The Theory of Comparative Advantage in Economics: An Overview

This essay provides a comprehensive overview of the theory of comparative advantage in economics, beginning with its theoretical framework and evolution from the absolute advantage theory. It explains the concept of opportunity cost and demonstrates how countries specialize in production based on their comparative advantages. The essay then delves into the limitations of the theory, discussing factors like transport costs, exchange rates, and diseconomies of scale. It also explores alternative theories, such as the Heckscher-Ohlin theory, and examines real-world examples like the Leontief paradox and intra-industry trade. The essay further analyzes the product life cycle theory and the new trade theory, concluding with a discussion of how these concepts apply to contemporary global trade dynamics. The essay highlights the complexities and nuances of international trade, providing a nuanced understanding of the subject.

Running head: FUNDAMENTALS OF ECONOMICS
Fundamentals of Economics
Name of the Student
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Author Note

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Comparative Advantage: Utilization of Scarce Resources
Introduction
Economics, as a subject, deals with several key aspects of concern, among which the
primary one is that of optimally meeting the demands and needs of all the people in an economy,
with the help of the scarce resources present in the economy. The resources of production, being
broadly classified into four types- labor, land, capital and entrepreneurship, are limited and are
therefore required to be utilized efficiently in order to maximize the production of goods and
services from the same (Baumol and Blinder 2015). However, not all countries have abundance
in all the resources of production and thus, different countries produce different types of
commodities and services based on the resources present with them, which in turn gives rise to
the concept of inter-country trade.
Over the years, various economic theories and concepts have come to existence in the
aspect of international trade and trade relations. One of the most widely used and comprehensive
trade theories present in the contemporary global scenario is the comparative advantage theory.
Keeping this into account, the essay tries to discuss the comparative advantage theory, its
implications and usefulness in the real scenarios of contemporary global trade activities (Laursen
2015). The primary objective of the essay is to explain the effectiveness of such theories in
explaining the production, consumption and allocation of scarce resources of production, in the
light of real trade scenarios in the global framework.

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Comparative Advantage: Theoretical Framework
The theory of Comparative Advantage in international trade came into existence as a
successor of the Absolute Advantage Theory, proposed by Adam Smith. This theory, first
highlighted the aspect of country specific specialization in production stating that a country
should emphasize in producing goods and services which can be more efficiently produced with
the help of the resources that are abundantly present in the country itself and should trade the
same in exchange of those commodities in the production of which the country do not enjoy such
productive advantages (Costino and Donaldson 2012).
However, in many real scenarios of trade set ups between two particular countries, it was
observed that one of the countries enjoy absolute advantage in production of all the goods and
services over the other country. This, in the absolute advantage framework, nullified the scope of
any trade relation among the two concerned countries. This, being the primary drawback of
absolute advantage theory, gave way to the Comparative Advantage Theory as was suggested by
David Ricardo (Hausmann et al. 2014). The Comparative Advantage Theory proposed by David
Ricardo, incorporates the economic notion of opportunity cost in the production process, while
assessing the comparative advantages of different countries in the production of different
commodities and services. The opportunity cost of production of one additional unit of a
commodity is measured in terms of the values of other commodities which have to be sacrificed
for the production of the former (Rios, McConnell and Brue 2013).
The above theoretical framework of the Comparative Advantage Theory, incorporating
the opportunity cost mechanism can be explained with the help of the following hypothetical
example, considering two countries, each producing ice cream and chocolates with their
resources:

