Hi everybody, David Ricardo's Fundamental Law of Comparative Advantage. Fundamental, of course, when it comes to international trade theory, but more generally in the whole of economics, really hardcore theory here. So in this video, I'm going to explain with examples...
what the law actually states. I'm going to draw PPC diagrams, trading PPC diagrams. I'm going to talk about how a rate of exchange is important for comparative advantage theory to hold. And at the end I'm going to talk about what determines how a country country gains the comparative advantage. Let's start, first of all, by looking at the key difference between two fundamental concepts in trade theory, that of absolute advantage and comparative advantage, both of which are defined at the top.
So, absolute advantage is a very simple idea that occurs when a country can produce a product using fewer factors of production than another nation. A very simple idea, whereas comparative advantage states that a country should specialise in producing goods or services at the lowest opportunity cost, only then should it trade with another nation. So key words here, specialization but only in goods and services a nation can produce at the lowest opportunity cost relative to another nation. So the key difference is in this notion of opportunity cost. Let's look at examples that make it fundamentally clear.
I'm going to assume here there are only two countries in the world producing only two goods and services in the world. Those goods and services are identical. We're going to assume that exactly the same quantity and quality of factors of production are available for both India and Ghana.
The assumptions sound ridiculous, but it enables us to come to conclusions that do apply to the real world. In a future video coming up, I'm going to actually go through the assumptions and how some of them do break down. So don't really kill the assumptions just yet. Go with the flow. So let's assume there's only India and Ghana and they can produce either cotton or computers using the same factor of...
of production exactly the same quantity and quality, India can produce either 20 tonnes of cotton or 10 computers, Ghana can produce either 16 tonnes of cotton or 2 computers. Using the law of absolute advantage, it's clear to see that India have the absolute advantage in producing both computers and cotton. Using the same factors of production, they can produce more. They're more efficient with the same factors of production.
But we know that the law of comparative advantage underpins everything, that's more important. So let's move away from that, let's move to this table and see for each ton of cotton made, for each computer made, how much is each nation giving up to produce it because that's what comparative advantage says we need to look out for, the opportunity cost of production. Let's look at cotton production first of all.
For India to produce one ton of cotton, how many computers are they giving up to do that? Well to work that out is very simple. You To produce one ton of cotton, right?
So what we need to do is divide both sides, right? Tons of cotton and computers, divide both sides by 20. Divide both sides by 20, then to produce one ton of cotton, India are giving up half a computer. What about Ghana?
For Ghana to produce one ton of cotton, how many computers do they give up? Divide both sides by 16, they're giving up an eighth of a computer. Let's do the same for computers. For India to produce...
produce one computer, how many tonnes of cotton are they giving up? Divide both sides by ten, they're giving up two tonnes of cotton. What about Ghana?
To produce one computer, how many tonnes of cotton are they giving up? Well, divide both sides by two, and Ghana have to give up eight tonnes of cotton to produce one computer. So David Ricardo says, right, having done those calculations, work out, whoever's got the lowest opportunity cost wins. They should then specialise in producing that good or service.
and trade freely with another country. So who's got the opportunity cost advantage in producing cotton? Well, it's Ghana, isn't it?
It's Ghana. Why is it Ghana? Because for each ton of cotton they're producing, they're only giving up an eighth of a computer, whereas India are giving up half a computer.
So Ghana are giving up less. They have the opportunity cost advantage. What about for computer production? Well, India have the comparative advantage there. How do we know that?
Well, India are only giving up... two tons of cotton for each computer made, whereas Ghana are giving up more, they're giving up eight. So India have the opportunity cost advantage there. So Ghana wins for cotton, India wins for computers.
Each country should therefore specialise in those respective products and trade with each other. Now, in your exam, you might have to draw a trading PPC. And if you do, it's very, very simple. You've done them before in micro.
This is another kind of micro PPC based. diagram We've got computers on the y-axis, cotton on the x-axis. We've got figures in this table on the left.
We just have to plot the PPCs with respect to the figures that were given. So for India, they can either, using the same factors of production, produce either 20 tonnes of cotton or... can produce 10 computers so plot the two points we get to a PPC that looks something like that so we can say that that is India's trading PPC for government it's either 16 tons of cotton or or it's two computers, plot the two points together, and we get Garner's PPC.
Now this is a really useful thing to do, to work out comparative advantage, without the need to do numerical calculation. The numerical stuff is easy anyway, but if you just drew the PPC curves, there's a little trick to work out who's got the comparative advantage in what product. The way to do it is, when you've done the PPCs, go to the axis where there is the biggest gap between the two PPCs. And this is... case is the y-axis, the computer axis.
Whoever's producing more on that axis has got the comparative advantage in whatever's on the axis. So here is India that's got, that's producing more where there's the biggest gap. So that means India has got the comparative advantage in computer production. And it means that on the other axis, which is cotton, the other country has got the comparative advantage there.
