Ricardo’s Law of Comparative Advantage

David Ricardo by Thomas Phillips, oil on canvas, circa 1821
Wikimedia Commons / Thomas Phillips (1770-1845)

The next classical law of economics we shall investigate is Ricardo’s law of comparative advantage. David Ricardo (1772-1823) was a highly successful British stockbroker and market speculator before he  became a political economist. Reputedly, he read Adam Smith’s Wealth of Nations in 1799 during a stay at Bath, and that book’s ideas began a life-long fascination with economics. 

The Wealth of Nations was written primarily as an attack on mercantilism, which was the reigning economic philosophy in Europe from the 16th to the late 18th century. Mercantilism held that the wealth of a nation was increased by accumulating monetary reserves (particularly in the form of gold). They advocated  establishing a positive balance of trade, where they sold more goods to other nations than those nations sold to them, thereby bringing in the desired monetary reserves. As a part of this policy, mercantilists advocated high tariffs on imported goods to discourage the loss of money from buying other nations’ goods. Other mercantilist policies to discourage imports and encourage exports included banning the export of gold and silver,  requiring the use of their own nation’s ships to export goods, subsidizing exports, and forbidding their colonies from trading with other nations.

Adam Smith banished mercantilism from Europe by the wide acceptance of the ideas in his Wealth of Nations. Smith thought the source of the wealth of a nation consisted primarily in its capacity to produce economic goods. The economic goods themselves were wealth. Money was only a claim-check for a portion of that wealth. Therefore, if a nation aspired to be wealthy, it should encourage the increase of the country’s  capacity to produce goods. But supply of goods must be balanced by their consumption, i.e. their economic demand, for the supply of wealth to be stable. If imports are discouraged or banned, foreign nations will not have the means to buy the country’s exports. Fundamentally, the real driver of wealth production in foreign trade is the exchange of one country’s goods for the goods of another nation. If a mercantilist encouraged exports and discouraged imports, then ironically he would actually be making his country poorer! He would be sending wealth out of the country without allowing a matching import of wealth.

Ricardo’s success in economic speculation was rooted in relatively free markets. As a result Adam Smith’s ideas fell on fertile ground when Ricardo read the Wealth of Nations, most especially the criticism of mercantilist barriers against free trade. In 1817 he published his thoughts on economics, including what is now called the law of comparative advantage, sometimes called the theory of comparative advantage.

Comparative advantage is a relatively subtle concept and requires some care in defining it. Absolute advantage is a much easier idea to understand. If nation A can produce a good at less cost than another country B, then it makes sense for A to export the good to B. Country A then has an absolute advantage in producing and exporting the good. One conceptual problem here is defining what cost means to both countries with differing units of money. Ricardo, being a believer in the labor theory of value, expressed costs in hours of labor to produce the good. However, we now know that the value of a good is defined by its utility to the buyer, as we will discuss in detail when we come to the law of marginal utility. Since the utility of a particular good is different for every human being, the value of a good is necessarily a subjective thing, not objective. And the cost of production is the value of the raw materials and labor needed to produce. So how are costs of  producing a good determined?

In a single market using the same denomination of money, this problem is solved by bargaining between the buyer and seller of a good, By this I do not mean bartering, although bartering  is one form of the kind of bargaining I mean. By bargaining I mean the process of finding the equilibrium price of a good that we discussed with the law of supply and demand. In this way people can come to an agreement on the price of a good, even though their personal valuations of the good are different. In the same manner the money of another country is a good that can be bought with an agreed-upon price, called the exchange rate of the foreign currency. Then people in both nations can compare the production costs of a good by conversion through the exchange rate.

Clearly, if country A has an absolute advantage in producing a good, it should export the good to country B and country B should import it. (At an agreed-upon price of course!) This is advantageous to both countries. But what Ricardo discovered was both more subtle and more far-reaching. Suppose a person in country A takes the ratio of the cost of producing a good to its value (i.e. its price) in his country’s market, This gives his country’s cost of production in terms of some  units of his country’s valuation of the good. Country B can similarly calculate their cost of production per unit of valuation in country B. If country B has a smaller cost of production per unit of their country’s valuation than country A’s cost per unit of country A’s valuation, then country B has a comparative advantage over country A in producing the good.

Ricardo’s law of comparative advantage can now be formulated as follows:

If one country has a comparative advantage over another country with some good, then even if that other country has an absolute advantage, it is advantageous to both countries for the country with the comparative advantage to export the good to the other country.

This is a counter-intuitive result to say the least! It is easy to see why   such a  trade is advantageous to the country with the comparative advantage, as they can demand a price for their export greater than the good’s valuation in their own country. It is not so easy to see why it is advantageous for the importing nation if they should have an absolute advantage. Having an absolute advantage means that they can produce the good at a smaller cost, but if the country does not have comparative advantage, their domestic companies would have a higher cost per “unit of value” sold in their own domestic market than what the country with the comparative advantage would have in supplying them; the valuation of the good compared to its cost is lower in their country than in the country with the comparative advantage. For this reason, even if the country possesses an absolute advantage, they can get a smaller price  for the goods if they allow the country with the comparative advantage to supply their needs. The capital freed up by not having to produce the good could then by used for production of other goods with a higher economic value.

There are times when mathematical reasoning is clearer and the conclusions more certain. If you would like to see a more mathematical demonstration of Ricardo’s law, click here to read a PDF file that gives it.

The law of comparative advantage says that there is only advantage to be had from free trade between countries.  Modern day controversies over this claim will be discussed in future posts.

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