Comparative Advantage:

One of the most important concepts in international trade is the theory of comparative advantage formulated by Ricardo. According to this model countries involved in trade, specialize in producing the products in which they have comparative advantage. The theory of comparative advantage states that even if a country is able to produce all its good at lower costs than another country can, trade still benefits both countries, based on comparative costs. A country is said to have a comparative advantage in the production of a good if it can produce cloth at a lower opportunity cost than another country. If Country X can produce some set of goods at lower cost than a foreign country, and if Country Y can produce some other set of goods at a lower cost than we can produce them, then clearly it would be best for Country X to trade its relatively cheaper goods for the relatively cheaper goods of Country Y. In this way both countries may gain from trade. In Ricardo's example, there are two countries, England and Portugal, producing two goods, cloth and wine, using labor as the sole input in production. He assumed that the productivity of labor (i.e., the quantity of output produced per worker) varied between industries and across countries. Ricardo assumed that Portugal was more productive in both goods. He demonstrated numerically that if England specialized in producing one of the two goods and if Portugal produced the other, then total world output of both goods could rise. If a suitable terms of trade (i.e., amount of one good traded for another) was then chosen, both countries could end up with more of both goods after specialization and free trade then they each had before trade. This implies that England may however benefit from free trade even though it is assumed to be technologically inferior to Portugal in the production of everything.