All You Need to Know about Comparative Advantage

Why do countries trade with each other? 

Should they trade with each other? 

What goods should countries export or import?

These are key questions for economists. 

One of the standard theories taught to answer this question is “comparative advantage”. 

Here we will examine this theory, its limitations and look at how this idea has been applied to the UK economy today.

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Contents

Absolute Advantage

Absolute advantage occurs when one country can produce a good more cheaply (or with higher productivity) relative to another country. 

In other words, suppose two countries A and B have the same number of workers say a million workers. 

In country A those one million workers can produce three million cars a year. But in country B, one million workers can only produce two million cars a year.

In that case country A has the ‘absolute advantage.’

Adam Smith wrote about this idea first in 1776 in his famous “Wealth of Nations” work. 

One issue is there will be some countries without any absolute advantages.

 In that case, what is the implication of Smith’s absolute advantage? 

That these countries should not produce anything does not sound satisfactory – surely their production could be useful to someone?

Enter David Ricardo who came up with the “comparative advantage idea”…

Comparative Advantage

What does comparative advantage mean?

A country has a comparative advantage in a particular good when that country can produce a good with a lower opportunity cost relative to another country

The textbook definition of opportunity cost is  “the next best alternative foregone when an economic decision is made”. 

When it comes to trade, consider an economy that only produces two goods – say apples and oranges. How many oranges need to be given up to produce one more apple? The oranges are what we give up or forgo to produce the apples.

Ricardo’s comparative advantage theory was that if a country has a comparative advantage in a good, they should specialise in producing that same good.

Let us use a diagram to illustrate this theory.

PPF Diagram

This diagram shows the production possibility frontiers for two countries, UK and Spain. They can use one factor of production e.g. labour to produce two different goods, say oranges and apples. Each country can produce lots of oranges and no apples, only apples and no oranges, or somewhere in between. 

To produce one (more) Apple, the UK has to give up more oranges compared to Spain. We can tell this from the diagram. In particular note the UK has a steeper PPF than Spain – for a given number of apples, the UK gives up more oranges.

So we could say the UK has a comparative advantage in oranges and Spain has a comparative advantage in Apples.

[Note the example above is fictional. The UK’s actual comparative advantages are different and are mentioned later on in the article.]

Under the theory of comparative advantage, this means the UK should specialise in oranges and Spain in apples. 

In the next diagram, that means the UK producing at point C on its PPF while Spain produces at point A.

“Gains from trade”

Why is it beneficial for countries to specialise according to their comparative advantages? Under the theory, there are “gains from trade”.

We can use the diagram above to show this. Remember Spain is initially producing at point A and the UK at point C. 

Spain and the UK could then agree to trade some of the UK’s oranges for some of Spain’s apples. They could trade at a mutually beneficial rate, allowing both countries to move beyond their domestic PPFs. For example, Spain could move from point A to B and the UK could move from C to D (not to scale).

The gains from trade are the ability to move beyond your domestic PPF.

It is more efficient for Spain to A) produce apples themselves and then trade with the UK for oranges than B) for Spain to produce oranges themselves.

Note that comparative and absolute advantages do not need to align. In this example above for example, Spain has absolute advantages in both apples and oranges.

Table Example

The table shows the same example but in numerical form. 

Let’s assume the countries UK and Spain have the same size workforce. 

The table shows the value of production, for apples and oranges, if that country put all labour force towards that good. Let the amounts be valued in billions of pounds (£bn). 

So the UK could produce either £0.5bn of apples if it produced solely apples. Alternatively the UK could produce £1bn of oranges if it produced only oranges. 

The final two columns show the opportunity costs (“opp. costs”) for each good. To produce one unit (in this case £1bn) of apples, the UK needs to give up half a unit (£0.5bn) worth of apples.

	Apples	Oranges	Opp. cost of apples	Opp. cost of oranges
UK	0.5	1	0.5/1 = 0.5	1/0.5 = 2
Spain	2	2	2/2 = 1	2/2 = 1

[Note Spain has absolute advantage in both goods.]

Under the theory of comparative advantage, Spain has the lower opportunity cost in oranges compared to the UK (1 is less than 2), so Spain should specialise in oranges. 

Yet the UK has a comparative advantage in apples (0.5 is less than 1) so the UK should specialise in apples.

The logic and results are exactly the same as those for the graph mentioned earlier.

Limitations

The limitations of the theory of comparative advantage include:

• Comparative advantage implies that countries should specialise in goods according to their comparative advantage. However specialisation exposes the economy to the risk that demand for the specialised good will suddenly drop. This would cause a significant fall in workers’ wages and the real GDP.
• Assumes only twp countries and two goods. In the real world there are many different goods being traded and by many different countries..
• No tariffs/protectionism. If there are protectionist measures in place, there may not be gains from trade.
• Assumes no transport costs. Particularly for island or geographically isolated economies, transport costs may be significant.
• Assumes perfect factor (e.g. labour) mobility between sectors. In practice there is likely to be diminishing marginal returns to moving labour into a new sector. Workers cannot easily move to a new sector to exploit comparative advantage – this is likely to lead to structural unemployment.
• Assumes the countries are willing to trade but in practice poor international relations may stop this.

