Comparative Advantage

Understanding Ricardo's Comparative Advantage

A nation has a comparative advantage in some product when it can produce that product at a lower domestic opportunity cost than a potential trading partner. This, of course, is the premise of David Ricardo’s comparative advantage.

To understand the theory, it is important to distinguish it from absolute advantage Opens in new window, which refers to an ability to produce more or better products or services than someone else.

Comparative advantage refers to the ability to produce products and services at a lower opportunity cost and not necessarily at a greater volume.

To illustrate, consider the case of an architect and a secretary.

The architect is both better at producing architectural services and at administering and organizing. The architect therefore has an absolute advantage Opens in new window when it comes to both producing architectural services and secretarial work.

However, both the architect and the secretary benefit from their exchange because of their comparative advantages and disadvantage. It is here that the role of opportunity costs enters the picture.

Opportunity cost, by the way, refers to the most desired goods or services that are forgone in order to obtain something else.

Imagine that the architect produces the equivalent of $100 per hour in architectural services and $50 per hour in secretarial tasks. The secretary can produce the equivalent of $0 in architectural services and $40 in secretarial duties per hour.

To produce $40 in secretarial tasks, the architect will lose $100 because s/he has to abandon one hour of architectural production. So the opportunity cost of secretarial work is high and the architect is better off producing one hour’s worth of architectural services and employing a secretary to do all the administration and organizing.

The secretary is much better off administrating and organizing for the architect because his or her opportunity costs are very low. This, of course, is where the comparative advantage is found.

In a similar example, Samuelson and Nordhaus illustrated the concept of comparative advantage by reference to the lawyer who contemplated whether to hire a typist for the law office or do the typing himself.

The question whether or not to hire a typist rested on the theory of comparative advantage, and according to Samuelson and Nordhaus, it is apparent that the income the lawyer will forgo by spending the time to do his own typing rather than his legal work is greater than the cost of paying for the typing services. The lawyer makes more money by specializing in the production of legal services, “exporting” these services to others and “importing” typing services. This free free trade arrangement pays the lawyer and pays the typist.

If we assume that the lawyer is absolutely more efficient at typing than the typist (that is, he has an absolute advantage Opens in new window), this still does not mean the lawyer should in fact do the typing. It should be left to the less efficient partner, and this ensures a market for the typist’s services.

The typist willingly provides this service—specializing in typing—because alternative uses of the lawyer’s time have less economic value both to the society and to the typist.

Role of Comparative Advantage in International Trade

David Ricardo applied the theory of comparative advantage to international trade and showed how two states (England and Portugal) were both better off by specializing and trading according to their comparative advantages in wine (Portugal) and cloth (England).

If each trading partner or a country has a comparative advantage in producing a specific good, international trade will lead to mutual gain because it allows the residents of each country to:

A country can have a comparative advantage in producing a good even if it has no absolute advantage in producing any good.

As long as the relative costs of producing the two goods differ in two countries, comparative advantage exists and gains from specialization and trade will be possible. When this is the case, each country will find it cheaper to trade for goods that can be produced only at a high opportunity cost.

Comparative advantage also results in mutual gains for each trading partner if each specializes in producing that which it can produce at relatively low cost and uses the proceeds to purchase goods that it could only produce at a higher cost.

Because trade permits countries to expand their joint output, it also allows each country to expand its consumption possibilities.

Trade between countries will lead to an expansion in total output and mutual gain for each trading partner when each country specializes in the production of goods it can produce at relatively low cost and uses the proceeds to buy goods it could produce only at a high cost.

As long as there is some variation in the relative opportunity cost of goods across countries, each country will always have a comparative advantage in the production of some goods.

Nowadays, the theory of comparative advantages explains why iPhones are assembled in China and not in the United States where they are invented and designed.

China’s comparative advantage with the United States is cheap labor and the fact that workers in China can assemble iPhones at a much lower opportunity cost. The comparative advantages of the United States, on the other hand, are in costly specialized labor in the sense that US workers invent and design sophisticated products at lower opportunity costs.

Where Does Comparative Advantage Come From?

Among the main sources of comparative advantage are the following:

This source of comparative advantage is the most obvious. Because of geology, Saudi Arabia has a comparative advantage in the production of oil and Australia has a comparative advantage in the production of minerals and natural gas.

Because of climate and soil conditions, Costa Rica has a comparative advantage in the production of coffee, and Australia has a comparative advantage in the production of wheat.

Some countries, such as Australia, have many highly skilled workers and relatively little capital. As a result, Australia has a comparative advantage in the production of goods and services that require highly skilled workers or sophisticated capital to produce, such as financial services and mining.

Indonesia has a comparative advantage in the production of goods that require low-skilled workers and small amounts of simple machinery, such as clothing and footwear.

Broadly defined, technology is the process firms use to turn inputs into goods and services. At any given time, firms in different countries do not all have access to the same technologies.

In part, this difference reflects past investments countries have made in supporting higher education or in providing support for research and development. Some countries are strong in product technologies, which involve the ability to develop new products.

For example, firms in the USA have pioneered the development of such products as televisions, computers, aircraft and many prescription drugs.

In Australia well-known product developments include mechanical refrigeration plants, the combine harvester, dynamic lifter fertilizer, the black box flight recorder, the bionic ear, ultra-sound scanners, spray-on skin for burn victims and a number of vaccines.

Other countries are strong in process technologies, which involve the ability to improve the processes used to make existing products. For example, firms in Japan, such as Toyota and Nissan, succeeded by greatly improving the processes for making cars.

It is difficult to explain the location of some industries on the basis of climate, natural resources, the relative abundance of labor and capital or technology. For example, why does Mumbai have a comparative advantage in making Bollywood movies or Switzerland in making watches or Sydney in providing financial services?

The answer is that once an industry becomes established in an area firms that locate in that area gain advantages over firms located elsewhere. The advantages include the availability of skilled workers, the opportunity to interact with other firms in the same industry and close proximity to suppliers.

These advantages result in lower costs to firms located in the area. Because these lower costs result from increases in the size of the industry in an area, economists refer to them as external economies.

Most economists have followed the neo-classical explanation and believe that factor endowment go a great way to explain international trade patterns. See FACTOR ENDOWMENT Opens in new window for deeper insights concerning the sources of comparative advantage.