Comparative Advantage Overview, Example and Benefits

In this analysis, we narrow down our sample of countries to those that have available R&D data at the industry level. With respect to the previous section, we lose 13 countries (12 countries and the rest of the world) that do not report data on R&D at the industry level for the sample of analysis. These countries include Bulgaria, Brazil, Cyprus, Greece, Croatia, Indonesia, India, Lithuania, Luxembourg, Latvia, Malta, and Russia. Labor is the only factor of production, and we assume it to be mobile across industries within a country but immobile across countries. In each country, there is a representative consumer who consumes a non-traded final good and saves.

  1. We then split the sample of countries into higher-income and lower-income countries.4 Higher-income countries are closer to the technology frontier, and we would expect them to benefit more from domestic innovation than lower-income countries.
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  4. Appeals to save American jobs and preserve a time-honored American craft abound, even though, in the long run, American laborers would be made relatively less productive and American consumers relatively poorer by such protectionist tactics.

If you’re comparing two different options, each of which has a trade-off (some benefits as well as some disadvantages), the one with the best overall package is the one with the comparative advantage. In this example, if each country split their workforce between the production of rice cakes and banana bread, they would make, in total, 1,000 rice cakes and 2,500 loaves of banana bread. Notice that the total time needed to prepare the garden has fallen from three hours to two hours. The garden is prepared in less time with the son’s help than it could have been done independently by the father.

The Heckscher-Ohlin theory focuses on the two most important factors of production, labour and capital. Some countries are relatively well-endowed with capital; the typical worker has plenty of machinery and equipment to assist with the work. On the other hand, goods requiring much capital and only a little labour (automobiles and chemicals, for example) tend to be relatively inexpensive in countries with plentiful and cheap capital.

Comparative advantage is one of the most important concepts in economic theory and a fundamental tenet of the argument that all actors, at all times, can mutually benefit from cooperation and voluntary trade. It is also a foundational principle in the theory of international trade. Even if countries have quite similar climates and factor endowments, they may still find it advantageous to trade.

U.S. businesses benefit from cheap natural resources and protection from a land invasion. Most important, the country has a diverse population with a common language and national laws. The diverse population provides an extensive test market for new products. In economics, a comparative advantage occurs when a country can produce a good or service at a lower opportunity cost than another country. The theory of comparative advantage is attributed to political economist David Ricardo, who wrote the book Principles of Political Economy and Taxation (1817).

In this example, Joe has a comparative advantage, even though Michael Jordan could paint the house faster and better. The best trade would be for Michael Jordan to film a television commercial and pay Joe to paint his house. So long as Michael Jordan makes the expected $50,000 and Joe earns more than $100, the trade is a winner. Owing to their diversity of skills, Michael Jordan and Joe would likely find this to be the best arrangement for their mutual benefit. Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader.

Customers’ Willingness to Pay

A perfectly competitive final producer combines the composite output of each industry in the domestic economy with a Cobb-Douglas production function. In each industry there is a producer of a composite good that operates under perfect competition and that sells the good to the final producer and to intermediate producers from all industries in that country. In this section, we describe the methodology used to estimate the relative productivity of a country-industry at a point in time. Differences in productivity determine the patterns of trade and, hence, comparative advantage. We start by obtaining an expression for bilateral trade shares as a function of technology level, trade costs, and production costs. Then we estimate the gravity equation and use the structure of the model to obtain our measure of relative productivity.

Comparative Advantage and Structural Change in the Portuguese Pattern of Trade in Manufactures

In the absence of trade, England requires 220 hours of work to both produce and consume one unit each of cloth and wine while Portugal requires 170 hours of work to produce and consume the same quantities. England is more efficient at producing cloth than wine, and Portugal is more efficient at producing wine than cloth. Consequently, both England and Portugal can consume more wine and cloth under free trade than in autarky.

