Comparative Advantage and the Benefits of Trade

Introduction

If you do everything better than anyone else, should you be self-sufficient and do everything yourself? Self-sufficiency is one possibility, but it turns out you can do better and make others better off in the process. By instead concentrating on the things you do the "most best" and exchanging or trading any excess of those things with someone else for the things that person does the "most best," you can both be better off. Comparative advantage fleshes out what is meant by "most best". It is one of the key principles of economics.

Definitions and Basics

Comparative Advantage. On Econlib.

A person has a comparative advantage at producing something if he can produce it at lower cost than anyone else.

Having a comparative advantage is not the same as being the best at something. In fact, someone can be completely unskilled at doing something, yet still have a comparative advantage at doing it! How can that happen?....

Comparative Advantage, by Donald J. Boudreaux. Concise Encyclopedia of Economics

If Ann spends all of her working time gathering bananas, she gathers one hundred bunches per month but catches no fish. If, instead, she spends all of her working time fishing, she catches two hundred fish per month and gathers no bananas. If she divides her work time evenly between these two tasks, each month she gathers fifty bananas and catches one hundred fish. If Bob spends all of his working time gathering bananas, he gathers fifty bunches. If he spends all of his time fishing, he catches fifty fish. Table 1 shows the maximum quantities of bananas and fish that each can produce....

If Ann and Bob do not trade, then the amounts that each can consume are strictly limited to the amounts that each can produce. Trade allows specialization based on comparative advantage and thus undoes this constraint, enabling each person to consume more than each person can produce.

Treasure Island: The Power of Trade. Part I. The Seemingly Simple Story of Comparative Advantage, by Russ Roberts on Econlib

We all have a good intuitive understanding of the power of trade. At the simplest level, if you have something I want and if I have something you want, and we trade we each other, we're both better off.

So if I can knit and you can't, and if you can grow corn and I can't, it obviously makes sense for me to swap one of my sweaters for some of your corn. You and I might argue about the "price"—how many ears of corn one of my gorgeous sweaters is worth—but once the deal is done, you're warmer and I'm on my way to being less hungry.

Trade seems simple.

Almost two hundred years ago, David Ricardo discovered something not so simple about trade that came to be called comparative advantage. Here is a story that will let us explore the mysteries of trade together.

Comparative Advantage, by Dwight Lee. At CommonSenseEconomics.com.

Absolute Versus Comparative Advantage: The most straightforward case for free trade is that countries have different absolute advantages in producing goods. For example, because of differences in soil and climate, the United States is better at producing wheat than Brazil, and Brazil is better at producing coffee than the United States. Obviously both countries are better off when Americans produce wheat and exchange a portion of it for some of the coffee that Brazilians produce.

But does this mean that a country with an absolute advantage in the production of a good should always produce that good rather than import it? No, as the English economist David Ricardo first explained in the early 1800s. A country can have an absolute advantage in the production of a good without having a comparative advantage. Comparative advantage is what determines whether it pays to produce a good or import it....

In the News and Examples

Don Boudreaux on Globalization and Trade Deficits. Podcast on EconTalk.

Don Boudreaux, of George Mason University, talks about the ideas in his book, Globalization. He discusses comparative advantage, the winners and losers from trade, trade deficits, and inequality....

Trading countries both achieve gains from trade: Foreign Trade, or The Wedding Gown, by Jane Haldimand Marcet in John Hopkins's Notions on Political Economy. 1831.

"Then I hope your honour will set us right," replied Bob.—"Why," said the landlord, "I maintain that, when two countries trade freely with each other, they are both gainers."...

"This requires some explanation," said the landlord, "which I will try to give you. Foreigners send over to us such goods as they can make or produce cheaper and better than we can; therefore, when we buy those goods, we get them cheaper or better than we could have made them ourselves."... [par. 8.20]

The Worldwide Decline in Conscription: A Victory for Economics?, by Joshua C. Hall.

Conscription is the compulsory enlistment of individuals into government service. Historically, however, conscription has referred primarily to the military. While governments since antiquity have conscripted people into their militaries, the conscription of a large segment of a country's citizens to meet military goals is a fairly recent phenomenon. Prior to the French Revolution, conscription occurred but was fairly rare....

The basic economic argument in favor of a volunteer army and against conscription rests on the fundamental economic principles of comparative advantage and specialization. People's opportunity costs of producing various goods and services, including military services, differ. Conscription ignores the fact that some individuals have a comparative advantage in food production or engineering or teaching and, instead, forces everyone drafted into a military occupation less directly in line with their abilities. Indeed, that thought is behind the title of an anti-draft book written in the late 1960s: The Wrong Man in Uniform. By ignoring comparative advantage, conscription reduces the productive capacity of society.

