Comparative Advantage

comparative advantage
U.S. President Barack Obama (L) shakes hands with Chinese President Xi Jinping (R) after a joint press conference at the Great Hall of People on November 12, 2014 in Beijing, China. Photo by Feng Li/Getty Images

Definition: Comparative advantage is when a country produces a good or service for a lower opportunity cost than other countries. Opportunity cost measures a trade off. The country make not be the world's best at producing something, but the trade off is worth it to other countries.

For example, oil-producing nations have a comparative advantage in chemicals. That's because the oil provides a cheap source of material for the chemicals when compared to countries without it.

As a result, Saudi Arabia, Kuwait, and Mexico compete well with U.S. chemical production firms. Their opportunity cost is low. That makes their chemicals less expensive. That's because a lot of the raw ingredients are produced in the oil distillery process. (Source: "Robust Growth and the Strong Dollar Set Pattern for Import and Export Prices," Bureau of Labor Statistics) 

Another example is India' call centers. U.S. companies buy this service because it is cheaper than locating the call center in America. Indian call centers aren't better than U.S. call centers. Their workers don't always speak English very clearly. But they can do it cheap enough to make the trade off worth it. (Source: "Comparative Advantage," Library of Economics and Liberty.)

In the past, comparative advantages occurred more in goods and rarely in services. That's because goods are easier to export. But telecommunications and the internet are making services easier to export.

That includes call centers, banking and entertainment. (Source: "Comparative Advantage," Bureau of Labor Statistics. "Comparative Advantage," Financial Times.)

What It Means to You: Comparative advantage is what you do best while giving up the least. For example, if you’re both a great plumber and a great babysitter, your comparative advantage is plumbing.

That's because you’ll make more money as a plumber. You can hire an hour of babysitting services for less than doing it yourself. That's because your opportunity cost of babysitting is high. Every hour you spend babysitting is an hour lost of revenue you could have gotten on a plumbing job. 

Theory of Comparative Advantage

David Ricardo created the theory of comparative advantage. He argued that a country boosts its economic growth the most by focusing on the industry in which it has the largest comparative advantage. 

For example, England was able to manufacture cloth relatively cheaply. Portugal had the right conditions to make wine pretty cheaply. Ricardo correctly predicted that England would stop making wine, and Portugal would stop making cloth. England made more money by trading its cloth for Portugal's  wine, and vice versa. It would have cost England a lot to try and make all the wine it needed because it lacked the climate. Portugal didn't have the manufacturing ability to make cheap cloth. Therefore, they both benefited by trading what they produced the most efficiently.

This theory of comparative advantage became the rationale for free trade agreements. Ricardo developed the his theory to combat trade restrictions on imported wheat in England.

He argued that it made no sense to restrict low-cost and high-quality wheat from countries with the right climate and soil conditions. England would receive more value by exporting products that required skilled labor and machinery. It could receive more wheat in trade than it could grow on its own. 

The theory of comparative advantage explains why trade protectionism doesn't work in the long run. Political leaders are always under pressure from their local constituents to protect jobs from international competition by raising tariffs. That only works temporarily. In the long run, it hurts the nation's competitiveness. It allows the country to waste resources on poor-performing industries. It also forces consumers to pay higher prices to buy domestic goods.

David Ricardo started out as a successful stockbroker, making $100 million in today's dollars.

After reading Adam Smith’s The Wealth of Nations, he became an economist. He was the first person to point out that significant increases in the money supply create inflation. This theory is known as monetarism

He also developed the law of diminishing marginal returns, one of the most important concepts in microeconomics. It states that there comes a point in production where the output isn't worth the additional input in raw materials. (Source: "David Ricardo," EconLib.)

Example 

United States: America's comparative advantage is its large land mass, bordered by two oceans. It also has lots of fresh water, arable land and available oil. It has a diverse population with a common language and national laws. For more, see The Power of the U.S. Economy.

Those all give U.S. businesses cheap natural resources and protection from land invasion. Most important, the diverse population provides a large test market for new products. That's helped the United States became a global leader in banking, aerospace, defense equipment and technology. For more, see The Four Major Things the U.S. Is Good at Producing and How Silicon Valley ls America's Innovative Advantage.

Comparative Advantage vs. Absolute Advantage

Absolute advantage is what a country, business or individual does better than the competition. A country can have an absolute advantage in producing oil and chemicals because it has a large oil supply. If it has lots of farmland and fresh water, it could also have an absolute advantage in producing food. It could easily be self-sufficient. 

But if its neighbor has no oil but lots of farmland and fresh water, it would be willing to pay a higher price for the oil. That means the first country will specialize in oil because it could trade it for more food from the second country.

Absolute advantage is important, but comparative advantage is what determines what a country will specialize in. (Sources: "Absolute Advantage," FT.com Lexicon.  "Comparative Advantage and Absolute Advantage," Shmoop.com. "Absolute Advantage in Trade," Study.com. 

What It Means to You: Absolute advantage is what you do best. You’re better than everyone else in the neighborhood at both plumbing and babysitting. But only plumbing is your comparative advantage.

Comparative Advantage vs. Competitive Advantage

Competitive advantage is what a country, business or individual does better than its competitors. There are three strategies companies use to gain a competitive advantage. First, they could be the low-cost provider. Second, they could offer a better product or service. Third, they could focus on one type of customer. (Source:"Free Trade and Protection: Why Do Nations Trade?" HSC Online.)

What It Means to You: Competitive advantage is what you do better than your competitors. You have a competitive advantage as a plumber and a babysitter because you do both better than anyone else in the neighborhood.

But it’s not necessarily because you do them more efficiently. It may be because you offer better customer service. For example, you bring brownies to you plumbing job. Your customers are willing to pay you more even though you aren’t more efficient.