Competitive advantage is what a country, business, or individual does that provides a better value to consumers than its competitors. There are three strategies companies use to gain a competitive advantage. In the past, comparative advantages occurred more in goods and rarely in services. But telecommunication technologies like the internet are making services easier to export.

Here, is the unit cost of producing an intermediate good in industry and country . We assume that the relative demand curve reflects substitution effects and is decreasing with respect to relative price. The behavior of the relative supply curve, however, warrants closer study. Recalling our original assumption that Home has a comparative advantage in cloth, we consider five possibilities for the relative quantity of cloth supplied at a given price. The Ricardian model is a general equilibrium mathematical model of international trade.

Comparative Advantage vs. Absolute Advantage

Therefore, the United States enjoys a comparative advantage in the production of cloth. Likewise, an agricultural country that focuses only on certain export crops may find itself suffering from soil depletion and destruction of its natural resources, as well as harm to indigenous peoples. Moreover, there are also strategic disadvantages to over-specialization, since that country would find itself dependent on global food prices. Absolute advantage refers to the ability to produce more or better goods and services than somebody else.

Specialization and trade will increase the set of consumption possibilities, compared with autarky, and will make possible an increase in consumption of both goods nationally. These aggregate gains are often described as improvements in production and consumption efficiency. Free trade raises aggregate world production efficiency because more of both goods are likely to be produced with the same number of workers. Free trade also improves aggregate consumption efficiency, which implies that consumers have a more pleasing set of choices and prices available to them. Our results confirm that both R&D and technology transfer are key determinants of productivity growth and convergence to the frontier. Our model follows closely the production and international trade structure of Caliendo and Parro (2015) and Cai et al. (2017).

In other words, low wages in another country in a particular industry is not sufficient information to determine which country’s industry would perish under free trade. From the perspective of a developed country, freer trade may not result in a domestic industry’s decline just because the foreign firms pay their workers lower wages. The primary issue in the analysis of this model is what happens when each country moves from autarky sources of comparative advantage (no trade) to free trade with the other country—in other words, what are the effects of trade? The countries with the highest average productivity growth rates are Romania, Indonesia, and China, whereas average productivity growth rates have been decreasing in Mexico, Turkey, and Luxembourg (Figure 2). The U.S. has a comparative advantage in producing a number of goods and services, especially when it comes to financial markets.

Sources of Competitive Advantage

We have implemented a methodology to determine differences in country-industry productivity from bilateral trade data. We departed from the standard model in that we allowed productivity to vary over time so that our estimation procedure delivered a time series of country-industry productivity. We then analyzed the sources of productivity and comparative advantage. Our results have shown that domestic innovation and the adoption of foreign innovations have a positive and statistically significant effect on the growth rate of productivity and on the speed of convergence at the country and industry level.

Sources of comparative advantage

In other words, no matter how you slice it, comparative advantage, plus international trade, equals higher aggregate output. The garden story offers an intuitive explanation for the theory of comparative advantage and also provides a useful way of interpreting the model results. The usual way of stating the Ricardian model results is to say that countries will specialize in their comparative advantage good and trade it to the other country such that everyone in both countries benefits. Stated this way, it is easy to imagine how it would not hold true in the complex real world. The movement to free trade generates an improvement in welfare in both countries individually and nationally.

From the perspective of a less-developed country, the developed country’s superior technology need not imply that less-developed country (LDC) industries cannot compete in international markets. Similarly, for the average country, the industries that experienced the highest average productivity growth rates are other transport products; chemicals; and computer, electronic, and optical products. In contrast, the industries that experienced the lowest average productivity growth rates are pharmaceutical products; textiles, apparel, and leather; and machinery and equipment n.e.c. (Figure 3). The distribution of for the years 2003 and 2012 is plotted in Figure 1. We observe that there is a lot of heterogeneity in productivity across countries and industries and that the distribution has shifted over time. Most countries and industries have experienced an increase in their productivity.