Comparative advantage occurs when one country can produce a good or service at a lower opportunity cost than another. This means a country can produce a good relatively cheaper than other countries
The theory of comparative advantage states that if countries specialise in producing goods where they have a lower opportunity cost – then there will be an increase in economic welfare.
Note, this is different to absolute advantage which looks at the monetary cost of producing a good.
Even if one country is more efficient in the production of all goods (absolute advantage) than the other, both countries will still gain by trading with each other, as long as they have different relative efficiencies.
Theory of Comparative Advantage
Comparative advantage was first described by David Ricardo in his 1817 book “On the Principles of Political Economy and Taxation” He used an example involving England and Portugal. Ricardo noted Portugal could produce both wine and cloth with less labour than England.
However, England was relatively better at producing cloth. Therefore, it made sense for England to export cloth and import wine from Portugal.
Example of Comparative Advantage
- Assume two countries, UK and India
- They both produce textiles and books.
- Their relative production levels are shown in the table below.
Output without trade
- For the UK to produce 1 unit of textiles it has an opportunity cost of 4 books.
- However for India to produce 1 unit of textiles it has an opportunity cost of 1.5 books
- Therefore India has a comparative advantage in producing textiles because it has a lower opportunity cost.
- The UK has a comparative advantage in producing books. This is because it has a lower opportunity cost of 0.25 (1/4) compared to India’s 0.66 (2/3)
Specialisation and trade
- If each country now specializes in one good then, assuming constant returns to scale, output will double.
Output after trade
- Therefore the total output of both goods has increased – illustrating the potential gains from exploiting comparative advantage.
- By trading the surplus books and textiles, India and UK can enjoy higher quantities of the goods.
There are many examples of comparative advantage in the real world e.g. Saudi Arabia and oil, New Zealand and butter, USA and Soya beans, Japan and cars e.t.c.
Criticisms of Comparative advantage
- Cost of trade. To export goods to India imposes transport costs.
- External costs of trade. Exporting goods leads to increased pollution from ‘air-freight’ and can contribute to environmental costs not included in models which only include private costs and benefits.
- Diminishing returns/diseconomies of scale. Specialisation means a country will increase the output of one particular good. However, for some industries increasing output may lead to diminishing returns. For example, if Portugal has a comparative advantage in wine, it may run out of suitable land for growing grapes. A contemporary example is Mongolia. Mongolia was believed to have a comparative advantage in cattle farming. However, according to Erik Reinert opening of markets to international competition in 1991 led to an increased size of animal herds, but this led to over-grazing and loss of grazing land. [Reinert, E (2004) “Globalization and economic development: an Alternative Perspective”, Edward Elgar pub. p 158.]
- Static comparative advantage. A developing economy, in sub-Saharan-Africa, may have a comparative advantage in producing primary products (metals, agriculture), but these products have a low-income elasticity of demand, and it can hold back an economy from diversifying into more profitable industries, such as manufacturing.
- Dutch disease. Dutch disease is a phenomenon where countries specialise in producing primary products (oil/natural gas) but doing this can harm the long-term performance of the economy. In the 1970s, the Netherlands specialised in producing natural gas, but this led to the neglect of manufacturing and when the gas industry declined, the economy was left behind its near neighbours.
- Trade – not a Pareto improvement. Trade can lead to an increase in net economic welfare. However, it doesn’t mean that everyone will become better off. Some workers in uncompetitive industries may lose out and struggle to gain employment in new industries.
- Gravity theory. Proposed by Jan Tinbergen, in 1962, this states that international trade is influenced by two factors – the relative size of economies and economic distance. The model suggests that countries of similar size will be attracted to trade with each other. Economic distance depends on geographical distance and trade barriers. The implication is that countries economically close and of similar size will engage in similar levels of bilateral trade. It also suggests trade is more likely between countries which are geographically close.
- Complexity of global trade. Models of comparative advantage usually focus on two countries and two goods, but in the real world, there are multiple goods and countries. Increasingly there is growing demand for a variety of goods and choice – rather than competing on simple price.