Comparative Advantage: Theories - Examples

‘Every great political campaign rewrites the rules; devising a new way to win is what gives campaigns a comparative advantage against their foes.’ – John Podhoretz

The theory of comparative advantage was invented by David Ricardo, an eighteenth-century economist. He argued that a country could boost its economic growth by focusing on the industry it has the most substantial comparative advantage in.

In other words, comparative advantage leads to an increase in economic welfare of different countries. But, what exactly is a comparative advantage? How will it be beneficial for people all over the world? Let’s find out.

What Do You Mean By ‘Comparative Advantage’?

Comparative advantage takes place when a country produces a good or service at a lower opportunity cost than the other countries. Opportunity cost is just a fancy word for ‘trade-off’. It implies that the benefits of buying services or goods at a cheaper price outweigh the disadvantages.

Sounds confusing? Check out this example here:

Nations that produce oil have a comparative advantage in chemicals. They produce oil locally and provide a cheap source of material for the chemicals as compared to other countries. Plenty of raw ingredients are produced in the oil-distillery process. This is exactly why Kuwait, Saudi Arabia and Mexico are competitive with chemical firms in the United States. These chemicals are available at cheap rates, thereby making their opportunity cost quite low.

Here is another example to make this concept simpler for you.

India houses quite a lot of call centres, which are usually bought by the companies located in the US. US companies buy services from India because it is cheaper than establishing the call centre in their native place.

Indian employees don’t speak English clearly. Yet, they provide the services at a cheaper rate and that makes the trade-off worth it.

Initially, the comparative advantage was mostly seen in goods rather than in services. This is because products are comparatively cheaper to export. Nowadays, services can also be exported easily due to the advent of advanced telecommunication technology such as the Internet.

A Detailed Analysis Of The Theories Related To Comparative Advantage

As mentioned earlier, David Ricardo came up with the theory of comparative advantage. Here is a brief example of his observation and analysis before coming up with the theory.

The cheap cloth was available in England during the eighteen century. Cheap wine was available in Portugal. Ricardo predicted that Portugal would stop making wine and England would stop producing cloth. As a matter of fact, Portugal made more money by trading its wine for England’s cloth and vice versa. Portugal did not have the right equipment or facility to make cheap cloth. So, they made a profit with what they are good at producing.

According to the observation mentioned above, the theory of comparative advantage is as follows:

If country A specialises in producing a specific product X and country B specialises in producing product Y, then country A and B should trade to obtain maximum output.

Consider this example here:

Country	Textile	Books
UK	1	4
India	2	3
Output	3	7

Chart 1: Output total of India and the UK

UK and India produce textiles and books as shown in the chart.

In the UK, 1 unit of textile is produced at an opportunity cost of 4 books.

Similarly, in India, 1 unit of textile is produced at an opportunity cost of 1.5 books.

Thus, India has a comparative advantage in producing textiles since it has a lower opportunity cost in textiles.

The total output of both countries is 3(T) and 7(B). But, after the application of comparative advantage theory, the total output of both countries would be:

Country	Textiles	Books
UK	0	8
India	4	0
Total	4	8

Chart 2: Output total of the UK and India

As seen in the chart, the gains obtained from comparative advantage is clearly visible for both the goods.

Now the total output is 4(T) and 8(B), which is comparatively higher than the previous output.

So, specialising in a good or service with a comparative advantage has led to greater economic welfare. You can click this link to know more about the theory of comparative advantage.

What Is The Difference Between Comparative Advantage and Competitive Advantage?

Economics students usually get confused between these two concepts. The thing is that the concept of comparative advantage is more rooted in the sector of economics. Competitive advantage, on the other hand, is rooted in the industry of strategic management and refers to the distinctive competencies of a firm.

The key difference between the two lies in the fact that competitive advantage provides decide the winners in a global competition. It also determines the reasons for which the firms could acquire that position.

Comparative advantage primarily focuses on patterns and gains from trade as explained in the previous sections of the blog.

Comparative advantage still exists due to lower costs or size. But, it does not confer a competitive advantage and does not support high wages as well. The concepts of comparative and competitive advantage are not the same. But, comparative advantage influences the other to some extent.

Competitive advantage is something that makes you better than everyone else. Comparative advantage arises when you can produce products at a lower cost than everyone else.

Are you still confused? Take a look at the example of each advantage:

Comparative advantage:

India has a comparative advantage of producing jewellery better than other countries due to the availability of craftsmen and artist. Australia has a comparative advantage of gold mining since they have natural gold mines. Japan lacks the same advantage because it doesn’t have the necessary resources.

