What Is Comparative Advantage, and How Does It Work?

Explained Comparative Advantage

The ability of a country to produce a good or service at a lower opportunity cost than other countries is known as comparative advantage. The opportunity cost of a trade-off is used to evaluate it. For a country with a comparative advantage, the trade-off is worthwhile. This means that the advantages of purchasing its product or service outweigh the drawbacks. Although the country may not be the best at producing a particular good or service, it has a low opportunity cost for other countries to import it. David Ricardo is the author of this economic theory. It was first used in international trade, but it can now be used at any business level.

Comparative Advantage: Definition and Examples

What you do best while giving up the least is referred to as comparative advantage. For example, plumbing is your comparative advantage if you're a great plumber and a great babysitter. This is due to the fact that you will earn more money as a plumber. After all, an hour of babysitting is much less expensive than an hour of plumbing. Babysitting, on the other hand, has a high opportunity cost. Every hour you spend babysitting is an hour you could have been earning money on a plumbing job. If you are superior to everyone else in the neighbourhood at both plumbing and babysitting, you have a clear advantage in both areas. However, you have a distinct advantage in the field of plumbing. That's because you're only willing to give up low-paying babysitting jobs in order to pursue your well-paying plumbing career.

What is Comparative Advantage?

Countries in international trade typically have a comparative advantage in a variety of industries and for a variety of reasons. Natural resources, workers, government investment, and other factors may be involved. These advantages are then used for trading between countries. Chemicals, for example, are a comparative advantage for oil-producing countries. When compared to countries without it, their locally produced oil provides a low-cost source of material for the chemicals. The oil distillery process produces a lot of raw ingredients. As a result, in the early 1980s, Saudi Arabia, Kuwait, and Mexico were able to compete with American chemical companies. Their chemicals are cheap, so they have a low opportunity cost. India's call centers are another example. Companies in the United States purchase this service because it is less expensive than locating a call center in the United States. When speaking with representatives at Indian call centers, some companies may have customers who have miscommunications due to language barriers. The call centers, on the other hand, provide the service at a low enough cost to make the trade-off worthwhile for the companies that hire them. The vast landmass of America, which is bordered by two oceans, is one of the country's comparative advantages. It also has a lot of fresh water, arable land, and oil that is readily available. Businesses in the United States benefit from low-cost natural resources and protection from a land invasion. Most importantly, the country's diverse population speaks the same language and follows the same set of laws. The diverse population serves as a large testing ground for new products. It aided the US in becoming a world leader in consumer goods production. Diversity in banking, aerospace, defense equipment, and technology has helped the United States become a global leader. Silicon Valley has made a name for itself as a leader in innovative thinking by harnessing the power of diversity. The US economy's strength stems from the combination of these advantages. Important: Maintaining a competitive advantage in the knowledge-based global economy necessitates investing in human capital. Comparative advantages were more common in goods than in services in the past. This is due to the fact that products are easier to export. However, telecommunications technologies such as the internet make exporting services easier. Call centers, banking, and entertainment are among the services available.

Who Invented the Comparative Advantage Theory?

David Ricardo, an economist, coined the term "comparative advantage" in the early 1800s. He claimed that a country's economic growth is boosted the most by concentrating on the industry in which it has the greatest comparative advantage. England, for example, was able to produce inexpensive cloth at the time. Portugal had ideal conditions for producing low-cost wine. Ricardo predicted that England would stop making wine and Portugal would stop making cloth as a result of this. Instead, he proposed, they should trade for the product that they were less efficient at producing. He was absolutely correct. Trading England's cloth for Portugal's wine, and vice versa, resulted in a greater profit for England. Because England lacked the right climate to grow grapes efficiently, making all the wine it required would have been prohibitively expensive. On the other hand, Portugal lacked the manufacturing capability to produce low-cost cloth. Both countries benefited financially by exporting what they could most efficiently produce and importing what they couldn't.

