Comparison advantage is an economic term that defines when one country produces a product or service at a lower cost relative to another country. It's not just about country economics, though. Comparative advantage can also mean how one company can produce a product or service at a lower opportunity cost than another firm.
Comparative advantage even pops up regularly in everyday life.
Make no mistake, comparative advantage is a big deal to economists, and to businesses and investors.
Basically, once a country or company develops a product or service in a more efficient and cost-prohibitive manner, that country or company should focus their efforts on producing that product or service over other ones. That gives them a comparative advantage - if they play the game right.
Examples of Comparative Advantage
It is all about competitive advantage. Consider the country of India, which excels at building customer call centers at an affordable price for corporate customers. While efficient and affordable, India's call centers aren't all that superior to call centers in Brazil, China or the U.S. But the intrinsic economic value in getting good call center help at such an affordable price gives India a comparative advantage in call centers over other countries.
Fabled investor Warren Buffett looks at comparative advantage as a castle moat. In times of financial hardship, a country or company could at least rely on the product they produce well. Thus, that country or company can count on the product to act as a defensive measure in times of toxic economics.
Here's the deal. Comparative advantage is the reason companies and countries hone in on producing specific goods (like the U.S. manufacturing cars and trucks, or Saudi Arabia producing oil) and foregoing the development of other products, which they can import using the revenues from the products they export.
Key influencers with comparative advantage focus on access to the means of production. These examples make that case:
- In Peru or Brazil, direct access to vast acres of land and jungle gives the country a leg up on developing hemp or rope.
- In Saudi Arabia or Iran, fertile fuel reserves under the sand make it easier to produce oil and gas.
- In the U.S., China and Germany, a highly educated workforce and robust infrastructure allows these countries to gain the upper hand in comparative advantages. Other countries lacking these advantages can't compete at the level of the U.S, or China in autos and oil.
The History of Comparative Advantage
The theory of comparative advantage dates back to the early 1800's, when author and economics expert David Ricardo used the term in his book, "On the Principles of Political Economy and Taxation." In it, Ricardo cited the nations of England and Portugal as examples.
While Portugal, at the time, produced goods like cloth and wine at a lower cost than England (as Portugal's labor costs were cheaper), England actually produced better cloth from a quality and timeline standpoint. In Ricardo's thinking, those factors made it more reasonable for England to make and export cloth, but to import wine from country's like Portugal. To economists, that's a classic comparative-advantage scenario.
For a more current real-world example of comparative advantage, consider an agrarian nation like Peru, which excels at producing products like rope or fish meal. Its success in doing so and exporting those goods to major trade partners like the U.S., Brazil and China provides the means to import goods and services like gas, oil and telecommunications equipment, which it's not good at producing. Based on economic theory, that export/import balance gives Peru a comparative advantage in the global economic marketplace.
How to Calculate Comparative Advantage
To properly assume the value of a comparative advantage, it's helpful to compare two countries who each rely on a major export to gain that advantage - but also produce other goods. Here's an example.
Country #1 produces wheat.
Country #2 produces wine.
But Country #1 also produces wine, albeit not on the scale of efficiency of Country #2. Meanwhile, Country #2 also produces wheat, but at a lesser efficiency rate than Country #1 produces wine.
Thus, Country #1 has a comparative advantage over Country #2, as it does a better job of manufacturing both wheat and wine than does Country #2, without giving up optimal wheat production outcomes.
To make that calculation, it's helpful to factor in opportunity cost; i.e., the trade-off countries or companies make when they choose to produce or prioritize one good over another.
What country that does a better, more efficient job in combining both the production of wheat and wine, after making that trade-off, including key factors like labor costs, access to machinery and equipment and general production costs? Since Country #1 does a better job of producing a mix of wheat and wine over Country #2, Country #1 has the better comparative advantage, as long as it continues to maximize the production of wheat, it's capstone economic product.
Country #1 Produces 1,000 bushels of wheat per day. It also produces 100 casks of wines every day.
Country #2 Produces 1,000 casks of wine every day. It also produces 25 bushels of wheat every day.
Thus, Country #1 has a comparative advantage, as it produces its combination of goods at a lower opportunity cost than another country. In other words, there are more benefits than downsides to buying Country #1 than with Country #2, as the products it produces have a lower opportunity cost trade-off.
The Theory of Absolute Advantage
There is value in comparing and contrasting comparative advantage against absolute advantage. Basically, absolute advantage is when a country or company produces a product or service that's vastly superior to other countries or companies.
Again, think the U.S. or Saudi Arabia and oil exploration.
Blessed with vast oil and gas reserves, both countries possess an absolute advantage over countries like Spain or Malaysia, which can't compete with the U.S. or Saudi Arabia in energy production, and thus must import more of it. That gives the U.S. and Saudi Arabia an absolute advantage.
But since Spain, for example, has more resources for growing and manufacturing olive oil than does Saudi Arabia, Spain can use that as leverage, and can trade olive oil for fuel oil. In short, Spain can get more oil and gas by trading its main product for it than it would trying to drill for oil itself.
Comparative Advantages in Real Life
Regular folks make decisions that lead to comparative advantage all the time.
Consider two farmers. One farmer, in Florida, grows oranges and one farmer, in Washington state, grows apples. Since one farmer excels at growing oranges and the other excels at growing apples, it makes good sense for both to trade with one another. That beats a farmer in Florida trying to grow apples, or a farmer in Washington trying to grow oranges.
In that regard, comparative advantages enable both farmers to maximize what they do best, and allows them to benefit from the advantages of trade. Each does what they do best, with one farmer having a comparative advantage in growing apples, while the other has the comparative advantage in growing oranges, as they wind up charging each other less to engage in trade for one another's product.
That's the beauty - and the economics - of comparative advantage.