Theory of Comparative Advantage
The term ‘comparative advantage’ is an economic term related with English economist of 19th century David Ricardo in his book Principles of Political Economy and Taxation (Hull 2017). It is among the most significant concepts in the economic theory and in international trade a foundational principle. It points to an economy’s capacity to deliver a good or service at a cheaper opportunity cost than different country or trade partners. It is due to a comparative advantage that a firm gets to be capable of exchanging services and goods at a price inferior to its competitors and experiences stern selling margin. According to the economist David Ricardo, a country should design products and services they are specialised by allotting their limited resources that gives a comparative cost advantage (Faccarello 2015). Two varieties of cost advantage are mainly present , comparative and absolute. Absolute advantage is when a country able to give more production than another country and comparative advantage is the amount by which a nation is productive than another country (Meihami and Meihami 2014). It can be debated that when a company or nation apply the principle of comparative advantage, the global output will increase. Through the application of comparative advantage, a company or a country will determine the goods and services they would specialise in producing. In this report, the concept of comparative advantage is discussed in elaboration. The report also presents the reason for using the principle of comparative advantages along with countries and industries adopting the policies of comparative advantage. A complete overview of the concept has been the primary focus of the report to provide a better comprehension.
The concept of comparative advantage in economics is that a country should specialise goods and services to produce and export only the goods and services that can be produced efficiently at lower opportunity cost than other countries. According to David Ricardo, it can be stated that a country can boost its economic growth maximum by paying attention on the industry in which the country has the most considerable comparative advantage (Schumacher 2013). It is often seen that due to many factors countries stop manufacturing certain goods or services as it is more profitable to trade the services and goods from another country instead of manufacturing in unfavourable conditions. Comparative advantage can be due to several factors responsible for products such as capital, labour, land, weather, power resources, entrepreneurial skill, technology and many more (De Medeiros, Ribeiro and Cortimiglia, 2014). Therefore, it is an internationally accepted principle where it is possible for every country to benefit by merely trading their specialised product and following comparative advantage. This process of countries specialising in producing goods with low opportunity cost will increase economic welfare. Ricardo developed the path to fight trade limitation on wheat in Britain. He aimed that it was not insignificant to limit low-cost and high-quality wheat from the states with suitable climate and soil requirements. Britain was capable of getting more value by exporting products that needed machinery and skilled labour. It could get more wheat in business than growing it on own (Hattori 2017). Comparison between Comparative Advantage and Absolute Advantage
Comparison between Comparative Advantage and Absolute Advantage
Often comparative advantage is compared with absolute advantage. Absolute advantage is when a country operates more efficiently than other countries and able to produce more or better goods (Levchenko and Zhang 2016). It is common for the nations that are blessed with farmland, fresh water, resources and oil reserves in abundance. In another way, when a country has an absolute advantage in gasoline, agriculture and petrochemicals. It is also important to mention that a state having absolute advantage does not mean that it will act as a comparative advantage as well (Meihami and Meihami 2014). The comparative advantage will depend on the opportunity cost of the trading nation. Comparative advantage does not refer to a nation’s capability of making goods and services at a higher volume, however, it relates to the capability of creating products and services at below opportunity cost. For example, a country has an abundance of farmland and fresh water, however, it has no oil. Since the state is lacking oil as a resource, it is willing to trade oil in exchange for food from the neighbouring country. Here, the neighbouring country possesses a comparative advantage in oil.
Comparative advantage is when a country produces a good or service that is of better value to consumers than the other country. The same principle applies in the case of a particular business or for an individual when the company or the individual can provide goods or services in a better value than its competitors in the market, it has a comparative advantage. To gain a comparative advantage, three strategies are followed. First, the company could provide its service or goods at a low cost. Second, the company could provide better service or products compared to its competitors. Third, the company could target a specific type of customer (Costinot, Donaldson and Smith, 2016).
