Learn Economics: The Law of Comparative Advantage

Comparative advantage is the ability of one party to manufacture goods and/or produce services at a lower opportunity cost than another party. In economics, the term is often applied to entire nations and their economies.

Understanding opportunity cost is essential to understanding comparative advantage. Opportunity cost is what is lost or missed out on when choosing one possibility over another. When a group of investors, or even a country, is presented with multiple options or trading partners, the opportunity cost is what money or productivity is lost when selecting the one option.

Example of Opportunity Cost

Suppose a candle factory made profits in producing candles that the owners would like to reinvest. The factory owners can either invest the money in an investment fund with a one year investment return of 20%, or they could reinvest the money into their factory buying new equipment that makes candles faster with less wasted candle wax.

Their advisor says that the dividends on the reinvestment in the factory is more difficult to project, but she estimates it will be a one year investment return of 10%. The factory owners decide to invest in their business and upgrade their equipment, which means the opportunity cost is the 10% investment return they did not earn by investing in a fund.

Real World Application of Opportunity Cost

A common, real world opportunity cost we experience everyday is the simple act of buying a coffee in a shop on the way to work. A $4.00 cup of coffee adds up to $1,460.00 if purchased every day, which is money that could be spent on a vacation. The vacation that was not taken is the opportunity cost of the convenience and camaraderie of buying coffee in a shop every morning

Absolute advantage is different than comparative advantage. A country will have absolute advantage in producing a good or providing a service if that country can do it better, faster, more efficiently, at greater volume and with less resources than another country. Comparative advantage lays in a country’s ability not at a greater quality or more efficiently, but at a lower opportunity cost.

A real world example could be one of the economic relationship and differences between a doctor in a hospital and the orderly who assist the doctors by helping set up operating rooms and cleaning up after operations. A doctor likely might have been an orderly in the past, and could perform the orderly’s duties more efficiently and faster than the orderly. The doctor has an absolute advantage in both performing the tasks of a doctor and in doing those of an orderly.

However, they both benefit due to comparative advantage. Neither of them suffer opportunity cost. The orderly makes less money than the doctor, so there is no opportunity cost to the doctor to focus on her tasks and let the orderly do his work.

The law of comparative advantage was developed by David Ricardo in 1817 to explain the reason behind international trade between countries even when one country’s businesses, factories, and workers are more efficient at producing every single good than the other country.

In explaining it, he offered this example: Suppose that England and Portugal were to trade cloth and wine. Economists of the day already understood that such a trade could be advantageous if England was better at making cloth and Portugal was better at making wine. The countries would specialize in the area in which they had an absolute advantage. That is, each country would focus on what they did better than any other country.

Ricardo showed that trade could be beneficial even if England was not only better at making cloth but better at making wine as well. Specifically, what if England was a little better than Portugal at making wine but much better than Portugal at making cloth. In that case, both countries could still produce more if England focused on making cloth and Portugal focused on making wine, and they engaged in trade. Portugal no longer had an absolute advantage in making wine but it still had a comparative advantage. Compared to the alternative of producing cloth, wine was still Portugal’s most competitive product.

A similar real world situation exists today between the United States and Bangladesh. The United States is more productive than Bangladesh in producing high-tech goods and clothing. However, Bangladesh is only a little behind the US in clothing while it is far behind the US in producing high technology. It therefore makes sense for Bangladesh to produce textiles and for the United States to produce high technology, and for the two countries to engage in trade