How does the theory of comparative advantage support the idea of free trade agreements?
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A country can produce a good or service at a lower opportunity cost than the other country Show
What is a Comparative Advantage?In economics, a comparative advantage occurs when a country can produce a good or service at a lower opportunity cost than another country. The theory of comparative advantage is attributed to political economist David Ricardo, who wrote the book Principles of Political Economy and Taxation (1817). Ricardo used the theory of comparative advantage to argue against Great Britain’s protectionist Corn Laws, which restricted the import of wheat from 1815 to 1846. In arguing for free trade, the political economist stated that countries were better off specializing in what they enjoy a comparative advantage in and importing the goods in which they lack a comparative advantage. What is an Opportunity Cost?To understand the theory behind a comparative advantage, it is crucial to understand the idea of an opportunity cost. An opportunity cost is the foregone benefits from choosing one alternative over others. For example, a laborer can use one hour of work to produce either 1 cloth or 3 wines. We can think of opportunity cost as follows: What is the forgone benefit from choosing to produce one cloth or one wine? Therefore:
Comparative Advantage and Free TradeComparative advantage is a key principle in international trade and forms the basis of why free trade is beneficial to countries. The theory of comparative advantage shows that even if a country enjoys an absolute advantage in the production of goods, trade can still be beneficial to both trading partners. Practical Example: Comparative AdvantageConsider two countries (France and the United States) that use labor as an input to produce two goods: wine and cloth.
The information provided is illustrated as follows: It is important to note that the United States enjoys an absolute advantage in the production of cloth and wine. With one labor hour, a worker can produce either 20 cloths or 20 wines in the United States compared to France’s 5 cloths or 10 wines.
To determine the comparative advantages of France and the United States, we must first determine the opportunity cost for each output: France:
The United States:
When comparing the opportunity cost of 1 cloth for both France and the United States, we can see that the opportunity cost of cloth is lower in the United States. Therefore, the United States enjoys a comparative advantage in the production of cloth. Additionally, when comparing the opportunity cost of 1 wine for France and the United States, we can see that the opportunity cost of wine is lower in France. Therefore, France enjoys a comparative advantage in the production of wine. Comparative Advantage and its Benefits in Free TradeHow does identifying each country’s comparative advantage aid in understanding its benefits in free trade? First, let’s assume that the maximum amount of labor hours is 100 hours. In France:
In the United States:
Following Ricardo’s theory of comparative advantage in free trade, if each country specializes in what they enjoy a comparative advantage in and imports the other good, they will be better off. Recall that:
In France, the country specializes in wine and produces 1,000 barrels. Recall that the opportunity cost of 1 barrel of wine in the United States is 1 piece of cloth. Therefore, the United States would be open to accepting a trade of 1 wine for up to 1 piece of cloth. The potential gains from trade for Europe by specializing in wine is represented by the arrow: In the United States, the country specializes in cloth and produces 2,000 pieces. Recall that the opportunity cost of 1 piece of cloth in France is 2 barrels of wine. Therefore, France would be open to accepting a trade of 1 cloth for up to 2 barrels of wine. The potential gains from trade for the United States by specializing in cloth is represented by the arrow: Therefore, using the theory of comparative advantage, a country that specializes in their comparative advantage in free trade is able to realize higher output gains by exporting the good in which they enjoy a comparative advantage and importing the good in which they suffer a comparative disadvantage. Related ReadingsThank you for reading CFI’s guide to Comparative Advantage. To keep advancing your career, the additional CFI resources below will be useful:
How does comparative advantage influence trade?Comparative advantage is a key principle in international trade and forms the basis of why free trade is beneficial to countries. The theory of comparative advantage shows that even if a country enjoys an absolute advantage in the production of goods, trade can still be beneficial to both trading partners.
How do free trade policies and comparative advantage benefit the global economy?Countries that are open to international trade tend to grow faster, innovate, improve productivity and provide higher income and more opportunities to their people. Open trade also benefits lower-income households by offering consumers more affordable goods and services.
What are theories in support of free trade?Free Trade Theories
Through the years of debates over the benefits versus the costs of free trade policies to domestic industries, two predominant theories of free trade have emerged: mercantilism and comparative advantage.
What does the theory of comparative advantage put forward about the gains from trade?The gains from trade are only based on comparative advantage, not on absolute advantage. A country or person can have an absolute advantage in both goods or activities, and yet still gain from trade by specializing in the good or activity in which it has a comparative advantage.
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