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RICARDO THEORY Notes

David Ricardo's theory of comparative advantage, introduced in 1817, argues that nations should specialize in goods with lower opportunity costs to enhance economic welfare through trade. His ideas challenged mercantilist views and emphasized the importance of free trade, influencing economic policies for centuries. The theory relies on several assumptions, including two countries producing two goods, labor as the only production factor, and perfect competition.

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18 views1 page

RICARDO THEORY Notes

David Ricardo's theory of comparative advantage, introduced in 1817, argues that nations should specialize in goods with lower opportunity costs to enhance economic welfare through trade. His ideas challenged mercantilist views and emphasized the importance of free trade, influencing economic policies for centuries. The theory relies on several assumptions, including two countries producing two goods, labor as the only production factor, and perfect competition.

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Introduction to Ricardo's Theory of Comparative Advantage

David Ricardo's theory of comparative advantage, introduced in his 1817 book "On the Principles of Political Economy and Taxation," posits that nations should specialize in producing goods
where they have a lower opportunity cost compared to other nations. This specialization allows for more efficient production and increased overall economic welfare, as countries can trade to
mutual advantage.

Historical Background

1. Adam Smith and Absolute Advantage:


Before Ricardo, Adam Smith laid the groundwork with the theory of absolute advantage, suggesting that nations should produce goods where they are most efficient. Ricardo built upon this by
explaining that even if one country is less efficient in producing all goods, it can still benefit from trade by focusing on goods with the least relative inefficiency.

2. Economic Context of Early 19th Century:


During Ricardo's time, the Industrial Revolution was transforming economies. Nations were beginning to see the benefits of specialization and trade, but there was no formal theory explaining
the potential advantages of trade between countries with different production capabilities.

3. Portugal and England Example:


Ricardo used the example of Portugal and England to illustrate his theory. He showed that even if Portugal could produce both wine and cloth more efficiently than England, it should still
specialize in wine, where its efficiency advantage is greatest, and trade for cloth. This practical example helped to solidify the theoretical concepts in real-world terms.

4. Influence of Classical Economics:


Ricardo's theory was deeply rooted in classical economics, emphasizing the importance of free trade and competition. His ideas challenged mercantilist views that dominated economic
thought, which favored protectionism and accumulation of wealth through trade surpluses.

5. Enduring Legacy:
Ricardo's comparative advantage theory became a cornerstone of international trade theory. It provided a strong argument for free trade policies and influenced economic policies and trade
agreements throughout the 19th and 20th centuries. Economists like John Stuart Mill and later, Paul Samuelson, further developed and refined the theory, cementing its place in economic
literature.

Key Points

Comparative Advantage vs. Absolute Advantage:


Ricardo's theory clarified that even if a country lacks an absolute advantage, it can still benefit from trade by focusing on comparative advantage.

Opportunity Cost Concept:


The theory introduced the concept of opportunity cost as a crucial factor in determining comparative advantage.

Policy Implications:
It advocated for free trade, influencing international economic policies and trade agreements.

Historical Context:
Emerged during the Industrial Revolution, challenging mercantilist protectionism.

Long-lasting Impact:
Continues to be a fundamental principle in economics, affecting contemporary trade theories and policies.

Assumptions of Ricardo's Theory

1. Two Countries and Two Goods:


Ricardo's model typically involves only two countries producing and trading two different goods. This simplifies the analysis and helps to clearly illustrate the principle of comparative
advantage.

2. Labor as the Only Factor of Production:


The theory assumes that labor is the sole input in the production process. This means that the productivity differences between countries are due to differences in labor efficiency rather than
differences in technology or capital.

3. Constant Returns to Scale:


It is assumed that the production of goods exhibits constant returns to scale, meaning that doubling the input of labor will exactly double the output. This implies no diminishing returns in
production.

4. Labor Mobility within Countries but Not Between Countries:


Within each country, labor can move freely between industries to ensure that it is allocated to the most productive uses. However, labor cannot move between countries.

5. Perfect Competition:
The markets for goods and labor are assumed to be perfectly competitive. This means there are many buyers and sellers, no single entity can influence prices, and all participants have perfect
information about the market.

6. No Transportation Costs:
The model assumes that there are no costs associated with transporting goods between countries. This simplification helps to focus on the pure gains from trade due to differences in
productivity.

7. Fixed Technology:
The technology used in production is assumed to be constant. Each country has a fixed level of technology that determines the productivity of labor in producing different goods.

8. Full Employment:
It is assumed that all labor resources in both countries are fully employed. There are no idle resources, so all labor is actively engaged in production.

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