Comparative Advantage Theory
Excellency in international business can be done through comparative advantage theory which uses the opportunity cost to determine the appropriate produce the country should produce. This theory was developed by a British economist David Ricardo, in his writing “On the Principle of Political Economy and Taxation”. This theory is useful where one country has the absolute advantage in producing all the goods. The comparative advantage theory directs the country, business organization, or individual to take benefit by producing which goods more efficiently than others. The comparative advantage theory uses opportunity cost to determine which goods the country can produce more efficiently than others however other goods can also be produced less efficiently overall.
Key concepts
Absolute advantage vs comparative advantage
Absolute advantage theory describes one country producing goods in more quantity in the same resources compared to another. For example, country A produces goods X in 50 units in the same resource another country B produces Goods Y in 20 units. Here country A has an absolute advantage over B in producing goods X.
Comparative advantage: comparative advantage theory describes how one country can produce goods more efficiently than another based on the opportunity cost even if that country is less efficient in producing the same goods overall.
Opportunity Cost
Comparative advantage theory guides a country to produce goods which opportunity cost less compared to others. Comparative theory can direct the country to produce the goods more efficiently even if it is less efficient in producing that good overall. As its opportunity cost is less compared to others it can be better than other goods.
Example of comparative advantage theory
Example 01
Assume India can produce Rice in 50 units and Wheat in 100 units at a specific cost.
Whereas Bangladesh can produce 20 units of rice and 200 units of wheat at a specific cost
Opportunity cost
Country A
1 unit of rice = 2 units of Wheat
1 unit of Wheat = 0.5 units of rice
Country B
1 unit of rice = 10 units of wheat
1 unit of wheat = 0.1 unit of rice
Analysis of the above opportunity cost
Comparative Advantage in Producing Rice
India: 1 unit of rice has cost of 2 units of wheat
Bangladesh: 1 unit of rice has cost of 10 unit of wheat
Here the opportunity cost of India in rice production is less than that of Bangladesh hence India has a comparative advantage in producing Rice.
Comparative Advantage in Producing Wheat
India: 1 unit of Wheat costs 0.5 units of rice
Bangladesh: 1 unit of costs 0.1 unit of rice
Here the opportunity cost of Bangladesh in producing Wheat is less than that of India. So Bangladesh has a comparative advantage in producing wheat.
Advantage of any country After Specialization and Trade
If any country specializes in producing goods according to comparative advantage then the world can take benefits from trade. Let us understand how much goods are produced with specialization and without specialization according to comparative advantage.
Without specialization
India produces 50 units of wheat and 100 units of rice
Bangladesh produces 20 units of rice and 200 units of wheat
Total output produced in the World
Rice= 100 +20=120 units
Wheat=50+200=250
With Specialization
India produces 200 units of rice
Bangladesh produces 400 units of wheat
Total output produced in the World
Rice = 200 units
Wheat =400 units
Assume India trades 50 units of rice in exchange of 100 units of wheat
Final Consumption
India has 150 Units of Rice and 100 Units of Wheat
Bangladesh has 50 units of rice and 300 units of Wheat
From the above example, it has been concluded that the world economies can take more benefits if all the countries implement the comparative advantage theory to produce goods more efficiently by becoming specialized in producing those goods.
Many countries are less efficient in many goods overall however they can implement comparative advantage and take advantage of trade. Through trade, they can increase their resources at the same cost. The trade bloc that is intergovernmental agreements can enable to implement of these theories successfully and get the benefits of trade.
Example 2
Assume
Japan produces 200 LED TVs and 50 units of Rice
India produces 50 units of LED TVs and 200 units of rice
Opportunity Cost
Country Japan
Opportunity Cost of 1 unit of LED TV
1 unit of LED =50 units of rice/ 200 LED TV=0.25 Unit of Rice
Hence Japan sacrificed 0.25 units of rice to produce 1 LED TV
The opportunity cost of 1 unit of Rice
200 LED TV/50 units of rice =4 LED TVs
Hence Japan sacrificed 4 LED TVs to produce 1 unit of rice
Country India
The opportunity cost of 1 LED TV
200 units of rice/ 50 LED TVs= 4 units of rice
The opportunity cost of 1 unit of rice
50 units of LED TV/200 Units of rice= 0.25 units of LED TVs
Comparative Advantage of LED
Japan has less opportunity cost in producing LED than India. Thus Japan comparative advantage in producing LED.
Comparative Advantage of Rice
India has less comparative opportunity cost in producing rice than that of Japan. Thus India has a comparative advantage in producing rice.
Based on the comparative advantage theory India has a comparative advantage in producing rice over Japan whereas Japan has a comparative advantage in producing LED over India.
Advantage of the world after specialization and trade
Before specialization
Japan produces 200 LED and 50 units of Rice
India produces 200 units of rice and 50 units of LED
Total consumption of the world before specialization and trade
Total LED TV= 200+50=250 units
Total Rice= 50+200=250 units
After specialization according to comparative advantage
Total Rice production = 400 units
Total LED TV = 400
After specialization, if India produces Rice instead of LED TV and Japan Produces LED TV instead of rice then the total production increases to 400 units of rice and 400 Units of LED TVs. This increased production quantity when exchanged under trade as follows
If Japan makes trade of 100 LED TVs they get 100 units of rice
Hence after specialization and trade both countries can get benefits as follows
Japan gets 100 units of rice and 300 units of LED TVs
India gets 100 units of LED and 300 units of rice.