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Comparative Advantage

Page history last edited by Brian D Butler 13 years, 9 months ago

Comparative Advantage:


Is one of the most important theories of international trade

Note: if competitive advantage is from the perspective of the company (firm), then comparative advantage is from the perspective of the country.



Table of Contents:




The Ricardian model


The Ricardian model focuses on Comparative Advantage and is perhaps the most important concept in international trade theory. In a Ricardian model, countries specialize in producing what they produce best. Unlike other models, the Ricardian framework predicts that countries will fully specialize instead of producing a broad array of goods. Also, the Ricardian model does not directly consider factor endowments, such as the relative amounts of labor and capital within a country.


The Ricardo One-Factor model was originally presented with England and Portugal producing cheese and wine, utilizing only one factor of production (labor).  Imagine if England were absolutely more efficient in producing both products.  England could produce cheese in 1 hour compared to Portugal's 6 hours, and England could produce wine in 2 hours compared to Portugals 3 hours.  England would have an "absolute advantage" in producing both products.  But, if you follow David Ricardo's reasoning, he would say that England has a comparative advantage in just the cheese, and that Portugal had a comparative advantage in producing wine.  The concept of comparative advantage is only applicable when comparing production between countries. 


                 England         Portugal            England's relative advantage

wine               1 hr               6 hrs                     6 x

cheese            2 hrs            3 hrs                     1.5 x


So, becasue England has more of an advantage in producing wine, they should specialize in just producing wine, and Portugal should specialize in producing just cheese, and the two countries should trade.  If they allow free trade, and if both countries specialize where they have a comparative advantage, then all consumers in both countries will be better off. For more information, visit the page about Comparative Advantage





If the US were to trade with Costa Rica in two products:  appliances and bananas...the US might have an absolute advantage in producing both products.  I.e the US might be more efficient at producing both products faster and with less resources.  But, when you are looking at comparative advantage, it is possible for the the US to have absolute advantage in both, but a comparative advantage in just one.  Ricardo's theory is that even though the US is absolutely more efficient in both, that the two countries should specialize only in what they have a comparative advantage, and that they should trade for the rest.  He proves that both countries will be better off.   Imagine if the US were 300% (3 times) more efficient at producing appliances, but only 25% more efficient at producing bananas.  In this case, the US would be absolutely more efficient at producing both products, but it would have a comparative advantage in just the the appliances.  Costa Rica would have a comparative advantage in producing the bananas.  Ricardo recommends that the US should then get out of the banana production and transfer all resources to production of appliances.  Costa Rica should get out of the appliance business and devote 100% to the banana.  Then the two countries should trade.  If they did this, then both countries would be better off. 


How many appliances should the US export?  How many bananas should Costa Rica export?   Let the US specialize in just producing appliances, and make sure to keep enough internally to meet US consumer demands, then export the rest (surplus for export).  Same for Costa Rica.  If you run the numbers, you will see that specialization leads to a massive surplus (extra goods for all consumers in both countries). 


Conclusion:  you get the most benefit if both countries 100% specialize and trade.  You get slightly less benefit if there is less than 100% specialization, or less free trade. 



Government uses of Ricardo's theories


Many governments use the comparative advantage theories when looking at their country as a whole, and when trying to determine what industries that they should focus on.  Which industries are the ones that have a "comparative advantage" here?  If you can figure out what your comparative advantage is, and then find a way to develop that industry, then you should be able to ensure long term economic growth.  So, from an economic development standpoint, the comparative advantage theory is very applicable, and is useful in helping regions around the world to determine which key industries to support (tax advantages, subsidies, trade protections, etc). 


Making it work for companies


Its simple to use this theory on a smaller scale.  Imagine if you had a fixed amount of money to invest in either producing agriculture or consumer goods.  If you had a piece of land of equal size (or investment size) in two countries, and you could figure out the relative efficiency (or cost) of producing products in two countries, then you could do a simple comparative advantage analysis to determine which location should specialize in producing which products. 


