WTO

WTO

Ricardian Model of Comparative Advantage

Absolute Advantage

One simplistic view of world trade would be to expect that whatever country is “better” at producing a good in some absolute sense will end up specializing in the production of that good. Was this the case, it would spell bad news for poor developing countries considering opening up their borders to free trade. Because industrialized countries such as the United States have high levels of productivity across all sectors, a less technologically advanced developing country would have no hope of competing in a free trade environment if absolute productivity levels were all that mattered. For example, consider the United States and Mexico. Suppose that one laborer using U.S. technology can produce a computer in 2 hours of work. That same person working with U.S. agricultural technology can harvest a bushel of corn in 1 hour. Now suppose that in Mexico, producing a computer takes a person 12 hours, and harvesting a bushel of corn takes 3 hours. In this example, Mexico is slower at producing both computers and corn. We say that the United States has an absolute advantage in producing both goods because it can produce each of them at a lower cost (measured in person-hours) than Mexico (Appleyard, Field & Cobb, 2006).

Comparative Advantage

In 1817, a British economist named David Ricardo turned this idea of absolute advantage on its head. Using a model with two countries and two goods, he demonstrated that even if one country has an absolute advantage in the production of both goods, both countries can still gain from trade as long as their relative productivities for each good differ. The implications of this insight were huge. A country does not have to be highly developed or technologically advanced to reap the benefits of the global economy.

To see how this works, consider the example of the United States and Mexico described before. In this case, the United States is absolutely better at producing each good. However, relative productivities differ across the countries. In the United States, making one computer takes twice as long as harvesting a bushel of corn. So for each computer produced, the United States must forgo production of two bushels of corn. This tradeoff between the outputs of each good is known as the opportunity cost of production. The opportunity cost of producing a computer in the United States is two bushels of corn, and the opportunity cost of producing a bushel of corn in the United States is one half of a computer. However, in Mexico, the opportunity cost of producing a computer is much higher. Mexico must give up four bushels of corn for every computer produced. Yet the opportunity cost of producing a bushel of corn in Mexico is only one fourth of a computer. So while the United States has the absolute advantage in producing both goods, Mexico is relatively better at making corn (e.g., they do not have to give up as many computers for each unit of corn ...