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.
Theory of comparative advantage
David Ricardo brought up 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, the 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.
Some critical assumptions in Ricardo’s theory of comparative advantage are:
- Production involves only two types of goods and two countries
- There are no transportation costs, which can eliminate the effect of the opportunity cost and affect the selling price
- Two markets in both countries operate under perfect competition.
- Production factor consists only of labor
- Labor is mobile in the domestic market but immobile between countries
Difference between absolute advantage and comparative advantage
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.
An example of comparative advantage
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:
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.
But, if we use a comparative advantage, the two countries should trade. Under this theory, the two’s 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:
The opportunity cost of 1 unit of fabric in Indonesia is equal to 1.2 units of shoes from the table above. Meanwhile, in Malaysia, the opportunity cost of 1 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:
As before, assume prices equal opportunity cost. In Indonesia, a shoe’s price is equal to 0.83, lower than Malaysia (1.125 fabric).
According to the comparative advantage theory, trade between Indonesia and Malaysia should be profitable. Comparatively, Indonesia has an advantage in shoe production, while Malaysia has an advantage in producing fabrics. So, Indonesia should buy cloth from Malaysia, and vice versa, Malaysia should buy shoes from Indonesia.
Criticisms of comparative advantage
Criticism is mainly about some of the assumptions in the Ricardian model.
First, production and trade involve not only two goods and two countries. The assumption of two goods in Ricardo’s concept is far from reality because export and import involve many countries and goods.
Second, trade between countries involves transportation costs. Thus, assuming it does not exist is impossible. Transportation costs affect the selling price and may take away the advantage of the opportunity cost difference.
Third, labor is not the only factor of production. Capital, natural resources, and entrepreneurship play an essential role in the production. Capital, like machines, for example, allows for faster production than by hand.
Fourth, labor is less mobile in the domestic market. Workers need time to find new jobs when switching to different industries. Also, in the current era of globalization, they can easily move between countries to pursue better opportunities.
Further, when a country specializes, workers tend to be immobile. When their industry closes, they cannot move from one sector to another easily. One of the reasons is limited skills.
To move, they had to upgrade their skills. And, it takes time and effort, and sometimes it’s difficult. For example, in the agricultural sector, mechanization leaves some workers unemployed. They usually cannot switch to other sectors, such as manufacturing, because of low education and skills. Finally, they are unemployed forever – resulting in structural unemployment.
Fifth, the model excludes technology effects. Technological advances affect differences in labor productivity. It also affects differences in the quality of capital goods in a country, not considered in the model.