According to Ricardo, two nations without input factor mobility, specialization and trade could gain more through trade than when producing in isolation (Federal Reserve Bank of Dallas). Ricardo’s argued that comparative advantage was the basis on which nations should specialize and then trade. Both specializing nations ends up better off if they concentrate in producing commodities in which they enjoy lower opportunity cost. This would be achieved through engaging in transactions for those they have a comparative disadvantage. In the world, today countries have an absolute advantage in production of multiple commodities, but Ricardo argued that what matters is not absolute advantage but comparative advantage.
Ricardo argued his comparative advantage theory of international trade based on various assumptions. He assumed that only two countries engage in transactions, and they exchange two commodities only. His explanations also assumed free trade and perfect competition in factor market and commodity with no externalities. Comparative advantage based the argument on labor as the only factor of production apart from natural endowments. Labor was considered to be homogenous and perfectly mobile within one country and not across countries. This model assumed no technological change and constant returns to scale and these commodities were valued and exchanged in terms of labor hours used in their production. It assumed barter trade between countries with full employment levels and no transportation costs between them. By minimizing expenditure, consumers will achieve real income while producers attempt to maximize production so as to increase gains from trade. Today, strong comparative advantage, exist in various sectors such as transportation and services primarily in developing countries with several potential for improving on business and financial services (Seyoum).
The argument of specialization according to classical theory of international trade requires a country to utilize natural endowment and generate in excess of home requirements. For example, China enjoy labor capacity while USA is capital endowed. China should specialize in production of labor intensive goods, and USA specializes in capital intensive goods. The surplus produce will be traded for imports from other countries in which it has cost disadvantages. It is on this argument that China’s trade surplus with USA remains valuable to both countries. Product and income groups through specialization combine to determine comparative advantage with higher income countries being stronger in capital intensive sectors and low income countries enjoying comparative advantage in labor intensive sectors (Kilduf and Chi 1-7). Therefore, a comparison of these two commodities relative prices in trading nations is necessary to determine the structure of trade.
Let’s consider a hypothetical case of two countries producing rice and cars in autarky. If relative prices of oranges to cars are better for country A compared to country B, then country A has a comparative advantage in oranges while country B enjoy comparative advantage in cars. Labor determines production of goods since labor requirements varies between them. Therefore according to Ricardo, comparative labor productivity influences trade patterns (Anderson 3). In some cases, a country can have an absolute advantage in production of both commodities. In this case, country B is better off manufacturing cars. Although country B may not be endowed with good soil and climate, it may decide to grow rice in green houses under autarky. Thus, it also ends up enjoying a higher absolute advantage in both oranges and cars than A. These two countries can still benefit from trade through orange car ratios as long as country A enjoys better orange to car ratio than country B.
Different countries have varied endowments in terms of capital, labor, Skills, technology and natural factors. Nowadays comparative advantage in terms of skills is a worthwhile consideration in the management appointments within firms. More capital endowed nations enjoy higher labor productivity, and when technology combines with endowment actual trade patterns are identified (Davis and Weinstein). Economies of scale are one of the difference encompassed in the trade theory indicating cost advantages to one country due to wider markets as a result of trade. Differentiated products flow as a result of wider markets as consumers seek specific foreign brands. This increased demand today emphasizes small business’s comparative advantage over large firms. These firms differ in terms of pricing policies, management consultation; start up resources and preferences for different equipments among others (Turvey and Escalante 1-3). Cost differences and trade liberalization lead to intra-industry trade and the emergence of new patterns of trade.
Labor productivity differences according to Ricardo lead to comparative advantage. In Ricardo’s case, 120 hours are needed to produce a unit of wine in England while Portugal requires 80 hours to produce the same unit. Alternatively 100 hours and 90 hours of labor are needed to produce a unit of cloth respectively. Ricardo observed that Portugal required fewer hours for production of both wine and cloth than England. Although Portugal holds absolute advantage in both commodities, Ricardo argued that it could gain more from trade if it specialized in the producing the good it holds higher comparative advantage. The cost ratio of wine to cloth is 80/120 and 90/100 for cloth to wine in Portugal. Respectively, England cost ratios are 120/80 and 100/90. Although Portugal has a lower cost ratio in both goods, it has a comparative advantage difference is greater in production of wine. It also enjoys an advantage in the absolute number of days of labor with 40 laborers less compared to 10 for cloth in England. Therefore, Ricardo in his example argued that Portugal should specialize in wine production and England Specialize in cloth production.
Argument has also been advanced that costs determine comparative advantage and comparative cost benefits both trading nations (Anderson 5). As outlined herein, the internal exchange rates are 1.2 and 0.89 for Portugal and England respectively. If the terms of trade is 1:1 then, England will produce clothes while Portugal produces wine then they engage in trade. England requires to give 1.2 units of cloth for one unit of wine and gains 0.2 units of cloth through trade. On the other hand, Portugal will give 1 unit of wine for a unit of cloth gaining 0.11 units since only 0.89 units is needed for 1 unit of cloth. Therefore, Ricardo argued from his example that both countries would benefit from trade by specialization although it was obvious Portugal had absolute advantage in both goods. Each nation would produce and export the product it enjoyed cost advantage.
Ricardo’s theory of international trade is a significant contribution even in marketing and business today. This theory is the basis of determination of external tariff by members of a preferential trade agreement in order to conform to an internal free trade neighborhood. We have also shown that the determination of specialization and gains from trade largely depends on the degrees of increasing returns, market power and differences in terms of factor endowment between countries. International trade, therefore, explains the structure of commerce and trade gains distributions. If each country specializes in producing a good in which it has a comparative advantage in, and then trade with other countries for products they have comparative disadvantage in eventually all trading countries will benefit. Therefore, comparative advantage principles provide a strong argument in support of free trade.
Anderson, James E. “International Trade theory”. (2006): 1-7. Print.
Davis, Donald and E. Weinstein. “An Account of Global Factor Trade”. American Economic Review.91, 2002.1423-53. Print.
Kilduff, P & Ting Chi. “Longitudinal patterns of comparative advantage in textile complex-part 2: Sectoral Perspectives”. Journal of fashion Marketing and Management. 10.2. (2006)
Seyoum, Belay. “Revealed Comparative Advantage & Competitiveness in Services: A study with emphasis on developing countries”. Journal of Economic studies, 34.5. (2007): 1-15. Print.
Turvey, G. & C.L Escalante. “Business startup survival challenges and strategies of agribusiness and non-agribusiness entrepreneurs”. Rev. Agricultural Finance. 66. 2007.print.