ABSOLUTE AND COMPARATIVE ADVANTAGE
During the seventeenth and eighteenth centuries the dominant economic philosophy was mercantilism, which advocated severe restrictions on import and aggressive efforts to increase export. The resulting export surplus was supposed to enrich the nation through the inflow of precious metals. Adam Smith (1776), who is regarded as the father of modern economics, countered mercantilist ideas by developing the concept of absolute advantage. He argued that it was impossible for all nations to become rich simultaneously by following mercantilist prescriptions because the export of one nation is another ...view middle of the document...
After exchanging 6C out of 30C, the U.K. is left with 24C, which is equivalent to almost five hours’ labor time. Nations can produce more quantities of goods in which they have absolute advantage with the labor time they save through international trade. Though Smith successfully established the case for free trade, he did not develop the concept of comparative advantage. Because absolute advantage is determined by a simple comparison of labor productivities, it is possible for a nation to have absolute advantage in nothing. In Table I, if the labor productivity in cloth production in the United States happened to be 8 instead of 4, then the United States would have absolute advantage in both goods and the U.K. would have absolute advantage in neither. Adam Smith, however, was much more concerned with the role of foreign trade in economic development and his model was essentially a dynamic one with variable factor supplies, as pointed out by Hla Myint (1977).
I N T E R N AT I O N A L E N C Y C L O P E D I A O F T H E S O C I A L S C I E N C E S , 2 N D E D I T I O N
Absolute and Comparative Advantage
David Ricardo (1817) was concerned with the static resource allocation problem when he defined the concept of comparative advantage, which is determined not by absolute values of labor productivity but by labor productivity ratios. Ricardo would have interpreted the numbers in Table I by pointing out that, whereas U.S. labor in wheat production is 1.5 (= 6/4) times as productive as it is in cloth production, the U.K.’s labor productivity in wheat is only one fifth of its labor productivity in cloth. Therefore, the United States has comparative advantage in wheat and by inverting these ratios one can show that the U.K. has comparative advantage in cloth. This pattern of comparative advantage will not be affected if the United Sates has absolute advantage in both wheat and cloth, which will be the case if we raise U.S. labor productivity in cloth from 4 to 8. This is because 3/4 will still be greater than 1/5. The rationale of labor productivity ratios comes from Ricardo’s labor theory of value. Ricardo treated labor as the only source of value, as all other factors of production (such as capital) are also produced by labor. Thus the price of a good (P) is simply equal to the wage rate (w) times the labor (L) used in production, divided by output (Q), as profit is zero in competitive markets: P = (w L)/Q. Because the average productivity of labor is a = Q / L, P = w / a. If the labor market is competitive, the wage rate paid in all industries will be the same. Therefore, the ratio between the price of wheat (Pw) and the price of cloth (Pc) will be equal to the ratio between average productivity of labor in cloth (ac) and average productivity of labor in wheat (aw): [Pw / Pc] = [ac / aw]. This creates a direct link between comparative advantage and relative commodity prices in a...