Keys to making it work:


  1. labor must be mobile and willing to move
  2. labor must be willing to shift to other industry



The "Diamond"- Porter


The first element to consider is “Resources factors” which have to do with the availability of factors of production such as land, labour, or raw materials. The second element to consider is “Demand factors” which have to do with the customer market for the products and services that the firm produces. The third element to consider is the “Firm strategy and structure” which has to do with the way in which a company is either prepared or not prepared to compete internationally based on its organizational strength, capabilities and strategy. The final element in Porter’s diamond is the “Related and supporting industries”, which has to do with the availability of world-class suppliers and support structure that a firm enjoys in a particular location. By mapping out these four elements of capabilities, and examining their interconnectivity, Porter showed us a way of visualizing the comparative advantage of locations.





In this example will briefly construct the “diamond” for JP Morgan private banking in Miami. I will focus on the market of high-net worth investors from Latin America to the USA. The question is; “why would a private bank chose to locate in Miami”? For “Resources factors”, I identify that Miami offers highly educated finance professionals from each of the Latin American countries. By choosing Miami, the banks are relatively certain that they will be able to recruit Brazilian bankers locally in Miami to cover the Brazilian market, for example, or Argentineans to cover the Argentine market. Because Miami is so diverse, a company can locate here and find local talent that has expertise in many Latin American markets. For the second element of “Demand factors”, Miami has the advantage that many wealthy Latin American already consider Miami to be a destination for where they want to invest (or how they want to get their money out of their countries). This makes Miami ideal for servicing the Lain American demand. The third element “Firm strategy and structure” is clearly met with these international private banks that have both the organizational structure and strength to have regional offices in Miami and not in NYC. The final element in Porter’s diamond is the “Related and supporting industries”, and again this is an area in which Miami excels. Because of the high number of private banking institutions in the area, it is cheap and easy to find support both in terms of legal and professional services.




Reflection / Personal Views:


I think it really makes sense to consider that certain areas of the world make specialization in certain business functions, and that those “clusters” of activity don’t happen just by chance. I appreciated Porter’s comments that quite often; the competitive advantage of a location is influenced by the policies of the government and on the actions of its citizens. There are some things that places can do in order to increase their competitive appeal for certain areas of the value chain. I liked the idea that no one place can be the ideal location for all functions, and that certain location swill need to specialize into certain areas in order to capture their advantage. I thought that this lesson was particularly interesting as a means of considering what places like Mexico or Brazil needed to do in order to compete internationally with China or other low cost Asian exporter. I took the message to be that each location needs to discover their own particular competitive advantage and that they needed to focus on specializing. It made me think of a situation that is developing in Recife, Brazil where a specialized technology university has helped with the creation of a video-gaming software cluster in the old part of town. Rather than investing in a general university, the business leaders are building up their specialty and are attracting investment from US based companies. I would like to know if the planners had ever read Porter, or if they had conducted the diamond analysis?




Comparative Advantage


The global scale efficiency is one of the goals that were described by Bartlet and co-authors. One of the goals of a firm is to achieve the greatest level of output with the minimal amount of input. The main focus of the authors was on the ability of firms to generate global scale production by centralizing production and exporting to worldwide audience. The second layer of competitive advantage was the “multinational flexibility” in which a firm would be able to respond to the various country-specific conditions in which they operated, and gain competitive advantage by tailoring their product or service offerings to match local tastes. The final layer that was mentioned by the authors was the goal of achieving “worldwide learning and knowledge”. This was the goal that a firm would try and capture knowledge and innovation anywhere in the world and leverage it into a competitive advantage. The goal is to cultivate knowledge from any geographic location and to find a way to benefit from diversity and operations in multiple locations.








The multinational flexibility model is one that is traditionally associated with European companies such as Unilever. This consumer-branded company has been very successful over the years by allowing each of their foreign subsidiaries to design and implement products that are unique to each of the local markets around the world. Local responsiveness is very important to Unilever, and so they were willing to give up some level of global scale and efficiency in order to maintain their local flexibility.



