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Comparative Advantage

A country can produce a good or service at a lower opportunity cost than the other country

What is a Comparative Advantage?

In economics, a comparative advantage occurs when a country can produce a good or service at a lower opportunity cost than the other country. The theory of comparative advantage is attributed to political economist David Ricardo, who wrote the book Principles of Political Economy and Taxation (1817).

 

Comparative Advantage

 

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 good 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 from the 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:

  • By producing one cloth, the opportunity cost is 3 wines.
  • By producing one wine, the opportunity cost is ⅓ cloth.

 

Comparative Advantage and Free Trade

Comparative 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 Advantage

Consider two countries (Europe and the United States) that use labor as an input to produce two goods: wine and cloth.

  • In Europe, one hour of a worker’s labor can produce either 5 cloths or 10 wines.
  • In the US, one hour of a worker’s labor can produce either 20 cloth or 20 wines.

 

The information provided is illustrated as follows:

 

Comparative Advantage - Example

 

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 Europe’s 5 cloths or 10 wines.

  • The United States enjoys an absolute advantage in the production of cloth and wine.

 

To determine the comparative advantages of Europe and the United States, we must first determine the opportunity cost for each output:

Europe:

Opportunity cost of 1 cloth = 2 wine

Opportunity cost of 1 wine = ½ cloth

 

The United States:

Opportunity cost of 1 cloth = 1 wine

Opportunity cost of 1 wine = 1 cloth

 

When comparing the opportunity cost of 1 cloth for both Europe 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 both Europe and the United States, we can see that the opportunity cost of wine is lower in Europe. Therefore, Europe enjoys a comparative advantage in the production of wine.

 

Comparative Advantage and its Benefits in Free Trade

How 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 are 100 hours.

In Europe:

  • If all labor hours went into wine, 1,000 barrels of wine could be produced.
  • If all labor hours went into cloth, 500 pieces of cloth could be produced.

 

In the United States:

  • If all labor hours went into wine, 2,000 barrels of wine could be produced.
  • If all labor hours went into cloth, 2,000 pieces of cloth could be produced.

 

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:

  • Europe enjoys a comparative advantage in wine.
  • The United States enjoys a comparative advantage in cloth.

 

In Europe, 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:

 

Europe's Potential Trade Gains

 

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 Europe is 2 barrels of wine. Therefore, Europe 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:

 

The US' Potential Trade Gains

 

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 Readings

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • Absolute Advantage
  • Aggregate Supply and Demand
  • Economies of Scope
  • Pareto Efficiency

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