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Comparative advantages come from the ability to produce goods and services at low opportunity costs, which is influenced by the availability of economic resources (also called factors of production) and their quality. For example, several countries are endowed with abundant natural resources. Thanks to their large population, they may also have had a more abundant workforce. Meanwhile, other countries may be poor in natural resources, forcing them to invest in human resources to grow their economies.
Comparative advantage emphasizes producing goods and services at the lowest opportunity cost. For example, developing countries have more labor than capital goods (low capital-to-worker ratio). They also have relatively low wages. Thus, they can produce customized or labor-intensive products cheaper than in other countries.
Meanwhile, developed countries may have more capital goods and high technology than labor. Thus, they specialize in high-tech products.
How does comparative advantage work?
Remember, comparative advantage is based on opportunity costs, not absolute costs. These are the costs involved when we choose to use resources to produce a particular product over another. Specifically, these costs represent the next alternative we do not choose to make.
For example, two countries, Indonesia and Malaysia, use their land for two choices: oranges or apples. Assume land leases cost the same in both countries. Then, the output per hectare for the two products in the two countries is as follows:
| Apple | Orange | |
| Indonesia | 100 | 120 |
| Malaysia | 90 | 80 |
If we use absolute advantage, Indonesia has an advantage in both products. This is because Indonesia can produce more output for both items. Therefore, under this theory, Indonesia and Malaysia will not trade with each other.
But, the conclusion will be different if we use comparative advantage. For example, Indonesia has a comparative advantage in oranges. Meanwhile, Malaysia’s comparative advantage lies in Apel.
Land in Indonesia is more suitable for producing oranges because it can produce more than using it to grow apples. In Indonesia, producing oranges yields an opportunity cost of 0.83 (100/120) apples. Conversely, the opportunity cost of producing an apple is 1.2 (120/100) oranges.
In contrast, land in Malaysia is more productive for growing apples than oranges. As a result, one apple has an opportunity cost of 0.89 (80/90) of oranges. Meanwhile, one orange has an opportunity cost of 1.125 (90/80).
Comparative advantage and international trade
Comparative advantage is the theoretical basis for international trade. According to this theory, countries should specialize in producing goods and services with a comparative advantage. In other words, they only focus on making an item if it has a lower opportunity cost. Meanwhile, for other goods (not having a comparative advantage), they can import them from abroad. Therefore, if all countries specialized on this basis, international trade would provide the greatest benefits because all countries would obtain the product at the lowest cost.
In the example above, Indonesia incurs a lower opportunity cost when producing oranges, so it will specialize in this production. In contrast, Malaysia specializes in apple production because it has a lower opportunity cost than Indonesia.
Assume Malaysia and Indonesia sell their products at opportunity cost. Therefore, Indonesia sells its oranges for $0.83, while Malaysia sells its apples for $0.89.
Imagine if Malaysia and Indonesia did not specialize. For example, apples produced in Indonesia cost $1.2 (opportunity cost for apples is $1.2 = 120/100). Meanwhile, oranges in Malaysia will cost $1,125 = 90/80.
By specializing and trading with each other, Indonesia can get cheaper apples from Malaysia (costing $0.89) than producing them domestically (would cost $1.2). Likewise, Malaysia can get oranges cheaper from Indonesia (costing $0.83) than from producing them domestically (costing $1.125).
Sources of Comparative Advantage
Comparative advantages come from variations in a country’s economic resources, also known as factors of production. These factors include:
- Land: Quality and quantity of land influence agricultural output, access to natural resources, and suitability for specific crops.
- Labor: The size, skill level, and mobility of a workforce determine a country’s comparative advantage in labor-intensive industries.
- Capital: The quantity and quality of machinery, equipment, and technology significantly impact production efficiency and overall competitiveness.
- Entrepreneurship: A nation’s spirit of innovation and ability to efficiently allocate resources play a crucial role in driving technological advancement and creating a comparative advantage.
While the availability (quantity) of these resources is important, their quality is equally significant in determining comparative advantage.
Land
Comparative advantages come from various factors, including a country’s natural resources. Some countries are endowed with large agricultural lands. For example, India, the United States, China, and Russia are among the countries with the largest agricultural land areas in the world. Other examples are Brazil, Indonesia, and Nigeria.
In addition, comparative advantages come from abundant natural resources. For example, petroleum and natural gas are widely available in the Gulf countries. Venezuela and Canada have the largest proven oil reserves. Several other countries are also blessed with metal mineral mining. For example, aluminum is mainly mined in China and Australia, and copper in Peru and Chile.
This advantage in natural resources allows those countries to produce at a lower cost. In addition, they can also process it into higher-value output with lower input costs because raw materials are abundant.
Furthermore, comparative advantages come from factors like climate. Due to climate factors, some products can only be produced in specific regions. For example, dates grow a lot in Arab countries because they have dry and semi-arid climates with long hot summers. Then, the oil palm thrives in the tropics, needing at least 5 to 6 hours of sunlight daily.
Labor
In other cases, comparative advantages come from labor, namely the skills and knowledge inherent in workers. However, in this case, the determining factor is not only their number but also their quality, which is influenced by factors such as education.
