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What is 'Comparative Advantage'

Comparative advantage is an economic term that refers to an economy's ability to produce goods and services at a lower opportunity cost than trade partners. A comparative advantage gives a company the ability to sell goods and services at a lower price than its competitors and realize stronger sales margins.The law of comparative advantage is popularly attributed to English political economist David Ricardo and his book “Principles of Political Economy and Taxation” in 1817, although it is likely that Ricardo's mentor James Mill originated the analysis.

BREAKING DOWN 'Comparative Advantage'

One of the most important concepts in economic theory, comparative advantage lays out the case that all actors, at all times, can mutually benefit from cooperation and voluntary trade. It is also a foundational principle in the theory of international trade.

Comparative Advantage vs. Absolute Advantage

Comparative advantage is contrasted with absolute advantage. Absolute advantage refers to the ability to produce more or better goods and services than somebody else. Comparative advantage refers to the ability to produce goods and services at a lower opportunity cost, not necessarily at a greater volume.

To see the difference, consider an attorney and her secretary. The attorney is better at producing legal services than her secretary and is also a faster typist and organizer. In this case, the attorney has an absolute advantage in both the production of legal services and secretarial work.

Nevertheless, they benefit from trade thanks to their comparative advantages and disadvantages. Suppose the attorney produces $175/hr in legal services and $25/hr in secretarial duties. The secretary can produce $0 in legal services and $20 in secretarial duties in an hour. Here, the role of opportunity cost is crucial.

To produce $25 in income from secretarial work, the attorney must lose $175 in income by not practicing law. Her opportunity cost of secretarial work is very high. She is better off by producing an hour's worth of legal services and hiring the secretary to type and organize. The secretary is much better off typing and organizing for the attorney; his opportunity cost of doing so is extremely low. It’s where his comparative advantage lies.

International Trade

David Ricardo famously demonstrated how England and Portugal both benefit by specializing and trading according to their comparative advantages, Portugal with wine and England with cloth.

A contemporary example: China’s comparative advantage with the United States is in the form of cheap labor. Chinese workers produce simple consumer goods at a much lower opportunity cost. The United States’ comparative advantage is in specialized, capital-intensive labor. American workers produce sophisticated goods or investment opportunities at lower opportunity costs. Specializing and trading along these lines benefits each.

Diversity of Skills

People learn their comparative advantages through wages. This drives people into those jobs they are comparatively best at. If a skilled mathematician earns more as an engineer than as a teacher, he and everyone he trades with is better off when he practices engineering.

Wider gaps in opportunity costs allow for higher levels of value production simply by organizing labor more efficiently. The greater the diversity in people and their skills, the greater the opportunity for beneficial trade through comparative advantage.

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