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written by | May 13, 2022

Comparative Cost Advantage Theory and Its Benefits

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British economist David Ricardo developed the comparative cost advantage theory. Ricardo's theory of comparative advantage describes the advantages of international commerce by highlighting the importance of opportunity costs of producing goods for various markets. 

Also, Ricardo looked at how effectively each country could manufacture each item and the benefits it could bring to the global trade market. Today, we'll understand comparative advantage meaning, highlights of the theory, advantages and much more.

Did you know?

David Ricardo, who summarised the concept of relative advantage, was among the most influential economists and a politician. 

Comparative Cost Advantage Theory

Comparative advantage occurs when the nation can create a product with an affordable opportunity cost. Also, the nation has to sacrifice less value for good A in order to create good B than some other countries. This contrasts with the absolute advantage since the nation may enjoy a competitive advantage. 

However, it's not more efficient than other nations. The concept of relative advantage was initially created by David Ricardo back in 1817. The law he defined as being a situation in which one country was more efficient in producing one particular product over another. But the relative advantage is different from the absolute advantage. Relative advantage relies on the cost of opportunity.

Comparative Advantage Theory of International Trade

Comparative advantage can be confusing when discussing countries that can effectively produce various items. However, that never means having an advantage in all product categories. It is more important to examine the benefits in a larger context. In case there is a bigger difference in efficiency between producers concerning a particular product than there is for another. In this situation, the work must be split in order to ensure the highest overall production, offering you the best price.

We generally use comparative advantage in international trade to measure the advantages of importing and exporting certain products from countries.

It does not necessarily indicate that the most efficient nation will always be the leader. If one nation is the top producer of multiple goods, the theory of comparative advantage suggests they should concentrate on the one product for which they hold the biggest advantage. Other countries could assume the production of different products, thus freeing the time and energy. 

Different factors affect the comparative advantages. In most cases, factors like the cost of labour and land are the most important. However, it's equally important to think about capital and the supply of products or materials within a particular country. Speed, efficiency and productivity all are important, though these aspects can be difficult to measure on a large scale. 

Also Read: List Of Import-Export Business Ideas To Carry Out In India

Difference Between Comparative and Absolute Advantage

Absolute advantage differs from a relative advantage.

  • A country will enjoy a huge advantage in producing a product or offering a service when it can accomplish it faster, better and more efficiently, in more volume and with fewer resources than a different country. 
  • The comparative advantage lies in a nation's ability at a lower opportunity cost rather than a greater quality or high efficiency.

An example from the real world could be one of the financial relationships and distinctions between a doctor at a hospital and an orderly who supports doctors by helping to set up operating rooms and cleaning up after surgeries. The doctor could have served as an orderly in the past, and he could be able to complete the duties of an orderly more effectively and more quickly than a person who is an orderly. A doctor has an advantage when it comes to doing the duties of doctors and being orderly.

But, both receive benefits of comparative advantage and are not affected by chance cost. The orderly person generates less income than the physician, and there's no replacement for the doctor who can concentrate on his work while the orderly does his job.

The Law of Comparative Advantage

David Ricardo created the comparative advantage law in 1817. The core aim was to clarify the reasons for international trade between nations regardless of whether one's factories, workers, businesses and companies are more effective in producing every item.

In explaining the situation the issue, he gave an example:

  • Imagine the scenario in Portugal and England had a plan to exchange clothes and wine. The day's economists realised that such a trade could be beneficial when England was more adept at making cloth and Portugal had a better record in making wine. Each country would specialise in the areas where they held an advantage. This means that each nation would be more focused on its strengths than other countries.

Ricardo demonstrated that trade could be beneficial if England wasn't just superior in making cloth but also at making wine. Particularly is it the case that England could be a bit better than Portugal in making wine, but far superior to Portugal in cloth production. In that scenario, both countries would still produce more if England was focused on producing cloth and Portugal concentrated on wine and were involved in the trade. Portugal did not have an undisputed advantage in the production of wine, but it had an advantage for sure. Compared to making fabric, the wine industry was Portugal's most competitive item.

Comparative Advantage Example 

Example 1:

A situation that provides the benefit of comparative advantage to do similar work at less cost. For example, let's say that a rock group wants to create t-shirts that it can sell at concerts. It could be:

  • A clothing company can create t-shirts and pay an amount to the company for every shirt it prints. 
  • Buy the printing equipment and plain t-shirts. Then, they can print the products on-site. 

On a smaller scale, outsourcing the garment production to another company can provide a benefit. Why? Because the band members' specialities are likely to be in music, not manufacturing.

If they did delve into the complexities of clothing manufacturing, this would incur the cost of time and energy they could have used to practise, write, or record new music. Furthermore, the band would have to make a substantial capital investment to get their manufacturing venture up and running and would require huge sales to cover that. However, a band might see a possibility to sell hundreds or thousands, perhaps even millions of T-shirts. In this case, making investments in the equipment they own and making the products in-house could give them a competitive advantage. 

It will require a substantial expense in the capital. It could include hiring employees to create the 

clothing. However, once they have started making clothing in a large size, the company could realise that it is making more money than outsourcing the job to an outside business.

Therefore, competitive advantage may not be uniform across all companies within a field. The size of the business can make a great difference.

Example 2:

To help put things in perspective, we'll examine another advantage in comparison from a different viewpoint.

A super-popular soccer star, Cristiano Ronaldo, has an unmistakable advantage over the average player considering his skills. He has always sealed his spot among the top players around the world. However, let's also suppose that he has a great musical talent.

He can't focus on his music and soccer without losing his abilities. Which one should he concentrate on? In each level of musical concentration, the musician must eliminate the soccer aspect of his life. This would be a mistake since he is among the top players in world soccer. Therefore, in terms of comparative advantage, soccer is a better choice. Although Cristiano Ronaldo is a superb musician, his talents in football surpass his talent as a musician. 

However, Mr Jack (just an imaginary name) may be average in football and music. However, he has an advantage because he needs to let go of much less of his soccer skills to concentrate on music.

Also Read: Best Tips To Start Import Export Business From Home - Complete Process Explained

Benefits of Comparative Advantage

Comparative advantage benefits everyone in the marketplace by ensuring that products are offered with the highest possible quality and price, giving each country the ability to focus efforts on the item that will produce the highest outcomes. In theory, comparative advantage promotes international trade and aids in the export/import model.

Conclusion

The theory of comparative advantage can appear confusing to business owners and students. However, a few criticise it for being simple. The theory typically considers labour costs and considers various other costs to be homogenous. Some critics have said that the theory doesn't apply to the world of work because it doesn't reflect real-world fluctuations or contradictions. Regarding international trade, it has been suggested that the theory cannot take into account the specific cultural characteristics of the different markets in the world regarding preferences and income levels.
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FAQs

Q: Which is the biggest benefit of comparative advantage?

Ans:

It's the ability to produce a service or good for a lower opportunity cost.

Q: Who discovered the comparative cost advantage theory?

Ans:

The economist David Ricardo discovered the comparative cost advantage theory in 1817.

Q: What is comparative advantage?

Ans:

A group or individual can carry out a specific economic activity more efficiently than other activities.

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The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.
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Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.