What is Comparative Advantage Formula?
Comparative advantage formula is an economic factorEconomic FactorEconomic factors are external, environmental factors that influence business performance, such as interest rates, inflation, unemployment, and economic growth, among others. that calculates comparative advantage between two countries producing the same goods in their own countries. On an absolute basis, a country can produce more quantity of a particular good in comparison to the quantity produced for the same good in another. But that does not imply that the country which produces more goods on an absolute basis has got an advantage over other countries. In order to find an advantage on a comparative basis, it is important to understand the opportunity costOpportunity CostThe difference between the chosen plan of action and the next best plan is known as the opportunity cost. It's essentially the cost of the next best alternative that has been forgiven. for producing other wells.
The equation for calculating comparative advantage has been developed by David Ricardo in the year 1817. It is calculated by finding the opportunity cost for a set of goods. Suppose two neighboring countries produce two sets of similar goods. So to find out the comparative advantage for those two goods we need to find out the opportunity cost for producing one good over the other good as the number of skilled labor is the same. Comparative advantage is calculated as
This formula will help us to calculate opportunity cost for product A; similarly, we need to calculate the opportunity cost for product B. We will do that for both the countries, we will be able to determine the comparative advantage of a particular good for a country in comparison to other by looking at the product of the formula.
Examples of Comparative Advantage Formula
Let’s see some simple to advanced examples of Comparative Advantage Equation to understand it better.
Example # 1
Let us try to understand the concept of comparative advantage with the help of an example. Suppose the two neighboring countries Italy and France both produce wine and manufactures clothes. Let us try and find out which country has a comparative advantage over the other for these two goods. The quantity of each good for each country is presented in the table below. For Italy, the opportunity cost for producing wine is 1.28 yards of cloth, and opportunity cost for manufacturing yard of cloth will be .82 bottle of wine. For France, the opportunity cost for producing wine is .86 yard of cloth and opportunity cost for manufacturing yard of cloth will be 1.17 bottle of wine. On an absolute basis, Italy produces a higher quantity of both goods. But on a comparative basis, the opportunity cost for producing a cloth with respect to wine is lesser so Italy should produce more cloth. Similarly, on a comparative basis for France, the opportunity cost for producing wine with respect to cloth is lesser so Italy should produce more wine.
Below is given data for the Calculation of Comparative Advantage formula.
Suppose Italy end up producing only cloth as Italy has the comparative advantage of producing cloth over France and France end up producing only wine as France has the comparative advantage of producing cloth over Italy. Let us see how that is going to increase the total economic output for both the countries.
Suppose Italy has 7 worker days and France has 9 worker days.
Calculation of Italy’s Quantity of Wine
The quantity of wine produced will be -7*430
Calculation of Italy’s Quantity of Cloth
The quantity of yard of cloth manufactured will be 7*550
Calculation of France’s Quantity of Wine
The quantity of wine produced will be 9*350
Calculation of France’s Quantity of Cloth
The quantity of yard of cloth manufactured will be -9*300
So the net result for the output for these goods for these two countries will be higher production of wine by (-3010+3150) = 140 bottles of wine and (3850-2700) = 1150 yards of cloth.
Example # 2
Oil-producing countries like countries that are part of OPEC have a comparative advantage for producing a lot of chemicals. A lot of chemicals are by-products of crude oil for which they have huge reserves. So a country that is producing crude has a comparative advantage over a country that is not producing crude in terms of manufacturing chemicals.
Example # 3
A country like India has a huge comparative advantage compared to the western country in terms of the outsourcing industries. Since India has a huge population of young educated English speaking population, this acts as an advantage to provide scale and price competitiveness which results in a lot of work being outsourced in India.
Relevance and Use of Comparative Advantage Formula
It is important to figure out the comparative advantage for goods among countries. As we have seen in the example above that if counties produce on the basis of their comparative advantages then the total output in the economy for both countries can be higher. This in a way enhances the chance of the much improved global trade between the two countries. In today’s age of globalization comparative advantage plays a major role. Countries end up producing goods in the region or country which has a higher comparative advantage due to labor, population, or the overall ecosystem.
This has been a guide to Comparative Advantage Formula. Here we discuss how to calculate comparative advantage using its formula along with examples and downloadable excel template. You can learn more about financing from the following articles –