The All important theory of Comparative Advantage by David Ricardo in his 1817
What Is Comparative Advantage?
Comparative advantage is when a person, company, or country can make something at a lower cost in terms of what they give up to produce it. This concept is used to explain why it's beneficial for them to trade with others.
Understanding Comparative Advantage
At its core, comparative advantage is about choosing the option that costs you the least. Imagine you're good at both playing the guitar and making videos, but making videos takes less of your time compared to others. Your "opportunity cost"—or what you give up—in making videos is lower than playing the guitar, so you have a comparative advantage in video production.
How It Works in Trade
In trade, this principle means that countries can benefit by specializing in what they are best at producing and then trading with each other. For example, if one country is great at making wine and another is great at making cloth, they should stick to these goods and trade with each other to get the best of both worlds.
Example of Comparative Advantage
Consider a famous athlete like Michael Jordan, who is exceptionally good at both sports and potentially simple tasks like painting a house. Suppose it takes him less time to paint his house than his neighbor Joe, but in the same time, he could earn a lot more by filming a commercial. Even though he is faster, Michael has a high opportunity cost for painting because he could lose out on earning $50,000 from the commercial. On the other hand, Joe, who might take longer, only gives up $100 from his regular job. So, Joe has a comparative advantage in painting the house, and Michael should focus on the commercial and pay Joe for the painting. This way, both benefit more than if they did the tasks themselves.
Difference Between Comparative and Absolute Advantage
Comparative advantage is different from absolute advantage, where absolute advantage is being able to produce more or better than someone else. Comparative advantage focuses on lower opportunity costs. For example, an attorney might be better at both legal services and secretarial work than their secretary, but the opportunity cost of the attorney doing secretarial work is higher because they could be earning more doing legal work. So, it's more efficient for the attorney to focus on legal services and the secretary on secretarial tasks.
The Role of Comparative Advantage in International Trade
Economist David Ricardo showed how countries like England and Portugal benefit from specializing and trading according to their comparative advantages. Portugal could make wine cheaply, while England could produce cloth cheaply. By focusing on these strengths and trading, both countries benefit more than if they tried to produce both items themselves.
Comparative advantage encourages free trade, where countries profit from trading goods that they produce more efficiently than others. This concept helps explain why imposing tariffs or trying to produce everything domestically without trading can lead to inefficiencies and higher costs.
Who Developed the Law of Comparative Advantage?
The concept of comparative advantage was detailed by David Ricardo in his 1817 book, "On the Principles of Political Economy and Taxation." Although David Ricardo is credited with developing this economic theory, the initial ideas might have come from his mentor, James Mill, who also explored similar concepts.
How Do You Calculate Comparative Advantage?
Comparative advantage is calculated using opportunity costs. Opportunity cost is what you give up when you choose to do one thing over another. For instance, if a factory uses its resources to make 100 pairs of shoes instead of 500 belts, the opportunity cost of producing one pair of shoes is five belts. If another factory can make three belts for every pair of shoes it doesn't make, the first factory has a comparative advantage in making belts (because it gives up fewer belts to make shoes), and the second factory has a comparative advantage in making shoes (because it gives up fewer shoes to make belts).
Example of Comparative Advantage
A good example of comparative advantage is seen in how high-powered executives work. An executive might be excellent at answering emails and doing secretarial tasks but even better at making big business decisions. The opportunity cost of the executive doing secretarial work is very high because it takes away time from more critical executive duties that could lead to bigger profits. Therefore, it makes sense for the executive to hire an assistant to handle emails and administrative tasks, even if the assistant isn't as skilled at these tasks as the executive. This way, both the executive and the assistant can focus on what they do best, making the entire office more productive.
The Bottom Line
Comparative advantage is a vital economic principle that explains why it's beneficial for individuals, companies, and countries to trade goods and services with each other. By focusing on producing goods and services where they have a comparative advantage, they can all achieve greater efficiency and productivity. This idea supports the case for free trade between nations. However, it's important to note that not all outcomes of trade are always equally beneficial for all parties involved; sometimes, trade can lead to exploitation or unequal benefits, which is an important consideration in modern economic discussions.