Ricardos Theory of Comparative Advantage Essay Example | Topics and Well Written Essays - 750 words

Ricardos Theory of Comparative Advantage - Essay Example Ricardo's Theory of Comparative Cost states that trade helps two parties - whether individuals or countries - if they focus on the production of the commodity in which they have a comparative advantage, and then trade that one for the commodity for which they do not have a comparative advantage. A country has an absolute advantage if it can produce all goods cheaper than another country. Even a country which has an absolute advantage should not produce all goods. It should concentrate on the production of that commodity in which it has a comparative advantage, and exchange it for the goods it needs - produced by other countries. These countries would be producing those goods in which it has the least comparative disadvantage, and overall consumption and satisfaction would thus be maximized. Ricardo used the example of England and Portugal producing wine and corn to explain the theory. Portugal finds it easier to produce wine instead of cloth although it can produce both cheaper than England does. England produces cloth relatively easier than it does wine, although the cost of production for both are more than when they are produced in Portugal. In this scenario it is beneficial for both countries if Portugal produces only wine, which it can do with relative ease, and England produces only cloth, in which industry it reduces its costs. Portugal trades its excess wine for England's cloth. (David Ricardo and Comparative Cost) Let us assume that one worker in Portugal can produce 8 yards of cloth or 8 gallons of wine, in a year; and one worker in England can produce 8 yards of cloth or 4 gallons of wine. Portugal has an absolute advantage in wine production, as compared to England. In cloth production, both countries are equal. However, England has a relative advantage in cloth production as against wine, when compared to Portugal. Situation 1 Both the countries have no trade. Both countries have ten thousand workers each. The production possibilities would be as follows. Portugal has 5000 workers producing wine and 5000 producing cloth. Then Portugal produces 40,000 (8 * 5000) yards of cloth, and 40,000 (8* 5000) gallons of wine. If England had 5000 workers producing wine and 5000 producing cloth then it would produce 40,000 (8* 5000) yards of cloth and 20,000 (4* 5000) gallons of wine. There is no trade, and the economies exist independently. However, total production for both economies would be 60,000 gallons of wine and 80000 yards of cloth. Situation 2: Now, let us suppose that Portugal puts all its workers in producing wine, and England puts all its workers in cloth. Then Portugal will produce 80,000 gallons of wine, and England would produce 80,000 yards of cloth. Situation 3: If England produced only wine, and Portugal only cloth, then the total wine production would be 40000 gallons and cloth production would be 80, 000 yards. Production is maximized in Situation 2, which is the one in which England has a relative advantage in the production of cloth. Ricardo's theory was a strong argument in favor of free trade, although the model was rather a simplistic one. Some of the assumptions it made do not correspond to the real world situation. It is assumed that full employment exists in the countries, and that opportunity costs are constant. Full mobility of factors of production within a country, and immobility across borders are assumed. Surely, it's not as easy