Comparative Advantage Examples and Theory

When we think about comparative advantage, we might think of it as a way for two different countries to benefit from their differences. For example, France might have a comparative advantage in wine production because they have good soil and the right climate, while Germany has a comparative advantage in automobile manufacturing because it has a large population and lots of skilled workers. We will look at different comparative advantage examples in real life, show how to calculate it, and outline some of its benefits in international trade.

Three things must be true for an entity to have a comparative advantage:

• it must have access to different inputs;
• it must produce a good or service that people want to buy;
• it must cost less to produce that good or service in that country.

Opportunity cost and comparative advantage

Comparative advantage is based on opportunity cost because it is not just about producing goods at a lower cost because whenever you produce one product, another is forfeited. The forfeited items are the opportunity cost. You cannot simply forfeit a product to produce another unless the new product is more profitable compared to the forfeited one.

Therefore, for comparative advantage to be of benefit, the opportunity cost must also be low. What this means is that you must produce a product better than another country and at a lower cost and it must be the most profitable opportunity for you (that is, it should be the best opportunity to use.

If one country can produce something better and at a lower cost than another country but the opportunity cost is high, it means the comparative advantage is of no benefit ( in fact, it becomes a “comparative disadvantage“).

Example of comparative advantage and opportunity cost

Take for example China has cheap labor and at the same time, it has made technological advancements. If China is to let go of one of the opportunities, which one would it be? Should China trade off cheap labor and concentrate on technology or it should trade off technology and specialize in offering cheap labor?

If technology brings more revenue and increases the GDP of China more than by offering cheap labor, then it would forfeit cheap labor (because the opportunity cost is high) and embrace technology (higher comparative advantage and lower opportunity cost).

Another example of comparative advantage and opportunity cost can occur when you know how to clean your house and do your laundry more than your housemaid. But you still get a housemaid to enable you to focus on your job which brings in more income for the household. If your job brings in 10,000 USD per month and you pay the housemaid 600 USD per month. It means you trade off saving 600 USD to earn 10,000 USD; this is a comparative advantage.

Therefore comparative advantage is what you are very good at doing compared to others while also giving up on the least beneficial opportunities.

Benefits of comparative advantage

Comparative advantage is the ability of a nation to produce more goods or services with fewer inputs than any other nation. There are many benefits of comparative advantage to any country, including:

1. Increased economic growth: When a country has a comparative advantage in a particular industry, it can grow more rapidly than other countries because it can export more products. This leads to increased jobs and higher wages.
2. Reduced poverty: having a comparative advantage in producing goods or services, it can help reduce poverty because more jobs would be created to meet demand from trading partners.
3. Increased stability: a country with a comparative advantage in certain industries is less likely to experience economic instability because there is always demand for the products that it produces.

Disadvantages of comparative advantage

1. A country that focuses only on comparative advantages often depletes its available resources.
2. Having a comparative advantage in terms of cheap labor may lead to the exploitation of laborers, especially in countries that practice capitalism because the companies would want to maximize profit by all means including overworking and underpaying workers in order to meet demand and supply to its international trading partners.
3. Being specialized and dependent on a single sector may have devastating effects on the economy when there is an economic downturn. For example, a country that depends on the exportation of petroleum may have an economic crisis when global prices of petroleum fall; a phenomenon known as Dutch disease.
4. Geographical distance is a barrier to most countries that may have comparative advantages to trade with one another. The cost of transporting goods across borders may not be profitable to such countries.
5. Comparative advantage alone is not good enough to determine who wins in international trade because other factors come into play.
6. Overspecialization might lead to structural unemployment because some workers cannot transfer from one industry to another.

Comparative advantage theory

The theory of comparative advantage states that a country can increase its wealth by specializing in what it is best at while trading with other nations to bring those goods and services to market. The opportunity cost is a factor that must be considered if truly comparative advantage would be of benefit to any entity (be it a country, business, or individual).

