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What’s it: Comparative advantage is a favorable position arising from producing goods and services at a lower opportunity cost. This concept is important in explaining international trade and specialization in production. That answers why countries trade with each other, even when they don’t have an absolute advantage. A country must focus on products that have a comparative advantage and buy other products from other countries.
Understanding comparative advantage
David Ricardo introduced the comparative advantage theory in his book Principles of Political Economy and Taxation (1817). He argued that production and trade should not be based on absolute advantage but on comparative advantage. In other words, opportunity cost is a consideration for production decisions, not absolute unit costs.
Countries should produce goods that have a lower opportunity cost. Each devotes scarce resources to produce those goods. They should not allocate resources to comparatively disadvantaged goods, even if they have low absolute costs. They can buy such in the international market. When all countries do this, free trade will provide maximum benefits and efficient resource allocation.
Absolute advantage vs. comparative advantage
The comparative advantage comes from lower opportunity costs. Opportunity cost is the benefit lost when we choose the next best alternative.
For example, a worker can spend an hour to produce 3 fabrics or 6 shoes. While there may be alternatives, assume they are not the next best alternative.
In this case, when he chooses to produce 3 fabrics, the opportunity cost is 6 shoes. Conversely, when he produces 6 shoes, the opportunity cost is ½ the fabric.
Meanwhile, the absolute advantage comes from a lower cost per unit. It appears when a country:
- produce a more massive output using the same input,
- produces the same quantity but uses less input, or
- produce the same quantity but faster
In the example above, the worker has an absolute advantage in producing shoes. He can produce 6 units for one hour of labor, more than just 3 units for fabric.
Comparative advantage assumptions
David Ricardo’s theory of comparative advantage laid the groundwork for understanding international trade. However, to make the concept easier to grasp, he relied on several simplifying assumptions that aren’t entirely true in the real world. Here’s a breakdown of these key assumptions:
- Limited goods and countries: Ricardo assumed only two countries trade two goods. In reality, the global market involves numerous countries and a vast array of products.
- Zero transportation costs: The theory disregards the cost of shipping goods between countries. Transportation can significantly impact the final price and potentially negate the advantage gained from opportunity cost.
- Perfectly competitive markets: The model assumes both countries have perfectly competitive markets, meaning many buyers and sellers with perfect information. This ensures prices accurately reflect production costs, which isn’t always the case in real-world markets with dominant players or limited information.
- Labor as the sole factor: Ricardo’s theory simplifies production by only considering labor as a factor. In reality, factors like land, capital (machinery), and technology also play crucial roles in production costs and comparative advantage.
- Labor mobility within, not between: The model assumes labor can move freely within a country to find higher-paying jobs (in industries with a comparative advantage). However, in reality, labor movement between countries can also occur, impacting the overall production landscape.
How the comparative advantage works: A simple example
Comparative advantage is a key theory in explaining international trade. That explains why free trade will benefit the countries involved.
Say, two countries, Indonesia and Malaysia, use labor to produce two goods: fabric and shoes. Assume the wages in the two countries are the same, and the quantities of fabric and shoes produced per hour for each are as follows:
| Fabric | Shoes | |
| Indonesia | 100 | 120 |
| Malaysia | 90 | 80 |
From the data, Indonesia has an absolute advantage over fabrics and shoes because it can produce more cloth and shoes than Malaysia. Per hour, Indonesia can produce 100 fabrics and 120 shoes. Meanwhile, for the same amount of time, Malaysia could only produce 90 fabrics and 80 shoes.
Therefore, according to the absolute advantage theory, Indonesia and Malaysia should not trade with each other. Indonesia has an absolute advantage over both types of products.
However, if we use a comparative advantage, the two countries should trade. Under this theory, their trade is mutually beneficial if each focuses on the product that has the lowest opportunity cost.