Reflection / Personal Views:


I think that in order for a company to try and capture all three objectives of global scale, flexibility and worldwide learning is extremely difficult. The concept of a transnational company is one that is trying to gain the benefits of all three systems, but is trying not to give up any of the weaknesses. I have considered what it would take for my company to become a truly transtnational organization, and I’m afraid that I don’t think we currently have the necessary management structure to do so.






A situation in which a country, individual, company or region can produce a good at a lower opportunity cost than that of a competitor. The economic motive and cause of international trade. Countries increase their economic prosperity by exporting the goods that they are relatively more efficient at producing and importing the goods that other countries are relatively more efficient at producing.


The advantage of some nations or regions to produce goods better and more cheaply than less favoured nations or regions. This comparative advantage leads to trade, as nations exchange those goods which they can produce more easily for goods not readily produced at home. The advantage is usually seen in resources of raw materials and labour, but very often the competitive performance of producers is based on better marketing, delivery, reliability, and quality control.


This is an important concept in understanding regional specialization, through which all regions actually benefit from exchanging the products they make best, even if each is capable of supplying all its own needs, but the system will only work properly if free trade is permitted. The danger of regional specialization, is, of course, overdependence.


Economic theory first advanced by Robert Torrens and David Ricardo that analyzes international trade in terms of differences in relative opportunity costs. The theory suggests that countries should specialize in the goods they can produce most efficiently rather than trying for self-sufficiency and argues strongly in favour of free international trade.


see also:

Competitive Advantage, Value Chain



History of Theory


Comparative advantage was first described by Robert Torrens in 1815 in an essay on the Corn Laws. He concluded that it was to England's advantage to trade various goods with Poland in return for grain, even though it might be possible to produce that grain more cheaply in England than Poland.


However, the theory is usually attributed to David Ricardo who created a systematic explanation in his 1817 book On the Principles of Political Economy and Taxation using an example involving England and Portugal. In Portugal it is possible to produce both wine and cloth with less work than it takes in England. However, the relative costs of producing those two goods are different in the two countries. In England it is very hard to produce wine, and only moderately difficult to produce cloth. In Portugal both are easy to produce. Therefore, while it is cheaper to produce cloth in Portugal than England, it is cheaper still for Portugal to produce excess wine, and trade that for English cloth. Conversely, England benefits from this trade because its cost for producing cloth has not changed but it can now get the cheaper Portuguese wine.


Stanislaw Ulam once challenged Nobel laureate Paul Samuelson to name one theory in all of the social sciences which is both true and nontrivial. Several years later, Samuelson responded with David Ricardo's theory of comparative advantage:


That it is logically true need not be argued before a mathematician; that it is not trivial is attested by the thousands of important and intelligent men who have never been able to grasp the doctrine for themselves or to believe it after it was explained to them.

General Theory:


A country should specialize in products and services in which they have a comparative advantage. They should then trade with another country that has products in which that country has a comparative advantage. In this way both countries become better off.





Let's break this down into a simple example. You have two firms that both produce two main products: ice cream and bicycles. The first firm, The Danish Ice Cream and Bicycle Co., is located in Denmark, where dairy milk is abundant; the second firm, The Gobi Ice Cream and Bicycle Co., is smack in the middle of the Gobi Desert.


The Gobi Ice Cream and Bicycle Co. must expend a lot of money to make ice cream, whereas The Danish Ice Cream and Bicycle Co. spends way less to produce the same amount. The two firms are dead even in their production costs for bicycles.


Since The Danish Ice Cream and Bicycle Co. has a comparative advantage with ice-cream production, it should probably consider turning exclusively to ice cream. Along the same vein, The Gobi Ice Cream and Bicycle Co. should probably give up the ice cream and focus on the product in which it is the least disadvantaged (bicycles).


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