David Ricardo’s comparative advantage theory

David Ricardo was a British economist who developed the theory of comparative advantage. The concept was first introduced in his Principles of Political Economy and Taxation. Ricardo argued that nations could benefit from specializing in certain goods and services and trading with other countries for the inputs needed to produce those goods. His theory states that a country should focus on producing what it is best at and importing what it isn’t good at. This will create a trade imbalance, but overall it will be in the country’s best interest.

The comparative advantage theory considers opportunity cost in the sense that, before specializing or concentrating on what you do best, you have to weigh other opportunities that will be forfeited. If a country specializes in the exportation of petroleum but wants to let go of agriculture, then the opportunity cost is agriculture. The country decided to let go of agriculture because the benefits of the exportation of petroleum are better than agriculture.

Therefore, the comparative advantage theory is based on the idea that countries can produce things more cheaply because of differences in their natural resources, abilities to organize labor, proximity to market, climate suitability, or other factors; the countries then capitalize on these differences.

The comparative advantage theory has been used to explain why some countries are successful in international trade and why others are not. It can also help us understand why some countries are better able to compete in the global economy than others.

Factors of comparative advantage

• Technological superiority
• Natural resources
• Skilled labor
• Cheap labor
• Suitable weather and climate

There are several different types of factors that can provide comparative advantage to various countries.

Technological superiority

The most common type is technological superiority. This means that one country has a better ability to produce items using technology, such as computers, cars, or missiles. Countries with technological superiority can often sell these products at a higher price because they don’t have to spend as much money on research and development.

Comparative advantage and specialization

Another type of comparative advantage is economic specialization. This means that one country produces more goods or services that use specific types of inputs (like oil) or require specific skills (like engineering). Countries with economic specialization can sell these products at a higher price because they don’t have to compete with other countries for the same types of inputs or skills.

How does one achieve a comparative advantage?

The concept of comparative advantage in economics is used to explain why some countries or groups of countries are better suited to produce specific goods or services than others. It can be applied to a wide range of economic situations, including trade between nations, international businesses, and individual businesses.

There are six different special factors of production: land, labor, capital, natural resources, innovation, and specialization. A country can have a comparative advantage in one or more of these factors. In many cases, one country or group of countries can produce a good or service more cheaply than any other country because of its natural resources or other advantages.

Natural resources

For example, the United States has a strong comparative advantage in producing automobiles and parts because it has abundant natural resources (such as oil) and skilled labor.

Capital

Comparative advantage in production is achieved by the reduction of the cost of inputs (capital). A company or country with more capital increases its chances of achieving a comparative advantage.

Labor

Labor is the most important factor in producing goods and services. It is responsible for making things that people need, such as food, clothing, and shelter; even services are provided by labor. Therefore, another way for a country to achieve a comparative advantage is to use labor to produce things that other countries cannot produce easily or cheaply. A clear example of this is China which has cheap labor and uses it in many sectors including the textile industries.

Technology

Technology can help companies and countries achieve a comparative advantage in specific sectors. By using technology, companies can reduce the costs associated with their products or services, increase their market share, and can also improve the quality of their products or services, which will make them more attractive to customers.

The level of education

Different people have different levels of education and this affects their ability to produce goods and services in a country. A country with highly skilled labor has a comparative advantage for the production of goods or services that require education. A country with unskilled labor and fewer educated people can have a comparative advantage in cheap labor. Some examples include large skilled labor in the US and large unskilled labor in India.

Skills in the workforce

Japan has a strong comparative advantage in producing electronics and other high-tech products because it has large pools of skilled labor and ample capital (such as money).

Importance

Comparative advantage is a key concept in economics and the concept can be applied to any sector of the economy. It is often used to explain why one country may be able to achieve economic success while another falls behind.

This concept is important because countries with a comparative advantage tend to be able to sell their products at a higher price than products from countries with less of an advantage. This means that countries with a comparative advantage can invest more in their industries, which can lead to greater economic growth.

Additionally, having a comparative advantage can help countries avoid being caught up in global market fluctuations. For example, when the global economy is booming, countries with a comparative advantage in exports will benefit because their exports will rise in value. Conversely, when the global economy crashes, countries with a comparative advantage will be less impacted since they specialize in products that are not as reliant on the global economy.

