Comparative Advantage

Updated on January 25, 2024
Article byJyotsna Suthar
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Comparative Advantage?

Comparative advantage is an economic theory stating that countries, businesses, and manufacturers who produce goods and services at a lower opportunity cost have the edge over others. The main purpose of this theory is to provide the maximum benefit possible by producing the right combination of goods.

How Comparative Advantage Works?

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Comparative advantage provides a higher efficiency rate for the participants. Entities with a greater comparative advantage get to increase their profit margins during the trade. However, it can lead to resource depletion in the country.

Key Takeaways

  • Comparative advantage states that every country, business, and individual must produce only those goods and services that need freely available resources and lower opportunity costs and trade them with others.
  • It is an economic theory given by British economist David Ricardo in 1817 in the book “On the Principles of Political Economy and Taxation.”
  • The major factors affecting the theory include productivity, availability of resources, geographic locations, technology, and others.
  • However, other economists like James Mill and Robert Torrens have also contributed to this theory.

Comparative Advantage Theory Explained

Comparative advantage theory in economics refers to the capacity of the firm, country, or individuals to produce the best of all and let go of the weak. Thus, the participants can focus on achieving higher efficiency. In addition, the principle of comparative advantage forms the base for international trade. First, however, selecting the right choice of resources and strategies is necessary to achieve a lower opportunity cost.

Renowned British political economist David Ricardo discovered the concept of comparative advantage in the March and early weeks of October 1816. The study was published in the book “On the Principles of Political Economy and Taxation” in 1817. However, the credits of the theory are equally shared among Robert Torrens, David Ricardo, and James Mill.

Ricardo’s principle of comparative advantage states that every country should produce only the best goods and services. And producers should stop the production of goods with less efficiency and quality.

Let us consider two countries following the concept of comparative advantage. Country A specializes in making cloth, and Country B in chocolates. However, the former’s cost of producing chocolates is more. Likewise, the latter’s cost for weaving cloth is expensive. Assuming each country has plenty of resources to produce them, the incurred cost is less. Thus, both countries decide to trade with each other. As a result, country A will receive chocolates, and Country B will get cloth. Since the formerly sold cloth for chocolate, the deficiency vanishes. Likewise, Country B will trade chocolate and receive cloth in return.

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Absolute Advantage vs. Comparative Advantage Explained in a Video

 

Factors

Let us look at the factors that play a major role in comparative advantage theory:

#1 – Labor

It is one of the important factors that aid in comparative advantage. Labor could be both skilled and unskilled. If a country wants to produce an item that is profitable but lacks labor, it can be a disadvantage. Thus, the theory states that a country should use highly skilled labor to produce goods that help them gain an advantage.

#2 – Resource (Raw Materials) Abundance 

It is another prime factor that affects Ricardo’s theory. If a country produces one raw material in abundance, it has the edge over other countries. For example, Belgium has many cocoa trees that greatly benefit the economy. As a result, they can produce high-quality chocolates using skilled labor.

#3 – Geographic Location

Depending on geographic factors, the production of a product can be advantageous to the firm. Since every country has a different climate and diversity, the resources available and trade also get affected. For example, dates grow in arid and semi-arid (very hot) locations. And as African and Arab countries act as favorable factors for the growth of dates, they gain an advantage in trade.

#4 – Productivity

Productivity differences also matter in this theory. So, the more unskilled labor, the productivity will be low. As a result, it is necessary to employ skilled labor to increase the overall productivity of the goods.

#5 – Technology

Technological differences between countries can lead to productivity gaps in labor and goods. However, the end product will be highly efficient if a country has advanced technology.

#6 – Product Innovation

Innovation in the product also causes the theory to shift its focus. Thus, if a product has a common scale, likely other countries will produce it at a lower cost. Therefore, the comparative advantage will shift from the original country to the other.

#7 – Traditions, Culture, And Preferences 

Customers’ tastes and preferences are a vital factor in Ricardo’s theory. If the demand for a highly skilled product in the international market increases, it can be a comparative advantage to the country.

Graph

Let us look at an imaginary example with England and France to understand the comparative advantage graph:

Schedule (Production Wise)

CountryCotton Wine 
England 10 units 6 units 
France 6 units10 units

In the above table, two countries (England and France) produce commodities (Cotton and wine). However, due to scarcity of resources, each of them faces less efficiency in one of the products. Therefore, the cotton produced by the former country is 10 units. Likewise, France produces similar units in wine.

Schedule (Cost wise)

CountryCotton Wine 
England $12 $20
France $20$12

In this table, the cost to produce cotton for England is less than wine because the resources are easily available. Likewise, for France, producing wine is much cheaper than cotton. Therefore, England has a cost advantage in producing cotton, and France has it in wine.

