Introduction
Comparative advantage is a fundamental principle of economics that considers a situation where a country is able to produce a certain product at a lower opportunity cost than the other country. An opportunity cost is referred to a cost incurred when doing one thing instead of another. For example, the opportunity cost of producing wine is foregoing the production of producing cheese.
Assumptions
- The Ricardian model is based on the following assumptions
- Two countries and two goods are involved in the trading activities
- The only factor of production is labor and the market structure is the perfect competition which brings about general equilibrium framework.
- Labor is considered homogeneous in the domestic country while goods are homogenous across countries.
Structure
According to the Ricardian model of trade, the comparative advantage determines which country will produce which good in the market. A particular country will tend to produce a good that it has a comparative advantage in producing over the other country. For instance, let assume that labor is the only production factor of producing shoes and wine. If one unit of labor is used to produce shoes in country A within and two units of labor to produce wine, while two units of labor in country B is used to produce shoes and one unit of labor to produce wine, country A has comparative advantage of producing shoes while country B has a comparative advantage of producing wine. In other words, country B gives up less to make wine than country A does.
Prediction
The comparative advantage principle brings about many implications in the economic arena. This principle tends to result into the international trade and specialization. In the previous example, the opportunity cost for a country A to produce wine is two pairs of shoes, since they produce shoes twice as fast. On the other hand, in country B, the opportunity cost for producing one unit of wine is 0.5 pairs of shoes since they make wine twice as fast. As a result, country A will specialize in producing shoes while country B will specialize in producing wine and the two will enter into the trade for a product they have a comparative advantage in producing.
Graphical explanation: Labor Productivity and Comparative Advantage: The Ricardian Model
The home country has a competitive advantage of producing cheese while the foreign country has the competitive advantage of producing wine. The RD and RD’ curves depicts that the demand for chees relative to wine is a decreasing function of price while RS is a supply curve showing that the supply for cheese relative to wine is an increasing function of the price. However, the RS is abnormal curve being a “step” with flat sections linked with vertical section. This indicates that there would be no supply of cheese when the price is below aLC/aLW. This is because home will produce cheese when Pc/Pw < aLC/aLW while the foreign country will produce wine when Pc/Pw<a*LC/a*LW, assuming that aLC/aLW < a*LC/a*LW. Therefore, the relative price of cheese that is below aLC/aLW result to no cheese production in the world.
When the relative price of cheese Pc/Pw = aLC/aLW implies that workers in the home country can earn the same amount when producing either cheese or wine. As a result, the home country will be willing to supply any relative amount of the two goods producing the horizontal section of the supply curve. When Pc/Pw>a*LC/a*LW, there will be no production of wine in the foreign country and more production of cheese. As a result the relative supply of cheese will become infinite.