Comparative advantage examples

Comparative advantage is based on the ability of different countries to produce more output from a given input than would be possible for each country using its resources alone. Below are the comparative advantage examples of different countries in the real world.

An example of comparative advantage between India and Japan

This type of comparative advantage example is based on specialization and availability of natural resources. India imports machinery, electrical appliances, transport equipment like motor vehicles, plastic, iron, and steel products from Japan; because Japan specializes in technology, while India exports petroleum products, non-metallic mineral ware, chemical elements, and metalliferous ores to Japan because of the availability of these resources in India.

An example of the comparative advantage between China and the United States

Another comparative advantage example is between China and the US. The United States has an absolute advantage in producing automobiles, clothing, toys, footwear, and electrical appliances because it has skilled workers and abundant resources but it may surprise you that it imports most of these items from China. This is a clear example of an absolute advantage not a guarantee of comparative advantage, we will talk more about this later. The reason is that these items are cheaper to produce in China because of the cheap labor; China has a comparative advantage in this regard.

On the other hand, the United States has a comparative advantage in highly skilled labor for the production of sophisticated machines and equipment such as medical equipment, pharmaceuticals, nuclear reactors and boilers, aircraft, and spacecraft. The US, therefore, exports these items to China.

Comparative advantage example between Germany and Russia

The comparative advantage example of Germany and Russia is based on skilled labor and natural resources. Germany has a long history of engineering and manufacturing high-quality goods. This is especially evident in the automotive industry, where many of the world’s top car brands are based in Germany. The German automakers have a long history of developing superior safety features, which gives their cars an edge when compared to their Russian counterparts.

Russia, on the other hand, has crude oil in excess and a large labor force. Therefore, Russia exports crude oil to Germany and imports Machinery, Vehicles, and Accessories from Germany.

The comparative advantage of Vietnam

The Republic of China supplies Vietnam with agricultural goods such as cotton, soybeans, corn, and dairy products while Vietnam supplies China with electrical products and accessories for the transmission and reception of images, data, and voice.

Also, the US imports furniture and bedding, knit apparel, and footwear from Vietnam and exports Agricultural products to Vietnam because Vietnam sees the U.S. products as safe and of high quality.

The comparative advantage of Mexico and Canada

Another comparative advantage example is between Mexico and Canada, where there is a difference in their types of natural resources as well as skilled labor. Mexico exports agricultural products such as coffee, tea, spices, fruits, and vegetables to Canada, this is because Mexico has vast agricultural land and has cheaper labor that is skilled in agriculture, especially in the use of protected culture farming where plants gain protection from harsh weather and pest using greenhouses.

On the other hand, Canada exports automobiles, nuclear reactors, steel, and iron casting to Mexico because of its mineral resources.

Comparative advantage formula

The comparative advantage formula is calculated using the opportunity cost incurred to produce another product. This means the amount of one product that is forfeited to produce a certain amount of another.

Assuming we have two products, A and B; if all resources were to be used for the production of product B.

Then the comparative advantage formula can be expressed using the opportunity cost of the two products as: (The max amount of product A)÷(The max amount of product B) = Opportunity cost of product B.

Assuming the United States of America can produce a maximum of 1,000 Tesla cars per day if all its workers were to be used for the production of cars or it can produce a maximum of 10,000 mobile iPhones if all the workers were to be used for the production of iPhones.

Then the opportunity cost of producing 1 Tesla car would be expressed as 10,000/1,000 = 10; that is, it will cost the USA 10 iPhones to be forfeited in order to produce 1 Tesla car per day. Therefore, the opportunity cost for producing 1 Tesla car is 10 iPhones.

When comparing two countries to know how best for them to trade, the opportunity cost of the products they intend to trade would be calculated and the country with the lowest opportunity cost for a particular product is expected to produce such a product and the other country should buy from the one with the lower opportunity cost. This way, both countries benefit from each other. We will outline this in the following calculation.

How to calculate comparative advantage

Let’s see an example for calculating comparative advantage between two countries.

Assume both the USA and Saudi Arabia can produce crude oil and cars at different efficiencies.

