Comparative Advantage
Ability to produce a particular good or service at a lower opportunity cost than its trading partners
What is a Comparative Advantage?
In economics, comparative advantage is the ability to produce a particular good or service at a lower opportunity cost than its trading partners. This term explains why countries, companies, or individuals can benefit from trading with others in international trade.
A country with a similar benefit makes the compromise beneficial. This implies the advantages of purchasing its great or administration offset the burdens.
The country may not be the best at producing something, but the goods or service has a low opportunity cost for other countries to import.
In 1817, the book On the Principles of Political Economy and Taxation, written by English political economist David Ricardo, presented this theory to the public.
Ricardo used the theory to argue against Great Britain’s protectionist Corn Laws, which restricted wheat import from 1815 to 1846.
In arguing for free trade, David Ricardo stated that countries were better off specializing in what they enjoy a comparative advantage and importing the goods in which they lack the Advantage.
Key Takeaways
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It is the ability to produce a particular good or service at a lower opportunity cost than its trading partners
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It is the key concept to understand international trade
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Absolute Advantage is the ability of an entity to produce a greater quantity of goods and services than its opponents.
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Competitive advantage refers to factors that allow a company to outperform its competitors.
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Opportunity cost is the forgone benefit that has been derived from another option not chosen.
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There are still some downsides to this concept, such as over-specialization.
Understanding Comparative Advantage
This is an essential concept in economics and crucial to understanding why countries benefit from international trade.
When describing international trade, this term means producing goods and services more efficiently and quickly.
To understand the theory, it is important to understand the concept of opportunity cost.
What is the Opportunity Cost? Opportunity cost is the forgone benefit derived from another option not chosen. While making a decision, we should give up the benefit of another possible choice. The Advantage of a will is opportunity cost.
For example, I can play basketball or do homework in the morning. If I choose to do the homework in the morning, my opportunity cost is the benefit of playing basketball, such as a stronger body and advanced basketball skills.
In international trade, if a country has a lower opportunity cost than another in producing a particular good, this country has a potential benefit when trading with another country.
We say the country with a lower opportunity cost has a comparative advantage in producing a particular good over another.
Example of Comparative Advantage
Let's understand by taking a few examples.
Example 1: In international trade, considering two countries(China and United States), both countries produce cars and trains.
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China can produce 30 cars and ten trains in one day.
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The United States can produce 60 cars and one train in one day.
We can put the information above in the form.
| Cars | Trains | |
|---|---|---|
| China | 30 | 10 |
| United States | 60 | 1 |
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The opportunity cost for China to produce a car is ⅓ of a train
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The opportunity cost for the US to produce a vehicle is 1/60 of a train
The opportunity cost for the US to produce a car is lower than China, we say the US has a lower opportunity cost than its trading partners in making cars.
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The opportunity cost for China to produce a train is three cars
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The opportunity cost for the US to produce a train is 60 cars
The opportunity cost for China to produce a train is lower than the US. We say China has an advantage in making trains compared to the United.
While trading like the above situation, it’s more efficient for the US to sell cars to China and for China to sell trains to the US. In this way, both countries can benefit from trading. Let’s get into another example.
Example 2: We take labor as an input to analyze this question. Both companies A and B produce T-shirts and shoes.
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Labor in Company A can make 10 T-shirts and two pairs of shoes in one day
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Labor in Company B can make 8 T-shirts and one pair of shoes in one day
The information provided above is illustrated below:
| T-shirts | Shoes | |
|---|---|---|
| Company A | 10 | 2 |
| Company B | 8 | 1 |
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The opportunity cost for labor in Company A to make one T-shirt is ⅕ pair of shoes
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The opportunity cost for labor in Company B makes one T-shirt is ⅛ pair of shoes
The opportunity cost for labor in Company B to make one T-shirt is lower than the labor in Company A, so we say Company B has a comparative advantage in producing T-shirts.
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The opportunity cost for labor in Company A to make one pair of shoes is 5 T-shirts
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The opportunity cost for labor in Company B to make one pair of shoes is 8 T-shirts
The opportunity cost for labor in Company A to make one pair of shoes is lower than in Company B, so we say Company A has a comparative advantage in producing shoes.
For trade like the above situation, it’s more efficient that Company B sells T-shirts to Company A and Company A sells shoes to Company B. In this way, both companies can benefit from the trading.
