Comparative advantage is an economic law, dating back to the early 1800s, that demonstrates the ways in which protectionism (or mercantilism as it was called at the time) is unnecessary in free trade. Popularized by David Ricardo, comparative advantage argues that free trade works even if one partner in a deal holds absolute advantage in all areas of production – that is, one partner makes products cheaper, better and faster than its trading partner.
The primary fear for nations entering free trade is that they will be out-produced by a country with an absolute advantage in several areas, which would lead to imports but no exports. Comparative advantage stipulates that countries should specialize in a certain class of products for export, but import the rest – even if the country holds an absolute advantage in all products.
- Comparative advantage is an economy's ability to produce a particular good or service at a lower opportunity cost than its trading partners.
- The theory of comparative advantage introduces opportunity cost as a factor for analysis in choosing between different options for production.
- Comparative advantage suggests that countries will engage in trade with one another, exporting the goods that they have a relative advantage in.
- Absolute advantage refers to the uncontested superiority of a country to produce a particular good better.
Explaining Comparative Advantage
Where Comparative Advantage Comes From
The essence of this law can be illustrated with a simple example. Imagine that you are a skilled cabinetmaker as well as a gifted painter. It takes you a day to build a cabinet or a day to paint a picture. In the local economy, paintings sell for $400 and cabinets go for $350. Your neighbor also shares the same skill sets, but it takes him a day and a half to build a cabinet and three days to complete a painting. You have an absolute advantage over your neighbor in both areas, so you should try to outproduce him across the board, right? Wrong.
Here's why: If you flip between painting and cabinetmaking over a six-day work week, you would produce three paintings and three cabinets worth $2,250. If your neighbor embarked upon the same work schedule, he would produce one painting and two cabinets worth $1,100. There would be a total of four paintings and five cabinets produced: a total of nine production units. If, however, you were to choose to focus on painting, the area where you have the greatest comparative advantage and the most profit, and leave cabinetmaking to your neighbor, something magical would happen. You would produce six paintings worth $2,400 per week, while your neighbor would produce four cabinets worth $1,400, bringing the total to 10 production units. In real terms, both you and your neighbor would be richer for specializing – and the local economy is one production unit the better for it.
Comparative Advantage and Free Trade
Economists have been uncommonly uniform in advocating free trade policies for centuries, and comparative advantage is the reason why. The theory suggests that total economic welfare in all countries is improved when countries focus on those industries where they have have the highest expertise and success, and the lowest opportunity costs.
To explain opportunity cost, we'll answer this question: Why don't NBA players mow their own lawns? Ostensibly, NBA players are stronger and faster than their landscapers and could do it more effectively. However, NBA players can maximize their value and productivity by focusing on basketball rather than wasting energy with a lawnmower; the opportunity cost is too high. Instead, the basketball player and landscaper each specialize and trade, using money as an intermediary representation of their respective productivity.
Comparative advantage says that countries should behave similarly. Laborers in the United States have relatively high levels of education and relatively advanced capital goods; this makes them very productive. However, that doesn't necessarily mean that American workers should produce everything that American consumers need. Instead, maximum efficiency and output can be achieved by specializing in those areas with the lowest opportunity costs and trading with other countries.
Free Trade Policies
Free-trade policies, in their truest form, advocate for a complete absence of import restrictions (such as tariffs and quotas) and for no subsidization of export industries. The proponents of free trade argue that restrictions on trade make all consumers, even Americans, poorer than they otherwise would have been.
The crux of the argument centers on the benefits of comparative advantage. When the laborers of one country specialize where they have the lowest opportunity costs, those industries achieve economies of scale and innovate. The increase in production causes prices to decline. American consumers see their real costs of living decline when cheap foreign goods are combined with cheaper domestic goods. Standards of living improve as a result.
Abbreviated as this explanation is, it highlights the academic arguments in favor of open international markets. During the 19th century Industrial Revolution, for example, Britain provided support for comparative advantage by essentially outsourcing its food growth (importing grains, meat, cheese, wine, etc.) and focusing on manufacturing goods for export, thus becoming the workshop of the world for decades. And in today's increasingly international economy, the theory is even more relevant (see How does globalization impact comparative advantage?).
Why Isn't There Complete Free Trade?
If economists – who rarely agree – are almost uniformly in favor of free trade, why doesn't the world have open trading between countries? There are many reasons, but the most influential is something that economists call rent-seeking. Rent-seeking occurs when one group organizes and lobbies the government to protect its interests.
Say, for example, the producers of American shoes understand and agree with the free-trade argument – but they also know that their narrow interests would be negatively impacted by cheaper foreign shoes. Even if laborers would be most productive by switching from making shoes to making computers, nobody in the shoe industry wants to lose his or her job or see profits decrease in the short run. This desire leads the shoemakers to lobby for, say, special tax breaks for their products and/or extra duties (or even outright bans) on foreign footwear. Appeals to save American jobs and preserve a time-honored American craft abound – even though, in the long run, American laborers would be made relatively less productive and American consumers relatively poorer by such protectionist tactics.
The Bottom Line
Comparative advantage urges nations to engage in true free trade and to specialize in areas where they have the highest expertise and most success – instead of looking to bolster weak industries from foreign competition by imposing protective tariffs that otherwise stifle the production that leads to overall gains in wealth. The benefits of comparative advantage are reduced when domestic industries are subsidized or when foreign industries are subjected to import tariffs.