David Ricardo in his book, the Principles of Political Economy and Taxation first described comparative advantage. Comparative advantage is a situation in which a country, organization, company or individual produces a good or service a lower opportunity cost than its or his competitor.
Let us consider the example of two companies which produce both cloth and wine. The first company English Textiles and Wine Co. is located in England where there is an abundance of cotton and Portuguese Textiles and Wine Co. is in Portugal. The Portuguese company has to spend a lot of money to manufacture cloth whereas the English company spends very less money on the same. Both the companies spend equal amounts of money to produce wine. The English have a comparative advantage over the Portuguese in manufacturing cloth. So it would be prudent for the Portuguese company to turn exclusively to produce wine and trade with the English company for cloth. Similarly, the English company could withdraw from wine making; concentrate solely on manufacturing textile and trade with the Portuguese for the wine.
In other words, Ricardo propounded that countries specialization in producing those goods and services in which they already have expertise, thereby enable the world economy to increase production.
This theory underlies the assumptions stated below:
- No transport costs
- Costs are constant
- Only two economies producing only two goods
- Traded goods are homogenous
- Factors of production are perfectly mobile
- No tariffs or trade barriers
- Perfect knowledge
Effects with respect to trade cost:
Trade costs include transportation, could reduce, and possibly eliminate the benefits from trade including comparative advantage. It is argued that changes in the cost of trade, particularly transportation, with respect to the cost of production may be a factor in changes in international trade patterns.
Effects on the economy
Trade deficits are not automatically resolved by conditions that maximize comparative advantage. Trade deficit may be required to obtain a comparative advantage.
Over time as the market changes, the proportion of goods produced by one country compared to that of another country changes while maintaining the benefits of comparative advantage. However, this can lead to accumulation of national currencies in the banks of other countries where a separate currency is used.