For more on tariffs and protectionism, see the link below:

Key Issues with Comparative Advantage

One key point is that comparative advantages are dynamic and not static. In other words, a country’s comparative advantage may change over time.

Related to this, there is the “infant industry” argument. That is the productivity in an industry may depend on the size of the firm(s) in that industry. 

Indeed there may significant “economies of scale” – growth of firms in that industry may increase productivity, reducing average costs and opportunity costs.

Comparative advantage is an argument that economists have used to promote free trade. 

Critically though, comparative advantage ignores distribution. Even if there are “gains from trade”, who receives these gains?

There are several other explanations for trade patterns. These include, for example:

• “Gravity” – countries trade more with countries in closer proximity, just like how closer planetary objects exert greater gravitational pulls on one another.
• Historical or current political/economic ties. For example being members of the same trading bloc or a former colony of an old empire.
• Current factor endowments (see the “Heckscher-Ohlin” model beyond the A-level course).
• Other ideas including increasing returns to scale.

The UK example

What are examples of comparative advantage for the UK?

Based on the measure of “revealed comparative advantage”, the UK has a comparative advantage in the following sectors:

• Financial and insurance activities
• Arts, entertainment, recreation and other service activities
• Publishing and broadcasting 
• Education 
• Telecommunications 

Note this is based on very old data (no easy-to-find more recent release exists of these data). See the source from BIS (2012) at the end of the article for the source for these data.

More on revealed comparative advantage (not needed for A-level Economics)

The standard measure for revealed comparative advantage (RCA) was introduced by Balassa (1965).

One formula (there are many other variations on this formula) for the RCA is to divide the proportion of the country’s exports in a particular sector by the same proportion for world exports. 

Consider the following fictional example with made-up numbers: suppose 10% of a fictional country X’s exports are of oil. This might compare with 5% of world exports being oil. 

The RCA index is then 10/5 = 2 . An RCA value greater than 1 means the comparative advantage for the good, in this case oil, is “revealed”.

According to the theory of comparative advantage, countries will export goods where they have the comparative advantage. The RCA being above 1 indicates the country specialises in that good more than average and thus its comparative advantage is revealed. 

For example in the UK, the financial and insurance sector often has one of the highest RCA values in the more recent data. (BIS, 2012)

Limitations of Revealed Comparative Advantage 

There are issues with this measure. For example:

• It does not take into account subsidies, taxes, tariffs, other protectionist measures (quotas, export subsidies, paperwork for exporting) and so on. For example if one government subsidies oil and hence exports more of it, it will appear as if this country has a revealed comparative advantage in oil. 
• Not symmetric. The RCA can take values 0 to infinity. This means it is difficult to compare values on either side E.g. the RCA values of 1.5 and 0.5 do not reflect the same degree of comparative (dis)advantage. Though this is easy to sort out. See for example Widodo (2009) for more on alternative measures to address this problem.

For policy making it is important to know how the RCA evolves over time. Is the RCA stable in a particular sector? What causes a country’s comparative advantage to vary?

To be continued….

Other Questions on Comparative Advantage

Why is comparative advantage important?

Specialising in goods where a country has a comparative advantage can lead to “gains from trade”. More simply, the country can produce more of more things, making its citizens better off.

At least in theory. There are lots of limitations to the theory of comparative advantage too.

But that does not make it any less important. We can study the theory and its limitations to figure out when we can use it and when we might need to think about other factors.

How to calculate / find / determine comparative advantage?

From a numerical example, you need to calculate the opportunity cost or view the gradients of the production possibility frontiers of each country. See the example above for this.

For a particular economy, one way to do this is to calculate the “revealed comparative advantage” measure. There is more on the idea above. But in short, if a country has a comparative advantage in a good, it will be expected to export more of that good relative to other goods and other countries, all else equal.

Of course in practice comparative advantage is not the only determinant of exports. It goes without saying that there are several limitations to this measure (see above!).

A qualitative but also more subjective approach would be to consider underlying advantages in a particular economy. Does a particular country have, say, a suitable climate, natural resource, education level, size of labour force, technology, machinery for production of a particular good or service?

What are examples of comparative advantage?

For numerical/graphical theoretical examples, see the examples above.

For real-world examples, I have mentioned UK examples above according to “revealed comparative advantage” calculations. This includes sectors such as the financial and insurance industries.

Other possible examples could include:

• Countries with beautiful natural environments having a comparative advantage for tourism. Think of Mount Everest for example.
• Countries with the correct climate for various crops. Oranges in Spain for example (the famous “Seville” oranges).

Other Resources

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References

Balassa (1965)

BIS Economics Paper No. 19 (2012) linked here.

Torok and Jambor (2016)

Widodo (2009)