So Nepal has a comparative advantage in producing of tea as we can see low opportunity cost in tea.
The opportunity cost for India to produce tea 1 kg of tea is 2/3 which is 0.66kg whereas for Nepal it is 0.25kg. It shows Nepal has comparative advantage in producing coffee. If the nation which has higher opportunity cost then they must not produce that products rather country should focus on production of that product in which they have the lower opportunity cost.
David Ricardo (1772-1823) probably got word the legal philosophy of comparative advantage around the first two weeks of October 1816. In his example, Ricardo imagined two countries, England and Portugal, producing two goods, cloth and wine, using labor as the sole input in output. He accepted that the productivity of project (i.e., the quantity of output produced per worker) varied between industries and across countries (Ruffin, 2002). Thus, through free trade Portugal and England can both reduce their labor hours and redirect those resources to their best relative use.
The key implication of the law of comparative advantage is that if free trade is taken into account, then all nations can and will be integrated through the international division of labor. No nation is so poor or ineffective that it cannot earn from free trade.
Guell, Robert C. (2015). Issues in Economics Today , 7th edition- 2015 ISBN: 978-0078021817
Ruffin, R. (2002). David Ricardo’s discovery of comparative advantage. History of political economy, 34 (4), 727-748.
Reserve ratio or cash reserve ratio (CRR) is the proportion of customers’ deposit that commercial banks are required to keep as cash according to the direction and regulation of central bank. The reserve ratio is set by a central bank for the safety of the nation’s financial institution. The reserve ratio of central bank directly affects banks’ deposit intermediation and checks bank leverage (Chowdhury, 2014). It influences the money supply of an economy and is used as a monetary policy tool.
For example, let’s assume that one commercial bank ABC has $10 million in deposits. If the central bank reserve ratio requirement is 10% then Bank ABC must keep at least $1 million in an account at a central bank as a reserve (see figure 1).
Figure 1: Reserve ratio
The central bank of a nation can adopt an expansionary or contractionary monetary policy tools to increase or decrease the money supply in a country.
An expansionary monetary policy focuses on increasing the money supply in an economy which lowers the interest rate. The lower interest rate reduces the cost of borrowing and the return to saving which leads to higher levels of capital investment by firms and households. Furthermore, an expansionary monetary policy will, by lowering the domestic interest rate, put downward pressure on the exchange rate (McDonald, 1993).
As shown in figure 2, when the central bank increases the money supply, it lowers the interest rate and increases the quantity demanded of goods and services at each and every price level. If a central bank is combatting a recessionary gap then it can increase the money supply which leads to a change in aggregate demand from AD1 to AD2. This results in greater Real GDP of a higher price level (See figure 2).
Figure 2: Expansionary monetary policy
In another hand, Contractionary monetary policy focuses on decreasing the money supply in the economy. If the economy faces an inflationary gap then central bank engage in contractionary monetary policy. In order to compact inflation, the central bank decreases the money supply that causes interest rate to rise. The higher interest rate means that borrowing is more expensive and the return to saving is higher. In consequent, there is a decrease in AD due to contractionary monetary policy.
As shown in figure 3, there is an increase in interest rate and a decrease in the quantity of goods and services demanded at every price level when the central bank decreases the money supply. That is, the aggregate demand (AD) curve shifts leftward from AD1 to AD2. This results in lower Real GDP and lower price level at E2.
Figure 3: Contractionary monetary policy
We can also exemplify and observe the changes of expansionary and contractionary monetary policy by the following figure. As shown in figure 4, the original equilibrium occurs at EO. An expansionary monetary policy will shift the supply of loanable fund to the right from the original supply curve (SO) to the new supply curve (S1) by lowering interest rate from 8% to 6 %. Similarly, a contractionary monetary policy will shift the supply of loanable fund to the left from the original supply curve (SO) to the new supply (S2) which raises the interest rate from 8% to 10 % (See figure 4).
Figure 4: Monetary Policy and Interest Rates
Chowdhury, A. K. (2014). From Loan to Deposit: Deposit Creation by Banks and the Significance of Cash Reserves. Drishtikon : A Management Journal, 5 (2).
McDonald, I. M. (1993, Dec). Macroeconomic Policy For Recovery. The Economic and Labour Relations Review, 4 (2), 198-217.
Comparative advantage is when a particular country produces a good or service for a lower opportunity cost than other countries. In other words, it is the ability to produce a good at a lower opportunity cost of the resources used (Guell, 2012).
Nowadays comparative advantage is very important for stabilizing overseas market demand and assuring exports. Chinese manufactured exports are of greater comparative advantage in the world market than in the US market (Hao & Zhao, 2012).
Nineteenth-century English economist David Ricardo propounded the theory of comparative advantage. He argued that in order to boost the economic growth of a country, the particular country should have to focus on the industry in which it has the most substantial comparative advantage.
Ricardo developed this theory to combat trade restrictions on imported wheat in England. He argued that when a high-quality and lost-cost wheat is imported from a country which has the right climate and soil conditions then there is no sense to restrict it. England can acquire more wheat from other countries in a trade that could grow on its own soil. Thus, instead of restriction of import, it should rather export that kind of product which requires more skilled labor and machinery.
This theory explains why trade protectionism doesn’t work in the long run. Local constitutes always give pressure to political leaders to protect jobs from international competition by raising tariffs. However, this doesn’t work in long run, it is only for a temporary fix instead. It says that a country shouldn’t waste its resources on unnecessary industries which hurts only the nation’s competitiveness. Instead, a country should focus on those industries which give a competitive cost advantage.
It is said that a country can increase its output when the theory of comparative advantage is applied
Ricardo considered that countries should specialize on producing that goods and services for which they have a comparative cost advantage. There are two types of cost advantage i.e. absolute and comparative. A country should apply a theory of comparative advantage in order to determine what goods and services it should specialize in producing for increasing its revenue and output.
We can understand the concept and the theory of comparative advantage with the help of the table and figure.
As seen in the table, suppose there are two countries (A and B) that produce only two goods i.e. cars and trucks. Country A can produce 30 motor cars and 6m commercial trucks whereas country B produce 35m motor cars and 21m commercial trucks (see figure 1).
Figure1: Comparative advantage matrix
Figure 2: Comparative and absolute advantage
In this situation, country B has an absolute advantage in producing both cars and trucks. Having said that, it has a comparative advantage in trucks as it is comparatively better at producing them than country A. Country B is 3.5 times better at trucks, and only 1.17 times better at cars than country A. Hence, country B should specialize in manufacturing trucks, leaving county A to produce cars because country B is more productive and find the greatest advantage in truck production (see figure2).
Guell, R. C. (2012). The Benefits of International Trade. In R. C. Guell, Issues in Economics Today (sixth ed., pp. 92-93). New York, United States: McGraw-Hill.
Hao, W., & Zhao, C. (2012). The comparative advantage of Chinese manufactured exports. Journal of Chinese Economic and Foreign Trade Studies, 5 (2), 107-126.