Comparative Advantage vs. Absolute Advantage
These two terms are different concepts that confuse people sometimes. The former is producing a good or service at a lower opportunity cost than other trading partners.
Absolute Advantage is the ability of an entity to produce a greater quantity of goods and services than its opponents. To determine the absolute advantage, we can use one of the following ways:
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Producing the same amount of goods or services with fewer inputs.
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Producing more goods or services using the same amount of inputs.
Let’s go back to the examples above:
Example 1: In international trade, considering two countries(China and the United States), both countries produce cars and trains.
-
China can produce 30 cars and ten trains in one day.
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The United States can produce 60 cars and one train in one day.
We can put the information above in the form.
| Cars | Trains | |
|---|---|---|
| China | 30 | 10 |
| United States | 60 | 1 |
In this example, the input is time. As we know, all the given information is in the same period (in one day).
The US can produce a more significant number of cars than China by using the same time, which indicates that the US has an absolute advantage in making cars.
China can produce a greater quantity of trains than the US by using the same time, which means China has an absolute advantage in producing trains.
In this case, the US has both comparative advantage and absolute advantage in producing cars, whereas China has both comparative advantage and absolute advantage in producing trains.
Example 2: We take labor as an input to analyze this question. Both companies A and B produce T-shirts and shoes.
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Labor in Company A can make 10 T-shirts and two pairs of shoes daily.
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Labor in Company B can make 8 T-shirts and one pair of shoes daily.
The information provided above is illustrated below:
| T-shirts | Shoes | |
|---|---|---|
| Company A | 10 | 2 |
| Company B | 8 | 1 |
In this example, we take labor as input. All the given information is in the same amount of input (one labor).
Company A can produce a greater number of T-shirts than Company B by using the same input, which indicates Company A has an absolute advantage in making T-shirts.
In addition, Company A can produce more shoes than Company B by using the same input. So Company A has an absolute advantage in producing shoes.
In this case, Company A has a comparative advantage in producing shoes and absolute advantage in producing T-shirts and shoes. In contrast, Company B only has a comparative advantage in producing T-shirts.
In conclusion, these two terms are two different concepts and have no connection. While calculating during the trade, we should analyze these two terms independently.
Comparative Advantage vs. Competitive Advantage
Competitive advantage refers to factors that allow a company to outperform its competitors, which include producing goods or services better and more cheaply than its rivals. These factors enable the productive entity to generate more sales or superior margins than its market rivals.
Here are some examples of competitive advantages:
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Product quality: A business has a distinct advantage when providing a product of higher quality than its rivals. It could be related to technology, research, or product development. Additionally, the product might be strong and constructed of premium components.
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Pricing: Low prices provide a company a competitive edge, especially if other aspects, like quality, aren't in a solid position to compete. Companies that manufacture their items more affordably can sell them to clients for less money while still making a more significant profit margin than rivals that can only afford to make their goods more expensive.
When companies seek a better competitive advantage, they want to find a way to set themselves apart from other businesses.
A sort of competitive advantage known as comparative advantage helps a company maintain a cost advantage by allowing it to sell items for less than its rivals while still making a more significant profit margin.
A company will have an advantage if it outsources production to nations where labor and materials are less expensive than its rivals. A company can produce goods and services more efficiently than its competitors.
When a business has an advantage over another, it can produce and sell a larger quantity of products at a lower market price.
Disadvantages of Comparative Advantage
Since countries may achieve better material results by manufacturing just the items, they have the advantage of exchanging those goods with other nations. This theory is frequently employed in international commerce to support globalization.
Countries with advantages in specific export-focused industries, such as China and the Philippines, have seen significant productivity improvements by concentrating their economy in these sectors.
However, excessive specialization may also be harmful, particularly for emerging nations. Free trade has enormous human costs because it exploits local labor forces, even giving industrialized countries access to inexpensive industrial labor.
Companies can take advantage of child labor and coercive employment practices prohibited in their own countries by moving production to nations with laxer labor regulations.
For example, suppose a country in the Middle East with a lower opportunity cost than its trading partners in oil production only focuses on drilling for oil. In that case, the government will likely result in environmental pollution and oil depletion.
A country’s over-specialization leads to extreme dependence on export from other countries. It is hard to realize in the global pandemic or global wars. Also, the price for imported goods is unstable.
The price of imported goods depends on many factors, including the global environment and domestic and international demand. If a country cannot manage it well, it would likely lead to a higher price or lack of resources for people to live.
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