Competitive advantage:

The USA had a comparative advantage in producing Boeing, one of the famous aircraft, due to their significant contribution to this technical field since the ‘80s. During the ‘60s, Europe too started investing heavily in R&D to build aircraft. Airbus of R&D was finally brought forth after four European nations invested money in it. After 20 years, Airbus was finally declared as the official competitor of Boeing. Airbus gained a competitive advantage over Boeing since it was better than other aircraft.

Airbus definitely enjoys a competitive advantage now. But, it never owned a comparative advantage. The competition was created due to constant engineering, planning and R&D. Europe now has a comparative advantage in building aircraft.

How Is Comparative Advantage Different From Absolute Advantage?

Comparative advantage and absolute advantage are two popular terms in the field of international trade. They influence the expenditure of resources to the production of specific goods by several nations.

As discussed earlier, the comparative advantage takes opportunity costs into consideration while choosing to produce multiple types of goods or services with restricted resources. Absolute advantage highlights the scenario in which one country can gain maximum profits by manufacturing products at a faster rate than others.

Absolute advantage focuses on the efficiency of producing a single product in isolation. It is based on the varying abilities of nations to produce products or goods efficiently. This helps countries to produce products that would yield a profit.

Comparative advantage, on the other hand, takes a more holistic approach towards the manufacturing of goods. It came into consideration when the country has limited resources and production advantages were minimal.

A country’s absolute advantage determines the type of products it can produce. For example, say Japan and the United States can both produce cars. But, Japan produces a higher quality of sports car at a comparatively faster rate. Thus, Japan is said to have an absolute advantage in that industry.

Comparative advantage introduces the concept of opportunity cost. For example, France and Italy have enough resources to produce either cheese or wine but not both. France is able to produce 10 units of cheese or 20 units of wine. The opportunity cost of each unit of cheese is two units of wine. The same for each unit of wine is 0.5 units of cheese.

Now, Italy can generate 22 units of cheese or 30 units of wine. As you can see, Italy has an absolute advantage of both wine and cheese. But, Italy’s opportunity cost of wine is higher than that of France. Thus, France has the upper hand in this case despite Italy being the more efficient producer. But, Italy has a lower opportunity cost for cheese. Hence, it has both absolute and comparative advantage in this case.

A Brief Analysis Of Comparative Advantage In International Trade

David Ricardo came up with the theory of comparative advantage in international trade to highlight the strategy that could increase the world output. Comparative advantage and absolute advantage contributes to the overall productivity and profit in international trade. Let’s see how.

As per the discussion so far, comparative advantage shows how much productive one country is related to another. Similarly, absolute advantage is all about being more productive than other countries. When these theories are applied in international trade, it could increase the overall profit rate.

For example:

Let’s say country A and country B produces two goods: cars and trucks.

Goods	Country A	Country B
Cars	30m	35m
Trucks	6m	21m

Chart 3: Production of Country A and country B

As shown in the chart, A produces 30m of cars or 6m of trucks. Country B produces 21m of trucks or 35m of cars.

As you can see, country B has an absolute advantage since it produces both the products at a faster rate. It is 1.17 times better at producing cars and 3.5 times better at producing trucks.

The greatest gap between the two countries is with the production of trucks. Thus, country A should focus on producing cars only while country B should focus on producing trucks.

As per the theory of comparative advantage or international trade, combined output will increase compared to the output produced by individual companies in an attempt to become self-sufficient. Considering the same example, if countries A and B distribute resources evenly, then the combined output will be:

Cars:

15+15= 30

Trucks:

12+3= 15

Hence, the total world output will be 45m units.

Thus, countries can produce goods at a faster rate and at a lower opportunity cost with fewer resources. This is what gives countries a comparative advantage. The production of one good can lead to less of another.

Here is a list of the key points related to the comparative advantage in international trade as deduced from the Ricardian Model:

The only productive factor is labour.
Labour is immobile internationally. But, it is perfectly mobile within a country.
The labour units involve determining the cost of production.
Labour is homogenous.
It leads to constant returns to scale.
There is free or unrestricted trade.
Healthy competition is also visible.
There is full employment equilibrium.

Despite the maximum world output, the theory of comparative advantage can also be criticised. For instance, it may overstate the privileges of specialisation by ignoring multiple costs. The costs include external costs such as trade and transport costs. The concept of comparative advantage is not constant and it may change with time.

Whatever the criticisms are in regards to the comparative advantage theory, its effect on international trade is unavoidable. It provides a shape to the pattern of world trade despite being irrelevant in the world of globalisation and modern theories.

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