Critically discuss the ricardian theory of comparative advantage. How is it different from adam smiths theory of absolute advantage?
Answers
Answer:
Absolute Advantage
The differentiation between the varying abilities of companies and nations to produce goods efficiently is the basis for the concept of absolute advantage. Absolute advantage looks at the efficiency of producing a single product. This analysis helps countries avoid the production of products that would yield little or no demand, leading to losses. A country’s absolute advantage, or disadvantage, in a particular industry, can play an important role in the types of goods it chooses to produce.
As an example, if Japan and Italy can both produce automobiles, but Italy can produce sports cars of a higher quality and at a faster rate with greater profit, then Italy is said to have an absolute advantage in that particular industry. In this example, Japan may be better served to devote the limited resources and manpower to another industry or other types of vehicles, such as electric cars, in which it may enjoy an absolute advantage, rather than trying to compete with Italy's efficiency.
Comparative Advantage
Comparative advantage takes a more holistic view, with the perspective that a country or business has the resources to produce a variety of goods. The opportunity cost of a given option is equal to the forfeited benefits that could have been achieved by choosing an available alternative in comparison. In general, when the profit from two products is identified, analysts would calculate the opportunity cost of choosing one option over the other.
For example, assume that China has enough resources to produce either smartphones or computers. China can produce 10 computers or 10 smartphones. Computers generate a higher profit. Therefore, the opportunity cost is the difference in value lost from producing a smartphone rather than a computer. If China earns $100 for a computer and $50 for a smartphone then the opportunity cost is $50. If China has to choose between producing computers over smartphones it will select computers.
The Ricardian comparative costs analysis is based upon the following assumptions:
(i) There is no intervention by the government in economic system.
(ii) Perfect competition exists both in the commodity and factor markets.
(iii) There are static conditions in the economy. It implies that factors supplies, techniques of production and tastes and preferences are given and constant.
(iv) Production function is homogeneous of the first degree. It implies that output changes exactly in the same ratio in which the factor inputs are varied. In other words, production is governed by constant returns to scale.
(v) Labour is the only factor of production and the cost of producing a commodity is expressed in labour units.
(vi) Labour is perfectly mobile within the country but perfectly immobile among different countries.
(vii) Transport costs are absent so that production cost, measured in terms of labour input alone, determines the cost of producing a given commodity.
(viii) There are only two commodities to be exchanged between the two countries.
(ix) Money is non-existent and prices of different goods are measured by their real cost of production.
(x) There is full employment of resources in both the countries.
(xi) Trade between two countries takes place on the basis of barter.