How Comparative Advantage Works

The theory underpinning trade

In economics, comparative advantage occurs when a country is able to produce a good or service at a lower opportunity cost than another country.

The theory of comparative advantage is attributed to political economist David Ricardo, who wrote the book Principles of Political Economy and Taxation (1817).

Real-world example

Consider two countries (France and the United States) that use laboras an input to produce two goods: wine and cloth.

  • In France, one hour of a worker’s labor can produce either 5 cloths or 10 wines.
  • In the US, one hour of a worker’s labor can produce either 20 cloths or 20 wines.

The information provided is illustrated as follows:

Comparative Advantage - Example

It is important to note that the United States enjoys an absolute advantage in the production of cloth and wine. With one labor hour, a worker can produce either 20 cloths or 20 wines in the United States compared to France’s 5 cloths or 10 wines.

  • The United States enjoys an absolute advantage in the production of cloth and wine.

To determine the comparative advantages of France and the United States, we must first determine the opportunity cost for each output:

France:

  • Opportunity cost of 1 cloth = 2 wine
  • Opportunity cost of 1 wine = ½ cloth

The United States:

  • Opportunity cost of 1 cloth = 1 wine
  • Opportunity cost of 1 wine = 1 cloth

When comparing the opportunity cost of 1 cloth for both France and the United States, we can see that the opportunity cost of cloth is lower in the United States. Therefore, the United States enjoys a comparative advantage in the production of cloth.

Additionally, when comparing the opportunity cost of 1 wine for France and the United States, we can see that the opportunity cost of wine is lower in France. Therefore, France enjoys a comparative advantage in the production of wine.

Comparative Advantage and Free Trade

How does identifying each country’s comparative advantage aid in understanding its benefits in free trade?

First, let’s assume that the maximum amount of labor hours is 100 hours.

In France:

  • If all labor hours went into wine, 1,000 barrels of wine could be produced.
  • If all labor hours went into cloth, 500 pieces of cloth could be produced.

In the United States:

  • If all labor hours went into wine, 2,000 barrels of wine could be produced.
  • If all labor hours went into cloth, 2,000 pieces of cloth could be produced.

Following Ricardo’s theory of comparative advantage in free trade, if each country specializes in what they enjoy a comparative advantage in and imports the other good, they will be better off. Recall that:

  • France enjoys a comparative advantage in wine.
  • The United States enjoys a comparative advantage in cloth.

In France, the country specializes in wine and produces 1,000 barrels. Recall that the opportunity cost of 1 barrel of wine in the United States is 1 piece of cloth. Therefore, the United States would be open to accepting a trade of 1 wine for up to 1 piece of cloth.

In the United States, the country specializes in cloth and produces 2,000 pieces. Recall that the opportunity cost of 1 piece of cloth in France is 2 barrels of wine. Therefore, France would be open to accepting a trade of 1 cloth for up to 2 barrels of wine.

Benefits of Comparative Advantage

Using the theory of comparative advantage, a country that specializes in their comparative advantage in free trade is able to realize higher output gains by exporting the good in which they enjoy a comparative advantage and importing the good in which they suffer a comparative disadvantage.