Theory of Comparative Advantage

Theory of Comparative Advantage

David Ricardo the British economist introduced the theory of comparative advantage in 1817. This theory belongs to international trade and describes the fundamental idea of efficient trade. This theory focuses on the idea of opportunity cost and describes how an economy produces goods or services more efficiently than others. Simply it focuses on specialization in producing goods and services more efficiently.

The theory of comparative advantage describes how well an individual business economy or country can take advantage of a trade by selecting the best alternative. Opportunity cost can describe or justify how the selected alternative is the best alternative than another alternative. The organization selects an alternative If its opportunity cost is less than the opportunity cost of another alternative.

For example

The theory was introduced the country Portugal was more efficient in producing wine whereas the country England was more efficient in producing cloth. Portugal has a favorable environment for producing more grapes and so more wine at a low cost. the theory of comparative advantage suggests that these two countries should produce and trade the goods in which they are specialized. This means England produced cloth and traded with Portugal whereas Portugal produced wine and traded with England.  

How to calculate the comparative advantages

Figure 1.1 shows the production of mobile phones and Earphones per week by companies A and  B. Company B produces thrice earphones than that of company A. Company B has greater comparative advantages over Company A. Hence for company B, it is better to select the alternative that indicates to produce earphones only instead of producing the mobile phones.

  

In the above examples company A produces fewer earphones than company P but equal mobile phones with company P. In the context of comparative advantages company B is more competitive in producing earphones. So considering the comparative advantage the company can take by producing earphones only instead of producing the mobile phone. So for company B, it is better to leave the production of mobile phones by company A and start producing earphones at full capacity. The opportunity cost of selecting this alternative is less than selecting the current which has shown in the figure

Comparative advantage vs absolute advantage

Comparative advantages are different from Absolute advantages. Comparative advantage theory was introduced by David Ricardo, and the theory is based on opportunity cost. whereas absolute advantage theory was introduced by Adam Smith. Absolute advantage theory focuses on productivity by determining the output with the same resources or the same output with fewer resources.

Comparative Advantages vs Competitive Advantages

Comparative advantages focus on the opportunity cost which should be less than another alternative. Competitive advantage is a broader concept that focuses on how will the company be superior in the market in product quality, efficiency of manufacturing producing product differentiation.

The scope of the competitive advantages is limited to two countries and two commodities which justifies the trade based on the opportunity cost. Where are the competitive advantages how much broader score in practice as it involves making the business superior by producing the product at a low cost with good quality and distinct features than any other products in the market?

The application of the competitive advantage theory is to international trade whereas the application of competitive advantages in strategic management can directly apply to the business strategy.

Comparative advantages theory considers the static world whereas it does not include various factors such as transportation cost quality of the product, distinct features, Technology, etc. Whereas competitive advantages with a broad approach consider All those factors in making the company more superior with quality technology cost-efficient.

Criticisms of the theory of comparative advantages

1. Competitive advantage theory is based on the opportunity cost and considering labor cost only. Transportation cost is not improved while determining the comparative advantage considering the opportunity cost. If transportation costs are included then the competitive advantages change or are lost. This theory ignores the impact of transportation cost on the opportunity cost or compared to advantages.
2. David Ricardo also ignored the demand or the impact of demand on the competitive advantage. If it is included then it also influences the value of comparative advantage.
3. The theory deals with two countries and two commodities which is the limitation of any economy. Because all the economies need to trade several commodities with several countries. Here according to the competitive advantage theory, there is a limitation. Considering the scope of applications of this theory in practice it is very restricted to two communities and two countries only. It is not beneficial in multilateral trade.