The economic theory which holds that countries can produce more if they trade with one another. This theory has been immensely influential. Although the theory is very much a simplification, the impact which international trade has had on economic growth in a number of countries is very striking. The theory does help to explain the connection.
The theory of comparative advantage was first set out by David Ricardo in his book The Principles of Political Economy, published in 1817. He argued that all countries would be able to increase output if they specialised and traded with each other. This would hold even if one country was more efficient at producing everything than the other, i.e. it had an absolute advantage. Specialisation works to increase output whenever the opportunity costs of particular products are different between countries. If one country is not the best at producing anything, it can still gain by specialising in the product it is least bad at producing.
It works like this. The theory assumes that there are two countries and two products. Think of a country like the US, producing computers and wine. It is highly efficient at producing both. Still, it trades with Chile, which also produces computers and wine, but is less efficient at producing both. It will still pay to specialise because Chile’s comparative disadvantage is less in wine.
Think of each country having 1000 workers. Before trade, half produce computers and half produce wine. The table shows how much each can produce.
Output of computers Output of wine (cases)
US 100 250
Chile 20 200
Total output 120 450
For Chile it takes 25 people to produce a computer. These 25 people could produce 10 cases of wine. So the opportunity cost of a computer is 10 cases of wine. Similarly, it takes 2.5 people to produce a case of wine and these people (i.e. this amount of labour) could produce one tenth of a computer, so this is the opportunity cost of the wine.
By contrast, in the US, it takes five people to produce a computer. Those five people could produce 2.5 cases of wine. The opportunity costs are shown in full in the table.
Opportunity cost of computer Opportunity cost of a case of wine
US 2.5 cases of wine 2/5 of a computer
Chile 10 cases of wine 1/10 of a computer
Now it is possible to see that the opportunity cost of wine in Chile is lower than it is in the US. It will pay Chile to specialise in the production of wine and give up producing computers. If each country concentrates on the product with the lowest opportunity cost, total output will increase. If the US moves people into computer production so that there are 800 altogether, it will be able to produce 160 computers, while still producing 100 cases of wine. Chile, specialising entirely in wine, will produce 400 cases of wine. The table shows the totals.
Output of computers Output of wine
US 160 100
Chile 0 400
Total output after specialisation 160 500
It is not possible to say which country will benefit most from the increase in output. In the real world, trade is greatly affected by all kinds of import restrictions and also by exchange rates. The theory of comparative advantage explains why trade and growth are linked and draws attention to the damage caused by trade restrictions. It does not make precise predictions possible.