Learn Economics: The Law of Comparative Advantage

Comparative advantage is the ability of one party to manufacture goods and/or produce services at a lower opportunity cost than another party. In economics, the term is often applied to entire nations and their economies.

In nations with a free trade agreement (such as the free trade agreement shared by the United States, Canada, and Mexico), the opportunity to produce goods tends to migrate toward regions that can manufacture products at a lower cost than their competitors. Moving manufacturing to these low-cost countries can have both a comparative advantage and a competitive advantage against rival manufacturers who produce their goods in a more expensive region.

Understanding opportunity cost is essential to understanding comparative advantage. Opportunity cost is what is lost or missed out on when choosing one possibility over another. When a group of investors, or even a country, is presented with multiple options or trading partners, the opportunity cost is what money or productivity is lost when selecting the one option.

A common, real-world opportunity cost we experience every day is the simple act of buying a coffee in a shop on the way to work. A $4.00 cup of coffee adds up to $1,460.00 if purchased every day, which is money that could be spent on a vacation. The vacation that was not taken is the opportunity cost of the convenience and camaraderie of buying coffee in a shop every morning.

Suppose a candle factory made profits in producing candles that the owners would like to reinvest. The factory owners can either invest the money in an investment fund with a one-year investment return of 20%, or they could reinvest the money into their factory buying new equipment that makes candles faster with less wasted candle wax.

Their advisor says that the dividends on the reinvestment in the factory are more difficult to project, but they estimate it will be a one-year investment return of 10%. The factory owners decide to invest in their business and upgrade their equipment, which means the opportunity cost is the 10% investment return they did not earn by investing in a fund.

A situation that offers a comparative advantage is one where similar work can be accomplished at a lower opportunity cost. For instance, let’s say that a rock band wants to make t-shirts it can sell at its gigs. It could either:

• Pay a clothing company to print those t-shirts, paying a fee to that company for each shirt it produces; or
• Purchase its own printing equipment and blank t-shirts, and produce the merchandise in-house.

On a small scale, outsourcing the clothing manufacture to another company presents a comparative advantage. Why? Because the band members’ areas of expertise would presumably involve music, not clothing manufacture. If they delved into the mechanics of the clothing business, that would come at an opportunity cost—time and energy that could otherwise go toward writing, practicing, recording, and performing new music. What’s more, the band would need to make a large capital investment to get their manufacturing operation off the ground, and it would take a massive volume of sales to pay that off.

But perhaps a band sees an opportunity to sell hundreds of thousands, if not millions, of t-shirts. In that case, investing in their own equipment and producing the merchandise in-house might provide a comparative advantage. There would be a large outlay of capital, including perhaps hiring staff to produce the shirts, but once they begin producing clothing on a mass scale, the band may find it makes far more money than it would by outsourcing the task to an outside company.

Thus, a comparative advantage is not uniform across all businesses within a particular industry. Scale can make a huge difference.

Absolute advantage is different than comparative advantage.

• A country will have absolute advantage in producing a good or providing a service if that country can do it better, faster, more efficiently, at greater volume and with fewer resources than another country.
• Comparative advantage lies in a country’s ability not at a greater quality or more efficiently, but at a lower opportunity cost.

A real-world example could be one of the economic relationship and differences between a doctor in a hospital and the orderly who assist the doctors by helping set up operating rooms and cleaning up after operations. A doctor likely might have been an orderly in the past, and could perform the orderly’s duties more efficiently and faster than the orderly. The doctor has an absolute advantage in both performing the tasks of a doctor and in doing those of an orderly.

However, they both benefit due to comparative advantage. Neither of them suffers opportunity cost. The orderly makes less money than the doctor, so there is no opportunity cost to the doctor to focus on her tasks and let the orderly do his work.

The law of comparative advantage was developed by David Ricardo in 1817 to explain the reason behind international trade between countries even when one country’s businesses, factories, and workers are more efficient at producing every single good than the other country.

In explaining it, he offered this example:

• Suppose that England and Portugal were to trade cloth and wine. Economists of the day already understood that such a trade could be advantageous if England was better at making cloth and Portugal was better at making wine. The countries would specialize in the area in which they had an absolute advantage. That is, each country would focus on what they did better than any other country.

Ricardo showed that trade could be beneficial even if England was not only better at making cloth but better at making wine as well. Specifically, what if England was a little better than Portugal at making wine but much better than Portugal at making cloth. In that case, both countries could still produce more if England focused on making cloth and Portugal focused on making wine, and they engaged in trade. Portugal no longer had an absolute advantage in making wine but it still had a comparative advantage. Compared to the alternative of producing cloth, wine was still Portugal’s most competitive product.

A similar real-world trade situation exists today between the United States and Bangladesh. The United States is more productive than Bangladesh in producing high-tech goods and clothing. However, Bangladesh is only a little behind the U.S. in clothing while it is far behind the U.S. in producing high technology. It makes sense for Bangladesh to produce textiles and for the United States to produce high technology, and for the two countries to engage in trade.

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