Comparative Advantage

Reviewed by Adam Hayes

Updated Jun 25, 2019

What Is Comparative Advantage?

Comparative advantage is an economic term that refers to an economy's ability to produce goods
and services at a lower opportunity cost than that of trade partners. A comparative advantage
gives a company the ability to sell goods and services at a lower price than its competitors and
realize stronger sales margins.

The law of comparative advantage is popularly attributed to English political economist David
Ricardo and his book “On the Principles of Political Economy and Taxation” in 1817, although it
is likely that Ricardo's mentor James Mill originated the analysis.

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Explaining Comparative Advantage

Understanding Comparative Advantage

One of the most important concepts in economic theory, comparative advantage is a fundamental
tenet of the argument that all actors, at all times, can mutually benefit from cooperation and
voluntary trade. It is also a foundational principle in the theory of international trade.

Key to the understanding of comparative advantage is a solid grasp of opportunity cost. Put
simply, an opportunity cost is the potential benefit that someone loses out on when selecting a
particular option over another. In the case of comparative advantage, the opportunity cost (that is
to say, the potential benefit which has been forfeited) for one company is lower than that of
another. The company with the lower opportunity cost, and thus the smallest potential benefit
which was lost, holds this type of advantage.

Another way to think of comparative advantage is as the best option given a trade-off. If you're
comparing two different options, each of which has a trade-off (some benefits as well as some
disadvantages), the one with the best overall package is the one with the comparative advantage.

Comparative advantage is a key insight that trade will still occur even if one country as an
absolute advantage in all products.

Diversity of Skills

People learn their comparative advantages through wages. This drives people into those jobs they
are comparatively best at. If a skilled mathematician earns more as an engineer than as a teacher,
he and everyone he trades with is better off when he practices engineering. Wider gaps in
opportunity costs allow for higher levels of value production by organizing labor more
efficiently. The greater the diversity in people and their skills, the greater the opportunity for
beneficial trade through comparative advantage.

As an example (adapted from Farnam Street), consider a famous athlete like Michael Jordan. As
a renowned basketball and baseball star, Michael Jordan is an exceptional athlete whose physical
abilities surpass those of most other individuals. Michael Jordan would likely be able to, say,
paint his house quickly, owing to his abilities as well as his impressive height. Hypothetically,
say that Michael Jordan could paint his house in 8 hours. In those same 8 hours, though, he could
also take part in the filming of a television commercial which would earn him $50,000. By
contrast, Jordan's neighbor Joe could paint the house in 10 hours. In that same period of time, he
could work at a fast food restaurant and earn $100.

In this example, Joe has a comparative advantage, even though Michael Jordan could paint the
house faster and better. The best trade would be for Michael Jordan to film a television
commercial and pay Joe to paint his house. So long as Michael Jordan makes the expected
$50,000 and Joe earns more than $100, the trade is a winner. Owing to their diversity of skills,
Michael Jordan and Joe would likely find this to be the best arrangement for their mutual benefit.

Key Takeaways

 Comparative advantage suggests that countries will engage in trade with one another,
exporting the goods that they have a relative advantage in productivity.
 The theory was first introduced by David Ricardo in the year 1817.
 Absolute advantage refers to the uncontested superiority of a country to produce a
particular good better. Comparative advantage introduces opportunity cost as a factor for
analysis in choosing between different options for production.

Comparative Advantage Versus Absolute Advantage

Comparative advantage is contrasted with absolute advantage. Absolute advantage refers to the
ability to produce more or better goods and services than somebody else. Comparative advantage
refers to the ability to produce goods and services at a lower opportunity cost, not necessarily at a
greater volume or quality.

To see the difference, consider an attorney and her secretary. The attorney is better at producing
legal services than the secretary and is also a faster typist and organizer. In this case, the attorney
has an absolute advantage in both the production of legal services and secretarial work.

Nevertheless, they benefit from trade thanks to their comparative advantages and disadvantages.
Suppose the attorney produces $175 per hour in legal services and $25 per hour in secretarial
duties. The secretary can produce $0 in legal services and $20 in secretarial duties in an hour.
Here, the role of opportunity cost is crucial.

To produce $25 in income from secretarial work, the attorney must lose $175 in income by not
practicing law. Her opportunity cost of secretarial work is high. She is better off by producing an
hour's worth of legal services and hiring the secretary to type and organize. The secretary is
much better off typing and organizing for the attorney; his opportunity cost of doing so is low.
It’s where his comparative advantage lies.

Some economic historians suggest that it was actually David Ricardo's editor, James Mill, who
slipped in the theory of comparative advantage (which is only a short section) into Principles.
They argue that the theory seems inconsistent with the bulk of the book and its labor theory of
value.

Comparative Advantage Versus Competitive Advantage

A competitive advantage refers to a company, economy, country, or individual's ability to

provide a stronger value to consumers as compared with its competitors. It is similar to but
distinct from comparative advantage.

In order to assume a competitive advantage over others in the same field or area, it's necessary to
accomplish at least one of three things: the company should be the low-cost provider of its goods
or services, it should offer superior goods or services than its competitors, and/or it should focus
on a particular segment of the consumer pool.

Comparative Advantage in International Trade

David Ricardo famously showed how England and Portugal both benefit by specializing and
trading according to their comparative advantages. In this case, Portugal was able to make wine
at a low cost, while England was able to cheaply manufacture cloth. Ricardo predicted that each
country would eventually recognize these facts and stop attempting to make the product that was
more costly to generate.

Indeed, as time went on, England stopped producing wine, and Portugal stopped manufacturing
cloth. Both countries saw that it was to their advantage to stop their efforts at producing these
items at home and, instead, to trade with each other in order to acquire them.

