comparative advantage

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Comparative advantage

Theory suggesting that specialization by countries can increase worldwide production.

Comparative Advantage

The ability of an individual, company, or economy to conduct an activity better than another for some fixed, almost unchangeable reason. Comparative advantage is important in making decisions such as what products one should make or sell; if a company is unable to make a product as well as another and that is unlikely to change, the company might be well advised to make a different product. For example, a lumber company in Oregon has a comparative advantage to a lumber company in Arizona because there are simply more trees in Oregon. This makes it unlikely that the company in Arizona will be able to fill orders as well or as quickly as the company in Oregon. For this reason, the Arizona company's management might consider investing in mining instead of lumber.

comparative advantage

Comparative advantageclick for a larger image
Fig. 24 Comparative advantage. The physical output of X and Y from a given factor input, and the opportunity cost of X in terms of Y. The opportunity cost of producing one more unit of X is 1Y in country A, and 2/3 Y in country B. The opportunity cost of producing one more unit of Y is 1X in country A, and 11/2X in country B.

comparative advantage

the advantage possessed by a country engaged in INTERNATIONAL TRADE if it can produce a given good at a lower resource input cost than other countries. Also called comparative cost principle. This proposition is illustrated in Fig. 24 with respect to two countries (A and B) and two GOODS (X and Y). The same given resource input in both countries enables them to produce either the quantity of Good X or the quantity of Good Y indicated in Fig. 24. It can be seen that Country B is absolutely more efficient than Country A since it can produce more of both goods. However, it is comparative advantage not ABSOLUTE ADVANTAGE that determines whether trade is beneficial or not. Comparative advantage arises because the marginal OPPORTUNITY COSTS of one good in terms of the other differ as between countries (see HECKSCHER-OHLIN FACTOR PROPORTIONS THEORY).

It can be seen that Country B has a comparative advantage in the production of Good X for it is able to produce it at a lower factor cost than Country A; the resource or opportunity cost of producing an additional unit of X is only 2/3 Y in Country B, whereas in Country A it is 1Y .

Country A has a comparative advantage in the production of Good Y for it is able to produce it at lower factor cost than Country B; the resource or opportunity cost of producing an additional unit of Y is only 1X, whereas in Country B it is 11/2X.

Both countries, therefore, stand to increase their economic welfare if they specialize (see SPECIALIZATION) in the production of the good in which they have a comparative advantage (see GAINS FROM TRADE for an illustration of this important proposition). The extent to which each will benefit from trade will depend upon the real terms of trade at which they agree to exchange X and Y.

A basic assumption of this presentation is that factor endowments, and hence comparative advantages, are ‘fixed’. Dynamically, however, comparative advantage may well change. It may do so in response to a number of influences, including:

  1. the initiation by a country's government of structural programmes leading to resource redeployment. For example, a country that seemingly has a comparative advantage in the supply of primary products such as cotton and wheat may nevertheless abandon or de-emphasize it in favour of a drive towards industrialization and the establishment of comparative advantage in higher value-added manufactured goods;
  2. international capital movements and technology transfer, and relocation of production by MULTINATIONAL COMPANIES. For example, Malaysia developed a comparative advantage in the production of natural rubber only after UK entrepreneurs established and invested in rubber-tree plantations there. See COMPETITIVE ADVANTAGE (OF COUNTRIES).