What is Comparative Advantage?

Robinhood Learn
Democratize finance for all. Our writers’ work has appeared in The Wall Street Journal, Forbes, the Chicago Tribune, Quartz, the San Francisco Chronicle, and more.
Definition:

A comparative advantage is something that a person, business, or country can do at a lower opportunity cost than another.

🤔 Understanding comparative advantage

A comparative advantage exists when you can produce something at a lower opportunity cost than someone else. In other words, the value of what you gave up to produce the thing is less than it is for another person. Having a comparative advantage doesn’t necessarily mean that you’re better than the next person — Instead, it looks at the trade-off you face when deciding what to do with your time and money. The basic idea is that when each person focuses on their comparative advantage, and trades with others to meet the rest of their needs, everyone gets what they need for less effort.

Example

Wyoming and Nebraska share a border, but the two states have some pretty different advantages. Wyoming is known for its mountains, which hold a lot of coal, while Nebraska’s flat farmlands produce high-quality crops.

This doesn’t mean that Wyoming can’t grow corn or that Nebraska can’t cultivate minerals. But, each state is better suited for one than the other — Each has a comparative advantage.

For example, Wyoming may create more economic value by focusing more attention on mining coal, then selling the excess to purchase corn from Nebraska. Likewise, Nebraska may benefit by focusing on growing more corn than they need, then trading the excess for coal.

Takeaway

Comparative advantage is like picking positions on the baseball field…

Some are fast runners, while others are great at scooping up a high-speed ball off the dirt. If your team’s best catcher is injured, you’d have to decide how to fill the spot. Do you sacrifice your best pitcher because they’re the only other decent catcher on the team, or do you have a weaker player fill the spot? If there’s a second decent pitcher, you may have less to lose — In other words, the comparative advantage is higher — by telling the best pitcher to crouch behind the plate.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.
Sign up for Robinhood
Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory.

Tell me more…

What is the theory of comparative advantage?

The idea behind comparative advantage stems from the concept of the division of labor. Early philosophers, like Plato, were among the first to recognize that different people excelled at different skills. Later, economists like Adam Smith pushed the division of labor concept further. In his book, The Wealth of Nations, Smith argued that society as a whole was better off when its individuals focused on what they’re good at.

The theory of comparative advantage goes another step further. Developed by economist David Ricardo in the early 1800s, comparative advantage explored not just the division of labor, but also how a person should specialize. In his book, On the Principles of Political Economy and Taxation, Ricardo suggested that simply picking any skill didn’t guarantee you the best outcome; you also needed to choose the right one.

Finding an individual’s comparative advantage means looking at the value they can provide in one profession relative to another. For example, Steven Hawking might have made for a great accountant. But had he chosen that profession, the world may not have benefited from his scientific breakthroughs. The idea is that the potential loss (aka opportunity cost) of Hawking pursuing science is much lower than the value that’d be lost if he pursued accounting instead — In which case, we might know far less about the universe than we do today.

Throughout the 19th century, ideas like comparative advantage pushed countries away from mercantilism (countries protecting their own merchants from foreign competition) and toward international trade. By the 20th century, free trade dominated trade policy, accelerated globalization, and resulted in more economic growth around the globe.

What is the difference between a comparative advantage and an absolute advantage (and which is better?)

Absolute advantage is an economic term used to describe being better at something without considering any other factors. A comparative advantage doesn’t necessarily mean that you’re better at something. It means that you give up less when you do it.

Let’s say there are two competing pastry chefs. The first pastry chef is also a great heart surgeon; the second pastry chef is good at making pastries and at fixing cars. Both chefs have an absolute advantage in different skill sets. In order to change the world with their sweets, the first pastry chef has to give up on saving lives; the second has to give up fixing cars. In this case, the second chef likely has the comparative advantage, because he’d have to give up less — A car is worth less than a life.

It’s important to note that just because you have an absolute advantage doesn’t mean you also have a comparative advantage.

Consider two countries that make cars and airplanes. For a given amount of time and resources, Country A can produce 10,000 cars or 1,000 planes, while Country B can make 100,000 cars or 5,000 planes. Country B has the absolute advantage in both products. But which one has the comparative advantage in making airplanes?