A Little History: Primary Sources and References

David Ricardo's famous paragraph on comparative advantage (before the term was coined): Chapter 7, by David Ricardo, in On the Principles of Political Economy and Taxation

To produce the wine in Portugal, might require only the labour of 80 men for one year, and to produce the cloth in the same country, might require the labour of 90 men for the same time. It would therefore be advantageous for her to export wine in exchange for cloth. This exchange might even take place, notwithstanding that the commodity imported by Portugal could be produced there with less labour than in England. Though she could make the cloth with the labour of 90 men, she would import it from a country where it required the labour of 100 men to produce it, because it would be advantageous to her rather to employ her capital in the production of wine, for which she would obtain more cloth from England, than she could produce by diverting a portion of her capital from the cultivation of vines to the manufacture of cloth. [par. 7.16 (See also pars. 7.13-7.15)]

A Brief History of Comparative Advantage, by Morgan Rose. Teacher's Corner on Econlib

For over 200 years, economists have touted an alternative approach in which specialization leads to wealth and self-sufficiency leads to poverty. In Book IV, Chapter 3, paragraph 31 of An Inquiry into the Nature and Causes of the Wealth of Nations (1789; 1st edition: 1776), Adam Smith showed how both parties can benefit from trade, but it was David Ricardo who is credited with what is commonly called "comparative advantage," the idea that both parties can benefit from trade even if one of them is better at producing everything than the other....

Part I, Chapter III, The Principle of Comparative Advantage, by Frank William Taussig, from Some Aspects of the Tariff Question

The doctrine of comparative advantage,--or, in the phrase more commonly used by the older school, of comparative cost,--has underlain almost the entire discussion of international trade at the hands of the British school. It has received singularly little attention from the economists of the Continent, and sometimes has been discussed by them as one of those subtleties that have little bearing on the facts of industry. I believe that it has not only theoretical consistency, but direct application to the facts; and that in particular it is indispensable for explaining the international trade of the United States and the working of our tariff policy. Neither the familiar arguments heard in our controversy nor the course of our industrial history can be understood unless the principle of comparative advantage is clearly understood and kept steadily in view....

David Ricardo's contribution: Chapter VIII. Gains From Trade: The Doctrine of Comparative Costs, by Jacob Viner, from Studies in the Theory of International Trade

In an earlier chapter, however, it has been shown that several writers prior to Adam Smith, and especially the author of Considerations on the East-India Trade, 1701, stated the case for free trade in terms of a rule which would provide the same limits for profitable trade as does the doctrine of comparative costs, the rule, namely, that it pays to import commodities from abroad whenever they can be obtained in exchange for exports at a smaller real cost than their production at home would entail. Such gain from trade is always possible when, and is only possible if, there are comparative differences in costs between the countries concerned. The doctrine of comparative costs is, indeed, but a statement of some of the implications of this rule, and adds nothing to it as a guide for policy....

Malthus had credited as a factor contributing to the prosperity of the United States her ability to sell "raw produce, obtained with little labor, for European commodities which have cost much labor." To this, Ricardo replied:

It can be of no consequence to America, whether the commodities she obtains in return for her own, cost Europeans much, or little labor; all she is interested in, is that they shall cost her less labor by purchasing them than by manufacturing them herself.

This explicit statement that imports could be profitable even though the commodity imported could be produced at less cost at home than abroad was, it seems to me, the sole addition of consequence which the doctrine of comparative costs made to the eighteenth-century rule. Its chief service was to correct the previously prevalent error that under free trade all commodities would necessarily tend to be produced in the locations where their real costs of production were lowest.

Advanced Resources

Roberts on Smith, Ricardo, and Trade. Podcast at EconTalk.

Economists have focused on David Ricardo's idea of comparative advantage as the source of specialization and wealth creation from trade. Drawing on Adam Smith and the work of James Buchanan, Yong Yoon, and Paul Romer, Russ Roberts argues that we've neglected the role of the size of the market in creating incentives for specialization and wealth creation via trade. Simply put, the more people we trade with, the greater the opportunity to specialize and innovate, even when people are identical. The Ricardian insight masks the power of market size in driving innovation and the transformation of our standard of living over the last few centuries in the developed world.

Critiques to Ricardo's idea of comparative advantage: Ed Leamer on Outsourcing and Globalization. Podcast at EconTalk. Discussion of comparative advantage and critiques starts at time stamp 16:21.

David Ricardo. Comparative advantage. Trade is driven by the differences between us and the opportunity to specialize in what we do most effectively even makes the observable differences more dramatic than the underlying differences. Critiques of Ricardo: 1. If you look at the pattern of trade, it seems to be between similars--wealthy nations trade with each other. 2. Ricardo didn't foresee the modern world, including capital mobility, other modern developments.

Related Topics

Exchange and Trade
Division of Labor and Specialization
Globalization, Interdependence, and Local Trade
Economic Growth
Barriers to Trade
Balance of Trade and Balance of Payments
Opportunity Cost