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Commodities Country 1 Country 2
Ice creams 30 35
Chocolates 6 21
The hypothetical table, given above, shows the maximum number of ice creams and
chocolates each of the two countries can produce by fully utilizing their productive resources.
From the above numbers, it can be seen that Country 1, with maximum utilization of its
resources, can produce either 30 ice creams or 6 chocolates, whereas Country 2, can produce
either 35 ice creams or 21 chocolates. This in turn, implies that Country 2 enjoys absolute
advantage of production in ice creams as well as chocolates, over that of Country 1, thereby
making trade an invalid option in the light of Absolute Advantage Theory (Schumacher 2012).
This in turn, in the Absolute Advantage Theoretical framework implies that all the commodities
should be produced by Country 2 only. However, this is not a feasible solution in real case
scenarios as the resources cannot remain non-utilized in country 1.
The Comparative Advantage Theory provides a more realistic solution with the help of
the opportunity cost mechanism, which is shown with the help of the following table:
Opportunity Cost Country 1 Country 2
Ice Creams 0.2 0.6
Chocolates 5 1.67
From the above table, it can be observed that the opportunity cost of production of ice
creams in Country 2 (0.6) is higher than the same in Country 1 (0.2). Again the opportunity cost

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of production of chocolates is higher in Country 1 (5) than that of the same in Country 2 (1.67).
This makes it more feasible for Country 1 to produce ice creams only and Country 2 to produce
chocolates only and trade between one another. In doing so, the global production of both
chocolates as well as ice creams is expected to be higher than the same in the autarkic condition
(Bernard et al. 2012).
The Comparative Advantage Theory, though sounds more realistic than its preceding
theory, however, has several drawbacks, especially in the aspect of explaining the dynamics in
international trade in real case scenarios. The comparative advantage theory, while analyze the
trade opportunities between different countries, does not take into account several other
exogenous factors which may affect the dynamics, which primarily includes components like the
cost of transport of the goods and services produced between the potential trading partner
countries (Noussair, Plott and Riezman 2013).
Often this cost if transport may be so high that they can entirely rule out any comparative
advantage in production of goods and services of the countries. Other affecting factors also
include components like international exchange rate dynamics, socio-political aspects affecting
the transport of commodities and others. The theory also overlooks the problems of
diseconomies of scale which might occur in a country due to over specialization and excess
supply issues. Another drawback of Ricardo’s theory is that it assumes that all the commodities
are produced using same resource, which Ricardo takes to be labor to be specific (Costinot and
Rodríguez-Clare 2014).
However, in reality, goods and services are produced with the help of combinations of
different amounts of various factors of production, which is considered in one of the succeeding

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trade theories, popularly known as the Hecksher-Ohlin’s Theory of Factor Endowment.
According to this theory, different commodities and services require different amounts of
productive resources, depending upon their nature and these factors of production are also
present in different proportions in different countries. Keeping these resource endowments in
consideration the countries need to produce and export different commodities and services, such
that both the domestic production as well as the global efficiency is maximized (Bond, Iwasa and
Nishimura 2012).
This theory of production and trade seems to be more close to reality than the Ricardian
Theory. However, there still remain several aspects in the Hecksher-Ohlin Theory, which are
found to be less relevant in the real world trade scenarios. There may remain several hurdles
which are faced by the countries in general in utilizing their abundant resources effectively,
which can be elaborated with the help of examples of such occurrences in the contemporary
global trade framework.
Example: The USA is considered to be one of the primary countries with highest per head capital
over the years. This high abundance of capital resources makes it apparently obvious for the
country to produce and export those commodities and services whose production are capital
intensive in nature and import those commodities and services which require more labor than
capital, as per the theoretical assertions of the Hecksher-Ohlin Framework. However, in reality
USA is seen to be producing and exporting more of labor intensive commodities than that of the
capital intensive goods, which directly contradicts the theoretical framework.
The above example of discrepancies between the theoretical assertions and observed
phenomena, particularly in the economy of the USA is named as the Leontief Paradox, which in