Example: Two men were living together on an island far away. To survive on the island, they must do several economic activities such as cooking, fishing, water carrying and construction of a shelter and maintenance. One person is young and healthy with proper education qualification that makes him faster, better and more productive at every work. In the economic term, his person has an absolute advantage in every works. The second man is uneducated, aged and weak lacking in absolute advantage. Although the younger man has the absolute advantage in all possible activities and the other person is lacking in absolute advantage, it is of no concern for both of them. Since both of them can benefit from each other and be useful to each other through specialisation and exchange. The two men can divide the task between them according to comparative advantage where the young man can perform the functions in which he is specialised and most productive while the older man can perform the tasks where he is most productive or little less than the young man. This pattern of working will profit both and increase total production in the given amount of labour.
Reasons that Explain Comparative Advantages
Tradition: often comparative advantage is the result of traditions and acquired skills. People get accustomed to doing a particular work and continue doing it generation after generation. Therefore, Tradition can result in a significant factor that can cause a difference in comparative advantage. For example, France has the tradition of producing cheese and Swiss have a tradition of making watches.
Geographical diversity: this is one of the critical factors that act as a significant advantage to a country. Differences in climate and natural resources make a country wealthy in its unique way and give a nation various benefits which the country utilises to achieve the comparative advantage (Harzing and Giroud 2014.). For example, since Kuwait is country blessed with a natural resource like oil, it is an exporter of oil.
The difference in productivity: Comparative advantage is determined by the amount of time, more precisely the labour hours required to produce a particular good or service. It is the difference in the productivity of labour that is accounted for comparative advantage. Changes in the productivity of labour do have an explanation for many trade patterns in the world.
Factors abundance: goods differ depending on resources, and factors inputs and country vary in term of the plenty of various factors of production such as land, labour, capital and entrepreneurial capacity. Therefore, it is evident that states will differ while producing a particular good where a specific country will have an added advantage, and another country might not have. For example, individual countries with a significant amount of capital would have a comparative advantage in manufacturing goods while some countries with a notable amount of farmland would have a comparative advantage in agriculture.
Technology: other than labour productivity, technology can also help explain the reason for some countries with comparative advantages in the goods they produce. The nations with relatively advanced technology will have the comparative advantage in the products and services they provide.
Human skills: The country with an abundance of highly skilled labour has the possibility to have a comparative advantage in producing those goods that required high skilled worker. Also, unskilled labour is seen as added advantages too when the country is a developing country.
Consumer preference: Often the countries depend on consumer preference for producing a good. Some countries produce goods that are for the sole purpose of experts only that explain intra-trade.
Every time a country having different opportunity cost in production of goods that they produce, it can have benefits from specialization and trade. The benefits of specialization are-
Greater efficiency: in the areas where the countries are naturally good it can specialize in the particular production and also get advantage from increasing returns to scale for the production of those particular goods and services. The countries benefits include economies of scale meaning average cost of producing the goods falls due to production of more goods. Countries also benefit from increased learning that gives more skilled labour (Hausmann et al. 2014). With all the years of experience country becomes specialised in the product they make and contribute to increased overall efficiency for the countries.
Opportunities for competitive sectors: the business firms get the opportunity to access the entire world market allowing them to expand and earn benefits from economies of scale (Enderwick 2013).
Consumer benefits: opportunity cost of production becomes low with specialization which let the consumer get to buy goods at lower prices and in large quantities (Laursen 2015).
Gains from trade: Every country will have benefit as countries will trade until the price equals the opportunity cost and till the point when instead of trading it will decide to produce the other good domestically. Therefore countries will benefit from specializing followed by trading.
Although specialization has several advantages it has some potential downsides as well. The potential downsides are as follows-
Threats to uncompetitive sectors: There is a possibility for few countries not being able to compete with better and cheaper imports. A country can be specialised in more than one product and not require to import from neighbour country. It may lead to structured unemployment.
Strategic vulnerability: Specialization makes a country depended on another country for important resources. However, changes in political and economic condition of the second country may cause disruption in supply of goods and services to the country depended on it.
Issue of Over-specialization: Demand of certain product or goods in the global market may take a shift that may impact on trade relation between countries. A country specialized in a particular good or service will depend solely on that particular specialize production, if the demand for the particular product fall down, the country will be affected massively (Adamopoulos and Tuzhilin 2014).
