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. U.S. President Barack Obama pays a state visit to China after attending the 22nd Asia-Pacific Economic Cooperation (APEC) Economic Leaders' Meeting. Photo by Feng Li/Getty Images

Definition: Comparative advantage is what a country is the best at producing, when compared to other countries, for the lowest opportunity cost. A country has a comparative advantage when it is better than any other country in producing something, AND it doesn't give up as much by producing it.

It's more likely to be goods, like jets, luxury automobiles, or cheese, than a service. That's because goods are easier to export.

But some countries do have an advantage in services, such as banking and entertainment. (Source: Comparative Advantage, Bureau of Labor Statistics. Comparative Advantage, Financial Times.)

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 are competing with U.S. chemical production firms.

Their opportunity cost is low. They don't have to give up much to produce chemicals. 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) 

What It Means to You: Comparative advantage is what you do best while giving up the least. If you’re a great plumber and a great babysitter, you should become a plumber.

You’ll make more money as a plumber and can buy more babysitting services. Even if you are the best babysitter in the world, you’ll be able to buy less plumbing services. That’s because you’ve given up the opportunity of making more money as a plumber. 

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 superior in manufacturing cloth. Portugal was better at making wine. Ricardo correctly predicted that England would stop making wine, and Portugal would stop making cloth. England made more money by trading its high-value cloth for Portugal's high-value wine, and vice versa. Why make inferior wine yourself when you can get a larger quantity of superior wine by selling your cloth?

This theory of comparative advantage became the rationale for free trade agreements. Ricardo developed the comparative advantage theory to combat trade restrictions on wheat in England. That's because it was lower cost and higher quality when grown in countries with the right climate and soil conditions. England received 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 a lot of pressure from their local constituents to preserve jobs by raising tariffs.

That temporarily protects local industries from overseas competition. However, it hurts the nation in the long run by allowing the country to waste resources on poor-performing industries. It also forces consumers to pay higher prices to buy lower-quality 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: EconLib, David Ricardo)

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, protection from land invasion, and a large test market to support innovation of new products and services. As a result, the United States became a global leader in banking, aerospace, defense equipment, and technology. For more, see The 4 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 at a lower cost than the competition. That's because it has abundant natural resources, such as oil, farmland or even labor. (Sources: Absolute Advantage, FT.com Lexicon. Comparative Advantage, Library of Economics and Liberty. Comparative Advantage and Absolute Advantage, Shmoop.com. Absolute Advantage in Trade, Study.com. 

What It Means to You: Absolute advantage is what you do most efficiently. You’re better than everyone else in the neighborhood at plumbing and babysitting. 

Comparative Advantage vs. Competitive Advantage

Competitive advantage is what a country, business, or individual does better than its competitors.  It can be because 1) it is the low-cost provider, 2) it offers a better product or service, 3) it is technologically superior. (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. You bring brownies, so others are willing to pay you more even though you aren’t more efficient. Or, you take pictures and send them to the owners, so they know how the repairs are going, or the children are doing. That is an example of innovation.