• If the USA can produce 100 cars per day with all its workforce or it can decide to produce 25 barrels of crude oil per day with all its workforce.
• On the other side, assuming Saudi Arabia can produce 15 cars per day when it uses all its labor force or it can produce 150 barrels of crude per day when it uses all its labor force.

We can outline this information in a table for a better understanding of calculating comparative advantage.

Let us calculate the opportunity cost for each product in both countries.

• The opportunity cost to produce 1 car in the USA would be 25/100 = 0.25
• The opportunity cost to produce 1 barrel of crude oil in the USA would be 100/25 = 4
• The opportunity cost to produce 1 car in Saudi Arabia would be 150/15 = 10
• The opportunity cost to produce 1 barrel of crude oil in Saudi Arabia would be 15/150 = 0.1

The output table for the opportunity cost between these two countries would be outlined below:

Graph

We can use the comparative advantage graph to visualize the importance of applying this principle in order to increase output.

Example

Let’s take another comparative advantage example of two countries: New Zealand and the United Kingdom (UK); let’s assume both can produce two goods: machinery and wool.

Assuming that all the resources are used by these two countries: then New Zealand can produce 30,000 metric tonnes of wool or 6,000 machinery per year and the UK can produce 35,000 metric tonnes of wool or 21,000 machinery per year. We can then use an output table to summarise this below:

We can see from the table that the UK has an absolute advantage to produce both items because it has more output in both products.

Calculating comparative advantage and opportunity cost for the two countries

From the table above, the UK has a lower opportunity cost for both products, which means it has an absolute advantage in both, but it has a comparative advantage in machinery because it has the lowest opportunity cost. New Zealand on the other hand has the lowest opportunity cost in wool.

Production possibility frontier plotted using the opportunity cost (assuming this forms our “comparative advantage graph”)

There is no comparative advantage graph literally but the concept can be visualized using the production possibility frontier (PPF).

The above graph shows the greatest advantage lies in the production of machinery by the UK because it has more output gains doing that. While New Zealand would specialise in producing wool.

Comparative advantage vs absolute advantage

Absolute advantage is the ability to produce better products or services than another. The fact that a country can produce better products than another doesn’t mean it should go ahead and manufacture such products because it may cost more to produce the better product. This is different from comparative advantage.

Why choose comparative advantage over absolute advantage?

1. It may be more costly to produce better quality.
2. There may be no market available to sell even with the absolute advantage. You can produce better quality phones but no one may be willing to buy at expensive prices.
3. Proximity to the available market. A country could produce better products at cheaper prices but the transportation to another country that needs such a product may be expensive.

Therefore, for a country, company, or individual with both absolute advantage and comparative advantage, it is more profitable and beneficial for the country to utilize the comparative advantage than the absolute advantage.

Comparative advantage vs competitive advantage

There is the concept of competitive advantage in trade which combines comparative advantage, absolute advantage, and cost reduction. What competitive advantage entails is the ability of a country, company, or individual to produce better products or services at a lower cost than the competitors when it specializes in what it knows how to do best.

Competitive advantage is the value you offer your customers that makes you more attractive to them than the competitors. In order to have a competitive advantage, one of the following must be included:

1. cheaper products or services
2. quality product or service
3. targeted customers or niche

Therefore, whatever makes a customer prefer your products over the competitors is a competitive advantage. But whatever opportunity that makes you more profit when you specialize and focus on it is a comparative advantage.

Misconceptions

There are three main misconceptions about comparative advantage:

• that it always exists between any two countries
• that it is static
• that it determines who wins and who loses in trade.

None of these misconceptions about comparative advantage is actually true. It is dynamic and can change; the mineral resources of a country may be depleted and therefore the comparative advantage the country enjoys over another would cease to exist. Again, it doesn’t determine who wins in trade because so many other market forces come into play.

FAQs

Conclusion

Having known the comparative advantage examples and theory, you should have a better understanding of the concept and how it can be applied to businesses and countries, especially in international trade. By understanding how different countries can trade and what advantages one country may have over another, you can create more efficient businesses and policies that will be better equipped to compete in today’s economy.