Comparative advantage | Trade theory

David Ricardo worked with Adam Smith's theory of absolute advantage and created the theory of comparative advantage.

David Ricardo asked the question: if a country has an absolute advantage in the production of two products compared with another country, should these two countries trade with each other then? David Ricardo argued that the two countries could benefit from trade with each other despite the fact that one country has an absolute advantage in both products.

If two countries specialize in the products in which they have a comparative advantage, then both these countries will benefit from trade with each other. With comparative advantage means that a country has a lower opportunity cost in the production of a product compared to the other country's opportunity cost of producing that product.

The opportunity cost is what you have to give up of one product to produce an additional unit of another product. If a country can produce 10 cars in an hour or two caravans in that hour, the opportunity cost of producing a car is 0.2 caravans and the opportunity cost of producing a caravan is 5 cars. Another country can produce 4 cars per hour or one caravan per hour, the opportunity cost of producing a car is 0.25 caravans and the opportunity cost of producing a caravan is 4 cars. The first country has a comparative advantage in producing cars (0.2 caravans) and the other country has a comparative advantage in producing caravans (4 cars).