The comparative advantage stems from the ability to produce goods and services at low opportunity costs, which is influenced by how available economic resources (also called factors of production) are and how good their quality is. For example, several countries are endowed with abundant natural resources. They may also have had a more abundant workforce thanks to their large population. 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:
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. Thus, Indonesia will specialize in its 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. In contrast, 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).
Where does comparative advantage come from?
The comparative advantage stems from differences in economic resources, including:
The comparative advantage is determined not only by their availability – in other words, by their number. But, their quality also determines it.
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 area in the world. Other examples are Brazil, Indonesia, and Nigeria.
In addition, several countries have 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 in mining metal minerals. 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.
Then, comparative advantage is also determined by factors such as 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.
Comparative advantage also comes 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 is a man-made tool to assist 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.
In addition to quantity, quality also has implications for productivity and costs. For example, a high-tech computer can produce much more output than an older computer. Likewise, laptops can enable the newspaper company’s employees to make more output because they can be more mobile and work at the times and places where they are most productive, not just the office.
Entrepreneurship contributes to pooling and allocating resources to the most efficient production process. Some countries like South Korea are resource-poor. However, they become advanced economies because they invest in human capital. They supported and built entrepreneurship which 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 utilizing labor and capital at their highest use to produce efficiently and generate maximum profits. Then, they also invest in technology, research, and development to advance their business.
When a country has abundant resources, the country has a factor endowment. This underlies the Heckscher-Ohlin model for explaining international trade. Meanwhile, the Ricardian model bases comparative advantage on technological differences between countries.
Technological differences affect our efficiency and productivity in using economic resources. It also contributes to their quality. For instance, more sophisticated technological machines allow us to be more productive. This is because we can produce more output with the same input. They also allow us to minimize waste or costs. Likewise, computer-assisted machines also enable automation and reduce human error – therefore more productive than manual machines.
In addition, technological advances also allow the workforce to be more productive. In the previous example, it was a computer. Newspaper workers, for example, could produce more articles faster using the latest computers instead of typewriters.
How do exchange rates and protectionism affect 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 makes buyers in the United States have 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.
Meanwhile, protectionism seeks to build a comparative advantage by reducing foreign competition. The government imposed trade barriers to strengthen the domestic economy. The goal is to give domestic producers a comparative advantage in the world economy.