What is comparative advantage and its benefits in free trade?

A comparative advantage occurs in economics, when a country can 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).

Ricardo used the theory of comparative advantage to argue against Great Britain’s protectionist Corn Laws, which restricted the import of wheat from 1815 to 1846. In arguing for free trade, the political economist stated that countries were better off specializing in what they enjoy a comparative advantage in and importing the goods in which they lack a comparative advantage.

What is Opportunity Cost?

To understand the theory behind a comparative advantage, it is crucial to understand the idea of an opportunity cost. An opportunity cost is the foregone benefits from choosing one alternative over others.

For example, a laborer can use one hour of work to produce either one cloth or three wines. An opportunity cost is the forgone benefit from choosing to produce one cloth or one wine.

Therefore, by producing one cloth, the opportunity cost is three wines.

Comparative Advantage and Free Trade

Comparative advantage is a key principle in international trade and forms the basis of why free trade is beneficial to countries.

The theory of comparative advantage shows that even if a country enjoys an absolute advantage in the production of goods, trade can still be beneficial to both trading partners.

Practical Example: Comparative Advantage

Consider two countries (France and the United States) that use labor as 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:

It is important to note that the US 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 five cloths or 10 wines.

The US 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:

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

Additionally, when comparing the opportunity cost of one wine for France and the US, 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 its Benefits in 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 US, 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, while the US enjoys a comparative advantage in cloth.

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

The potential gains from trade for Europe by specializing in wine is represented by the arrow:

In the US, 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 two barrels of wine.

Therefore, 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.

Source: Corporate Finance Institute