The theory of comparative advantage was first set forth in 1817 by yet another British economist from the classical days, David Ricardo. And the historical context for the development of Ricardo's theory of comparative advantage is interesting in and of itself. At the time Europe was considering protecting its markets from American imports through the use of tariffs supporters, Europe's obvious concern was that America with its abundant land and relatively cheaper labor would have an absolute advantage in producing many goods. Under such a circumstance, America might therefore not import anything from Europe but merely export its cheaper goods, and thereby destroy jobs in Europe. To address these concerns, Ricardo articulated the principle of comparative advantage. The key concept is this, each country in the global trading market will benefit the most by specializing in the production and exports of those goods that it can produce domestically at relatively lower costs. At the same time, each country should import those goods it produces at relatively higher costs. Let me repeat that because it is so important. According to the theory of comparative advantage, each country will benefit by specializing in the production and export of those goods that it can produce domestically at relatively lower costs. At the same time, each country should import those goods it produces at relatively higher cost. Thus, in our previous example, Germany should specialize in auto production, and Algeria should specialize in food production, and both countries will benefit from trade even though Germany may have an absolute advantage in both food and auto production. And that was a pretty startling conclusion at least back in the classical days of David Ricardo. To demonstrate the theory of comparative advantage, let's go back in our time machine to David Ricardo's day and imagine a debate between Ricardo and another economist in front of a group of European trade ministers trying to decide whether to impose protective tariffs on America. The other economists, we will call John Strawman, and he is a strong supporter of the theory of absolute advantage. In fact, Strawman has just presented this table in support of his recommendation for a heavy tariff against American imports. This table illustrates how much labor is necessary to produce food and clothing in America versus Europe. So, looking at the table, which country has the absolute advantage in food? And which country has the absolute advantage in clothing? Please jot down your answer now before moving on. You can see clearly from this table that America has the absolute advantage in the production of both food and clothing. For example, in Europe it takes three full hours of labor to produce a unit of food but only one unit of labor in America. So, America has the clear absolute advantage. At the same time, in Europe it takes four hours of labor to produce a unit of clothing but only two hours of labor in America. Again, America has a clear absolute advantage. But looking at this table, the skeptical David Ricardo asked John Strawman the same question I am now going to ask you, which country has the comparative advantage in food versus clothing? Take a minute now to think about this and jot down your answers before moving on. So, which country has the comparative advantage in food versus clothing? Clearly, America has the comparative advantage in food, while Europe has the comparative advantage in clothing. This is because clothing is relatively more expensive in America, while food is relatively more expensive in Europe. Here's the way to think about this? In America, one unit of food costs one-half that of a unit of clothing. To put this another way, for the same amount of labor resources, you can make either one unit of food or one-half of the unit of clothing. So the ratio of food to clothing is two to one. In contrast, in Europe, one unit of food costs three-quarters of a unit of clothing. Again, to put this another way, for the same amount of labor resources, you can make either one unit of food in Europe or three-quarters of a unit of clothing. Now, here is the key point and the essence of the theory of comparative advantage, because food production is relatively cheaper in the US compared to US clothing production and because food production is relatively more expensive in Europe compared to European clothing production, Europe can trade some of its clothing for American food and both countries will be better off. Is this clear to you yet? If not, go back to the beginning of this module and work your way back to this point in the lesson. On the other hand, if you feel like you are well on your way to understanding the theory of comparative advantage, let's keep moving forward, as I will now use a production possibilities frontier analysis in our next module to shed further light on theory.
