Free Trade Theory of Comparative Advantage

I am reading one of the great books of modern times, The World is Flat. The writer, Thomas Friedman is a visionary. It is a must read for any MBA aspirant.

While reading, came across this Free Trade Theory of Comparative Advantage, put forth by David Ricardo in the late 19th century. It states that any nation which can produce a good in a cost effective and productive way should trade that good with other goods with other countries which can produce those other goods in mass and cost effective way. This will lead to high trade volumes in both nations and ultimately income levels of both nations will increase. This theory entails that each nation should engage in production of goods in which it has relative advantage like low cost of raw materials, labor cost etc.

One good example is the way US outsources its low skilled manual jobs to China and India which can be accomplished here in lower cost and thus increases the income levels of Indians. Then these  affluent Indians in turn can be the market for the iPod, KFC or Microsoft Windows.

In the context of globalization this hold very true. In an ideal world free of trade barriers, this could lead to equal distribution of wealth and employment opportunities. However, believers in protectionist systems disagree and hence we have trade barriers between nations.

This law applies everywhere, other than between trading nations as well. For example in the context of India, it applies between states. Example, Bihar can provide low cost labor to other states, and in turn create a market for the textile industry of Gujrat or Mumbai.

References:

1. David Ricardo on Wikipedia.

2. The World is Flat