Agribusiness Management and Trade 3(3+0)

Lesson-38 Comparative Advantage Theory of International Trade

38.2 UNDERSTANDING COMPARATIVE ADVANTAGE THEORY

Suppose country A is better than country B at making automobiles, and country B is better than country A at making bread. It is obvious (the academics would say “trivial”) that both would benefit if A specialized in automobiles, B specialized in bread and they traded their products. That is a case of absolute advantage.

But what if a country is bad at making everything? Will trade drive all producers out of business? The answer, according to Ricardo, is no. The reason is the principle of comparative advantage.

It says, countries A and B still stand to benefit from trading with each other even if A is better than B at making everything. If A is much more superior at making automobiles and only slightly superior at making bread, then A should still invest resources in what it does best — producing automobiles — and export the product to B. B should still invest in what it does best — making bread — and export that product to A, even if it is not as efficient as A. Both would still benefit from the trade. A country does not have to be best at anything to gain from trade. That is comparative advantage. It is one of the most widely accepted among economists. It is also one of the most misunderstood among non-economists because it is confused with absolute advantage.

Let us again assume a world of two countries and two commodities. Malaysia and India are two countries and two countries, rubber and textiles are the two commodities. The production possibilities (supply conditions) in the two countries are such that both countries can produce both goods if they wanted. In this model we assume that one country has the absolute advantage over the other country in both the lines of production, and the other country has absolute disadvantage in both the lines of production (contrast to the Smith’s model, where one country has absolute advantage in one line and the other country in the other line). In Ricardo’s model, one country’s comparative advantage is greater in one line of production and the other country’s comparative disadvantage is smaller in the other line of production. International trade would bring production gains when these two countries enter into trade with each other. Let us see with the help of a numerical model, how that happens.

The following table shows the production possibilities in the two countries

Table 38.1. Production Possibilities in India and Malaysia

Countries	Commodities		International Opportunity (cost ratios)
	Textiles (units)	Rubber (units)
Malaysia	120 or	120	1:1
India	40 or	80	1:2

With ‘x’ factors of production, India can produce 120 units of textiles or 120 units of rubber of any combination of textiles and rubber at the constant opportunity cost ratio of 1:1 i.e., India can produce 1 unit of rubber (or textiles) by giving up the opportunity of producing 1 unit of textiles (or rubber). India is equally efficient in the production of the two commodities.

Malaysia on the other hand, is equally inefficient in either line of production compared with India; because, with ‘x’ factors of production it can produce either 40 units of textiles (compared with 120 units) or 80 units of rubber ( compared with India’s 120 units) or any combination of textiles and rubber at the constant opportunity cost ratio of 1:2. Here it can be noted that unit cost of producing rubber is less than the unit cost of producing textiles, when we measure unit costs in terms of the units of alternative commodity foregone.

In terms of comparative advantages and disadvantages following observations can be made.

1. India’s comparative advantage over Malaysia is greater in production of textiles (3:1) as compared to rubber (1.5:1). Therefore, India should specialize in the production of textiles rather than rubber, although India can produce both the goods equally efficiently.

2. Malaysia’s comparative disadvantage in relation to India is lower in the production of rubber (1:1.5) as against textiles (1:3). Hence Malaysia should specialize in the production of rubber, not because it has absolute advantage over India in this line but because its comparative disadvantage is less in this line of production than in the other line of production (textiles).

The theory of comparative advantage suggests that a country should specialize in the production and export of those goods in which either its comparative advantage is greater or its comparative disadvantage is less; and it should import those goods in the production of which its comparative advantage is less or comparative disadvantage is greater. Thereby, a country would be able to maximize its production and its consumption.

Before we examine the gains from trade for the two countries arising out of such specialization, let us consider what the production levels would be, for the two countries, in absence of trade. The table 38.2 represents this equilibrium under autarky. India produces and consumes 80 units of textiles plus 40 units of rubber, for a total production of 120 units. Malaysia produces and consumes 20 units of textiles plus 40 units of rubber for a total production of 60 units. The world production is 180 units.

Table 38.2. Production and consumption levels under autarky

Countries	Commodities		Total production & consumption (Units)
	Textiles (units)	Rubber (units)
Malaysia	80	40	120
India	20	40	60
World	100	80	180

If, however, the two countries decide to enter into trade breaking their isolation, there would be international specialization in production, leading to increase in the world production. In the table 38.3 the production gains are shown. World production has gone up from 180 to 200 after the introduction of trade. This is entirely due to production gains resulting from specialization in Malaysia, after trade. There are no production gains to be derived from specialization as far as India is concerned, because India’s level of production is the same both before and after trade. This suggests that small countries tend to benefit more than the large countries from the standpoint of specialization in production resulting from the international trade.

Table 38.3. Production Levels after International Trade

Countries	Commodities		Total production & consumption (Units)
	Textiles (units)	Rubber (units)
Malaysia	80	40	120
India	20	40	60
World	100	80	180

Unless both countries stand to gain from trade, there can be no trade between them. Production gains have gone to only Malaysia and India has no production gains from the trade. This means that Indian and Malaysia must have some consumption gains in order that there is mutually beneficial trade between two. How much each country gains from trade in terms of consumption depends entirely on the terms of trade. Instead of considering different terms of trades let us take one case where in the terms of trade between India and Malaysia are, say, 3:4 (i.e., 3 units of textiles have to be exported in order to import 4 units of rubber or vice versa). In this case, the both the countries will share the benefits equally. This is because these international terms of trade lie exactly between the two internal opportunity cost ratios of India and Malaysia. The consumption gains resulting from such international terms of trade for the two countries are shown in table 38.4.

India after trade produces 120 units of textiles and consumes 90 units of it and exports the remaining 30 units to Malaysia. By exporting 30 units of textiles, India receives 40 units of rubber as imports from Malaysia at the terms of trade of 3:4. This means, when the trade transacting is completed, Malaysia will have 30 units of textiles plus 40 units of rubber for its own consumption. Compare India’s post-trade consumption of the two commodities in table 38.4. (viz 90+40) with their pre-trade levels in table 38.2 (viz. 80+40) and will notice that a net consumption gain of 10 units. Similarly the gain for Malaysia will be 10 units.

Table 38.4. Consumption Levels after International Trade

Countries	Commodities		Total production & consumption (Units)
	Textiles (units)	Rubber (units)
Malaysia	80	40	120
India	20	40	60
World	100	80	180

Here you can notice that the world production gain of 20 units has resulted entirely from the production gain in Malaysia, and the production gain has been in terms of Malaysia product viz, rubber. Consumption gain for the two countries, 10 each for India and Malaysia has been in terms of India’s product viz, textiles. If the terms of trade are different gains for the countries will also differ.