The Theory of Comparative Cost Advantage

Adam Smith’s theory of absolute advantage fails to explain the basis of trade in a situation where a country has absolute advantage in the production of both goods.

David Ricardo in his “Principle of Political Economy and Taxation” published in 1817 proved that even if a nation has absolute advantage in the production of both commodities; it is still possible for mutual beneficial trade to exist. He pointed out that what was relevant therefore was comparative advantage and not absolute advantage. According to Ricardo, absolute advantage is not a sufficient condition for mutually beneficial trade. According to him, the sufficient condition for mutually beneficial trade is a pattern of comparative advantage across nations. According to the theory of comparative advantage, whether or not one of the two countries is, in absolute terms, more efficient in the production of every commodity than the other, if each specializes in the product in which it has a greater comparative advantage, trade will be mutually beneficial.

Illustration:

From the previous example in Table 21.1, suppose that a nation becomes more efficient in both Crude Oil and Cocoa Production. Now, if each nation devotes half of its resources to each good, the production totals are:

Table 21.3: Production and Consumption Totals before Trade

Table 21.3 shows that Nigeria has an absolute advantage over Ghana in the production of both Crude oil and Cocoa. Both commodities can be produced more cheaply in Nigeria than in Ghana. In this case, the principle of absolute advantage fails to explain the reason for specialization and trade. The principle of comparative cost advantage is needed here to explain the basis for specialization and trade. With given resources, more of each good could be produced in Nigeria than in Ghana. To determine which good Nigeria and Ghana should specialize in, we need to calculate the opportunity cost ratios as done in Table 21.4 below.

Table 21.4: Opportunity Cost Ratio of Production

In Nigeria, the opportunity cost of producing one unit of crude oil in terms of cocoa is \( \cfrac{1}{2}\) unit of cocoa. This means that if Nigeria needs one more unit of crude oil, they must be prepared to reduce the production of cocoa by \( \cfrac{1}{2}\) unit. It also means that a unit of crude oil in Nigeria costs \( \cfrac{1}{2}\) unit of cocoa. In Ghana, the opportunity cost of producing one unit of crude oil in terms of cocoa is 2 units of cocoa. That is, in Ghana, the price of a unit of crude oil equals 2 units of cocoa. Nigeria (which has the absolute advantage in both commodities) possesses a comparative cost advantage in crude oil production, whereas Ghana (with an absolute disadvantage in both) has comparative cost advantage in cocoa production. Nigeria should specialise in crude oil and Ghana in cocoa.