Strategic Management: Formulation and Implementation

Theory Of Comparative Advantage

David Ricardo, in 1817, enunciated his refinement of Smith's concept by postulating the principle of comparative advantage (as opposed to Smith's concept of absolute advantage). The theory of comparative advantage states that even if a country is able to produce all its good at lower costs than another country can, trade still benefits both countries, based on comparative costs. His writings demonstrated what has become known as:

"... the principle of comparative advantage: a nation, like a person, gains from the trade by exporting the goods or services in which it has its greatest comparative advantage in productivity and importing those in which it has the least comparative advantage."

The key word is comparative, meaning relative and not necessarily absolute. There are gains from trade whenever the relative price ratios of two goods differ under international exchange for what would be under conditions of no trade. In addition, the theory of comparative advantage demonstrates that countries jointly benefit from trade (under the assumption of both goods).

With the theory of absolute advantage, Ricardo's theory of comparative advantage does not answer why production cost differ within each country and also no consideration is given to the possibility of producing the same goods with different combinations of factors.

The leading theory of what determines nations' trade patterns was presented by Eli Heckscher in 1919 and a clear overall explanation was developed and publicized in the 1930s by Heckscher's student, Bertil Ohlin.