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The Theory of Comparative Advantage - Overview Historical Overview The theory of comparative advantage is perhaps the most important concept in international trade theory.
It is also one of the most commonly misunderstood principles. First, the principle of comparative advantage is clearly counter-intuitive. Many results from the formal model are contrary to simple logic. Secondly, the theory is easy to confuse with another notion about advantageous trade, known in trade theory as the theory of absolute advantage.
The logic behind absolute advantage is quite intuitive. This confusion between these two concepts leads many people to think that they understand comparative advantage when in fact, what they understand is absolute advantage. Finally, the theory of comparative advantage is all too often presented only in its mathematical form.
Using numerical examples or diagrammatic representations are extremely useful in demonstrating the basic results and the deeper implications of the theory. However, it is also easy to see the results mathematically, without ever understanding the basic intuition of the theory.
The early logic that free trade could be advantageous for countries was based on the concept of absolute advantages in production. Adam Smith wrote in The Wealth of Nations"If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage.
If our country can produce some set of goods at lower cost than a foreign country, and if the foreign country can produce some other set of goods at a lower cost than we can produce them, then clearly it would be best for us to trade our relatively cheaper goods for their relatively cheaper goods.
In this way both countries may gain from trade. The original idea of comparative advantage dates to the early part of the 19th century. Although the model describing the theory is commonly referred to as the "Ricardian model", the original description of the idea can be found in an Essay on the External Corn Trade by Robert Torrens in David Ricardo formalized the idea using a compelling, yet simple, numerical example in his book titled, On the Principles of Political Economy and Taxation.
Finally, the concept became a key feature of international political economy upon the publication of Principles of Political Economy by John Stuart Mill in Indeed some variation of Ricardo's example lives on in most international trade textbooks today.
See page in this text In his example Ricardo imagined two countries, England and Portugal, producing two goods, cloth and wine, using labor as the sole input in production.
He assumed that the productivity of labor i. However, instead of assuming, as Adam Smith did, that England is more productive in producing one good and Portugal is more productive in the other; Ricardo assumed that Portugal was more productive in both goods.
Based on Smith's intuition, then, it would seem that trade could not be advantageous, at least for England. However, Ricardo demonstrated numerically that if England specialized in producing one of the two goods, and if Portugal produced the other, then total world output of both goods could rise!
If an appropriate terms of trade i. This means that England may nevertheless benefit from free trade even though it is assumed to be technologically inferior to Portugal in the production of everything. As it turned out, specialization in any good would not suffice to guarantee the improvement in world output.
Only one of the goods would work. Ricardo showed that the specialization good in each country should be that good in which the country had a comparative advantage in production. To identify a country's comparative advantage good requires a comparison of production costs across countries.
However, one does not compare the monetary costs of production or even the resource costs labor needed per unit of output of production.
Instead one must compare the opportunity costs of producing goods across countries. A country is said to have a comparative advantage in the production of a good say cloth if it can produce cloth at a lower opportunity cost than another country. The opportunity cost of cloth production is defined as the amount of wine that must be given up in order to produce one more unit of cloth.
Thus England would have the comparative advantage in cloth production relative to Portugal if it must give up less wine to produce another unit of cloth than the amount of wine that Portugal would have to give up to produce another unit of cloth.
All in all, this condition is rather confusing. Suffice it to say, that it is quite possible, indeed likely, that although England may be less productive in producing both goods relative to Portugal, it will nonetheless have a comparative advantage in the production of one of the two goods.
Indeed there is only one circumstance in which England would not have a comparative advantage in either good, and in this case Portugal also would not have a comparative advantage in either good. In other words, either each country has the comparative advantage in one of the two goods or neither country has a comparative advantage in anything.
Another way to define comparative advantage is by comparing productivities across industries and countries. Thus suppose, as before, that Portugal is more productive than England in the production of both cloth and wine.
If Portugal is twice as productive in cloth production relative to England but three times as productive in wine, then Portugal's comparative advantage is in wine, the good in which its productivity advantage is greatest. Similarly, England's comparative advantage good is cloth, the good in which its productivity disadvantage is least.A sustained competitive advantage is simply a competitive advantage that lasts for a longer period of calendar time (Porter, ).
A competitive advantage is sustained only after the efforts to duplicate the advantages of the strategy have been ceased (Lippman and Rumelt,). Economics: Economics, social science that seeks to analyze and describe the production, distribution, and consumption of wealth.
Economics was formerly a hobby of gentlemen of leisure, but today there is hardly a government, international agency, or large commercial bank that .
David Ricardo and Comparative Advantage. The Theory of Comparative Advantage. David Ricardo, working in the early part of the 19th century, realised that absolute advantage was a limited case of a more general theory.
The more sustainable the competitive advantage, the more difficult it is for competitors to neutralize the advantage.
The two main types of competitive advantages are comparative advantage and. Economics essay writing help on: Digitization & Competitive advantage Introduction In an era of digitalization, emphasis of business was shifting more towards integration of various attributes of business so as to achieve the ultimate objective of cost, quality and efficiency.
A globalized economy in its theory entails opening up of the local economy of a certain country towards internationalization, creating a “borderless world economy”.