Theory of Comparative Advantage

The theory of comparative advantage provides a basis for explaining and justifying international trade in a model world assumed to enjoy free trade, perfect competition, no uncertainty, costless information, and no government interference. The theory contains the following features:

  • Exporters in Country A sell goods or services to unrelated importers in Country B.
  • Firms in Country A specialize in making products that can be produced relatively efficiently, given Country A’s endowment of factors of production; that is, land, labor, capital, and technology. Firms in Country B do likewise, given the factors of production found in Country B. In this way the total combined output of A and B is maximized.
  • Because the factors of production cannot be moved freely from Country A to Country B, the benefits of specialization are realized through international trade.
  • The way of benefits of the extra production are shared depends on the term of trade, the ratio at which quantities of the physical goods are traded. Each country’s share is determined by supply and demand in perfectly competitive markets in the two countries. Neither Country A nor Country B is worse off than before trade, and typically both are better off, albeit perhaps unequally.
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