The theory of comparative advantage is David Ricardo's theory that specialization and free trade will benefit all trading partners, even those that may be absolutely less efficient producers. Ricardo's theory is often used to advocate free trade.
The simplest way to understand the theory of comparative advantage is to use examples that only involve two producers and two products. Before we get to examples though, we have to discuss the two key concepts of Ricardo's theory:
Absolute Advantage:
The aboslute advantage in the production of a product is held by the producer/country that uses the fewest resources to produce the same product as the other producers. For the country with the absloute advantage, it costs the least to produce the good.
Comparative Advantage:
The comparative advantage is held by the producer/country that can produce the product at lower cost in terms of OTHER GOODS. The country with the comparative advantage has the lowest opportunity cost.
Examples
Our two producers are Japan and Korea. Each country can either produce radios or cameras.
Case 1
One unit of resources can produce:
Japan - 2 Radios------OR------4 Cameras
Korea - 3 Radios------OR------1 Camera
In this case, Japan has the absloute advantage in producing cameras and Korea has the absolute advantage in producing radios.
The opportunity cost for Japan to produce 1 radio would be 2 cameras, and the opportunity cost for Japan to produce 1 camera would be 1/2 radios.
The opportunity cost for Korea to produce 1 radio would be 1/3 cameras, and it's opportunity cost to produce one camera would be 3 radios.
From this we can see that Japan also has the comparative advantage for producing cameras because it's opportunity cost of 1/2 radio for every camera produced is lower than Korea's opportunity cost of 3 cameras for every radio produced. Korea has the comparative advantage in radios for the same reasons
In this case, Japan would specialize in the production of cameras and Korea would specialize in the production of radios. When Japan and Korea trade, they will now both get more cameras and radios for a lower cost than if they had tried to each produce both items.
Case 2
One unit of resources can produce:
Japan - 2 Radios------OR------4 Cameras
Korea - 1 Radio-------OR------3 Cameras
In this case, Japan has the absolute advantage in both cameras and radios. This is where the theory of comparative advantage comes in.
The opportunity cost for Japan to produce 1 radio would be 2 cameras, and the opportunity cost for Japan to produce 1 camera would be 1/2 radios.
The opportunity cost for Korea to produce 1 radio would be 3 cameras, and the opportunity cost for Korea to produce 1 camera would be 1/3 radios
Japan has the comparative advantage and the absolute advantage in producing cameras. But, while Japan may have the absolute advantage in producing radios, Korea has the comparative advantage (it's opportunity cost of 1/3 cameras being less than Japan's opportunity cost of 1/2 cameras per radio produced).
Because it costs Korea comparitively less to produce radios, Japan will trade with Korea even though it can produce both products more effectively given the same resources. In the end, both contries will end up with a larger amount of cheaper cameras and radios and both will benefit.
Why It Works:
Ricardo's scheme works because the REAL cost of producing any good is what must be given up in order to produce it. So, it is less costly for Korea to produce radios, even though Japan can produce more radios with the same resources. When countries specialize in producing goods in which they have the comparative advantage, they maximize their combined output and have a more efficient allocation of resources.