Comparative advantage: the Ricardian model

David Ricardo’s Principles of Political Economy and Taxation (1817) has a four-number example that changed economics. Here are the hours of labour needed for one unit of each good:

Portugal needs less labour for both goods. It has an absolute advantage in cloth and in wine, so by Adam Smith’s rule England has nothing to sell it. Ricardo showed that both still gain if England makes cloth and Portugal makes wine. Portugal is better at both, but it is much better at wine (80 hours against 120) and only a little better at cloth (90 against 100). What matters is where each country’s edge, or handicap, is relatively largest.

Ricardo measured cost in labour hours, following the labour theory of value: goods exchange in proportion to the labour in them. That is why CUET 2021 and Hyderabad 2012 say his theory “is based on the labour theory of value”, and why Ricardo’s comparative advantage comes from differences in technology, meaning labour productivity (JNU 2019; Hyderabad 2010).

In England, 100 hours make one unit of cloth. The same 100 hours could make 100/120 = 0.83 unit of wine. So one unit of cloth costs England 0.83 unit of wine. That is the opportunity cost of cloth: what you give up to make it.

In Portugal, a unit of cloth costs 90/80 = 1.125 units of wine. Cloth is cheaper in England, in wine given up, than in Portugal.

A country has a comparative advantage in a good if its opportunity cost of that good is lower than its partner’s (CUET 2018; Hyderabad 2013; JNU 2010). It should specialise in and export that good: the one with the lowest opportunity cost, which isn’t always the one with the lowest labour cost (CUET 2019).

Two facts follow. Each country always has a comparative advantage in exactly one good, unless the ratios are equal, since if England’s cloth is cheaper in wine, England’s wine is dearer in cloth. And a country can have a comparative and an absolute advantage in the same good: they are different measures, not exclusive ones (Hyderabad 2019).

Exam tables come in two kinds, and the one mistake that costs marks is treating one as the other.

In an input table, a big number is bad. In an output table, a big number is good. So the ratio flips. If you’d rather not think about it, cross-multiply: in an input table, Home has the comparative advantage in X if a_X × b_Y < b_X × a_Y, where the b’s are Foreign’s numbers.

With labour as the only input and constant hours per unit, each country’s production possibility frontier is a straight line. Its slope is the opportunity cost. Load Ricardo’s numbers, then type in any table from a past paper. The dashed lines show what each country can consume if it specialises and trades at the price on the slider.

England will sell cloth only if it gets more than the 0.83 wine it could make itself with the same labour. Portugal will buy cloth only if it pays less than the 1.125 wine a unit of cloth costs it at home. So the price of cloth, in wine, must lie between the two opportunity costs:

Where in the band the price settles depends on demand, the subject of Lesson 3. If it lands at one end, say exactly at England’s own cost, England gains nothing and is willing to make both goods; Portugal takes all the gains (CUET 2022). So with trade, “both countries produce both goods” is the one outcome that can’t happen: the price can’t equal two different opportunity costs at once (DSE 2006). And both countries specialise completely only when the price is strictly inside the band (CUET 2023).

Trade needs different opportunity costs. If the ratios are the same, neither country has a comparative advantage and there is nothing to gain, whatever the absolute numbers. In JNU 2013, England needs 6 hours for wine and 10 for clothing, Portugal 3 and 5. Portugal is twice as productive at both, the ratios are both 0.6, and neither country will trade.

CUET 2025 asked when trade fails to benefit both: when the opportunity costs are the same in both countries, which is the same thing as one country’s absolute disadvantage being the same proportion in both goods. Being worse at both, or better at both, doesn’t stop trade.

In autarky a country consumes on its frontier. With trade it produces at one end of its frontier and swaps along the terms-of-trade line, which lies outside the frontier. So it can consume a bundle it could never make alone: a point beyond its production possibility frontier (CUET 2018). The world as a whole produces more because each country does what it is relatively best at (DSE 2019), and average well-being rises in both countries (Hyderabad 2020), even though, as Lesson 5 shows, some groups inside each lose.

Autarky prices. With one factor and constant costs, the price of X in terms of Y is a_X/a_Y, whatever people want to buy. Demand decides how much of each good is made, not the price. So pre-trade prices are independent of demand (JNU 2014; JNU 2021).

Wages. If Portugal is better at everything, why don’t its goods undersell England’s in both markets? Because wages adjust. England can sell cloth only if its wage is low enough to offset its lower productivity: English cloth costs 100w_E, Portuguese 90w_P. And Portugal sells wine only if 80w_P < 120w_E. So the English wage must lie between 80/120 and 90/100 of the Portuguese wage, between about 67% and 90%. If every price in one country were higher at the going wages, as in Hyderabad 2020, its exports would dry up and its wage would have to fall until it could sell something.

The assumptions. Two countries and two goods; labour the only factor, mobile between industries inside a country but immobile between countries (JNU 2015); constant labour costs; perfect competition; no transport costs. Constant costs give straight-line frontiers and complete specialisation. Lesson 3 relaxes them.