So, if both countries trade with each other, the following is the benefit gained by them:

CountryProduction before trade Production after trade Gains from the trade 
England 10 + 6 20 + 10 (- 6)
France6 + 10 20+ 10 (- 6)

The above table shows that column 2 (production before the trade) depicts the current quantity manufactured by both countries. However, when both nations realize their cost advantage factor, they focus on their strength and stop producing weak (or less quantity) products. Here, England shifts the production of cloth, and now it produces ten extra units (a total of 20 units). Likewise, in France, wine was a highly efficient commodity. Therefore, even they produce an extra ten units of wine (now 20 units).

Thus, after applying the comparative advantage or comparative cost theory, each country gains ten extra units and loses six units since the production of less efficient commodities stops. And each trades the highly efficient product and purchases the less efficient one.

Comparative Advantage Graph

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The above graphs depict the cost advantage before and after the trade. For example, in the first figure (1.0), Y1 is a curve that shows the quantity produced by France. The steep line shows high wine production and low cotton production. Likewise, X1 is a slanted curve of England that shows high cotton and low wine production.

However, when they apply comparative cost theory, there is a shift in the production and cost incurred. For example, in figure 1.2, RS is the production curve for England and AB for France. And PQ is the comparative cost advantage they gain after trading with each other.

Examples

Let us look at the examples of comparative advantage to understand the concept better:

Example #1

Suppose England and France are countries self-sufficient in certain resources. While the former grows more cotton, they own plenty. Likewise, the latter cultivates more wine trees in their country. However, England faces a deficiency of wine in their country. At the same time, France has a lesser efficiency in producing cloth. Therefore, both countries try to trade what they cannot afford. In the former case, it is wine, and the latter requires cloth. So, as per the comparative advantage theory by David Ricardo, England will sell cloth and buy wine. And France will buy that cloth from England and give wine in return.

Thus, both nations will profit by selling their highly efficient goods and balancing their less efficient ones.

Example #2

As per the reports in August 2022, the United States was the major exporter of India in the fiscal year 2021. Based on the above theory, the latter tried to provide pharmaceuticals, boilers, electric components, and machinery to the former. However, it plans to reduce around 40% of imports from China.

Advantages And Disadvantages

Comparative advantage in economics is a crucial component of international trade. It provides a way to develop better relations with other countries. Also, the country gets a chance to trade its best products profitably. As a result, the margins also increase. Moreover, since these products reach overseas markets, the number of potential customers has risen. In addition, it brings many other benefits like an absolute advantage, competitive advantage, and others.

However, this theory might only sometimes succeed. While countries assume they are saving on costs, the costs actually outweigh the expectations. Also, if countries try to stop their domestic production of less efficient goods, the chances of unemployment increase.

AdvantagesDisadvantages 
Lower opportunity costsLimitations on trade conducted
Higher profit margins Illusion of savings 
Access to more customersDifficult to find skilled labor
Improved efficiency Assumptions fail to succeed. 
Brings other advantages Unemployment rate increases 
Promotes International trade 

Comparative Advantage vs Competitive Advantage

Although comparative and competitive advantages are part of a trade, they have distinct differences. The former is a principle given by David Ricardo in 1817, stating that countries and businesses should produce cheaper and highly efficient goods. However, in the latter case, Michael Porter suggests that businesses produce different or unique products that are unmatchable from their competitors. Here, they aim to add uniqueness to their goods, while the former will only produce those goods with plenty of resources.

BasisComparative AdvantageCompetitive Advantage
Meaning It is a concept of producing cheaper goods and services than other businesses and countries.Competitive advantage is an ability to produce goods better than competitors.
Purpose To produce goods whose resources are available in plenty. To develop highly efficient products than the competitors. 
Participants Countries, businesses, and individuals. More common within businesses.
Origin 1817 by David RicardoMichael Porter gave it in 1985
Gain Lower opportunity cost, high profits, etc.A distinct feature in their products and services. 

Frequently Asked Questions (FAQs)

What is the dynamic comparative advantage?

It is a trade-off focusing more on the specialization in the existing advantage theory. It occurs in the low- technology sector, which lacks an advantage in the current startup.

What is the revealed comparative advantage?

It is an index of calculating a relative benefit or limitation of one country about a certain category of goods and services. This concept is dependent on the Ricardian trade theory.

Can comparative advantage change over time?

Comparative advantage theory is a flexible, dynamic concept that can change its application with time. For example, if the freely available resources are extinguished, the theory can go wrong for that economy. Likewise, discovering or employing resources like labor can benefit the firm.

Who has the comparative advantage in producing oil?

Countries with an abundance of oil resources have a comparative advantage in trade. In this case, Arab countries like Iran, Iraq, Saudi Arabia, and other gulf countries produce more crude oil.

This article has been a guide to what is Comparative Advantage. Here, we explain its comparison with competitive advantage, examples, graph, & disadvantages. You may also find some useful articles here –

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