What is comparative advantage? Definition and meaning
Comparative advantage is an economic concept that a nation should specialize in making and exporting only those products and services which it is able to produce more efficiently – at lower opportunity cost – than other goods and services. It should specialize even if it has superior productivity in making all goods compared to another country. The goods it does not make should be imported.
Imagine there are two countries, Jonlandia and Marilandia. Jonlandia knows how to make cars and airplanes, while Marilandia only knows how to make cars. Jonlandia’s productivity in car-making is slightly superior to Marilandia’s.
Jonlandia would be better off making just airplanes and importing cars from Marilandia, because airplanes sell for much more money, i.e. it can buy many more cars if they are imported and it just makes planes.
If Pam knows how to do Ann’s work, why doesn’t she do everything herself? Her secretary’s wages bill would be saved, wouldn’t it? Yes it would, but her practice would earn considerably less money.
If Marilandia only makes cars and Jonlandia just makes airplanes, they can trade so that the two countries end up with both cars and planes. Jonlandia’s workers can buy more cars per head of population if they just makes planes. Total production and consumption of Jonlandia and Marilandia combined is considerably greater.
The theory of economic advantage can be applied to whole economies, companies or individuals.
If you find the example above confusing, look at the example of a lawyer and secretary below – the concept is the same.
According to the Financial Times Lexicon, comparative advantage is:
“The idea that a country or region should specialize in making and exporting goods and services that it can produce most efficiently. In turn, the country should import goods and services that it has a comparative disadvantage producing. This should in theory lead to an increase in overall trade.”
“This can be the case even if one country has an absolute advantage over another in producing a number of different goods.”
Economist David Ricardo used the comparative advantage theory to explain why nations engage in international trade. The video at the bottom of this page explains that communities in total isolation – such as Tasmania when it became cut off from the mainland – fall rapidly behind technologically.
Absolute vs. comparative advantage
Comparative advantage and absolute advantage are terms often used in the same text, however, their meanings are quite different.
Imagine a lawyer and her secretary. This lawyer can type faster and is better at producing legal services than the secretary. The lawyer has an absolute advantage over the secretary.
Even so, both people benefit thanks to their comparative advantages as well as disadvantages. Imagine legal services and secretarial duties charge $150 and $25 per hour respectively. The lawyer is capable of providing both legal and secretarial services, while the secretary can only provide secretarial duties.
However, for every hour the lawyer spends on secretarial work, she is not earning $150 by practicing law – she loses a net $125. She would be better off working full time as a lawyer and employing a full time secretary. Look at the difference in income below for a 40-hour week:
– Lawyer just does secretarial work and has no help: $25 x 40 hours = $1000.
– Lawyer practices law full time and employs a full time secretary: Lawyer’s fees of $150 x 40 hours = $6,000. Minus secretary’s wages of $1,000 ($25 x 4). The net income for the week is $5,000.
Even though the lawyer can do the secretary’s job, she earns considerably more by delegating all the secretarial work to an employee.
This opportunity cost in employing a secretary is very low – this is where her comparative advantage lies.
Opportunity cost refers to how much you have to give up by not doing something – which in this case is the lawyer giving up doing secretarial work.
Thomas Sowell, an American economist, political philosopher and social theorist, is currently Senior Fellow at the Hoover Institution at Stanford University. He writes from a libertarian conservative viewpoint, advocating supply-side economics. (Image: aei.org)
David Ricardo (1772-1823), a British economist, considered as one of the most influential of the classical economists, developed the classical theory of comparative advantage in 1917. He also introduced the Ricardian equivalence proposition.
He used it to explain why nations engage in international trade, even when the workers in one country are more efficient in producing every single product than those in another.
Ricardo showed that if two national economies, which are capable of producing two commodities, engage in international trade, then each nation will increase its overall consumption by exporting the product for which it has a comparative advantage, while importing the other product, as long as there is a difference in labor productivity between the two nations.
Ricardo’s theory implies that comparative advantage, and not absolute advantage, is responsible for the bulk of international trade.
David Ricardo was born in London, he was third of seventeen children of a Sephardic Jewish family of Portuguese origin. His parents had recently relocated from the Dutch Republic when he was born. He started working with his father, a successful stockbroker, when he was 14. He was a strong supporter of free trade. His ideas had a powerful influence in later developments in economics. In the USA, economists rank him as the second most influential economic thinker, after Adam Smith, before the 20th century. (Image: wikipedia)
Adam Smith (1723-1790), a Scottish moral philosopher and pioneer of political economy, dubbed the ‘father of modern economics’ by many current economists, first alluded to the idea of absolute advantage as the basis for international trade in the publication of The Wealth of Nations in 1776.
“If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry employed in a way in which we have some advantage. The general industry of the country, being always in proportion to the capital which employs it, will not thereby be diminished . . . but only left to find out the way in which it can be employed with the greatest advantage.”
The concept of comparative advantage appeared in Ricardo’s book On the Principles of Political Economy and Taxation, published in 1817.
Comparative advantage: Ricardo’s example
Ricardo compared England and Portugal, which produce cloth and wine of equal quality. In Portugal, the a priori (presumed to be) more efficient, both wine and cloth can be produced with less manpower than required for the same amount of production in England. However, the relative costs of producing cloth and wine differ between the two nations.
In Ricardo’s example, Portugal is presumed to have superior productivity in both cloth and wine making.
In the above table, England could commit 100 labor hours to produce one unit of cloth, or produce 5/6 (five-sixths) of wine. Meanwhile, Portugal could commit 90 hours of labor to make one unit of cloth, or produce 9/8 (nine-eighths) units of wine. As we can see, Portugal has an absolute advantage in making cloth due to fewer labor hours, while England has a comparative advantage due to lower opportunity cost.
If the two countries did not trade, England would need 220 hours of work to produce as well as consume one unit each of cloth and wine, while Portugal would require 170 hours to do the same.
England can produce cloth more efficiently that wine, while Portugal is more efficient in wine production than cloth. Therefore, if each nation specialized in making the product for which it had a comparative advantage, then total production of both goods would increase. England could spend 220 labor hours making 2.2 units of cloth while Portugal could spend 170 hours making 2.125 units of wine.
If England specialized in cloth and Portugal in wine, and England traded one unit of its cloth for 5/6 to 9/8 units of Portuguese wine, then both nations could consume at least one unit each of cloth and wine, with 0 to 0.2 units of cloth and 0. to 0.125 units of wine remaining in each respective nation to be exported or consumed.
By doing things in this way, both Portugal and England could consume more wine and cloth through international trade than if they tried to be totally self-sufficient (autarky).
Do not confuse the term with competitive advantage, which simply refers to the characteristics that give a company an edge over its competitors regarding a specific product or service. Examples of competitive advantage include price, quality, credit terms, longer-lasting guarantees, faster delivery times, and access to raw materials.
Video – What is comparative advantage?
This Marginal Revolution University video explains what comparative advantage is, and why it is crucial not only for international trade, but also for the technological advance and often very survival of communities and civilizations.
The history of Tasmania, off the south coast of Australia, is given as an example.