It's a law that never fails. It's a little trick that never failed and that can help you a lot if you're given figures like this. and you're not comfortable working out opportunity costs, you can just draw the PPCs and use that trick.
So just a reminder, you go to the axis where there is the biggest gap between the two PPCs. Whoever is producing more on that axis has got the comparative advantage in whatever good is on that axis. The other country has got the advantage in the other good on the other axis. However, this theory doesn't just stop there.
For trade to be mutually beneficial, for each country to exploit its comparative advantage for it to be worthwhile, there needs to be a suitable rate of exchange. To work out that rate of exchange, I'm going to draw an opportunity cost ratio kind of diagram here. Very simple idea.
I'm just going to say for each computer, how many tonnes of cotton could each country have produced instead? So for India, for each computer they could have produced 2 tonnes of cotton instead. For Ghana, for each computer they could have produced 8 tonnes of cotton instead.
So now we have what are called opportunity cost ratios there. So the one on the right, that is... Ghana's opportunity cost ratio and this one here is India's opportunity cost ratio And theory says that for each country to exploit its comparative advantage and then trade, for that trade to be mutually beneficial, a rate of exchange has got to be suitable. And that rate of exchange must last. between the opportunity cost ratios of production for the two given countries.
Let's see how that works. India should specialise in computers according to this theory. produce computers and sell computers to Ghana.
But for India, it's only worth selling to Ghana if what they get back in return is more than what they could have made themselves with that one computer. So India will need at least two tonnes of cotton in return for each computer they sell to Ghana. Why? Because if they don't get two tonnes of cotton, if they get less than two tonnes of cotton, then what was the point of selling to Ghana?
They may as well have to sacrifice one computer themselves and produce... produce two tons of cotton themselves. So for India they need at least two tons of cotton for a trade to be beneficial for them. What about for Ghana?
We say Ghana should specialise in cotton production and buy computers from India. Well for Ghana it's only worthwhile buying from India, buying computers from India, if what they have to pay is either eight tons of cotton or less. Why is that?
Well if Ghana have to pay more than eight tons of cotton for each computer, they're paying more than eight tons of cotton for each computer. they buy from India, what's the point? They could have just sacrificed 8 tonnes of cotton themselves and produced one computer themselves. If they had to pay more than 8 tonnes, it doesn't make sense for them to buy from India.
They could have done so better if they produced the computer themselves. They could have paid less. So for trade to be mutually beneficial, therefore the opportunity cost, sorry, therefore the exchange rate, the suitable exchange rate, must lie between the opportunity cost ratios of production for both countries.
So one computer... look at the exchange rate in terms of the price of a computer, one computer should cost between two and eight tonnes of cotton. So an exchange rate that will benefit both countries equally will be one computer is priced at five tonnes of cotton.
The more we move towards 8 tonnes of cotton for one computer, the more that benefits Guyana. So let's say the exchange rate was one computer is 7 tonnes of cotton. That benefits India very much because India are getting more tonnes of cotton for each computer they're selling.
That's great for them, whereas Ghana are having to pay quite a lot. Still beneficial for both countries, but more in terms of India's favour. The more we move towards less tonnes of cotton for each computer, the more it benefits Ghana.
For each computer, they actually buy in. They're only having to pay three tonnes. tons of cotton.
Whereas India are getting less in terms of how much they're getting back from a computer that they're selling. But as long as the exchange rate lies between the two opportunity cost ratios, it's always beneficial to trade for countries to exploit their advantage. That's a nice little bit of theory for you to take away. The last thing I want to talk about is what determines whether a country has a comparative advantage or not.
Very simply, it comes down to the quantity and the quality. of factor endowments in a given nation. So why are Ghana specialising in cotton?
Well, maybe it's because they have an abundance of cotton plants, an abundance of fertile soil to produce cotton plants in Ghana. That's just the luck of their factor endowment, that's the luck of the land that they have which is suitable for producing cotton. That's just how it's worked out for Ghana.
Okay, in which case that might lead them to having a comparative advantage in cotton production. Whereas for India it might be the case that the quality of their... labour force, the skills that the labour have lend themselves very, very well to producing computers, in which case their factor endowments are well suited towards computer production.
That might lead to the comparative advantage there. So the quantity and the quality of factor endowments in a given nation will determine what goods and services that nation has got a comparative advantage in. Thanks so much for watching guys.
My next video, really interesting video, I'm going to look and see how this theory, as long as there is a... mutually beneficial exchange rate can actually lead to each country here actually consuming beyond their PPC, a real benefit of comparative advantage theory. So both countries instead of just stopping on their own PPCs can actually end up consuming beyond. How does that work? Because that's another add-on to the theory.
Watch my next video to understand that. Hopefully you understand the idea of comparative advantage, it's a really interesting theory, important theory. Thanks for watching, see you all next time.