Lecture Notes: David Ricardo's Law of Comparative Advantage

Introduction

• David Ricardo's Law of Comparative Advantage
  • Fundamental in international trade theory and general economics.
  • Explains how countries can benefit from trade by specializing in goods they can produce at a lower opportunity cost.

Key Concepts

• Absolute Advantage

  • When a country can produce a product using fewer resources than another country.
  • Example: India can produce more cotton and computers than Ghana using the same resources.

• Comparative Advantage

  • Occurs when a country specializes in producing goods or services at the lowest opportunity cost.
  • Key difference from absolute advantage is the focus on opportunity cost.

Example Scenario

• Assumptions

  • Two countries: India and Ghana.
  • Two goods: Cotton and Computers.
  • Identical quantity and quality of production factors in both countries.

• Production Capabilities

  • India: 20 tonnes of cotton or 10 computers.
  • Ghana: 16 tonnes of cotton or 2 computers.

• Opportunity Cost Calculations

  • India
    • 1 ton of cotton = 0.5 computers
    • 1 computer = 2 tonnes of cotton
  • Ghana
    • 1 ton of cotton = 0.125 computers
    • 1 computer = 8 tonnes of cotton

Comparative Advantage Analysis

• Cotton Production

  • Ghana has a comparative advantage because it gives up less (0.125 computers) compared to India (0.5 computers).

• Computer Production

  • India has a comparative advantage because it gives up less (2 tonnes of cotton) compared to Ghana (8 tonnes of cotton).

Practical Application: Trading PPC

• Production Possibility Curve (PPC) Diagrams
  • Plot PPC using production capabilities.
  • Identify comparative advantage by locating the biggest gap on the PPC axis between two countries.

Exchange Rates and Mutual Benefits

• Suitable Exchange Rate

  • Must lie between the opportunity cost ratios of the two countries.
  • Example: For 1 computer, exchange rate should be 2-8 tonnes of cotton.

• Mutual Benefits of Trade

  • As long as the exchange rate is within the opportunity cost ratios, trade is beneficial.

Determinants of Comparative Advantage

• Factor Endowments
  • Quantity and quality of resources such as land, labor, and capital.
  • Examples:
    • Ghana's abundance of fertile soil for cotton.
    • India's skilled labor force for computer production.

Conclusion

• Comparative advantage enables countries to trade and consume beyond their PPC.
• Upcoming content will explore how these theories allow for consumption beyond PPC.

Note: Future discussions will address real-world applicability and the breakdown of theoretical assumptions.