The Basic Idea
The concept of comparative advantage is a cornerstone of international trade, as the country with this advantage can produce goods or services at a lower opportunity cost than other countries.1 Opportunity cost refers to the potential gains a country forfeits when electing to produce a certain good or service over others. Comparative advantage is also applicable in terms of companies, such that one company may have this advantage over another.
Comparative advantage has been used as an argument in favor of free trade, as it suggests that it is mutually beneficial for countries to produce goods for which they have a comparative advantage and export them to other countries. When British economist David Ricardo developed this theory, the Corn Laws in England limited the amount of wheat that could be imported from other countries. Ricardo argued that these laws should be repealed, since high-quality wheat could be imported at a low cost from countries with a comparative advantage in this domain.2
When this theory was first developed, it was almost exclusively applied to the production of goods, such as wheat or cloth. However, due to the rise of telecommunications technology, it has come to be applied to services as well. It is cheaper for American companies to buy services from call centers in India, for example, than it is to locate call centers in the United States.3
Under a system of perfectly free commerce, each country naturally devotes its capital and labor to such employments as are most beneficial to each. This pursuit of individual advantage is admirably connected with the universal good of the whole. … It is this principle which determines that wine shall be made in France and Portugal, that corn shall be grown in America and Poland, and that hardware and other goods shall be manufactured in England.
– David Ricardo in Principles of Political Economy and Taxation (1817)
