Comparative advantage is a principle developed by David Ricardo in the early 19th century to explain the benefits of mutual trade (Carbaugh, 2008). Many underlying assumptions of comparative advantage depend on states of economic equilibrium and an absence of economy of scale. In reality, economies are dynamic and subject to innovation and interference; which has led to revised assumptions of return and competition (Krugman, 1987). These factors have created questions of free trade and governmental participation in an economy by the development of strategic trade policies. These new concepts do not replace the theory of comparative advantage; however, they further explain how trade can benefit a country's economy (Krugman, 1987).
Comparative Advantage Theory
The principle of comparative advantage holds that trade can exist internationally even when one country holds a distinct advantage over another country in the production of a good. Ricardo made several assumptions for his theory to hold true including: the existence of a two nation model with labor as the only input, fluid labor transfer across industries, fixed technology with zero transportation costs, the absence of governmental barriers allowing for balanced free trade and ignorance of price and production models (Carbaugh, 2008). Under the Heckscher-Ohlin theory, the basis for trade is resource abundance, however trade equilibrium is assumed via equal technology and demand between nations (Nobel Media, 2006). Both theories require constant returns and assume the existence of perfect competition (Schweinberger, May, 1996).
Constant return means input and output costs remain the same over time regardless of production levels (AmosWEB LLC, 2000-2012). The concept of perfect competition assumes goods are homogenous, individual buyers and sellers have no influence on pricing, are attempting to maximize profits and are free to leave or enter the market. Manufacturing adjusts to meet a constant return on the product (Hunt & Morgan, 1995). Effectively, these theories rely on national monopolistic models to explain comparative advantage (Ossa, n.d.). While the standard of comparative advantage explains why trade can exist between countries, the assumptions do not account for conditions of increasing returns and imperfect competition.
A Dynamic Economy
The principle of comparative advantage provides a simplified theory explaining why free trade is possible, even when one country has an economic disadvantage. Both the Ricardian and Heckscher-Ohlin theories rely on fixed economic assumptions of constant return and perfect competition. However, intuitively the basic principle of business is to increase returns through innovation, improving processes and technology or increasing economies of scale. Organizations understand they control pricing and are price setters, rather than price takers as suggested by perfect competition (Krugman & Obstfeld, 2003). The idea...