Law of 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 “Principles of Political Economy and Taxation” in 1817, although it is likely that Ricardo’s mentor James Mill originated the analysis.

Theory of Comparative Advantage

Eighteenth-century economist David Ricardo created the theory of comparative advantage. He argued that a country boosts its economic growth the most by focusing on the industry in which it has the most substantial comparative advantage. 

For example, England was able to manufacture cheap cloth. Portugal had the right conditions to make cheap wine. Ricardo predicted that England would stop making wine and Portugal stop making cloth. He was right. England made more money by trading its cloth for Portugal’s wine, and vice versa. It would have cost England a lot to make all the wine it needed because it lacked the climate. Portugal didn’t have the manufacturing ability to make cheap cloth. Therefore, they both benefited by trading what they produced the most efficiently.

Ricardo developed his approach to combat trade restrictions on imported wheat in England. He argued that it made no sense to restrict low-cost and high-quality wheat from countries with the right climate and soil conditions. England would receive more value by exporting products that required skilled labor and machinery. It could acquire more wheat in trade than it could grow on its own. 

The theory of comparative advantage explains why trade protectionism doesn’t work in the long run. Political leaders are always under pressure from their local constituents to protect jobs from international competition by raising tariffs. But that’s only a temporary fix. In the long run, it hurts the nation’s competitiveness. It allows the country to waste resources on unsuccessful industries. It also forces consumers to pay higher prices to buy domestic goods.

David Ricardo started out as a successful stockbroker, making $100 million in today’s dollars. After reading Adam Smith’s “The Wealth of Nations,” he became an economist. He was the first person to point out that significant increases in the money supply create inflation. This theory is known as monetarism. 

He also developed the law of diminishing marginal returns. That’s one of the essential concepts in microeconomics. It states that there is a point in production where the increased output is no longer worth the additional input in raw materials. 

Example 

One of America’s comparative advantages is its vast land mass bordered by two oceans. It also has lots of fresh water, arable land, and available oil. U.S. businesses benefit from cheap natural resources and protection from land invasion. 

Most important, it has a diverse population with a common language and national laws. The diverse population provides an extensive test market for new products. It helped the United States excel at producing consumer products

Diversity also helped the United States became a global leader in banking, aerospace, defense equipment, and technology.  Silicon Valley harnessed the power of diversityto become a leader in innovative thinking. Those combined advantages created the power of the U.S. economy. 

Comparative Advantage Versus Absolute Advantage

Absolute advantage is anything a country does more efficiently than other countries. Nations that are blessed with an abundance of farmland, fresh water, and oil reserves have an absolute advantage in agriculture, gasoline, and petrochemicals. 

Just because a country has an absolute advantage in an industry doesn’t mean that it will be its comparative advantage. That depends on what the trading opportunity costs are. Say its neighbor has no oil but lots of farmland and fresh water. The neighbor is willing to trade a lot of food in exchange for oil. Now the first country has a comparative advantage in oil. It can get more food from its neighbor by trading it for oil than it could produce on its own. 

Comparative Advantage Versus Competitive Advantage

Competitive advantage is what a country, business, or individual does that provide a better value to consumers than its competitors. There are three strategies companies use to gain a competitive advantage. First, they could be the low-cost provider. Second, they could offer a better product or service. Third, they could focus on one type of customer. 

How It Affects You

Comparative advantage is what you do best while also giving up the least. For example, if you’re a great plumber and a great babysitter, your comparative advantage is plumbing. That’s because you’ll make more money as a plumber. You can hire an hour of babysitting services for less than you would make doing an hour of plumbing. Your opportunity cost of babysitting is high. Every hour you spend babysitting is an hour’s worth of lost revenue you could have gotten on a plumbing job.  

Absolute advantage is anything you do more efficiently than anyone else. You’re better than everyone else in the neighborhood at both plumbing and babysitting. But plumbing is your comparative advantage. That’s because you only give up low-cost babysitting jobs to pursue your well-paid plumbing career.

Competitive advantage is what makes you more attractive to consumers than your competitors. For example, you are in demand to provide both plumbing and babysitting services. But it’s not necessarily because you do them better (absolute advantage). It’s because you charge less.