To measure the opportunity cost, let’s first calculate the relative price of 1 unit of fabric in terms of shoes in each country. The results are as follows:
| Fabric | Shoes | |
| Indonesia | 1 | 1.2 (120/100) |
| Malaysia | 1 | 0.89 (80/90) |
In Indonesia, the opportunity cost of one unit of fabric is equal to 1.2 units of shoes from the table above. Meanwhile, in Malaysia, the opportunity cost of one unit of fabric is equal to 0.89 shoes.
Assume the price for each product is equal to the opportunity cost. Therefore, the price of fabric in Malaysia is lower than in Indonesia because its relative price to shoes is lower.
Next, we reverse the calculations. Let’s calculate the relative price of 1 unit of the shoe to the fabric in each country. The following are the results:
| Fabric | Shoes | |
| Indonesia | 0.83 (100/120) | 1 |
| Malaysia | 1.125 (90/80) | 1 |
As before, assume prices equal opportunity costs. In Indonesia, a shoe’s price is equal to 0.83, lower than in Malaysia (1.125 fabric).
According to the comparative advantage theory, trade between Indonesia and Malaysia should be profitable. Indonesia has an advantage in shoe production, while Malaysia has an advantage in fabric production. So, Indonesia should buy clothes from Malaysia, and vice versa; Malaysia should buy shoes from Indonesia.
Criticisms and considerations
While comparative advantage offers a powerful lens for understanding trade, it’s important to acknowledge some key criticisms of the Ricardian model that move beyond its basic assumptions:
Real-world complexity
The theory assumes a simplified world with just two countries and two goods. In reality, international trade involves a vast number of countries and a mind-boggling array of products. This complexity can make it challenging to pinpoint clear-cut comparative advantages.
Imagine a global marketplace with thousands of instruments, each country specializing in a few based on opportunity cost. It becomes trickier to determine which country has a definitive advantage in a specific good, especially when considering factors like quality variations and evolving consumer preferences.
Transportation costs
The model ignores the cost of shipping goods between countries. Transportation can significantly add to the final price, potentially eroding the advantage gained from a lower opportunity cost.
Imagine a country with a comparative advantage in textiles due to lower labor costs. But if the cost of shipping textiles to major markets is high, this advantage might shrink or disappear altogether. Transportation costs act like invisible friction in the system, influencing the feasibility of trade based on comparative advantage.
More than just labor
The theory focuses solely on labor as a production factor. However, factors like natural resources (oil, minerals), capital (machinery, technology), and even entrepreneurial ingenuity all play crucial roles in determining a country’s comparative advantage.
A country rich in natural resources like copper might have a comparative advantage in copper wiring, while a country with a highly skilled workforce and advanced technology might excel in areas like medical devices. These additional factors act like different instruments in a production orchestra, each contributing to the final melody of a country’s comparative advantage.
Labor mobility
The model assumes workers can easily move within a country to find jobs in industries with a comparative advantage. While true to some extent, worker mobility can be limited by factors like skill sets and retraining needs. Additionally, globalization allows for movement between countries, further complicating the picture.
Imagine a decline in the steel industry due to a shift in comparative advantage. Steelworkers might struggle to find new jobs in other sectors if they lack the necessary skills or face challenges migrating to countries with booming steel production. This highlights the potential for social unrest and economic hardship during periods of economic transformation.
Specialization and worker woes
When a country specializes based on comparative advantage, some workers might be left behind. For instance, if a country shifts from agriculture to manufacturing due to comparative advantage, agricultural workers might struggle to find new jobs in manufacturing if they lack the necessary skills.
This highlights the potential for structural unemployment in specific sectors that lose their comparative advantage. Policymakers need to consider these potential consequences and implement retraining programs or social safety nets to ease the transition for workers impacted by specialization.
The tech factor
Technological advancements can significantly impact a country’s comparative advantage. The model doesn’t account for how technology can boost labor productivity or the quality of a country’s capital goods (machinery), both of which can influence its production capabilities.
Imagine a breakthrough in automation that reduces the labor required for textile production. This could shift the comparative advantage in textiles, even if the underlying labor costs haven’t changed. Technological innovation is a constant wild card in the game of comparative advantage.
