Comparative Advantage

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 Ricardo argued that these laws should be repealed, since high-quality wheat could be imported at a low cost from countries with a comparative advantage in this domain.2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)

Key Terms

Absolute advantage

When a country can produce more of a given product using the same amount of resources or can produce the same amount of a given product using fewer resources relative to another entity that produces the given product.4

Opportunity cost

The potential gains that are missed out on when one alternative is selected over others.5 It addresses the question of what you would have gained had you selected the next best option.6 It can be thought of as a trade-off; when you choose one thing, you are giving up the benefits that would come from choosing another.7 When a company has a comparative advantage over another, they have smaller opportunity cost relative to the other company.8

History

In his magnum opus, An Inquiry into the Nature and Causes of the Wealth of Nations, published in 1776, British political economist and moral philosopher Adam Smith outlined the rudimentary theory behind comparative advantage. He wrote that “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.”9

Like Smith, David Ricardo, a British political economist of the early nineteenth century, was a proponent of free trade. While Smith initially outlined the basic idea of comparative advantage, Ricardo is credited with the development of the concept. He first presented the idea in his most famous book, Principles of Political Economy and Taxation, which was released in 1817. Ricardo illustrated the concept through an example of trade between England and Portugal. He explained that because Portugal can produce both cloth and wine at lower costs than England, Portugal has the absolute advantage. However, in England, the opportunity cost is less for the production of cloth than wine. In Portugal, the opportunity cost is less for the production of wine than cloth. Thus, while Portugal has the absolute advantage over England, England has a comparative advantage in the production of wine, while Portugal has a comparative advantage in the production of cloth. From there, Ricardo suggested that it would be mutually beneficial for Portugal to specialize in the production of wine and for England to specialize in the production of cloth, and for them to trade with one another.10 Through this example and, more broadly, the theory of comparative advantage, Ricardo hoped to underscore the benefits of free trade, in order to encourage the British economy to repeal its protectionist policies.

People

 

Adam Smith

The father of modern economics, Adam Smith, lived from 1723 to 1790.11 He is known for his numerous contributions to the field of economics, including the division of labor, gross domestic product, and the theory of the invisible hand of the economy. In his famous book, An Inquiry into the Nature and Causes of the Wealth of Nations, he introduced the concept of absolute advantage 12 and provided the basis on which David Ricardo developed the theory behind comparative advantage.13

David Ricardo

Smith may be regarded as the father of economics, but Ricardo’s contributions, such as the theory of comparative advantage, were also key to the development of the field. After retiring from his successful career as a stockbroker, Ricardo set his sights on economics, an interest that was incited by his reading of Smith’s Wealth of Nations.14 Ricardo favored free trade and frequently spoke out against the Corn Laws, the British protectionist policies of the nineteenth century. Beyond that, he is recognized for his influential theories of rent, wages, and profits.

Consequences

Comparative advantage has been used to promote free trade and specialization among countries.15 When Ricardo first introduced it, his goal was to have the protectionist Corn Laws in place in England at the time abolished. He believed England would benefit from importing wheat and exporting machine-made goods.16 While he did not see the Corn Laws repealed in his lifetime, shortly after his death they were replaced with free trade policies – something that Ricardo likely deserves at least partial credit for.17 Comparative advantage continues to be a relevant topic to this day and is still used as justification for free trade, although there has been some controversy as to whether this theory is as good in application as it is on paper.

Controversies

Ricardo made a compelling case in favor of comparative advantage, however, even in the presence of free trade, some countries do not thrive as he suggested they would. One argument against comparative advantage is that it is too simple a model to accurately reflect the consequences of free trade among countries.18 For example, it does not take into consideration the costs of transport or the environmental cost of exporting goods, which includes increased pollution. Additionally, typical models of comparative advantage are based on scenarios like the one provided by Ricardo of the trade of cloth and wine between England and Portugal. However, there are generally multiple countries and products involved in trade agreements, making the reality far more complex.19

Another explanation given for why free trade is not always mutually beneficial is rent seeking.20 This economic concept refers to when companies aim to increase their wealth without increasing productivity by lobbying the government to protect their interests, such as by implementing tariff protection.21

Related TDL Content

Globalization Policy (2/2): Winners, Losers, And Solutions

In developing his theory of comparative advantage, David Ricardo pushed for free trade, but may not have recognized that lowering tariffs comes at a cost. This article addresses a troubling symptom of globalization: the increased inequality within countries that results from a reduction in tariffs.

Sources

  1. Hayes, A. (2020). Comparative Advantage Definition. Investopedia. https://www.investopedia.com/terms/c/comparativeadvantage.asp
  2. Amadeo, K. (2020). Comparative Advantage Theory and Examples. The Balance. https://www.thebalance.com/comparative-advantage-3305915
  3. See 2
  4. Absolute Advantage Definition. Investopedia. https://www.investopedia.com/terms/a/absoluteadvantage.asp
  5. Hayes, A. (2020). Opportunity Cost Definition. Investopedia. https://www.investopedia.com/terms/o/opportunitycost.asp
  6. Kennon, J. (2020). What Is Opportunity Cost?. The Balance. https://www.thebalance.com/what-is-opportunity-cost-357200
  7. See 6
  8. See 5
  9. Benjamin, J.R. (2013). David Ricardo on the Principle of Comparative Advantage. JRBejamin.com. https://jrbenjamin.com/2013/08/07/david-ricardo-shapes-the-principle-of-comparative-advantage/
  10. Comparative advantage. Policonomics.https://policonomics.com/comparative-advantage/
  11. Heilbroner, R.L. (2020). Adam Smith. Encyclopaedia Britannica. https://www.britannica.com/biography/Adam-Smith
  12. See 4
  13. See 9
  14. Spengler, J.J. (2020). David Ricardo. Encyclopaedia Britannica.https://www.britannica.com/biography/David-Ricardo
  15. Comparative Advantage. Encyclopaedia Britannica. https://www.britannica.com/topic/comparative-advantage
  16. See 2
  17. See 14
  18. See 15
  19. Definition of comparative advantage. Economics Help. https://www.economicshelp.org/blog/glossary/comparative-advantage/
  20. See 1
  21. Majaski, T. (2019). Rent Seeking Definition. Investopedia. https://www.investopedia.com/terms/r/rentseeking.asp

Read Next