Free trade agreements were founded on the theory of comparative advantage

Ricardo developed his strategy in England to combat trade restrictions on imported wheat. He argued that limiting low-cost, high-quality wheat from countries with the right climate and soil conditions made no sense. Exporting products that require skilled labor and machinery would provide more value to England. It could trade for more wheat than it could produce on its own. David Ricardo began his career as a successful stockbroker, earning more than $100 million in today's money. He became an economist after reading Adam Smith's The Wealth of Nations. In England in 1809, he pointed out, significant increases in the money supply caused inflation. "Monetarism" is the term for this theory. The law of diminishing marginal returns was also developed by Ricardo. One of the fundamental concepts in microeconomics is this. It claims that there comes the point in production when the increased output is no longer worth the extra raw material input.

What Role Does Comparative Advantage Play in International Trade?

Trade protectionism does not work in the long run, according to the theory of comparative advantage. Local constituents are constantly pressuring politicians to raise tariffs in order to protect jobs from international competition. Local constituents are constantly pressuring politicians to raise tariffs to protect jobs from international competition. However, this is only a band-aid solution. Because trade protectionism is inefficient, it hurts the country's competitiveness in the long run. It allows the government to waste money on failing industries. Consumers are also forced to pay higher prices for goods produced in their own country.

Absolute Advantage vs. Comparative Advantage

Anything a country does more efficiently than other countries is referred to as an absolute advantage. Agriculture, gasoline, and petrochemicals are advantages for countries with plenty of farming land, fresh water, and oil reserves. However, just because a country has an absolute advantage in one industry does not mean it will have a comparative advantage in another. That is contingent on the trading opportunity costs. Assume its neighbor doesn't have any oil but does have plenty of farmland and clean water. In exchange for oil, the neighbor is willing to trade a lot of food. The first country now has a comparative advantage in terms of oil. Trading for oil allows it to obtain more food from its neighbor than it could produce on its own.

What's the Difference Between Comparative and Competitive Advantages?

What a country, business, or individual does to provide a better value to consumers than its competitors is known as a competitive advantage. Companies use three strategies to gain a competitive advantage. They could, for starters, be a low-cost provider. Second, they might be able to provide a better product or service. Third, they could concentrate on a single customer segment. Your competitive advantage makes you more appealing to customers than your competitors. For instance, you may be in high demand for plumbing services even though there are other plumbers who are just as good or better. It's possible that it's because you're charging less. This gives you an upper hand over your competitors.

What Is Comparative Advantage, and How Do You Calculate It?

Compare the opportunity cost of producing the same good or service between two businesses or countries to find a comparative advantage for a particular good or service.
Factory A Factory B
Tables 300 900
Chairs 1000 1005
Let's say that Factory A and B make chairs and tables. Factory A can make 300 tables or 1000 chairs in a single week. Factory B can make 900 tables or 1005 chairs in the same week. Factory B has a significant advantage in terms of both chairs and tables because it can produce more of each in the same amount of time. In the case of tables, however, it has a much greater comparative advantage because it can produce three times the number of tables for the same time cost as Factory A. Factory B should devote its resources to the production and trading of tables. At the same time, Factory A should focus on the production of chairs.

Important Points to Remember

  • With a comparative advantage, a country will focus its capital, labor, and natural resources on goods and services with lower opportunity costs and higher profit margins.
  • The concept of comparative advantage was developed by David Ricardo, a 19th-century economist, to end tariffs on wheat imports in England.
  • Even if a country has an absolute or competitive advantage over another, it will often choose to concentrate on producing goods where it has a comparative advantage.
  • Protectionism from trade protects inefficient industries, contrary to the comparative advantage concept.

Most Commonly Asked Questions (FAQs)

What are the advantages of comparative advantage for developing countries?

Because developing countries have lower labor costs than developed countries, they have a competitive advantage in many labor-intensive industries like construction and manufacturing.

What are the advantages of comparative advantage for the United States?

The United States has a comparative advantage in the production of a variety of goods and services, particularly in the financial markets. It benefits from the fact that it can purchase goods and services through trade for less money than it would cost to produce them domestically, where it lacks a comparative advantage.

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