comparative advantage

Comparative advantage is an economic theory created by British economist David Ricardo in the 19th century. It argues that countries can benefit from trading with each other by focusing on making the things they are best at making, while buying the things they are not as good at making from other countries. This theory is based on the idea that every country has different cost structures and opportunity costs (costs in terms of other goods given up). By focusing on their strengths, they can produce more efficiently. Ricardo’s research demonstrated that even if one country can make everything more efficiently than another country, international trade is still beneficial.

Picture two countries, country A and country B. Consumers in each country like to eat a mixture of rice cakes and banana bread.

In country A, the workforce could make 1,000 rice cakes, or they could bake 3,000 loaves of banana bread. Or, they could split the workforce in half, and make 500 rice cakes and 1,500 loaves of banana bread.

In country B, the same size workforce could also produce 1,000 rice cakes, but if they were to instead make only banana bread, they could only make 2,000 loaves. Or, if they split their workforce in half, they could produce 500 rice cakes and 1,000 loaves of banana bread.

In this example, if each country split their workforce between the production of rice cakes and banana bread, they would make, in total, 1,000 rice cakes and 2,500 loaves of banana bread.

But if country B were to make enough rice cakes for both nations (1,000), country A could make 3,000 loaves of banana bread, for a final total of 500 more loaves.

According to Ricardo, a properly structured international trade agreement could work out for both countries, even if country A is more efficient at making both banana bread and rice cakes.

The theory of comparative advantage supports free trade and specialization among countries. In other words, no matter how you slice it, comparative advantage, plus international trade, equals higher aggregate output.

But the issue gets more complex when you take into account real-life elements such as varying factors of production, limited resources, the state of a country’s labor and employment, and the ability of countries to construct mutually beneficial trade agreements.