The famous example of two England and Portugal published on April 19, 1817, by the British economist David Ricardo. The Principle of Political Economy and Taxation, the two countries were used as an example with two products, wine and cloth. Portugal required fewer workers to make wine as it is a country with a long history of wine-making. England needed fewer workers to make cloth as it was a textile powerhouse during that time. Thus, England should be shipping cloth to Portugal and Portugal should be shipping wine to England. It was not only the workers that acted as the only factor but also other considerations such as equipment, skills and the value of currencies (Watson 2017).
Fig: 1
In the illustration (Fig:1), it is shown that it takes 100 hours of labour to make one piece of cloth for Britain, or make 5/6 units of wine. When compared during the very time, it takes 90 hours of labour to create one piece of cloth for Portugal, or make 9/8 units of wine. Therefore, Portugal has an absolute advantage in making cloth since labour hours needed are fewer, and Britain has a comparative advantage since it has a lesser opportunity cost.
In the recent days, the United States is a leading manufacturer of aeroplanes. Boeing is a major exporter of jets to airlines and countries all around the world. The Boeing Company sells planes to Avianca, the Colombian airline (Dunning 2015). Colombia has less aeroplane manufacturing industry due to specific factors that do not support aeroplane manufacturing. Colombia has a robust coffee industry, and Americans love coffee. Therefore, comparative advantage in aeroplanes lies with the United States and comparative advantage in the production of coffee lies with Colombia (Boansi and Crentsil 2013).
Another contemporary illustration would be China and the US where China possess a comparative advantage with the US in the shape of inexpensive labour. At a very cheaper opportunity cost the Chinese workers can produce essential consumer goods. There is a comparative advantage in specialised, capital-intensive employment for the US. Americans workers are the producers of sophisticated products at more reasonable opportunity costs (David, Dorn and Hanson 2013).
The principle of comparative advantage has several criticisms needed to take notice:
- The principle of comparative advantage can state too strongly the advantages of specialisation by disregarding the different types of costs associated with trade. The number of costs includes transportation cost and external costs such as taxation and environmental pollutions.
- The theory of comparative advantage assumes the market as an ideal competitive market. Specifically, the market is assumed without any diminishing return and with perfect mobility of factors. The reality is different from the assumption as in reality there is existence of transport cost, and factors that are subject to diminishing return. There is presence of increasing opportunity cost related with increasing specialisation.
- A complete specialisation can result to greater circumstances such as too much reliance on the other nation and lack of creativity. Also, as some workers will not be able to shift from sector to another, structural unemployment may be created.
- The theory of comparative advantage has not included relative prices and exchange rates. Price of a certain commodity may vary when another commodity related to the production of that particular commodity fluctuates.
- The concept of comparative advantage is not static since it has the tendency to change over the time. Extinction of non-renewable resources and increase in the cost of production are examples that show the way comparative advantage can be affected.
- The concept of comparative advantage is too simplistic in nature where the model is based on two nation and two goods. However, the reality of the global business is far more complex.
- Although the concept has a range of criticism, it still plays a significant role in economics as it gives shape to the pattern of world trade in a basic and traditional way. The concept helps developing complex theories that are more relatable in the present time of highly competitive pattern of trade.
Conclusion:
When a country specializes in producing goods, it is beneficial to the nations as they have a comparative advantage. International trade is an exchange of goods, capitals and services across international territories. The primary goal of the trading partners is mutual gains through the exchanging products having a comparative advantage. Each country should take emphasis on products they can produce in fewer hours and labours which will give them a comparative advantage. Comparative advantage is one of the traditional theories on which international trading is based on. The theory was presented in the 19th century and has been one of the essential concepts of economics since then. Based on the principle of comparative advantage countries make economic decisions. Although the theory has many advantages, it also has several disadvantages. Specifically, in the present decade when the economy has taken a global extent in every minor aspect, the theory is too simple to consider. Although Ricardo has presented the theory for trading between two countries, it applies to individuals, companies or the economy. It is often compared and evaluated with an absolute advantage of countries or business. Several neoclassical economists have argued for and against the theory and modified along with the temporal changes. At the end of the discussion, nations should be specialised and export the specialised goods to other countries when it can produce lower opportunity cost. However, the like several debater nations cannot depend solely on the specific product and service. The real market in the 21st century is complex and highly competitive by trait. In the present time, companies focus on competitive advantage rather than comparative advantage. Also, the adoption of the principle of competitive advantage explains the great competitive market present today
References:
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