The Principle (Theory) of Comparative advantage explained

The Principle (Theory) of Comparative advantage

• This principal    states   that   given   two   countries    producing    two   commodities     using    similar resources,   a country should specialize in the production   of a commodity   where it incurs the least opportunity   cost than the other.
• According to  this  theory,   a country   is  said  to  have   comparative    advantage   if  it can  produce commodity at  a  lower   opportunity    cost   than   the   other   country   irrespective    of  the   absolute advantage.

Example

Opportunity cost of producing cotton

This means   that to produce one unit of cotton,   Uganda foregoes 2 units of coffee.

This means   that to produce one unit of cotton,   Kenya foregoes 4 units of coffee.

Therefore  Ugandan   should  specialize  in the production   of cotton  since it has a lower  opportunity   cost (2  tons   of  coffee)   than   Kenya   (4  tons   of  coffee). This    means   that  Uganda   has  comparative advantages   in the production   of cotton.

Opportunity cost of producing coffee

This means   that to produce one unit of coffee,   Uganda foregoes ½ units of cotton.

This means   that to produce one unit of coffee,   Kenya foregoes ¼ units of cotton.

Therefore  Kenya   should  specialize  in the production   of coffee  since it has a lower  opportunity   cost (¼   tons )   than   Kenya   (4  tons   of  coffee). This    means   that  Uganda   has  comparative advantages   in the production  of cotton.

Assumptions   of the theory of Comparative advantage

1. It assumes only two countries participating in trade in the world.
2. It assumes that each country produces only two commodities
3. It assumes free trade that is international trade is free from trade barriers
4. It assumes constant technology in the two countries.
5. Is assumes absence of the law of diminishing returns such that there are no economies and diseconomies of scale.
6. It assumes perfect mobility of factors of production within the country but perfect immobility of factors of production between the two countries.
7. It assumes full employment of factors of production in the two countries that is there is no excess capacity.
8. It assumes similar tastes and preferences in the two countries.
9. It assumes existence of perfect competition in the international markets.
10. It assumes barter system of exchange
11. It assumes that labour is the only factor of production and all labour units are homogeneous in the two countries that is labour has the same efficiency and skills in the two countries.
12. It assumes the same exchange rate for the two countries,

Weaknesses (Criticisms/Limitations) of the theory of comparative advantage     

1. The assumption that the world is composed of two countries is unrealistic. In the real world there are many countries producing a variety of commodities.
2. Factors of production are not perfectly mobile as assumed by the theory. Some factors like land are highly immobile.
3. It assumes free trade, yet in the real world, international trade is dominated by restrictions and other trade barriers in form of tariffs, quotas etc.
4. The assumption that factors of production are equally efficient in two countries is unrealistic. This is because different factors of production have different efficiency and productivity between countries.
5. It assumes constant technology, yet technology is constantly changing and this leads to changes in efficiency and comparative advantage.
6. It assumes absence of diminishing returns, yet production in countries is characterized by the law of diminishing returns due to poor farming methods especially in the agricultural sector.
7. The assumption that there are no transport costs in international trade is unrealistic. Transport costs do exist and they determine the nature and pattern of international trade.
8. It is possible for two countries to have the same opportunity cost and in this case it is hard to determine which country should specialize in the production of a given commodity.
9. The   theory    does   not   take   account   the need for   diversification.   Instead    it   encourages specialization   which under mines the countries need for self-reliance   and independent.
10. The theory assumes perfect competition which does not exist in the real world.
11. The theory assumes full employment or resources yet there are high rates of unemployment and under employment  of resources in all countries.

Relevance (Applications)   of the theory of comparative advantage

1. The theory emphasizes specialization which  forms   the basis   of international    trade.   This   is because   countries   should specialize   in the production   of commodities   where they have greatest comparative   advantage over others.
2. The theory is relevant in the process of bi-lateral trade. This is because it assumes countries which apply under this form of trade.
3. The  theory  is applicable under economic  (regional) integration where  certain  countries   remove or eliminate  certain  trade  barriers  in order  to encourage   free trade in the integrated   region.
4. Due   to differences   in resource   endowments,   some   countries    have   managed    to   produce commodities    at lower   costs than others   and have become   major   suppliers   to other   countries basing on the theory of comparative   advantage.
5. The   theory   is   relevant   under   barter trade between    two   countries    where    they   exchange commodities   for commodities   basing on the law of comparative   advantage.   For example   Uganda used to exchange beans for oil in the late 1870’s with Libya
6. According   to  this  theory  countries  have been  able to acquire more goods  and services  from other  countries  which  have  ability  to produce  them more  cheaply.
7. The   theory   is relevant because it encourages market expansion which   forms   the basis   of international   trade.