What Is Comparative Advantage Theory? Benefits & Examples
When you’re running a business, you want every edge you can get. The market is competitive, and most people want a competitive advantage. However, there is another advantage that should be studied, too. It’s called comparative advantage, and you may not have heard of it before. Keep reading to learn all about comparative advantage, and how it can benefit your business!
Here’s What We’ll Cover:
What Is a Comparative Advantage?
Comparative advantage is an economic theory. Comparative advantage itself is an economy’s ability to produce a good or service at a lower opportunity cost than its trading partners. This means that the cost of production is lower than a competitor’s, allowing a company to realize stronger sales margins.
When the costs of production are lower, it means that the price can be reduced as well. Price reduction leads to stronger sales, meaning a higher volume of products can be sold. This means that the company that has the advantage has an increase in profits. Meanwhile, the competition sees their profits decrease.
Comparative Advantage Has Been Around a While
Comparative advantage was introduced in the early 19th century by David Ricardo. Its origin is probably with David Ricardo’s mentor, James Mill. It is one of the stronger modern theories of economy and has been used for the better part of 2 centuries.
The First Example of Comparative Advantage
Ricardo’s original writings surrounding comparative advantage came from the production of wine. In his writings, he discusses that to make wine in Portugal it takes the labour of 80 men. When considering the production of cloth, it takes the labour of 90 men. Therefore, producing wine has a comparative advantage in Portugal over cloth.
The example goes on to describe the ability to leverage the wine opportunity cost over the ability to make other goods. As such, receiving other goods (like cloth) in exchange for wine is the most advantageous option for Portugal. In terms of wine, cloth is more expensive than wine is, and wine should be produced instead.
The Need for International Trade
This theory relies heavily on international trade. It assumes that different countries are going to trade with one another. As such, certain countries will have a comparative advantage over others on certain goods. This is entirely based on the country’s resources, of course.
When trading between countries, let’s assume that Country A has a large timber industry. Country B has a large mineral industry and a need for timber. While Country B could produce their own timber, it may be more advantageous for them to produce more minerals. Then they would be able to trade with Country A.
Modern comparative advantage has come a long way, though. There are many companies based in many countries. As such, companies now have a comparative advantage, rather than countries. International trade is still required, but the model has become far more complex.
What Is Absolute Advantage?
Absolute advantage is often contrasted with comparative advantage. It refers specifically to the uncontested superiority of a country (or company) to create a good. While comparative advantage refers to the opportunity cost of a product, the absolute advantage does not. Absolute advantage means that the entity can create more goods than any other entity, no matter what. Hence the term ‘absolute’ in the name.
The Benefits of Comparative Advantage
There are a handful of different benefits to having comparative advantage. They are listed below:
- Lower opportunity costs mean higher sales margins. This is, of course, the biggest benefit. A company that can focus on labour, capital, and resources on production that needs a lower opportunity cost allows for larger profits.
- Increased efficiency. When you can focus on a product that is more efficient to make, you can then obtain what isn’t efficient from other trading partners.
- Comparative advantage leads to other advantages. Often, when a company has a comparative advantage it can also gain a competitive advantage.
Does Trade Still Have to Be International for Comparative Advantage?
While the theory originally centred on international trade, it no longer has to. There are regional advantages that lend themselves to comparative advantage now. There are also technologies that can provide a comparative advantage if kept exclusive. International trade still plays an important part, but it is no longer the key factor.
Comparative advantage is an economic theory that focuses on producing goods at a lower cost. When a company does this, they increase their profit margins in most cases. If you need to know more about financial terms and theories, be sure to visit our resource hub! It’s packed with useful information.