J. Watkins

The argument in favor of free trade is found in Adam Smith's invisible-hand doctrine, the doctrine that each individual freely pursuing his or her self-interest involuntarily promotes the interest of all. David Ricardo provided a formal proof of the invisible-hand doctrine in his theory of comparative advantage. Trade Ricardo argued is based on comparative advantage, not absolute advantage.

Absolute advantage is defined as a situation in which one party produces a good with fewer resources than another. For example, in the table below it takes Portugal fewer hours to produce a case of wine than England.

Comparative advantage is defined as a situation in which the opportunity cost of producing a commodity is less for one party than another. Comparative advantage focuses on the tradeoffs involved in production. For example, in the table below to produce a bolt of cloth means that both countries must forgo producing some wine. The country that gives up less wine than the other has a comparative advantage. England producing a bolt of cloth gives up less wine than Portugal.

Producing one item means foregoing producing another. Countries and individuals trade those things that it costs them less to produce. Hence, it becomes advantageous to trade, even if the other party can produce the item as fast. The table below illustrates our points.

Even though Portugal has an absolute advantage in producing both commodities, Portugal has a comparative advantage in only one commodity: wine. In turn, England has an absolute disadvantage in producing both commodities, yet England has a comparative in producing cloth. Hence, both countries will find it in their self-interest to specialize in that commodity in which they have a comparative advantage, and engage in trade.

Portugal, specializing in wine, will reallocate the 40 hours formerly used in cloth production to wine production. Since 60 hrs are now allocated to producing wine, and it requires 20 hours to produce 1 case of wine, wine production will increase to 60/20=3.

Both countries specializing in producing that commodity in which they have a comparative advantage causes total world production to increase, benefiting both countries. Their self-interest to specialize in that commodity in which they have a comparative advantage leads to an increase in output, thereby benefiting both countries.

What happens if one country has an absolute advantage in producing all commodities? Not to worry. Even if a country can produce all things with fewer resources, trade remains advantageous. The manager may be able to type faster and better than her secretary. But does this mean the manager should type? No. She should focus on other matters that yield a higher return, and allow the secretary to type.

The theory of comparative advantage is the corner stone of the free-trade argument. Individuals and countries always have the option of producing the goods themselves. No one forces them to engage in trade. They do so presumably because it costs them less to trade than to produce the item themselves.