Comparative Advantage Theory and Examples
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. A nation with a comparative advantage makes the trade-off worth it. The benefits of buying its good or service outweigh the disadvantages. The country may not be the best at producing something. But the good or service has a low opportunity cost for other countries to import.
For example, oil-producing nations have a comparative advantage in chemicals. Their locally-produced oil provides a cheap source of material for the chemicals when compared to countries without it. A lot of the raw ingredients are produced in the oil distillery process. As a result, Saudi Arabia, Kuwait, and Mexico are competitive with U.S. chemical production firms. Their chemicals are inexpensive, making their opportunity cost low.
Another example is India's 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 provide the service cheaply enough to make the tradeoff worth it.
In the past, comparative advantages occurred more in goods and rarely in services. That's because products are easier to export. But telecommunication technology like the internet is making services easier to export. Those services include call centers, banking, and entertainment.
Theory of Comparative Advantage
Eighteenth-century economist 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 most substantial comparative advantage.
For example, England was able to manufacture cheap cloth. Portugal had the right conditions to make cheap wine. Ricardo predicted that England would stop making wine and Portugal stop making cloth. He was right. England made more money by trading its cloth for Portugal's wine, and vice versa. It would have cost England a lot to make all the wine it needed because it lacked the climate. Portugal didn't have the manufacturing ability to make cheap cloth. So, they both benefited by trading what they produced the most efficiently.
The theory of comparative advantage became the rationale for free trade agreements.
Ricardo developed his approach 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 acquire 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. But that’s only a temporary fix. In the long run, it hurts the nation's competitiveness. It allows the country to waste resources on unsuccessful 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 pointed out that significant increases in the money supply created inflation in England in 1809. This theory is known as monetarism.
He also developed the law of diminishing marginal returns. That’s one of the essential concepts in microeconomics. It states that there is a point in production where the increased output is no longer worth the additional input in raw materials.
One factor in America's comparative advantages is its vast landmass bordered by two oceans. It also has lots of fresh water, arable land, and available oil. U.S. businesses benefit from cheap natural resources and protection from a land invasion.
Most important, it has a diverse population with a common language and national laws. The diverse population provides an extensive test market for new products. It helped the United States excel in producing consumer products.
Diversity also helped the United States became a global leader in banking, aerospace, defense equipment, and technology. Silicon Valley harnessed the power of diversity to become a leader in innovative thinking. Those combined advantages created the power of the U.S. economy.
Investment in human capital is critical to maintaining a comparative advantage in the knowledge-based global economy.
Comparative Advantage Versus Absolute Advantage
Absolute advantage is anything a country does more efficiently than other countries. Nations that are blessed with an abundance of farmland, fresh water, and oil reserves have an absolute advantage in agriculture, gasoline, and petrochemicals.
Just because a country has an absolute advantage in an industry doesn't mean that it will be its comparative advantage. That depends on what the trading opportunity costs are. Say its neighbor has no oil but lots of farmland and fresh water. The neighbor is willing to trade a lot of food in exchange for oil. Now the first country has a comparative advantage in oil. It can get more food from its neighbor by trading it for oil than it could produce on its own.
Comparative Advantage Versus Competitive Advantage
Competitive advantage is what a country, business, or individual does that provide a better value to consumers 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.
How It Affects You
Comparative advantage is what you do best while also giving up the least. For example, if you’re 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 you would make doing an hour of plumbing. Your opportunity cost of babysitting is high. Every hour you spend babysitting is an hour’s worth of lost revenue you could have gotten on a plumbing job.
Absolute advantage is anything you do more efficiently than anyone else. You’re better than everyone else in the neighborhood at both plumbing and babysitting. But plumbing is your comparative advantage. That's because you only give up low-cost babysitting jobs to pursue your well-paid plumbing career.
Competitive advantage is what makes you more attractive to consumers than your competitors. For example, you are in demand to provide both plumbing and babysitting services. But it’s not necessarily because you do them better (absolute advantage). It's because you charge less.
The Bottom Line
Individuals, corporations, and nations engage in commerce to capitalize on their advantages. These advantages could be absolute, competitive, or comparative in nature.
Nations mostly base their decisions on what to import or export on the concept of comparative advantage. This states:
- A country may have an absolute or competitive advantage over another. But, it often chooses to specialize production on a good or service which it can make most efficiently, relative to its trading partners.
- A nation with comparative advantage channels its capital, labor, and natural resources on production requiring lower opportunity costs and higher profit margins.
- Trade protectionism shields inefficient industries. It allows the squandering of resources on uncompetitive production. This goes against the grain of the comparative advantage concept.
- David Ricardo, an 18th-century economist, developed this concept. He wanted to end tariffs on wheat importations to England.
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