David Ricardo developed this international trade theory based in comparative advantage and specialization, two concepts that broke with mercantilism that until then was the ruling economic doctrine. He introduced this theory for the first time in his book “On the Principles of Political Economy and Taxation”, 1817, using a simple numerical example concerning the trade between Portugal and the England in the following way:
Let’s say the labour costs per unit of cloth (C) and wine (W) produced by England (E) and Portugal (P) are as those seen in the adjacent figure. Even though Portugal has an absolute advantage on wine and cloth production, England has a comparative advantage on cloth production.
Because of this advantage, both countries would benefit from international trade. This can be seen using an Edgeworth box, as seen in the figure below.
Without international trade, each country would only be able to produce (and therefore to consume) any amount of both wine and cloth inside or at the country’s production-possibility frontier (green for England and red for Portugal). For instance, point E cannot be reached by any of these countries, since it is outside their production-possibility frontier.
However, point E can be reached by trading goods.
Portugal would specialize on producing wine, which is relatively less costly to produce. This is, Portugal is better off producing more wine that it will consume in order to trade it for cloth, since production of cloth would be more costly than the production of the exported wine. For the same reason, England would specialize on cloth. Portugal would produce only wine, consuming Cw and exporting Xw to England, while England would produce only cloth, consuming Cc and exporting Xc to Portugal.
As a result of international trade, point E would become reachable, defining the terms of trade line, which shows how great the gains from trade are. The further from each production-possibility frontier, the better the terms of trade are, and therefore the gains from trade are also greater.
The implications of this theory were great as it meant a breakthrough in the economic science, especially, due to the contribution of the comparative advantage principle.
However, this theory is not spared of flaws as some critics pointed out. John Stuart Mill was concerned with reciprocal demand as he argued that it was not necessarily true that demand and supply across countries would be met. Furthermore, although Ricardian theory of comparative costs may show the limits within which the equilibrium must be, it does not show how to determine the terms of trade, and hence the price of the goods. As this is an unresolved matter, it considerably limits a model that aims to explain international trade. Nevertheless, as Jagdish N. Bhagwati pointed out in his article “The Pure Theory of International Trade: A Survey”, 1964, this model ought to be analysed form a normative point of view, since it does help prove the welfare proposition that trade is beneficial.