RICARDOS THEORY OF COMAPARATIVE ADVANTAGE
First and foremost, you need to understand what an Opportunity
Cost is. This is fundamental but not difficult to get.Opportunity
Cost: Suppose youre a farmer who can produce in a given amount of
time either X unit of rice or Y unit of meat. Now you have to make
a very hard choice, which one to give a shot, obviously the
configuration which will fetch him the most bucks. You can either
cultivate only rice or only meat or an optimum combination of both.
Here comes Opportunity Cost (O.C). Its nothing but how much of a
certain product he has to give up in order to produce 1 unit of the
other. Here, for example, O.C of rice is (Y/X) and (X/Y)
vice-versa. He can produce 10 quintals of rice against 100 kilos of
meat. So O.C of rice = amount of meat production given up for 1kilo
rice= 0.1. For meat O.C is 10.P.S.:- Remember, from now on profit
(revenue) is no longer just (Sales cost of production=) but the O.C
must be also reduced to get the net profit because the producer can
then judge whether his investment is truly more profitable than the
other option. If not, hes in loss and hed switch business.Actually,
here the development is not accurate. The commodities must be
expressed in terms of monetary units i.e., 1kilo rice 30 Rs , 1kilo
meat 50 Rs.But here we can avoid those complications; well consider
it like a barter system. Suppose a laborer in China can either make
400 shirts or 20 cars in a month. Then 400 shirts are worth20 cars.
(production/laborer in a month):-CHINAEUROPE
SHIRTS40050
CAR2010
Here China has absolute advantage (lower productivity in both
cases) in both the industries but Europe has comparative advantage
for cars.According to Ricardos Theory, the countries should
specialize in the item where theyve comparative advantage. This
increases the total world consumption. Ill show how.CHINA: So O.C
of cars= 20 shirts.EUROPE: O.C of cars =5 shirtsWorld Market: 10
shirts1 car.So, according to Ricardos Theory (Dont think of the
statement too much now. You might get confused because the notions
of advantage and comparative have not been defined), China should
specialize in shirts and not in cars.20 shirts cost China 1 car but
after selling it in the world market (exporting), it can fetch 2
cars. So theres a net gain in consumption. Otherwise, if it had
manufactured cars, 1 car costs 20 shirts whereas finally China can
only manage a return of 10 shirts bad investment.For Europe, its
just the opposite. Itll make cars. It gave up shirts for a car but
ultimately hell come home happy with double that amount.
A country is said to have a comparative advantage in the
production of one good if its opportunity cost is lower than in any
other country.In the Ricardian model, market mechanisms insure that
each country indeed specializes in its comparative advantage.
Lets be a bit more formal.THE RICARDIAN BASIC
MODELAssumptions:1. 2 countries: Home and Foreign (*).2. 2 goods X
and Y.3. Different technologies :Technical coefficients: aX , a*X ,
aY , a*Y. Opportunity costs of X in terms of Y : (aX/aY),
(a*X/a*Y).This needs a clarification. Here aX,.. is the number of
laborers needed to produce unit good in unit time (here, month).
So, to in terms of the table, i.e, amount of goods manufactured by
a single laborer in a month= (1/aX). Therefore O.C of X in terms of
Y= { (1/aY)/(1/aX)}= aX/aY.Suppose, (aX/aY)> (a*X/a*Y).Then
Foreign has comparative advantage in X.Now in the World Market, the
relative price ratio is (pX/pY)=p.This means, when pY=1, p=pX lets
always be in the barter system, really handy. Price of Y with
respect to itself=1. So price of X relative to Y=pX/pY=p. So, 1
unit of X in the world market costs p unit of Y. To make it more
interesting, lets substitute X for cars and Y for shirts.So in the
world market 1 car buys p shirts. 1 shirt will fetch (1/p)
cars.Oppurtunity Cost of shirts in Home= (aY/aX) (aY/aX) cars had
to be given up.Now if, (a*X/a*Y) < p < (aX/aY), (1)Then Home
will go for shirts rather than cars and vice-versa.Because p <
(aX/aY) (1/p) > (aY/aX). Opportunity cost of Y is lower than the
relative price. Therefore, specialization in Y as exportation of Y
will bring back more cars. (Do you see the point of profit with
opportunity costs?).By similar arguments, you can show yourself
that Foreign will specialize in X.P.S.: The world price must be in
between in (1), otherwise countries wont produce any one of the
items depending on where the p lies- in front or behind. ( p
