Comparative advantage

Page written by AI. Reviewed internally on May 24, 2024.

Read this article to me

Definition

Comparative advantage is an economic principle that describes the ability of a country, individual, or entity to produce a particular good or service at a lower opportunity cost than another.

What is a comparative advantage?

Here’s a breakdown of comparative advantage:

  1. Opportunity cost: Refers to the value of what must be foregone in order to choose a particular option. In simpler terms, it’s the benefits or value sacrificed by choosing one alternative over another.
  2. Absolute advantage vs. comparative advantage: Absolute advantage refers to the ability of a country or entity to produce a particular good or service with fewer resources (e.g., less labour, capital, or time) than another. Comparative advantage, on the other hand, considers the opportunity cost of producing one good relative to another.
  3. Specialisation: The theory of comparative advantage asserts that nations, firms, or individuals should specialise in the production of goods or services in which they have the lowest opportunity cost.
  4. Mutually beneficial trade: When countries specialise in producing what they have a comparative advantage in, they can engage in trade with other nations. This leads to mutually beneficial outcomes.
  5. Enhances global welfare: The principle of comparative advantage contributes to overall global welfare. It allows resources to be allocated more efficiently across the world, leading to increased total production and a higher standard of living.
  6. Long-term economic growth: Embracing comparative advantage fosters economic growth through specialised industries, enabling investment in research, development, and infrastructure for innovation and competitiveness

Comparative advantage is influenced by various factors, including natural resources, technological advancements, labour skills, and capital availability. Changes in these factors can alter a country’s comparative advantage over time.

While comparative advantage provides valuable insights into international trade, it’s not without criticism. Some argue that in practice, factors like imperfect information, transportation costs, and market imperfections can complicate the application of this theory.

Example of comparative advantage

Country A and Country B both have the ability to produce two goods: wheat and cloth.

  1. Production capabilities:
    • In a given time period, Country A can produce either 100 units of wheat or 50 units of cloth.
    • Country B can produce either 80 units of wheat or 40 units of cloth.
  2. Opportunity costs:
    • The opportunity cost is the value of the next best alternative foregone when a choice is made. Let’s calculate the opportunity costs for both countries:
      • Country A:
        • Opportunity cost of 1 unit of wheat = (50 units of cloth) / (100 units of wheat) = 0.5 units of cloth.
        • Opportunity cost of 1 unit of cloth = (100 units of wheat) / (50 units of cloth) = 2 units of wheat.
      • Country B:
        • Opportunity cost of 1 unit of wheat = (40 units of cloth) / (80 units of wheat) = 0.5 units of cloth.
        • Opportunity cost of 1 unit of cloth = (80 units of wheat) / (40 units of cloth) = 2 units of wheat.
  3. Comparative advantage:
    • Both countries have the same opportunity costs for producing wheat and cloth. However, for the sake of illustration, let’s assume that Country A has a slight advantage in cloth production (lower opportunity cost).
  4. Specialisation:
    • Recognising their comparative advantages, Country A decides to specialise in cloth production, while Country B specialises in wheat production.
Ready to grow your business?

Clever finance tips and the latest news

delivered to your inbox, every week

Join the 70,000+ businesses just like yours getting the Swoop newsletter.

Free. No spam. Opt out whenever you like.

We work with world class partners to help us support businesses with finance

close
Looks like you're in . Go to our site to find relevant products for your country. Go to Swoop No, stay on this page