Countries such as China, India, the United States, and Indonesia have large populations dominated by productive age (age 15-64). This factor makes them have an abundant workforce. But, related to its quality, the United States outperformed the other three countries because it was more productive.
Apart from quantity and quality, other factors related to the labor market can also contribute to comparative advantage. Examples are wage levels, labor unions, labor market reforms, and labor mobility. For example, higher inter-industry or regional labor mobility positively impacts comparative advantage in China’s industry.
Capital
Comparative advantages come from factors like the quantity and quality of capital, which refers to man-made tools like machinery and equipment used in the production process. They include machinery and equipment. The comparative advantage derived from the capital can be because:
- More capital available to use
- Higher quality capital
More available capital allows us to produce more output. For example, a newspaper company can write more articles when one person uses one computer. Imagine if 10 people only use one computer.
Long story short, increasing the capital-to-worker ratio is a way to increase output in the economy. The situation in which the ratio increases is known as capital deepening.
This increase in output relative to the workforce is achieved by capital deepening, which essentially means increasing the capital-to-worker ratio. However, comparative advantages come from not just the amount of capital but also its quality. A high-tech computer can produce much more than an older model. Similarly, laptops offer mobility to newspaper employees, allowing them to work productively from various locations, potentially boosting overall output.
Entrepreneurship
Comparative advantages come from a nation’s entrepreneurial spirit. Entrepreneurs contribute to pooling and allocating resources to the most efficient production process.
Some countries like South Korea are resource-poor. However, they became advanced economies because they invested in human capital and fostered a strong entrepreneurial culture. This support for entrepreneurship later gave rise to leading global companies such as Samsung and LG.
Entrepreneurship plays a crucial role in building comparative advantage. Entrepreneurs build a business by utilizing labor and capital at their highest use to produce efficiently and generate maximum profits. They also invest in technology, research, and development to advance their business, further solidifying their country’s comparative advantage.
Technology advances
While comparative advantages come from a variety of factors like land, labor, and capital, technological advancements play a crucial role in influencing a country’s efficiency and productivity in utilizing these resources.
The Ricardian model of comparative advantage highlights how technological differences between countries can be a key driver. More sophisticated technological machines allow for:
- Increased output: Producing more output with the same amount of input (labor, materials).
- Reduced waste: Minimizing waste during production leads to lower costs.
- Automation and reduced error: replacing manual labor with automation to improve efficiency and reduce human error.
Technological advancements also empower the workforce. In the past, newspaper workers relied on typewriters. Now, computers allow them to produce articles faster and more efficiently.
In essence, advancements contribute to the quality of a country’s economic resources, ultimately impacting their comparative advantage in various sectors.
Exchange rates impact comparative advantage
The four factors above determine or explain long-term comparative advantage. However, the comparative advantage may change in the short term due to factors such as the exchange rate.
Exchange rates affect comparative advantage when products are sold to international markets. For example, a company in the eurozone produces at the lowest opportunity cost. However, when selling it to global markets—say, the United States market—the advantage is reduced because the euro appreciates. Appreciation forces buyers in the United States to spend more US dollars to get 1 euro. Thus, the comparative advantage is lost by appreciation, and the product becomes more expensive when it arrives in the United States market.
Appreciation in the exchange rate explains why the US industry has a declining trade surplus despite having a comparative advantage. Likewise, appreciation makes the trade deficit bigger for industries with a comparative disadvantage.
Protectionism: a double-edged sword for comparative advantage
Protectionism is a government strategy that aims to bolster domestic industries and create a comparative advantage by limiting foreign competition. Here’s a deeper look at its potential benefits and drawbacks:
Potential benefits:
- Shelter for infant industries: Protectionist measures like tariffs or quotas can temporarily shelter new or struggling domestic industries. This allows them time to develop their skills and technology, potentially reaching a point where they can compete effectively in the global market without needing protection.
- Strategic industries: Some governments might prioritize protecting industries deemed strategically important, such as steel or defense production. This ensures a degree of self-sufficiency and national security.
- Job Creation: Protectionism can create jobs in protected industries in the short term. However, potential job losses in export-oriented industries due to retaliatory tariffs should be considered.
Potential drawbacks:
- Inefficiency: Protectionist measures can shield domestic firms from foreign competition, potentially reducing their incentive to innovate and become more efficient. This can lead to higher production costs and, ultimately, less competitive products.
- Higher prices for consumers: Tariffs and quotas make imported goods more expensive for consumers. This reduces overall economic welfare, as consumers have fewer choices and potentially lower-quality products at higher prices.
- Retaliatory measures: Protectionist policies can trigger trade wars, in which other countries retaliate with their own tariffs and quotas, ultimately harming all involved economies.
- Limited long-term advantage: Protectionism might create a temporary advantage, but it doesn’t necessarily foster the development of skills and innovation needed for long-term comparative advantage.
Economists are divided on the effectiveness of protectionism in achieving long-term comparative advantage. While it can offer some temporary benefits, the potential for inefficiency, higher prices, and trade wars raise concerns. Free trade advocates argue that specialization based on genuine comparative advantage leads to greater overall economic efficiency and consumer benefit.