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turn makes the Hecksher-Ohlin Theory practically infeasible in explaining the actual
mechanisms in producing, consuming and allocating the scarce resources (Mariolis and
Tsoulfidis 2016). The anomaly in the expected and proposed outcomes in the international trade
dynamics can be explained by the presence of several regulatory or natural bindings in the
economies in general. One such example of regulatory hurdles is the presence of minimum wage
laws in many of the countries, especially the developed ones. The presence of high minimum
wage makes the cost of labor high in these countries, even when labor are abundantly present in
such economies. Minimum wages, implemented with the objective of increasing the welfare of
the society as a whole, leads to a tradeoff between equity and efficiency aspects, thereby
hampering efficient allocation of resources in the production of goods and services (Meer and
West 2015).
Another aspect of the actual international trade scenario, which has become increasingly
relevant in the contemporary periods, is the aspect of intra-industry trade, which cannot be
considerably, explained by none of the above comparative advantage theories in this aspect. The
phenomenon of intra-industry trade refers to the similar commodities or services exchange
among different countries, the commodities exchanged belonging to the same industry.
Example: Europe is seen to export millions of automobiles to different countries. However,
Europe also imports automobiles in huge numbers from other countries, which indicates towards
the presence of intra-industry trade, which is overlooked by the conventional trade theories.
There have been substantial works in the aspect of explaining this phenomenon of intra-industry
trade. While some of the economists proposes the presence of commodities of different factor
endowments in single industry, due to subtle variations in the nature of the goods produced,

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several others points out that not all commodities, even in the same industry, are produced under
similar technical conditions.
One of the prevailing trade theories, which try to explain this phenomenon to some
extent, keeping into consideration the aspects of comparative advantages in production of
commodities and economies of scale is the Product Life Cycle Theory of Vernon, which can be
explained with the help of the following diagram, depicting the different stages of trade cycle of
most of the commodities produced in an economy and the corresponding sales volume of the
same:
Figure 1: Stages in the Product Life Cycle Theory
(Source: Wright.edu, 2018)
As is evident from the above figure, in the initial stage of introduction of the product in
the market of a country, the product relevant to the productive advantages and factor intensities

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of the economy is introduced in the market. In the growth stage, the product sees increased
demand, which increases the cost efficiency of the firms, thereby leading to economies of scale
in production. However, the demand for most of the products becomes saturated after some time,
with the maturity stage being reached (Bilir 2014). This denotes stagnation in the demand for the
same product, with the same being present with all the customers and the customers waiting for
new and improved products. The final stage sees a decline in the demand for the same, thereby
decreasing the profit in the industry. The customers start preferring higher end products, thereby
leading to intra-industry trade in the concerned economy.
Another theory, proposed by Paul Krugman, known as the New Trade Theory, which
emphasizes on the fact that the countries tend to produce commodities according to the
increasing returns, though the consumption habits of the residents do not depend on the same.
However, the theory does not take into account the aspects hampering free flow of commodities
and intra industry trade among the different nations, which primarily includes the trade
restrictions and socio-political tensions among the nations, which makes imports and exports
difficult (Ossa 2012).
All the previously discussed trade theories emphasize on the natural comparative
advantages which the countries enjoy due to the inherent presence of advantageous factors of
production, failing to highlight the fact that the countries can create several factor advantages for
themselves, which are highlighted by the Porter’s Diamond Strategy. These include skilled labor,
human capital, increased efficiency of government infrastructure and technological innovations
(Riasi 2015). According to the theory, there are several interrelated factors which lead to national
comparative advantages for the economy, which are diagrammatically represented as follows:

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Figure 2: Porter’s Diamond Strategy
(Source: Claessens, 2018)
This theory, focusing on the factors like the demand conditions, backward and forward
industry linkages, the scopes of expansion of new industries, the factor conditions and the
structure of rivalry and strategic options of the firms, provides a more comprehensive outlook in
the aspects of the international trade dynamics and in the aspects of allocation of scarce
resources in the production of different commodities and services.
Conclusion
From the above discussion, it is evident that with the consistently increasing complexities
in the global trade and commerce and with more determining factors getting involved in both the
demand as well as the supply side, the trade theories like that of Comparative Advantage Theory
or Hecksher-Ohlin Theory, provide only partial explanations to the usage and allocation of

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scarce resources in different production activities across different countries. More inclusive
frameworks are developing, like that of Porter’s Model or Trade Cycle Model, which aims to
discuss these issues in a multidimensional framework, incorporating wider ranges of causal
factors and determinants of the production behavior of the countries in the international scenario.

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