What Is the Law of Comparative Advantage?

Peter Hann
Peter Hann
Businessman with a briefcase
Businessman with a briefcase

The law of comparative advantage was first proposed by David Ricardo, an economist working in London, England, in the first part of the 19th century. His work built on previous economic thought such as the theory of absolute advantage put forward by Adam Smith. Smith suggested that a country should engage in international trade using those products in which it had an absolute advantage — mean those it could make more efficiently than other countries could. Ricardo went further, pointing out that it makes sense for a country to specialize in products in which it has a comparative advantage, meaning the opportunity cost of producing certain goods or services is lower in that country than in other countries. By specializing in these goods and services and engaging in international trade, a country may increase its output.

The law of comparative advantage uses the concept of opportunity cost, which looks at available alternative uses of the same resources. For example, if England can produce a unit of cheese in 20 hours and a unit of wine in 30 hours, while Denmark can produce a unit of cheese in 10 hours and a unit of wine in 25 hours, then Denmark has an absolute advantage in both products. When England produces a unit of wine, however, it skips producing 1.5 units of cheese, while Denmark skips 2.5 units of cheese, making Denmark's opportunity cost of producing wine greater than England's, even though Denmark has an absolute advantage. It can, therefore, be said that England, in this example, has a comparative advantage in making wine. If England specializes in producing wine and Denmark specializes in producing cheese — in which it retains a comparative advantage in this example — both countries may increase their total output and national income by engaging in international trade.

The law of comparative advantage as put forward by Ricardo rests on the assumption that costs of production are constant, that transport costs are zero and that the products are exactly the same wherever they are made. The theory also assumes that the factors of production — such as capital — are mobile, that there are no tariffs, and that buyers and sellers have a perfect knowledge of the market. The theory only takes into account labor costs, because Ricardo held that all costs may in the last analysis be reduced to labor costs, an idea known as the labor theory of value. In the modern world, the law of comparative advantage may be seen to have some relevance to trade between developed and developing countries, though its operation is less evident in relation to trade between industrialized countries.

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