Comparative advantage is a term that is often used in economics, but what does it mean and why is it important? In this article, we will explain the concept of comparative advantage, how it is related to opportunity cost and trade, and how it can be applied in various scenarios.
Contents
What is Comparative Advantage?
According to Investopedia, comparative advantage is an economy’s ability to produce a particular good or service at a lower opportunity cost than its trading partners. Opportunity cost is the potential benefit that someone loses out on when selecting a particular option over another. For example, if you have two hours to study, you can either study math or history. If you choose to study math, the opportunity cost is the benefit you could have gained from studying history, and vice versa.
Comparative advantage is used to explain why companies, countries, or individuals can benefit from trade. When used to describe international trade, comparative advantage refers to the products that a country can produce more cheaply or easily than other countries. For example, Brazil has a comparative advantage in producing coffee because it has a suitable climate and soil for growing coffee beans. Norway has a comparative advantage in producing salmon because it has abundant natural resources and expertise in fish farming.
The theory of comparative advantage is attributed to political economist David Ricardo, who wrote the book On the Principles of Political Economy and Taxation in 1817. Ricardo used the theory of comparative advantage to argue against Great Britain’s protectionist Corn Laws, which restricted the import of wheat from 1815 to 1846. In arguing for free trade, Ricardo stated that countries were better off specializing in what they enjoy a comparative advantage in and importing the goods in which they lack a comparative advantage.
How is Comparative Advantage Related to Trade?
The theory of comparative advantage shows that even if a country enjoys an absolute advantage in the production of goods, trade can still be beneficial to both trading partners. Absolute advantage refers to the uncontested superiority of a country to produce a particular good better. For example, the United States has an absolute advantage in producing airplanes because it can produce more airplanes per unit of input than any other country.
However, having an absolute advantage does not mean that a country should produce everything by itself. Rather, it should focus on producing the goods that have the lowest opportunity cost and trade for the goods that have a higher opportunity cost. This way, both countries can increase their total output and consumption by exploiting their comparative advantages.
To illustrate this point, let us consider a simple example of two countries (France and the United States) that use labor as an input to produce two goods: wine and cloth. The following table shows how much of each good one hour of labor can produce in each country:
| Country | Wine (bottles) | Cloth (yards) |
|---|---|---|
| France | 10 | 5 |
| United States | 20 | 20 |
As we can see, the United States has an absolute advantage in both wine and cloth production because it can produce more of each good with one hour of labor than France. However, this does not mean that the United States should produce both goods by itself. Rather, we need to compare the opportunity costs of producing each good in each country.
The opportunity cost of producing one unit of a good is the amount of another good that has to be given up. For example, in France, the opportunity cost of producing one bottle of wine is half a yard of cloth because one hour of labor can produce either 10 bottles of wine or 5 yards of cloth. In other words, by producing one bottle of wine, France gives up the opportunity to produce half a yard of cloth. Similarly, in the United States, the opportunity cost of producing one bottle of wine is one yard of cloth because one hour of labor can produce either 20 bottles of wine or 20 yards of cloth.
The following table shows the opportunity costs of producing each good in each country:
| Country | Opportunity Cost of Wine (yards) | Opportunity Cost of Cloth (bottles) |
|---|---|---|
| France | 0.5 | 2 |
| United States | 1 | 1 |
As we can see, France has a lower opportunity cost of producing wine than the United States because it has to give up less cloth to produce one bottle of wine. This means that France has a comparative advantage in producing wine. On the other hand, the United States has a lower opportunity cost of producing cloth than France because it has to give up less wine to produce one yard of cloth. This means that the United States has a comparative advantage in producing cloth.
According to the theory of comparative advantage, both countries can benefit from trade if they specialize in their respective comparative advantages and exchange their surplus output with each other. For example, suppose that each country has 100 hours of labor available for production. If each country produces only its comparative advantage good, the total output of each good will be as follows:
| Country | Wine (bottles) | Cloth (yards) |
|---|---|---|
| France | 1000 | 0 |
| United States | 0 | 2000 |
The total output of wine is 1000 bottles and the total output of cloth is 2000 yards. Now, suppose that France and the United States agree to trade at a rate of one bottle of wine for one yard of cloth. This means that France can exchange 500 bottles of wine for 500 yards of cloth, and the United States can exchange 500 yards of cloth for 500 bottles of wine. After trade, the consumption of each good in each country will be as follows:
| Country | Wine (bottles) | Cloth (yards) |
|---|---|---|
| France | 500 | 500 |
| United States | 500 | 1500 |
As we can see, both countries are better off after trade than before trade. France can now consume more cloth than before trade, and the United States can now consume more wine than before trade. The total consumption of wine is still 1000 bottles and the total consumption of cloth is still 2000 yards, but the distribution of consumption is more efficient because it reflects the comparative advantages of each country.
How Can Comparative Advantage Be Applied in Various Scenarios?
The concept of comparative advantage can be applied to various scenarios beyond international trade. For example, comparative advantage can explain why individuals specialize in different occupations, why companies outsource some of their activities, or why regions develop different industries.
- Individuals: Individuals can have different comparative advantages in performing different tasks based on their skills, talents, education, experience, or preferences. For example, a lawyer may have a comparative advantage in writing legal documents, while a plumber may have a comparative advantage in fixing pipes. By specializing in their respective comparative advantages and trading their services with each other, both individuals can increase their productivity and income.
- Companies: Companies can have different comparative advantages in producing different goods or services based on their resources, technology, location, or brand. For example, a software company may have a comparative advantage in developing software applications, while a hardware company may have a comparative advantage in manufacturing computer components. By outsourcing some of their activities to each other, both companies can reduce their costs and increase their quality.
- Regions: Regions can have different comparative advantages in producing different goods or services based on their natural endowments, infrastructure, labor force, or culture. For example, a coastal region may have a comparative advantage in producing seafood, while a mountainous region may have a comparative advantage in producing winter sports equipment. By trading with each other, both regions can diversify their economies and increase their welfare.
Conclusion
Comparative advantage is related most closely to opportunity cost and trade. It is a concept that explains how individuals, companies, countries, or regions can benefit from specializing in what they do best and exchanging their surplus output with others. By exploiting their comparative advantages, economic agents can increase their total output and consumption and achieve a more efficient allocation of resources.