A contemporary example: China’s comparative advantage with the United States is in the form
of cheap labor. Chinese workers produce simple consumer goods at a much lower opportunity
cost. The United States’ comparative advantage is in specialized, capital-intensive labor.
American workers produce sophisticated goods or investment opportunities at lower opportunity
costs. Specializing and trading along these lines benefit each.

The theory of comparative advantage helps to explain why protectionism is typically

unsuccessful. Adherents to this analytical approach believe that countries engaged in
international trade will have already worked toward finding partners with comparative
advantages.

If a country removes itself from an international trade agreement, if a government imposes

tariffs, and so on, it may produce a local benefit in the form of new jobs and industry. However,
this is not a long-term solution to a trade problem. Eventually, that country will be at a
disadvantage relative to its neighbors: countries that were already better able to produce these
items at a lower opportunity cost.

Criticisms of Comparative Advantage

Why doesn't the world have open trading between countries? When there is free trade, why do
some countries remain poor at the expense of others? Perhaps comparative advantage does not
work as suggested. There are many reasons this could be the case, but the most influential is
something that economists call rent-seeking. Rent-seeking occurs when one group organizes
and lobbies the government to protect its interests.

Say, for example, the producers of American shoes understand and agree with the free-trade
argument—but they also know that their narrow interests would be negatively impacted by
cheaper foreign shoes. Even if laborers would be most productive by switching from making
shoes to making computers, nobody in the shoe industry wants to lose his or her job or
see profits decrease in the short run.

This desire leads the shoemakers to lobby for, say, special tax breaks for their products and/or
extra duties (or even outright bans) on foreign footwear. Appeals to save American jobs and
preserve a time-honored American craft abound—even though, in the long run, American
laborers would be made relatively less productive and American consumers relatively poorer by
such protectionist tactics.

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Factor Proportions Theory of International
Trade
Almost after a century and a quarter of the classical version of the theory of international trade,
two Swedish economists, Eli Heckscher and Bertil Ohlin, propounded a theory that is known as
the factor endowment theory or the factor proportions theory. In fact, it was Eli Heckscher
(1919) who mooted the notion of a country’s comparative advantage (disadvantage) based on
relative abundance (scarcity) of factors of production. Later on, his student, Bertil Ohlin (1933)
developed this notion of relative factor abundance into a theory of the pattern of international
trade.

Factor Proportions theory of international trade explains that in a two-country, two-factor, and

two-commodity framework different countries are endowed with varying proportions of different
factors of production. Some countries have large populations and large labour resources. Thus, a
country with a large labour force will be able to produce the goods at a lower cost using a labour
intensive mode of production. Similarly, countries with a large supply of capital will specialize
in goods that involve a capital intensive mode of production. The former will export its labour
intensive goods to the latter and import capital intensive goods from the latter. After the trade,
both the countries will have two types of goods at the least cost (Ohlin, 1933).

All this means that the theory holds good if a capital abundant country has a distinct preference
for the labour intensive goods and a labour abundant country has a distinct preference for capital
intensive goods. If it not so, the theory may not hold good. Again, the theory does not hold good
if the labour abundant economy is technologically advanced in capital intensive goods or if the
capital abundant economy is technologically advanced in the production of labour intensive
goods.

Samuelson (1948, 1949) introduced refinements to factor proportions theory by considering the
effect of trade upon national welfare and the prices of the factors of production. He stated that
the effect of the free trade among nations would be to increase the overall welfare by equating
not only the prices of goods exchanged but also the prices of factors of production involved in
the production of those goods in different countries. For example, the price of capital in the
capital abundant economy of the USA will be much lower than that in case of the labour surplus
economy of India. But after trade is established between the two countries, more capital intensive
commodities will be produced in the USA. As a result, the price of capital will increase in the
USA and the existing differential in this respect between the two countries will be lower.
Similarly, more labour intensive commodities will be produced in India. Wage level will
increase in India, with the result that the wage differential between level will increase in India,
with the result that the wage differential between the two countries will be narrower.

Leontief (1954) put this theory to empirical testing and found in case of US trade during 1950s
the country was exporting less capital intensive goods even when it had an abundance of capital
compared to labour. Had the factor proportions theory been true, the USA would have exported
more capital intensive goods. This is really a paradox, generally known as the Leontief Paradox.
However, Leontief himself re-examined this issue and found that the paradox disappeared if the
natural resource industries were excluded. Moreover, he found that the USA exported more
labour intensive goods because the productivity of labour in this country was higher than in
many labour abundant countries. According to him, even in case of labour abundant economics
different countries differ in the sense that some countries posses a large skilled labour pool,
whereas in other countries the labour resource may be largely unskilled. A country with a large
skilled labour force will be to manufacture the same labour intensive product in a more capital
intensive fashion and will be able to export that product to labour abundant countries where
skilled labour is not employed in the manufacture of the same product. Thus, it is not only that
factor endowments are not homogeneous; they differ along parameters other than that of relative
abundance. Leontief’s later views find support in a couple of studies. The studies of Hufbauer
(1966) and Gruber, Mehta, and Vernon (1967) reveal that improved technology was involved in
the US export of labour intensive goods that characterized US exports as technology intensive
rather than labour intensive.

Soon after Leontief’s study Tatemoto and Ichimura (1959) found that in the case of US-Japan
trade, Japan exported labour intensive goods to the USA and imported capital intensive goods
from the latter. Similarly, Bharadwaj (1962) found that in case of Indo-US trade, India mainly
imported capital intensive goods from the USA and exported labour intensive goods to the latter
in 1951. These two empirical tests support the Heckscher-Ohlin theory of international trade.