Explain why the theory of comparative

Comparative advantage is an economic law, dating back to the early s, that demonstrates the ways in which protectionism or mercantilism as it was called at the time is unnecessary in free trade. Popularized by David Ricardocomparative advantage argues that free trade works even if one partner in a deal holds absolute advantage in all areas of production — that is, one partner makes products cheaper, better and faster than its trading partner. The primary fear for nations entering free trade is that they will be out-produced by a country with an absolute advantage in several areas, which would lead to imports but no exports.

Explain why the theory of comparative

Read more Comparative advantage It can be argued that world output would increase when the principle of comparative advantage is applied by countries to determine what goods and services they should specialise in producing.

Comparative advantage is a term associated with 19th Century English economist David Ricardo. Ricardo considered what goods and services countries should produce, and suggested that they should specialise by allocating their scarce resources to produce goods and services for which they have a comparative cost advantage.

Absolute Advantage

There are two types of cost advantage — absolute, and comparative. Absolute advantage means being more productive or cost-efficient than another country whereas comparative advantage relates to how much productive or cost efficient one country is than another.

Example In order to understand how the concept of comparative advantage might be applied to the real world, we can consider the simple example of two countries producing only two goods - motor cars and commercial trucks. Comparative advantage Using all its resources, country A can produce 30m cars or 6m trucks, and country B can produce 35m cars or 21m trucks.

This can be summarised in a table. In this case, country B has the absolute advantage in producing both products, but it has a comparative advantage in trucks because it is relatively better at producing them.

Country B is 3. However, the greatest advantage - and the widest gap - lies with truck production, hence Country B should specialise in producing trucks, leaving Country A to produce cars. Economic theory suggests that, if countries apply the principle of comparative advantage, combined output will be increased in comparison with the output that would be produced if the two countries tried to become self-sufficient and allocate resources towards production of both goods.

The gradient of a PPF reflects the opportunity cost of production. Increasing the production of one good means that less of another can be produced. The gradient reflects the lost output of Y as a result of increasing the output of X. Only when the gradients are different will a country have a comparative advantage, and only then will trade be beneficial.

In this case, international trade does not confer any advantage. Criticisms However, the principle of comparative advantage can be criticised in a several ways: It may overstate the benefits of specialisation by ignoring a number of costs.

These costs include transport costs and any external costs associated with trade, such as air and sea pollution. The theory also assumes that markets are perfectly competitive - in particular, there is perfect mobility of factors without any diminishing returns and with no transport costs.

The reality is likely to be very different, with output from factor inputs subject to diminishing returns, and with transport costs. This will make the PPF for each country non-linear and bowed outwards.

What is International Trade?

If this is the case, complete specialisation might not generate the level of benefits that would be derived from linear PPFs. In other words, there is an increasing opportunity cost associated with increasing specialisation.

For example, it may be that the maximum output of cars produced by country A is only 20 million compared with 30and the maximum output of trucks produced by country B might only be 16 million instead of 21 million.

Hence, the combined output from trade might only be 46 million units instead of the 51 million units initially predicted. Complete specialisation might create structural unemployment as some workers cannot transfer from one sector to another.

Relative prices and exchange rates are not taken into account in the simple theory of comparative advantage. For example if the price of X rises relative to Y, the benefit of increasing output of X increases. Comparative advantage is not a static concept - it may change over time.

For example, nonrenewable resources can slowly run out, increasing the costs of production, and reducing the gains from trade.

Countries can develop new advantages, such as Vietnam and coffee production.

Comparative Advantage

Despite having a long history of coffee production it is only in the last 30 years that it has become a global player. Many countries strive for food securitymeaning that even if they should specialise in non-food products, they still prefer to keep a minimum level of food production.

Explain why the theory of comparative

The real world is far more complex, with countries exporting and importing many different goods and services. According to influential US economist Paul Krugmanthe continual application of economies of scale by global producers using new technology means that many countries, including China, can produce very cheaply, and export surpluses.

This, along with an insatiable demand for choice and variety, means that countries typically produce a variety of products for the global market, rather than specialise in a narrow range of products, rendering the traditional theory of comparative advantage almost obsolete.The Theory of Comparative Advantage It seems obvious that if one country is better at producing one good and another country is better at producing a different good (assuming both countries demand both goods) that they should trade.

Absolute advantage and comparative advantage are two important concepts in international trade that largely influence how and why nations devote limited resources to the production of particular.

Jan 19,  · Using the principle of comparative advantage, explain why economic theory suggest that countries should specialize and trade with each other. Theory of International Trade International Trade takes place because of the variations in productive factors in different countries.

The variations of productive factors cause differences in price in different countries and the price differences are the main cause of international trade.

Economic Theories: Theory of International Trade and Comparative Advantage

The principle of camparative trade advantage is an important concept in the theory of international leslutinsduphoenix.com can be argued that world output would increase when the principle of comparative advantage is applied. To explain his theory of comparative cost advantage, Ricardo constructed a two-country, two-commodity, but one-factor model with the following assumptions: 1.

Explain why the theory of comparative

Labour is the only productive factor.

Comparative Advantage