A country can produce a good or service at a lower opportunity cost than the other country Show In economics, a comparative advantage occurs when a country can produce a good or service at a lower opportunity cost than another country. The theory of comparative advantage is attributed to political economist David Ricardo, who wrote the book Principles of Political Economy and Taxation (1817).  Ricardo used the theory of comparative advantage to argue against Great Britain’s protectionist Corn Laws, which restricted the import of wheat from 1815 to 1846. In arguing for free trade, the political economist stated that countries were better off specializing in what they enjoy a comparative advantage in and importing the goods in which they lack a comparative advantage. What is an Opportunity Cost?To understand the theory behind a comparative advantage, it is crucial to understand the idea of an opportunity cost. An opportunity cost is the foregone benefits from choosing one alternative over others. For example, a laborer can use one hour of work to produce either 1 cloth or 3 wines. We can think of opportunity cost as follows: What is the forgone benefit from choosing to produce one cloth or one wine? Therefore:
Comparative Advantage and Free TradeComparative advantage is a key principle in international trade and forms the basis of why free trade is beneficial to countries. The theory of comparative advantage shows that even if a country enjoys an absolute advantage in the production of goods, trade can still be beneficial to both trading partners. Practical Example: Comparative AdvantageConsider two countries (France and the United States) that use labor as an input to produce two goods: wine and cloth.
The information provided is illustrated as follows: It is important to note that the United States enjoys an absolute advantage in the production of cloth and wine. With one labor hour, a worker can produce either 20 cloths or 20 wines in the United States compared to France’s 5 cloths or 10 wines.
To determine the comparative advantages of France and the United States, we must first determine the opportunity cost for each output: France:
The United States:
When comparing the opportunity cost of 1 cloth for both France and the United States, we can see that the opportunity cost of cloth is lower in the United States. Therefore, the United States enjoys a comparative advantage in the production of cloth. Additionally, when comparing the opportunity cost of 1 wine for France and the United States, we can see that the opportunity cost of wine is lower in France. Therefore, France enjoys a comparative advantage in the production of wine. Comparative Advantage and its Benefits in Free TradeHow does identifying each country’s comparative advantage aid in understanding its benefits in free trade? First, let’s assume that the maximum amount of labor hours is 100 hours. In France:
In the United States:
Following Ricardo’s theory of comparative advantage in free trade, if each country specializes in what they enjoy a comparative advantage in and imports the other good, they will be better off. Recall that:
In France, the country specializes in wine and produces 1,000 barrels. Recall that the opportunity cost of 1 barrel of wine in the United States is 1 piece of cloth. Therefore, the United States would be open to accepting a trade of 1 wine for up to 1 piece of cloth. The potential gains from trade for Europe by specializing in wine is represented by the arrow: In the United States, the country specializes in cloth and produces 2,000 pieces. Recall that the opportunity cost of 1 piece of cloth in France is 2 barrels of wine. Therefore, France would be open to accepting a trade of 1 cloth for up to 2 barrels of wine. The potential gains from trade for the United States by specializing in cloth is represented by the arrow: Therefore, using the theory of comparative advantage, a country that specializes in their comparative advantage in free trade is able to realize higher output gains by exporting the good in which they enjoy a comparative advantage and importing the good in which they suffer a comparative disadvantage. Related ReadingsThank you for reading CFI’s guide to Comparative Advantage. To keep advancing your career, the additional CFI resources below will be useful:
Comparative advantage is the ability of a country to produce a good or service for a lower opportunity cost than other countries. Opportunity cost measures a trade-off. A nation with a comparative advantage makes the trade-off worthwhile. This means the benefits of buying its good or service outweigh the disadvantages. The country may not be the best at producing something, but the good or service has a low opportunity cost for other countries to import. This economic theory was developed by David Ricardo. It was originally applied to international trade, but it can be applied to any level of business. Comparative advantage is what you do best while also giving up the least. For example, if you’re a great plumber and a great babysitter, your comparative advantage is plumbing. This is because you’ll make more money as a plumber because an hour of babysitting services costs far less than you would make doing an hour of plumbing. The opportunity cost of babysitting, on the other hand, is high. Every hour you spend babysitting is an hour’s worth of lost revenue you could have gotten on a plumbing job.
