Comparative advantage
Comparative advantage is an economic theory that suggests entities should specialize in producing goods for which they have a lower opportunity cost, leading to more efficient trade. Originating from the works of economists like Adam Smith and David Ricardo, the theory posits that even if one entity can produce all goods at a lower cost (absolute advantage), they should focus on the goods they produce most efficiently relative to others. This encourages trade, where each entity can benefit by exchanging their specialized products, which is seen as a foundation for free trade over protectionist policies.
While the theory provides a straightforward rationale for specialization and trade, it becomes more complex in real-world scenarios involving multiple countries and products. Factors such as transportation costs and varying levels of skilled labor can complicate the dynamics of comparative advantage. Critics often point out that traditional models do not account for these complexities or for the diverse economic contexts that exist globally. Despite this, supporters argue that the principle of comparative advantage remains a valuable guide for understanding trade relations and economic interactions.
Comparative advantage
The concept of economic advantage was first described by the renowned Scottish economic theorist Adam Smith (1723–90), who wrote about absolute advantage in his seminal 1776 work, An Inquiry into the Nature and Causes of the Wealth of Nations, or The Wealth of Nations for short. At its core, the concept is a simple one, but it can lead to rather complex interrelationships between marketplace entities. The central tenet of the theory of comparative advantage is that if two entities A and B are capable of producing a product, but it is cheaper for A to do so than it is for B, then B should refrain from producing the product itself and instead purchase it from A, or trade with A to receive the product in exchange for some commodity that B is able to produce with less expense than A. The overall effect of market actors making decisions based on comparative advantage is for producers to specialize in goods that are most economical for them to make.
Background
The theory of comparative advantage is most often raised in order to assert the superiority of free trade over other systems of economic governance. It appears in contrast to protectionism, in which a nation’s internal production is favored over goods from other countries through the imposition of import taxes that make domestic goods cheaper.
Free-market proponents argue that protectionist trade policies are unnecessary due to the natural effect of comparative advantage, which should, without regulatory interference, motivate domestic producers to create those goods that they are able to produce more cheaply and efficiently than others. Under this theory, rather than try to compete in all segments of the market, a country should specialize in the production of certain goods—those for which it has a comparative advantage—and export these to other countries, importing all other goods that it needs.
Comparative advantage must be distinguished from the related concept of absolute advantage. A country that possesses an absolute advantage with regard to a particular activity is simply the best at performing that activity. Comparative advantage differs in that it is relative to a particular situation or circumstance. A country may have a comparative advantage over its neighbor in producing widgets due to abundant natural resources, a highly skilled workforce, or some other factor, even though, absent that factor, the neighbor would actually have an absolute advantage.
Overview
Two factors can complicate the simple model of comparative advantage. The first is the difficulty of disentangling the trade in products when there are more than two nations and two products to account for; while such a binary arrangement makes comparative advantage relatively simple to explain to the layperson, in the real world, trade interactions are rarely so straightforward. Countries interact not just with one other nation at a time but with many simultaneously, and each trade relationship involves the exchange of dozens, hundreds, or thousands of commodities, rather than just two.
Another drawback of the classical formulation of comparative advantage is that it sometimes does not account for the influence of trade costs between countries. Even though country A may be able to make a product with less expense than country B, some products are very expensive to transport, which could mean that while A’s production cost for the product is lower than B’s, it would still be uneconomical for B to import the product from A.
These complications were in some sense addressed through the work of English political economist David Ricardo (1772–1823), who was able to clarify that absolute advantage most often concerns itself with costs of production, while comparative advantage focuses on a different quantity, something called opportunity costs. Put simply, opportunity cost is the cost of giving up something in order to do something else. The classical example developed by Ricardo is the production of wine and cloth in England and Portugal. Both countries can produce wine, and both can produce cloth, but their production costs for each are different. For example, it might cost England more to produce wine than it would cost Portugal to do so, and it might cost Portugal more to produce cloth than it would cost England. This is where opportunity costs come in, separate from the cost required to produce something (the costs of the materials, the fuel for the factory, the machinery, etc.). Opportunity cost means that when one produces cloth on a given day, one gives up the opportunity to produce wine on that same day.
Ricardo imagined two different scenarios in order to explain comparative advantage. The first is autarky, where each country trades with no other country and thus must produce some quantity of all the goods it needs. The second scenario changes the landscape by making trade between countries freely available. With the restrictions removed, countries discover that the same goods are available in different countries at different prices, depending on which goods a particular country has a comparative advantage in. If one assumes that trading costs can be ignored because they balance out, then trade between countries is stimulated by the opening of markets, because residents of country A will buy their wine from country B, where it is cheaper due to B’s comparative advantage, instead of buying it domestically. Likewise, residents of B will purchase the cheaper cloth made in A instead of paying a higher price for cloth from B.
Critics of this view of comparative advantage generally point out the many ways in which economic models of comparative advantage diverge from the real world. In the models, there are no trade costs, all laborers are equally skilled, there is full employment, no attention need be paid to trade in intermediate goods such as raw materials, and so on. Defenders of comparative advantage theory respond that all models involve some degree of simplification, but this does not mean that they are without worth.
Bibliography
Appleyard, Dennis R., and Alfred J. Field Jr. International Economics. 9th ed., McGraw, 2017.
Arvis, Jean-François. How Many Dimensions Do We Trade In? Product Space Geometry and Latent Comparative Advantage. World Bank, 2013.
Bhattacharyya, Rajib. Comparative Advantage in the Knowledge Economy: A National and Organizational Resource. Emerald Publishing Limited, 2021.
Choi, Nakgyoon. "Empirical Tests of Comparative Advantage Factor Proportions, Technology, and Geography." SSRN, 2013, doi.org/10.2139/ssrn.2319770. Accessed 28 Dec. 2024.
"Comparative Advantage - Overview, Example and Benefits." Corporate Finance Institute, corporatefinanceinstitute.com/resources/economics/comparative-advantage. Accessed 28 Dec. 2024.
Costinot, Arnaud. “On the Origins of Comparative Advantage.” Journal of International Economics, vol. 77, no. 2, 2009, pp. 255–64, doi.org/10.1016/j.jinteco.2009.01.007. Accessed 28 Dec. 2024.
Free, Rhona C., editor. 21st Century Economics: A Reference Handbook. SAGE, 2010. 2 vols.
Hayes, Adam. "What Is Comparative Advantage?" Investopedia, 26 June 2024, www.investopedia.com/terms/c/comparativeadvantage.asp. Accessed 28 Dec. 2024.
Linarelli, John, editor. Research Handbook on Global Justice and International Economic Law. Elgar, 2013.
Segal, Troy. "Absolute vs. Comparative Advantage: What's the Difference?" Investopedia, 27 June 2024, www.investopedia.com/ask/answers/033115/what-difference-between-comparative-advantage-and-absolute-advantage.asp. Accessed 28 Dec. 2024.
"6 Comparative Advantage Examples." Indeed, 16 Aug. 2024, www.indeed.com/career-advice/career-development/comparative-advantage-example. Accessed 28 Dec. 2024.
Stern, Robert M., editor. Comparative Advantage, Growth, and the Gains from Trade and Globalization: A Festschrift in Honor of Alan V. Deardorff. World Scientific, 2011.