Comparative advantage: definition, calculation and examples

Comparative advantage: definition, calculation and examples

Comparative advantage is an economic concept mainly developed in international trade within the framework of a free trade economy. What is this theory? How to calculate comparative advantage? Let’s take a closer look at this concept.

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What is comparative advantage?

In economics, comparative advantage is the main concept of the classical theory of international trade. It is a theory that defends the interest for a country to specialize in the production of a product or service in which it has the best advantage over the competition. Comparative advantage is a notion that is equally applicable to all economic actors, in particular to businesses, and to human activity in general.

The theory of comparative advantage was introduced in 1817 by David Ricardo in his book “Principles of Political Economy and Taxation”. The British economist explains that, in a context of free trade, each country must devote itself to the production of a good for which it enjoys a greater advantage in terms of productivity. This makes it possible to put an offer on the market at a lower production cost than its competitors, thus giving each country the possibility of increasing its GDP and entering a period of growth.

The characteristics of comparative advantage

The theory of comparative advantage is based on the idea that each economic system must allow the free movement of goods and services by removing customs taxes and any element preventing the fluidity of trade. We are talking about a free trade system. Each country must then specialize in the production of the good in which its productivity is the most advantageous or the least disadvantageous in relation to that of its partners. This will be the product for which he has the best ratio between working time and quantity produced.

If each country specializes in the sector of activity in which it is privileged, the world market will be able to benefit from goods at attractive prices. Indeed, according to David Ricardo, the value of a good varies according to the quantity of work necessary for its production. It is then a question of the labor value of a product. Thus, the lower the number of hours to produce the good, the lower its production cost and therefore the higher its price. It is for this production that a country then has a comparative advantage over the others. By being competitive, it can easily export its production, thus generating a certain economic growth.

The theory of comparative advantage demonstrates that each country gains from opening up to international trade, even if its productivity is less advantageous than that of its partners. This is why this concept is particularly appreciated by supporters of free trade.

What is the difference between comparative advantage and absolute advantage?

David Ricardo’s comparative advantage theory was developed to complement Adam Smith’s absolute advantage theory. Also, it is important to know the difference between these two concepts. Adam Smith argues that a country must produce a good or service for which it has higher productivity than all other countries. David Ricardo, for his part, argues that to take advantage of openness to the world market, a country does not need to be better than its competitors in a particular sector of activity. According to the theory of comparative advantage, countries can benefit from international trade whether they have an absolute advantage or not. The fact that countries should specialize in the production of goods for which their comparative advantage is most favorable is in itself an argument for free trade. It is by specializing that they can take advantage of the free trade system.

Adam Smith’s theory emphasizes that, in order to trade with a country having an absolute advantage different from one’s own, one must produce what one knows how to do best. Indeed for him, a country having no absolute advantage on any product has no interest in specializing in the production of a particular good. In the absence of absolute advantage, Adam Smith recommends closing borders and implementing protectionist measures. The country will therefore not be able to benefit from free trade or international trade. It is from this limit that David Ricardo will deepen Adam Smith’s theory.

For David Ricardo, it is indeed essential for a country to trade with other nations. To prevent countries from finding themselves isolated from international trade, he therefore recommends the specialization of a country in a sector of activity in which its productivity is higher or less disadvantageous.

How to measure comparative advantage?

Determine comparative advantage through resource analysis

To determine whether a country has a comparative advantage in the production of a good, it is necessary to compare its relative production costs with competing countries. Productivity is the ratio between the quantity produced and the quantity of labor a country needs to produce the good in question.

Calculate opportunity cost

It is also possible to define comparative advantage using the notion of the opportunity cost of a product. It is the cost of producing a good expressed in units of another product. It is on this notion that David Ricardo relies mainly to explain his theory.

The opportunity cost is calculated by calculating the ratio between the production of a unit of a product A and the value to be sacrificed of a product B to achieve this production A. Example.

  • France produces 5 kg of good A per week and per worker and 8 kg of product B.
  • Belgium manufactures 8 kg of product A and 10 kg of B.
  • For France, 8 kg of product B must be given up to manufacture an additional 1 kg of product A. The opportunity cost is therefore 8/5, or 1.6.
  • Similarly, to produce 1kg of product B, 5kg of product A must be given up, the opportunity cost is then 5/8, or 0.625.
  • For Belgium, the opportunity cost of product A is 10/8 (1.25) and 8/10 (0.8) for product B.

A country has a comparative advantage in the manufacture of a product if the opportunity cost of producing this good is lower in this country than in the others. So, in our example, the comparative advantage is in favor of Belgium for the manufacture of product A, because it gives up less product B to produce one unit. The opportunity cost of product B is, for its part, in favor of France.

2 examples of comparative advantages

Example of David Ricardo on comparative advantage: England and Portugal

The case of England and Portugal was cited by David Ricardo to prove the effectiveness of his theory of comparative advantage. In the 19th century, these two countries produced wine and cloth.

For example, in Portugal, the production of a piece of cloth mobilizes the annual work of 90 people and that of a barrel of wine, the annual work of 80 people. In England, it takes the annual labor of 100 persons for a piece of cloth and the annual labor of 120 persons for a cask of wine. Portugal is then more productive than England on both types of goods. Indeed, it enjoys higher productivity and lower production costs, and therefore an absolute advantage over England.

However, Portugal’s productivity gap is greater in the wine sector since it takes 40 fewer people to produce a barrel of wine. That is why it is more interesting for the country to specialize in wine production. Here, Portugal enjoys a comparative advantage in this specific area.

As for England, if its productivity is lower than that of other countries, it must specialize in the production of the good for which it is least disadvantaged compared to other countries, that is to say in the production of sheets. Indeed, this is where the productivity gap is the smallest, because it takes 10 more people to make a piece of cloth. It is therefore in the production of sheets that England has a comparative advantage.

Morocco and China

In terms of international trade, the example of Morocco and China can also be cited. Morocco makes one dress per hour and one pair of shoes per hour. For its part, China produces 4 dresses and 2 pairs of shoes in the same time frame. This means that 2 dresses made in China are worth a pair of shoes produced in Morocco and that one of a Moroccan dress is worth 0.5 units of a Chinese shoe. Morocco therefore has a comparative advantage in dress design and China in shoe manufacturing. Morocco and China can therefore each specialize in their production and export to each other.

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