If you are better than everyone else in the neighborhood at both plumbing and babysitting, you have absolute advantage in both fields. But plumbing is your comparative advantage. That's because you only give up low-cost babysitting jobs to pursue your well-paid plumbing career. In international trade, countries usually have comparative advantage in different industries and for different reasons. These can be related to natural resources, workers, government investment, or other factors. Countries then trade based on these advantages. Oil-producing nations, for example, have a comparative advantage in chemicals. Their locally-produced oil provides a cheap source of material for the chemicals when compared to countries without it. A lot of the raw ingredients are produced in the oil distillery process. As a result, Saudi Arabia, Kuwait, and Mexico became competitive with U.S. chemical production firms in the early 1980s. Their chemicals are inexpensive, making their opportunity cost low. Another example is India's call centers. U.S. companies buy this service because it is cheaper than locating the call center in America. Some companies may have customers who experience miscommunications due to language barriers when they're speaking with representatives at Indian call centers. But the call centers provide the service cheaply enough to make the trade-off worth it for the businesses that hire them. One factor in America's comparative advantages is its vast landmass bordered by two oceans. It also has lots of fresh water, arable land, and available oil. U.S. businesses benefit from cheap natural resources and protection from a land invasion. Most important, the country has a diverse population with a common language and national laws. The diverse population provides an extensive test market for new products. It helped the United States excel in producing consumer products. Diversity also helped the United States become a global leader in banking, aerospace, defense equipment, and technology. Silicon Valley harnessed the power of diversity to become a leader in innovative thinking. Those combined advantages created the power of the U.S. economy.
Investment in human capital is critical to maintaining a comparative advantage in the knowledge-based global economy. In the past, comparative advantages occurred more in goods and rarely in services. That's because products are easier to export. But telecommunication technologies like the internet are making services easier to export. Those services include call centers, banking, and entertainment. The concept of comparative advantage was developed in the early 1800s by the economist David Ricardo. He argued that a country boosts its economic growth the most by focusing on the industry in which it has the most substantial comparative advantage. For example, at the time, England was able to manufacture cheap cloth. Portugal had the right conditions to make cheap wine. As a result, Ricardo predicted that England would stop making wine and that Portugal would stop making cloth. Instead, he suggested, they would trade with each other for the product that they were less efficient at producing. He was right. England made more money by trading its cloth for Portugal's wine, and vice versa. It would have cost England a lot to make all the wine it needed because it lacked the correct climate to grow grapes efficiently. Portugal, on the other hand, didn't have the manufacturing ability to make cheap cloth. Both countries benefited economically by exporting what they could produce most efficiently and importing what they couldn't produce as easily. Ricardo developed his approach to combat trade restrictions on imported wheat in England. He argued that it made no sense to restrict low-cost and high-quality wheat from countries with the right climate and soil conditions. England would receive more value by exporting products that required skilled labor and machinery. It could acquire more wheat in trade than it could grow on its own. David Ricardo started out as a successful stockbroker, making $100 million in today's dollars. After reading Adam Smith’s The Wealth of Nations, he became an economist. He pointed out that significant increases in the money supply created inflation in England in 1809. This theory is known as "monetarism." Ricardo also developed the law of diminishing marginal returns. That’s one of the essential concepts in microeconomics. It states that there is a point in production where the increased output is no longer worth the additional input in raw materials. The theory of comparative advantage argues that trade protectionism doesn't work over time. Political leaders are always under pressure from their local constituents to protect jobs from international competition by raising tariffs. But that’s only a temporary fix.
In the long run, trade protectionism hurts the nation's competitiveness because it isn't efficient. It allows the country to waste resources on unsuccessful industries. It also forces consumers to pay higher prices to buy domestic goods. Absolute advantage is anything a country does more efficiently than other countries. Nations that are blessed with an abundance of farmland, fresh water, and oil reserves have an absolute advantage in agriculture, gasoline, and petrochemicals. Just because a country has an absolute advantage in an industry, though, doesn't mean that it will be its comparative advantage. That depends on what the trading opportunity costs are. Suppose its neighbor has no oil but lots of farmland and fresh water. The neighbor is willing to trade a lot of food in exchange for oil. Now the first country has a comparative advantage in oil. It can get more food from its neighbor by trading it for oil than it could produce on its own. Competitive advantage is what a country, business, or individual does that provides a better value to consumers than its competitors. There are three strategies companies use to gain a competitive advantage. First, they could be the low-cost provider. Second, they could offer a better product or service. Third, they could focus on one type of customer. Competitive advantage is what makes you more attractive to consumers than your competitors. For example, you might be highly in demand to provide plumbing services, even though there are other plumbers available who are just as good or better. It could be because you charge less. This gives you a competitive advantage. To find comparative advantage for a specific good or service, compare the opportunity cost of producing that same good or service between two businesses or countries.
Say Factory A and Factory B both produce chairs and tables. In a single week, Factory A can produce either 300 tables or 1000 chairs. In the same week, Factory B can produce either 900 tables or 1005 chairs.
Factory B has absolute advantage in both chairs and tables because it can produce more of each in the same amount of time. However, it has a far greater comparative advantage in tables because it can produce three times the number of tables as Factory A can for the same time cost. Factory B should focus its resources on making and trading tables, leaving Factory A to produce chairs.
Developing nations tend to have much lower labor costs than industrialized nations, so that gives them a comparative advantage in many labor-intensive industries, such as construction and manufacturing.
The U.S. has a comparative advantage in producing a number of goods and services, especially when it comes to financial markets. Where it does not have a comparative advantage, it benefits by paying less for those goods and services through trade than it would cost to produce them domestically.
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What do economists mean when they say a country has a comparative advantage in the production of a particular good?
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