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Theory of Comparative Advantage

David Ricardo, who wrote the book On the Principles of Political Economy and Taxation, took Adam Smith's theory of absolute advantage one step further. He called his theory comparative advantage. Comparative advantage, according to Ricardo, is the term used when a country has the ability to produce a good or service more cheaply, relative to other goods and services, than is possible in any other country or countries. Therefore, instead of a country being really good at producing two items absolutely positively better than the other countries, they can sit back a little and just be really good at producing one product. That way there is the possibility for trade with another country, the country that produces the good or service that has its own comparative advantage.

 Comparative advantage can be exemplified in this way: suppose that a country has a certain number of labor hours available to them. If a country (let's call it Utopia) has two products to produce, say oak tables and green shag carpet, then Utopia splits up the labor hours of their workers evenly between the two products. All told, Utopia may be better at producing those two things than any other country. However, let's say that Utopia allows a different country, Untopia, to take over the production of oak tables. Untopia had previously been behind Utopia in production of oak tables, but couldn't quite beat them. Now, though, since Utopia has given up their pursuit of oak table production, Untopia can quickly soar beyond all the rest of the competition and produce even more oak tables than before, because they can focus solely on producing oak tables. Utopia, in the meantime, now produces only green shag carpet. They now have twice the available labor hours than they did when they had to split the labor hours between shag carpet and oak tables. Now that Utopia is only producing one product, they can focus on becoming the best of all in that market. 

Also, now Utopia and Untopia can trade freely between countries, and also gain more internationally. Giving up one thing could mean a great increase in another. Another issue might be in the time it takes to produce green shag carpet or an oak table. It might take Utopia an hour to make one oak table, while it only takes Untopia thirty minutes. In this case, Untopia has a distinct comparative advantage. This is what David Ricardo's theory of comparative advantage is all about.

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