Comparative Advantage Theory
of International Trade
Dr R. K. Das
Revisiting the Absolute Advantage Theory of
International Trade
• The theory suggested, among the trading
countries, a country should specialize in the
production of that goods or services over
which it holds absolute advantage than
others.
Limitations of this theory #1
• According to the absolute advantage theory, one
country has an absolute advantage in producing
one good while the other country has an
absolute advantage in producing another good.
But, many developing countries are lacking
behind in the area of technology therefore they
are not able to compete in the global market in
order to the production of goods, hence they are
unable to benefit form the free trade market.
Limitations of this theory #2
• In the real world, the production of goods are
dependent of various factors, such as land,
labour, capital and many other factors. Thus,
the goods cannot be divided according to
their absolute advantage for a country in
production basis. One country may require
more of one input and simultaneously, less of
another input than in another country.
Limitations of this theory #3
• According to the absolute advantage theory,
there is an exchange of one type of good with
another type of good between two countries.
But in today’s world many countries do
exchange similar types of goods also, such as
cars etc. this type of trade is also becoming a
trend in today’s world. It can be based on
market power and economies of scale.
Modification in the Theory
• David Ricardo, introduced this theory of
international trade, where he mentioned, among
the trading countries a country should specialize
over that good over which it holds comparative
advantage within the country.
• Absolute advantage means being more productive
or cost-efficient than another country whereas
comparative advantage relates to how much
productive or cost efficient one country is than
another product domestically produced.
Lets take an example
Country Country
A B
Good X 15 18
Good Y 12 20
In this setup, country A holds absolute advantage over both the
goods X and Y. hence, as per the absolute advantage theory,
international trade is not possible.
The theory of Comparative Advantage demonstrates that, in this
set up trade is still possible, but the art of specialization will be
different.
The Assumptions of the Model
• All other assumptions of Absolute Advantage
Theory will remain unchanged.
Country Country
A B
Good X 15 18
Good Y 12 20
• Country A holds absolute Advantage over both the
goods;
• But out of good X and good Y, for country A it is
comparatively advantageous to produce Y than X
as it enjoys lowest cost of production domestically;
• Similarly, in country B, good X is comparatively
advantageous than good Y.
Country Country
A B
Good X 15 18
Good Y 12 20
• So, as per the theory, country A should
specialize in the production of good Y and
country B should specialize in the production
of good X.
• Hence, country A should produce only good Y
and exports them to country B, whereas,
country B should produce only good X and
exports it to country A.
• Autarky without specialization
Country A Country B World
Output
Good X 15 (1) 18 (1) 1+1=2
Good Y 12 (1) 20 (1) 1+1=2
• Autarky with specialization
Country A Country B World Output
Good X 0 18 + 20 = 38 2.11 > 2
2.11
Good Y 12 + 15 = 27 0 2.25 > 2
2.25
Exchange Price
Good Autarky Exchange Price
Country A Country B
X 15 18 15 < 17 <18
Y 12 20 12 < 16 <20
Revenue Effect
Goods Country A Country B Revenue in Autarky
X 15 18 15 + 12 = 27
Y 12 20 18 + 20 = 38
Goods Country A Country B Revenue after Trade
X 15 18 Country A: (16 X 1) +
(12 X 1.25) = 31
Y 12 20 Country B: (17 X 1) +
(1.11 X 18) = 36.98
• World Revenue in Autarky : 27 + 38 = 65
• World Revenue after trade: 31 + 36.98 = 67.98
• Gain in revenue: 2.98
• World output in Autarky: 4 units
• World output after trade: 2.11 + 2.25 = 4.36
• Gain in output: 0.36
Conclusion
• Comparative Advantage theory of
international trade has demonstrated that
when trade was not possible following
absolute advantage theory, international trade
benefit both the countries as well as the
world.
