Comparative Advantage
Comparative Advantage
What It Means
Many economists agree that the theory of comparative advantage is one of the most difficult but important ideas in global economics. Comparative advantage is challenging because at first glance the hypothesis appears to defy simple logic. According to this theory, even if Country A can produce all goods more cheaply than Country B can, both Country A and Country B will maximize their production and economic well-being if they trade with each other.
To understand the basic idea, take the example of a highly skilled heart surgeon. Arguably one of the abilities that makes the surgeon successful in her profession—an unusually high level of manual dexterity—would also make her an excellent typist. Still, while the surgeon could perform both tasks at a high level, it makes more sense for her to allow her office assistant (who has good typing skills) to do all the typing, because surgery offers a greater opportunity for gain (both in terms of how much money the surgeon will earn for performing surgery and in terms of the good it provides to the patients). In other words, the surgeon has a comparative advantage over the office assistant (who has no medical skills at all) in the field of surgery and will therefore keep the office assistant employed to perform the typing duties.
For an example of how comparative advantage applies to an economy, consider the imaginary countries of Freeland and Homeland trading beef and cereal. Freeland can produce both beef and cereal more cheaply than Homeland. While Homeland has some capacity to produce cereal, its geography makes it very difficult to produce beef by raising cattle there.
Because both products are made more cheaply in Freeland, there seems to be no reason that Freeland should buy either beef or cereal from Homeland. This is not necessarily true, however. According to the theory of comparative advantage, if Freeland makes more money from beef than from cereal, the best way for the country to be profitable is to specialize in beef production and purchase cereal from Homeland. By producing less cereal, Freeland can sell more beef and make the largest possible amount of money. Homeland, meanwhile, can specialize in cereal and benefit by having a foreign market for its goods. Homeland’s economy will then be stronger, and it will be able to purchase more of Freeland’s beef. Because Freeland produces cereal more cheaply than Homeland, Freeland has what is called an absolute advantage in cereal production. But cereal production benefits Homeland’s economy more than Freeland’s, so Homeland has a comparative advantage in producing cereal.
When Did It Begin
The theory of comparative advantage grew out of the theory of free trade that was developed by the Scottish philosopher Adam Smith (1723–90), which he documented in his influential book The Wealth of Nations (1776). Smith reasoned that, if one nation makes a product cheaply, and another nation makes a different product cheaply, then those nations should specialize and trade with each other instead of producing both products for themselves.
The free-trade theory gained acceptance among economists who tested the hypothesis by considering more complicated trade scenarios. In “An Essay on the External Corn Trade” (1815), British economist Robert Torrens (1780–1864) was the first person to argue that a nation should specialize and import certain goods even if it produced all goods more efficiently than its trading partner. He used the examples of England and Poland trading corn and wool. English economist David Ricardo (1772–1823) introduced the theory of comparative advantage in full detail in his book On the Principles of Political Economy and Taxation (1817). Ricardo used an example involving the trade of cloth and wine between Great Britain and Portugal. The theory gained credence as a key factor in understanding international trade after John Stuart Mill (1806–73) published Principles of Political Economy in 1848.
More Detailed Information
Ricardo’s theory of comparative advantage is based on several assumptions and economic terms. The first assumption is that all trading countries must be following the principles of free trade. No country can tax the goods it imports. In an environment of free trade, a country will make more money in the long run through specialization and exchange than by producing as many different goods as possible for its own consumers. This means that if a country can produce cars, meat products, agricultural goods, cloth, and televisions, it should dedicate the majority of its labor force to the production of the single most profitable good and import the others. Specialization maximizes the total world output of goods, which helps economies grow in all trading countries. Notice that Ricardo’s model considers only the supply of goods (the amount that producers make) and not the demand (the amount that consumers are willing to buy). It was John Stuart Mill who factored demand into the theory of comparative advantage.
Comparative advantage is dependent upon two other economic concepts: labor productivity and opportunity cost. Labor productivity is the average amount of output per worker that a country can get from its labor force. This output varies depending on the product and the country. For example, in the case of Freeland, labor productivity is greater for beef than it is for cereal. On average, in one hour a worker in Freeland can produce more beef products than cereal. In Homeland a worker can produce more cereal in an hour. Remember that a worker in Freeland can still produce more cereal in one hour than a worker in Homeland can. This brings up the idea of opportunity cost.
Opportunity cost refers to the choices a producer has when making goods. Specifically, the opportunity cost is the value of the item not chosen, that is, the item given up. In Freeland there is a high opportunity cost for choosing to produce cereal instead of beef products. Each worker assigned to produce cereal is making the country less money than the worker producing beef. To maximize profits, Freeland needs to maximize labor productivity. To do this, Freeland needs to have as many workers as possible making beef products. In Homeland, however, there is no opportunity cost for producing cereal instead of beef (because it could not produce beef in any case), and to maximize labor productivity there, Homeland needs to have as many workers as possible producing cereal.
The main criticism of the theory of comparative advantage is that it does not take important factors into account, including the costs of transporting goods and retraining the labor force. In the example of Freeland, the cost of producing beef products will rise if more of those products have to be shipped to other countries. Also, if Freeland decreases its production of cereal, many laborers will have to be retrained to work in the beef industry. This may also involve building new factories and moving people to different areas of the country, which may not be cost-effective. Defenders of comparative advantage say that the theory holds up even after these factors are taken into account.
Recent Trends
Some economists think that the idea of comparative advantage is not as relevant as it used to be because of the rise of intra-industry trade (IIT). IIT refers to the exchange of goods within the same industry. For example, in 2000 the European Union exported nearly as many motorized vehicles as it imported. It is estimated that IIT increases by 5 percent each year throughout the world. This means that more and more countries are exporting the same types of goods that they are importing, regardless of the comparative advantage. Therefore, it is argued, these countries are not choosing a specialty based on comparative advantage.