What is a comparative advantage?

By Anita Kalra4 min read · Posted Mar 7, 2024

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Comparative advantage is the ability of an individual, company, or entity to produce a good or service at a lower opportunity cost compared to others. It also applies to nations around the globe. This can come about due to advantages among nations like availability of certain raw materials; mineral richness of one nation over another; technological, educational, or weather-related differences; or simply geographical location.

The theory of comparative advantage was suggested by British economist David Ricardo in the 19th century; he argued that countries can benefit from trading with each other if they focus on producing which goods and services they are best at, leading to economies of scale. Given each country’s cost of raw goods and opportunity cost, if the countries focus on what they are good at, then their efficiency at production of this good will improve, leading to further cost lowering. The more the production and the higher the specialization, the lower the cost.

In his 1817 book “Principles of Political Economy and Taxation,” Ricardo argued against Great Britain’s protectionist Corn Laws, which restricted the import of wheat from 1815 to 1846. In arguing for free trade, the economist stated that countries were better off specializing in what they enjoy a comparative advantage in and importing the goods in which they lack a comparative advantage.

Any advantage in production of a good or service is collectively derived from:

  • Financial cost
  • Efficiency cost
  • Opportunity cost
  1. Financial cost is the cost of raw materials, machinery, etc. As mentioned above, some countries may have access to cheaper raw materials for many reasons, hence their cost of production will be lower.

  2. Efficiency cost refers to the speed with which a country can produce a product, even if the cost of materials is higher in that country. This could be due to educational differences or technological differences.

  3. Opportunity cost is the forgone cost of not producing an alternative good or service that could have been produced within the same time frame, with the same effort and money. Opportunity cost may be measured in terms of profit, international relations, or preservation of certain raw materials.

Although it may seem financially cheaper for a country to produce a certain product, it is not only the financial cost of producing that good or service that matters, but also the efficiency in its production, and any missed opportunities. Since efficiency eventually feeds into the final financial cost of production, efficiencies are assumed to go hand in hand with financial cost—both making up what is called absolute advantage.

The opportunity cost of forgoing an alternative decision drives countries to decide what to focus on, leading to a comparative advantage.

Absolute advantage takes into account the basic cost of production.

Comparative advantage goes a step further and takes into account the opportunity cost of forgoing other opportunities.

Comparative advantage rather than absolute advantage is considered the basis of international trade.

Let’s look at an example.

If country A can produce microchips at a lower cost than country B, then country A is said to have an absolute advantage financially over country B in microchip production. In international trade markets, it may seem beneficial from an economic standpoint for Cy A to produce microchips and export to Cy B. (We will refer to country A and country B as Cy A and Cy B from here onward.)

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Now, let’s say both countries want to produce semiconductors, and Cy A can again produce semiconductors cheaper than Cy B.

Given a limited production capacity, Cy A will have to decide between microchips and semiconductors.

Per the table below, if Cy A makes a higher profit from making semiconductors, that is its opportunity cost. Cy A will not choose to make microchips over semiconductors, because its cost to let go of making semiconductors is higher in terms of lost profits.

Thus, Cy A has a comparative advantage in producing semiconductors where its profits are higher, vs. microchips with a lower profit, as shown in the two tables.

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In the real world where resources are limited, businesses or societies must make a decision, or market forces eventually decide for them what to focus on and how to allocate resources. Production of goods and services may get split globally, to take advantage of available efficiencies around the globe at each stage of production.

Microchip production can be split among countries such that its design and research are conducted in one country, actual production facilities can be in another country, testing and market testing in another, and shipping and distribution in yet another. Production is thus distributed according to raw material availability, efficiency of production, and making the best of available opportunities regionally. This will allow companies to capitalize on global efficiencies, cost advantages, and specialized capabilities in different regions. It can enhance efficiency, reduce costs, and contribute to the overall competitiveness of the final product in the global market.

This type of comparative advantage production has been carried out in auto making, mobile phone assembly, microchips, clothes, food, medicine, and many other industries.

Disadvantages of focusing on comparative advantage are that it may deplete a country’s natural resources, or that excessive focus on one aspect will eventually lessen other capabilities that are not sharpened. An example would be a computer coding professional who focuses excessively on code writing and turns out to be an introvert, lacking social skills and ability to express in writing and speech.

In such cases, splitting production around the globe may be more desirable.

References

Corporate Finance Institute Investopedia

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