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Comparative Advantage

Comparative advantage was developed by David Ricardo and is when a country can produce a certain good with less forgone output of another good than another country¹. Comparative advantage is therefore based on the lowest opportunity cost, as opposed to the lowest absolute cost. A country can have absolute advantage in all goods, which is when a country can produce a good at a lower absolute cost than another country, but can never have a comparative advantage in all goods.

World output will increase if countries specialize in the production of goods that they have a comparative advantage in and trade for other goods. This is beneficial to both parties of trade. Comparative advantage shows that everyone can benefit from trade but follows the assumption that there are few transaction costs and some restrictions to flow of capital. Comparative advantage can only work if countries have different production costs. To identify which country should specialize in a product, the internal opportunity costs should be assessed. Countries must agree on an acceptable rate of exchange for the trade to be mutually beneficial for the countries involved.

Comparative advantage does change overtime because factors that determine a country’s costs of production will change over time. Changes in exchange rates affect the prices of imports and exports, causing changes in demand, which therefore cause fluctuations in comparative advantage.

A contrived comparative advantage for domestic producers is created when the government imposes import restrictions like tariffs and quotas. Comparative advantage is self-reliant because entrepreneurs can create new ways to efficiently produce a product or create a new product entirely that is demanded in different markets¹.

 

References:

1. Baumol, William J. and Alan S. Binder, 'Economics: Principles and Policy'. 2009.

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