The answer requires looking at the possible combinations of making cars and planes for each country (aka their production possibility frontier), and comparing their opportunity costs. For example, to make one airplane, Country A gives up the opportunity to make 10 cars. In other words, Country A’s opportunity cost to make one plane is 10 cars. Country B’s opportunity cost is higher: 20 cars. Country A’s opportunity cost to make one airplane is lower, so it has the comparative advantage.

In order to determine each country’s comparative advantage, you’d divide the amount of production of one product by the amount of the other, using the same resources. Here’s what the general formula looks like:

Opportunity cost of a plane = production of cars / production of planes Imagine that Country A needs 500 planes, and Country B needs 2,500. If each country made the planes they needed on their own, and used their remaining resources to make cars, Country A would end up with 5,000 cars and Country B with 50,000 cars.

Now imagine a second scenario, where each country specialized in its comparative advantage — Country A in making planes and Country B in making cars — then traded their excess production. If Country A made an excess of 500 planes, and could trade each plane for 15 cars, it could gain 6,500 cars (500 planes x 15 cars per plane).

Knowing it will get 500 planes through the trade, Country B now only needs to make 2,000 airplanes on its own, freeing up enough resources to make an additional 10,000 cars. After trading 6,500 cars to Country A for those 500 planes, they still end up with 3,500 extra cars.

Both countries get the same number of airplanes in either scenario. But by focusing on their comparative advantages and opting to trade, each can gain more cars than they would working on their own. This sums up the economic upside of focusing on comparative advantage. Even though one country has an absolute advantage in both products, each country’s comparative advantage allows them to gain more overall than either could on its own.

What is the difference between a comparative advantage and a competitive advantage?

A business has a competitive advantage over other companies in the same market when it can provide a better product or a lower price than its competitors. This advantage can stem from a better brand, proprietary process, a superior supply chain, or other factors.

In contrast, a business has a comparative advantage when it can give up less (money, time, etc.) to offer a product or service than its competitor. For example, a chocolate manufacturer might have an easier time retooling its equipment to make caramels compared to a cheese processor.

That gives the chocolatier a comparative advantage over the cheese processor in making caramel. However, the chocolatier may not have a competitive advantage over other caramel companies.

Typically, competitive advantage means a company can produce something at a lower cost compared to others, whereas comparative advantage means a company can produce a good at a lower opportunity cost compared to others.

What advantages and disadvantages come from focusing on your comparative advantage?

Ideally, when countries focus on their own comparative advantages and trade with each other to meet their remaining needs, everyone is better off. The idea is that each country may be able to meet their needs for less effort and gain wealth beyond the limits of what they could produce on their own (aka their production possibility frontier).

For example, let’s say Saudi Arabia wants to choose between expanding its automobile factories or growing its oil operations. Since Saudi Arabia has a comparative advantage in oil production, it may cost a lot to diversify its economy. The country may be better off focusing on oil and buying cars with the proceeds.

In the real world, however, being too specialized can come with risks. For example, if an economy is too focused in one area, workers that produce goods in an industry outside of that area could be at greater risk of losing their jobs. And lost jobs could lead to calls for mercantilist policies (laws that protect domestic merchants from foreign competition).

An economy that’s too specialized may also be more vulnerable to any changes. If a country only produced stamps, for example, a new technology like email could disrupt its entire economy.

Or, if a nation decides not to produce its own oil, and instead elects to only import it from other countries, it could find itself at the mercy of those oil-exporting countries. Some countries subsidize their agricultural and energy industries so that they don’t depend solely on foreign governments for their basic needs.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory.

1340721

Related Articles

You May Also Like

The 3-minute newsletter with fresh takes on the financial news you need to start your day.
The 3-minute newsletter with fresh takes on the financial news you need to start your day.


© 2020 Robinhood Markets, Inc. Robinhood® is a trademark of Robinhood Markets, Inc.

This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Robinhood Financial LLC provides brokerage services. Robinhood Securities, LLC, provides brokerage clearing services. Robinhood Crypto, LLC provides crypto currency trading. All are subsidiaries of Robinhood Markets, Inc. ('Robinhood').

1200251