Comparative Advantage

Comparative advantage is an economic term that refers to an economy's ability to produce goods and services at a lower opportunity cost than that of trade partners. A comparative advantage gives a company the ability to sell goods and services at a lower price than its competitors and realize stronger sales margins.

The law of comparative advantage is popularly attributed to English political economist David Ricardo and his book “On the Principles of Political Economy and Taxation” in 1817, although it is likely that Ricardo's mentor James Mill originated the analysis.

One of the most important concepts in economic theory, comparative advantage is a fundamental tenet of the argument that all actors, at all times, can mutually benefit from cooperation and voluntary trade. It is also a foundational principle in the theory of international trade.

Key to the understanding of comparative advantage is a solid grasp of opportunity cost. Put simply, an opportunity cost is the potential benefit that someone loses out on when selecting a particular option over another. In the case of comparative advantage, the opportunity cost (that is to say, the potential benefit which has been forfeited) for one company is lower than that of another. The company with the lower opportunity cost, and thus the smallest potential benefit which was lost, holds this type of advantage.

Another way to think of comparative advantage is as the best option given a trade-off. If you're comparing two different options, each of which has a trade-off (some benefits as well as some disadvantages), the one with the best overall package is the one with the comparative advantage.

Diversity of Skills

People learn their comparative advantages through wages. This drives people into those jobs they are comparatively best at. If a skilled mathematician earns more as an engineer than as a teacher, he and everyone he trades with is better off when he practices engineering. Wider gaps in opportunity costs allow for higher levels of value production by organizing labor more efficiently. The greater the diversity in people and their skills, the greater the opportunity for beneficial trade through comparative advantage.

As an example (adapted from Farnam Street), consider a famous athlete like Michael Jordan. As a renowned basketball and baseball star, Michael Jordan is an exceptional athlete whose physical abilities surpass those of most other individuals. Michael Jordan would likely be able to, say, paint his house quickly, owing to his abilities as well as his impressive height. Hypothetically, say that Michael Jordan could paint his house in 8 hours. In those same 8 hours, though, he could also take part in the filming of a television commercial which would earn him $50,000. By contrast, Jordan's neighbor Joe could paint the house in 10 hours. In that same period of time, he could work at a fast food restaurant and earn $100.

In this example, Joe has a comparative advantage, even though Michael Jordan could paint the house faster and better. The best trade would be for Michael Jordan to film a television commercial and pay Joe to paint his house. So long as Michael Jordan makes the expected $50,000 and Joe earns more than $100, the trade is a winner. Owing to their diversity of skills, Michael Jordan and Joe would likely find this to be the best arrangement for their mutual benefit.

Comparative advantage is contrasted with absolute advantage. Absolute advantage refers to the ability to produce more or better goods and services than somebody else. Comparative advantage refers to the ability to produce goods and services at a lower opportunity cost, not necessarily at a greater volume or quality.

To see the difference, consider an attorney and her secretary. The attorney is better at producing legal services than the secretary and is also a faster typist and organizer. In this case, the attorney has an absolute advantage in both the production of legal services and secretarial work.

Nevertheless, they benefit from trade thanks to their comparative advantages and disadvantages. Suppose the attorney produces $175 per hour in legal services and $25 per hour in secretarial duties. The secretary can produce $0 in legal services and $20 in secretarial duties in an hour. Here, the role of opportunity cost is crucial.

To produce $25 in income from secretarial work, the attorney must lose $175 in income by not practicing law. Her opportunity cost of secretarial work is high. She is better off by producing an hour's worth of legal services and hiring the secretary to type and organize. The secretary is much better off typing and organizing for the attorney; his opportunity cost of doing so is low. It’s where his comparative advantage lies.

A competitive advantage refers to a company, economy, country, or individual's ability to provide a stronger value to consumers as compared with its competitors. It is similar to but distinct from comparative advantage.

In order to assume a competitive advantage over others in the same field or area, it's necessary to accomplish at least one of three things: the company should be the low-cost provider of its goods or services, it should offer superior goods or services than its competitors, and/or it should focus on a particular segment of the consumer pool.

David Ricardo famously showed how England and Portugal both benefit by specializing and trading according to their comparative advantages. In this case, Portugal was able to make wine at a low cost, while England was able to cheaply manufacture cloth. Ricardo predicted that each country would eventually recognize these facts and stop attempting to make the product that was more costly to generate.

Indeed, as time went on, England stopped producing wine, and Portugal stopped manufacturing cloth. Both countries saw that it was to their advantage to stop their efforts at producing these items at home and, instead, to trade with each other in order to acquire them.

A contemporary example: China’s comparative advantage with the United States is in the form of cheap labor. Chinese workers produce simple consumer goods at a much lower opportunity cost. The United States’ comparative advantage is in specialized, capital-intensive labor. American workers produce sophisticated goods or investment opportunities at lower opportunity costs. Specializing and trading along these lines benefit each.

The theory of comparative advantage helps to explain why protectionism is typically unsuccessful. Adherents to this analytical approach believe that countries engaged in international trade will have already worked toward finding partners with comparative advantages.

If a country removes itself from an international trade agreement, if a government imposes tariffs, and so on, it may produce a local benefit in the form of new jobs and industry. However, this is not a long-term solution to a trade problem. Eventually, that country will be at a disadvantage relative to its neighbors: countries that were already better able to produce these items at a lower opportunity cost.

Why doesn't the world have open trading between countries? When there is free trade, why do some countries remain poor at the expense of others? Perhaps comparative advantage does not work as suggested. There are many reasons this could be the case, but the most influential is something that economists call rent-seeking. Rent-seeking occurs when one group organizes and lobbies the government to protect its interests.

Say, for example, the producers of American shoes understand and agree with the free-trade argument—but they also know that their narrow interests would be negatively impacted by cheaper foreign shoes. Even if laborers would be most productive by switching from making shoes to making computers, nobody in the shoe industry wants to lose his or her job or see profits decrease in the short run.

This desire leads the shoemakers to lobby for, say, special tax breaks for their products and/or extra duties (or even outright bans) on foreign footwear. Appeals to save American jobs and preserve a time-honored American craft abound—even though, in the long run, American laborers would be made relatively less productive and American consumers relatively poorer by such protectionist tactics.

[Fast Fact: Some economic historians suggest that it was David Ricardo's editor, James Mill, who slipped in the theory of comparative advantage (which is only a short section) into Principles. They argue that the theory seems inconsistent with the bulk of the book and its labor theory of value.]