Theory of Comparative Advantage of Trade

Theory of comparative advantage of trade explains that why different countries specializes in export of only fewer goods despite having all types resources.

What is Trade?

  • The exchange of goods and services between two or more parties is called trade.
  • The trade is of two types i.e. Internal Trade and International Trade.
  • The internal trade where the different regions of the same country exchange goods and services with each other.
  • International trade refers to the exchange of goods and services between one or more countries.
  • Therefore, geographical differences in the resource endowment is primary cause of trade.

Why Trade is helpful?

  • Some countries have scarce resources.
  • Some countries have abundance of resource.
  • So, the products are exchanged between regions of abundance and scarcity.
  • Example: A country, say America, who has abundant Iron and Steel resources but the demand within America for Iron and Steel is less than supply. Therefore, it will be logical for America to sell the additional Iron and Steel and earn money. Hence, America will sell the additional Iron and Steel to the country where there is lack of Iron and Steel resources. Hence, both parties i.e. seller and buyer, benefit from trade.

What is absolute advantage of trade?

  • Take the example of India and Japan.
  • India has very large deposits of Iron ore whereas Japan has very small deposits of Iron ore.
  • Therefore, the supply is high in India because the price of Iron ore and wages of labour is less in India. In Japan, the price of iron ore is high due to low supply and high wage of labour.
  • In this case, India has absolute advantage over Japan in trade of iron ore because India can supply greater amount of Iron ore at lower price than Japan in the International market.

What is Comparative Advantage?

  • Definition: When first country can produce multiple products at a cheaper price than second country.
  • The first country has absolute advance in production of all those multiple products. But, the first country will not produce all those products.
  • It will produce only that product which yields the highest revenue per unit.
  • Let us understand this concept with the help of some numbers.
  Price per unit Units Sold Revenue (Rs.)
Product USA India USA India USA India
Wheat 2000/Quintal 3000/Quintal 10 10 20000 30000
Iron 4000/Quintal 5000/Quintal 10 10 40000 50000
Computers 20000/piece 30000/piece 10 10 200000 300000
Total     30 30 260000 380000

Let’s Disaggregate the theory of Comparative Advantage

  • In the Table. 1, one can see that the price of wheat, iron and computers is lower in USA whereas all the goods are costly in India.
  • Any set of countries who want to purchase 10 units each of these products, will have to pay Rs. 120000 more to India than the USA. Therefore the USA has an absolute advantage in all the products.
  • However, the USA will not produce all these products because USA has high end technology for production of Computers, requires lesser labour and yields highest revenue per unit.
  • Hence, the USA will try to produce and sell the maximum number of computers rather than diverting its resources to produce low end products like Wheat and Iron.
  • So, instead of producing 10 units each of these products, the USA will produce just 30 units of computer and earn Rs. 600000 (30 Units x Rs.20000) in revenue which is much higher than Rs. 260000 earned by selling all three products (See Table. 1) .

So, we can say that USA has comparative advantage of producing computers than other products. This way the USA can maximize its revenue.

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